Over the course of three weeks, we’ll hear from Aon colleagues on how economic challenges are impacting all solutions, clients and colleagues in a special edition takeover of the “On Aon” podcast.
This week, Aon’s U.S. President, Charles Philpott, and Aon’s North America Commercial Risk Leader, Joe Peiser, discuss insights from risk markets and clients, and what risk managers should be thinking about when facing increased economic volatility.
Additional Resources:
Aon's Global Market Insights Report Q2 2022
Making Better Decisions in Uncertain Times: Aon’s 2022 Executive Risk Survey
Inflation is Influencing Business Risk Management — Take Steps to Mitigate its Impact
Tweetables:
Voiceover:
Welcome to the second episode of the special edition takeover series of “On Aon,” a podcast featuring conversations between colleagues on, well, Aon. In this three-part takeover series, we’ll hear from Aon colleagues on how economic challenges are impacting all solutions, clients and colleagues.
This week, we hear from Joe Peiser about the challenges that risk managers are facing given increased economic volatility. And now, this week’s host, Charles Philpott.
Charles Philpott:
Hi everyone and welcome to our fabulous On Aon podcast. I'm Charles Philpott, President of Aon's U.S. region. I've held this position for one exciting year, and I've been with Aon since 1997. I hope you had the opportunity to catch our last On Aon episode with my colleagues Jen Bell, Leslie Follmer, and Eric Andersen. They had a great discussion and covered some of the challenges organizations are facing given a more uncertain economic environment. They dove into how companies should think about slower growth in a tight labor market as we continue to see the Fed and central banks intervene and try to tame inflation. So, today in the second episode of our three-part On Aon takeover series, we'll discuss what we're hearing from our risk markets and clients, specifically what risk managers should be thinking as we close the year and ready ourselves for 2023. With me today, I'm delighted be joined by my friend and colleague, Joe Peiser. Joe leads Commercial Risk for North America. Thanks for being here today, Joe.
Joe Peiser:
Thanks, Charles. I'm really glad to be here. I'm one year now with Aon, but I'm well into my fourth decade of being in this business and I've been looking forward to our conversation because it's all about what's changed and it's that, the constant change in our business that keeps it fascinating for me.
Charles Philpott:
You're a man of experience. So, Joe, let's get started. In the first podcast of this series, Jennifer, Leslie, and Eric discussed a lot about the impact of inflation at a 40-year high, five recent interest rate hikes in the real prospect of a recession, which frankly some would say we're already in. So, Joe, for our first question, I know we're here to focus on what clients should be thinking about, but maybe could you set the stage and give us your thoughts about what this macroeconomic landscape means for insurers?
Joe Peiser:
Yeah, thanks Charles. I think it's important to provide that context. I want to talk mostly about what clients are doing, but it's the environment that they operate in. So, for insurance companies, rising interest rates in the long run is a good thing. Okay? Insurers earn about two thirds of their revenue from their investments. So, one third from underwriting and about two thirds from investments. And they tend to invest in conservative instruments that are interest-rate sensitive. So, when interest rates go up, they make more investment income. However, in the short run, it's actually a problem because they already hold these instruments. So, when interest rates go up, the value of the bonds that they're holding goes down. So, it's actually a short-term balance sheet hit to them. Now, it takes about two to three years for that to work itself out as insurance companies turn over their investments.
But in the short run, unfortunately it's not a good thing. Then inflation, that also causes a problem because it drives up the value of losses. So, we see that already with property catastrophes where the value of the actual loss is much higher than what was already contemplated or what the insured had submitted as the value of that property. And a lot of that's driven by inflation. So, we see the cost of labor and materials going up. So, when you have a loss, it takes longer to actually get the loss settled and the property back up to speed. So, inflation drives up losses. In addition, it drives up the reserves that the insurer already has for incurred but not reported losses or liability losses that take a long time to settle. And when we talk about inflation, Charles, we all know about the inflation that we're dealing with on a personal level, but on a corporate level, there's also this phenomenon of social inflation.
And we've been talking about social inflation for a number of years, and what that is these enormous jury verdicts that have a knock-on effect to settlements, and it's leading to much higher liability losses. So, you have regular inflation, plus you have social inflation, and before you know it, we're going to be dealing with medical inflation. Again, that was the thing that really rattled the workers' compensation market some time ago, and we're bracing for a new round of medical inflation that'll affect workers' compensation losses, general liability losses, auto losses, et cetera. So, unfortunately, the context that our clients are dealing with insurance companies, it's not good because it's likely that all of these things are going to lead to more pressure on rates and rates may go back up again.
Charles Philpott:
So, first of all, you sound like an economist out there that is a whole brew of issues and none of them sound good. And frankly, I was just concerned about a cup of coffee of going up, but you touched on a few of the underlying economic drivers impacting insurers. So, let's discuss maybe what this means for our clients. I'm sure this volatility leads to uncertainty and then more complex risks for them. What would you say our clients are most concerned about?
Joe Peiser:
Well, Charles, our clients are dealing with a lot. So, they have this new specter of inflation, a possible recession, rising interest rates, but we all know they've been through a whole lot in the last few years. So, we had a pandemic which affected every company, every organization on the planet. It also changed the way that we work, especially in our business, we see a big change in the way that we work. So, our clients have had to deal with that. They've had to deal with the longest hard market in a couple of generations for some lines of businesses going on five years of hard market conditions.
Now, you have the Russia - Ukraine ground war, first time since World War II we've seen a ground war in Europe and all of the instability and uncertainty that brings up. And at the same time, with all of these things happening, the basic underlying cause of the hard market that we've been through is still real, and that underlying cause is a systemic change in losses. So, we've seen a systemic change in property losses, probably driven by climate change. We've seen a systemic change in liability losses, I already mentioned social inflation, and we've seen a systemic change in cyber through war cybercrime and cyber breaches. So, unfortunately, our clients have been dealing with a ton as they go through this.
Charles Philpott:
Well, that's some great background, Joe. I was kind of hoping that you would say that the insurance market would be sunny and 70 next year, but kidding aside, it strikes me that Aon is so well positioned, help our clients better understand the risk tolerance, how to control retain losses, how our data and analytics can help them have the right conversation as they think about traditional and alternative insurance programs and captives and other structured solutions. Would you agree with that?
Joe Peiser:
Absolutely, Charles. I talked about how our clients have been through a lot and now they have to face potentially recessionary environment and in a recession, it's tempting for many organizations to cut all kinds of costs, and it's tempting to have a risk management program or a risk financing program kind of come under the knife, if you will. And what we're seeing is the more experienced risk managers are aware of that temptation and really resisting that temptation. Cuts in maintenance, plant maintenance, et cetera, can have a real long term negative effect on a company's risk profile. Same can be said about safety. So, we just had that Executive Risk Survey that came out and it was just published last month, and it was interesting that it revealed that confident leaders don't hit the brakes on long-term investments, nor do they ignore long-term or long-tail risks.
So, that's confident leaders see the value in that. Now, safety and maintenance may not grab a whole lot of headlines, but they definitely impact the company's risk profile and their long-term cost of risk. So, we certainly throw up a word of caution about reducing safety and reducing maintenance. And then let's go a bit further. So, a lot has changed. So, it's time, and we're seeing more experienced risk managers do this. It's time to take a holistic approach to their risk financing program and assess all the things that have changed, including their risk profile, including the losses that they've had, but also start with your company's risk tolerance. That may very well have changed and will certainly change as inflation rises and a recessionary environment happens. What we see often is that at the very time when companies want to cut costs, it's a time when their risk tolerance goes down, so they're less likely to deal well with an uninsured loss or an unbudgeted loss.
So, you have the risk tolerance going down. So, it's important to measure that so that you can assess the tradeoffs between risk retention and risk limits. In addition, it's important to look at other forms of funding in the event of a loss. So, if a company is considering cutting back on insurance, well, if they have a loss, how will they fund that loss? And in a rising interest rate environment, know companies start to have less liquidity than they had before, and the cost to fund a loss through say a revolver or line of credit, actually becomes more expensive. So, it's a good time to rethink everything and take a clean sheet of paper. We already have a number of clients who are working with our teams in our consulting teams in a AGRC (Aon Global Risk Consulting) to take that clean sheet of paper approach, remodel their risks, re-look at their risk profile, and then in conjunction with that, look at what the insurance market is likely to offer so that they can start over and start looking at their program with a clean sheet of paper.
You want to decide what's the best way to spend the next dollar, or more importantly in this environment, what's the best way to save the next dollar? And there are a lot more sophisticated models these days to help risk managers make those decisions and examine those tradeoffs. As part of this process, it's very useful to look at if a company has a captive, where that captive can play in their program. If a company doesn't have a captive, to consider forming a captive during the past five years in the hard market, those companies who had captives have been very happy that they had those captives to fill holes in their program, take on greater risk retention, and also to access other forms of capital.
Oftentimes, a captive can be a real good conduit to the reinsurance market, to the capital markets who all look to stand behind an insurance company like a captive. So, that's the last point I really want to make, Charles, is that there's a lot of different risk takers in the marketplace these days. It's not just the traditional insurers, the line between insurers and reinsurers, and now the capital markets has blurred quite a bit. However, all of these risk takers want to take the specific risk that they like packaged in a way that they like.
So, if our clients can look at their risk and sort of segment it into those areas of risk that these risk takers like and package that up, that becomes a much more successful program. We like to say that risk managers should think of themselves as the first line underwriter. They look at the risk first of their company, they decide what they want to retain and what they should so-called pass off or trade off or sell into the marketplace. And packaging up their risks in such a way that these various risk takers prefer is really a great road to success for risk manager.
Charles Philpott:
If I step back and think about it, the job of the risk manager has become more relevant than ever. And frankly, the dynamic resources and the way that we think about bringing tools and cutting-edge solutions to them is also as relevant as ever. So, maybe if we kind of step back, Joe, and dig in a little bit deeper, how about your thoughts on a few key lines of insurance and how our clients should be thinking about those in the coming months?
Joe Peiser:
Yeah, let's start with casualty, Charles, because casualty is often the single biggest component of our client's total cost of risk. And by total cost of risk, I'm looking at both retain losses as well as the insurance costs for the actual risk transfer premium that a client purchases. And when we look at casualty, again, in a recessionary environment, there's going to be pressure to reduce premium spend. And given the social inflation that I talked about before, it would be much wiser to consider increasing a retention on the bottom of the program than giving up catastrophe limits at the top. Now, in order to do that, a client has to pay attention to their total cost of risk and the loss activity within that retention. And again, there are a lot of tools these days that can help clients run scenarios and simulations to decide what's the optimal retention for them to take based on their own risk tolerance.
But as we hit rising interest rates as well as inflation, there's a couple things that are going to go on. One, the value of the loss reserves that clients have on their books already from past retentions. Remember casualty, losses take a while to liquidate, they're likely to start going up because of inflation, but at the same time, as interest rates rise, there's going to be a bit more appetite in the marketplace to do what we call loss portfolio transfers to sort of transfer those existing reserves to an insurer. But before doing that, it would be wise to consider doing a claims closure project to try to reduce those reserves as much as possible and then package them out and sell them to a potential insurer. Other things to bear mind with casualty, as inflation goes up and payrolls go up, workers comp losses can be expected to go up.
But as you do your renewal negotiations with an underwriter, they're going to be looking to raise rates and they're going to be looking at your exposures and saying, "They're going up." And they'll be a natural disposition from underwriters to say, "Well, not only are your workers comp exposures going up, but so are your product liability loss exposures because look at your revenues." There, you need to fight back. There, you need to point out to insurers that just because your revenue has gone up because of price increases, that doesn't mean your risk has gone up. So, experienced risk managers will be prepared to argue that "Well, let's look at product counts. Or, let's look at, in the case of general liability, let's look at footfall traffic," or some other exposure base. So, I know that's kind of nitty gritty, but it can become pretty important during a renewal.
When I look at property, Charles, in property, it's all about valuation. It's all about what are the values of the buildings and the assets that our clients have, and also what are the business interruption values? Remember that recession and inflation affect those things differently. Inflation is going to drive them up, but recession is going to be a counterbalance driving down business interruption exposure. So, it's really important that clients take a hard look at that. We've been talking about property values for, well, more than a year, I mean, really quite some time, but it's been a hot topic for the past year. And as inflation continues, it's going to become a very extreme, potentially very important topic. And we've already seen catastrophes where, I mentioned this earlier, where the actual value of the catastrophe is much higher than what a client had put in, in their schedule of values for a particular location.
And that's leading to coverage issues, that's leading to difficult claim scenarios. And a company doesn't really have the tolerance for risk when it comes to a loss that could have been insured but wasn't insured because of an error like that in mistaken values. When I look at the financial lines, so here D&O, employment practices, liability insurance, clients should be ready for even more rigorous underwriting meetings than they've had before, and they've been rigorous the last few years, but they're going to be even more rigorous because as we head into a recessionary environment, underwriters will worry about an uptick in D&O losses due to financial performance or even bankruptcy.
You start to see an uptick in employment practices liability claims when there's actions taken against employees. So, clients should be ready to talk about their governance for their public boards and also talk about their diversity, equity and inclusion statistics because that's going to figure into their employment practices, liability insurance renewals. And then lastly, cyber. I talked before about how cutbacks in safety and maintenance is usually not a good idea. Well, never more so than when it comes to cyber hygiene. Our clients have been through a lot. Cyber has been a very difficult and challenging line of business, and there's been a lot of great work done by a lot of our clients upgrading their cyber systems and putting in protections, and that has to continue regardless of what the economic environment looks like.
Charles Philpott:
Joe, you are an encyclopedia of knowledge. I think everybody that's listening to this podcast is impressed with your description by line of business here. If we step back, and I don't know if this is just a property issue, but how should clients take into account recent events like Hurricane Ian, for example? How does this impact the market forecast? Is this just property or does it impact the general market?
Joe Peiser:
Hurricane Ian is the hot topic right now, Charles. Ian is a big event. It was a major storm. The actual insured, total insured value of that storm or the loss of that storm is yet to be calculated. And we'll take some time before we know the final answer, but everyone agrees that this will be one of the largest insured events in our industry's history. So, a lot of it is residential loss as opposed to commercial losses. So, homeowners as opposed to corporations. However, both those markets, the personal lines marketplace and the commercial marketplace access the same reinsurers. And this is going to hit the reinsurance community or the reinsurance business very hard. And the reinsurance business was already in a difficult spot. We've had six years of catastrophes and not just we call modeled catastrophes, meaning hurricanes or earthquakes, but the so-called secondary perils, you know, so that’s tornadoes, floods, freezes.
Those have been significant over the past six years. And in fact, the alternative capital market that provides a big segment of the reinsurance business, is about 20 percent of the reinsurance business. Those investors, first off, they're kind of attracted to the fact that interest rates are going up. So, they might find alternatives to insurance to invest their monies in. That's one problem. But the other problem is they've had these six years of losses. So, we're seeing a real constriction in the reinsurance market for catastrophe property coverage. So, our clients who have catastrophe exposures will for sure encounter difficult conditions starting frankly with the end-of-year renewals, particularly one-one renewals, and into the next few quarters into 2023. And there I'm talking about they could probably expect a north of 20 percent rate increases if they have significant CAT exposures. Now whether that'll bleed, whether that those conditions will bleed into the general property market and even beyond the property market into casually et cetera, remains to be seen.
I'm kind of optimistic though. I think it's going to be mostly contained to the catastrophe exposures and less so to general property, which has seen significant rate increases over the last several years. And it's got to a point where most property insurers are pretty attracted to the rates that they get. And I'm not so sure that it's going to bleed over into the liability lines, but it's definitely going to be a significant event for our clients. And one of the things that we're doing to help clients think of another way is we're presenting to them parametric insurance, which is used quite a bit for catastrophe covers. It's a technique that has become more common. It's certainly not a very common approach, but it's more common than it was when they were introduced a decade or so ago. And they could be a very good alternative to traditional insurance for catastrophe coverages.
Or it might even just compliment with, if you don't have enough capacity for your CAT exposures, maybe use a parametric to fill in your program. So, there are things that our clients can do. One thing I can say, Charles, even though I did say that it's not going to ... I'm hopeful that it won't bleed into the other lines of business. However, the deceleration of rate increases that we were seeing for the first half of 2022, unfortunately, I think that's probably going to stop and we're going to start to see things sort of level off at the kind of rate increases we were seeing in August and September. I don't think they're going to continue to go down. And then, like I said, in property, they're likely to go up a bit.
Charles Philpott:
You gave us some slivers of optimism there, Joe. And then you retracted a little bit toward the end there. We've covered a lot of ground here. 2022 has been such an extraordinarily busy year. It looks like 2023 is got to be about the same. Would you agree with that?
Joe Peiser:
Yeah, there's always change. And you know what's kind of fascinating to me, Charles, is that a year ago when I joined Aon, we weren't talking about inflation or recession or interest rates. We were talking about other issues. We were talking about climate, we were talking about ESG, and we were talking about supply chain, and you know what, those are still significant issues that are on the risk horizon that our clients are dealing with and will probably continue to deal with. If we look at climate, to me, climate is the risk issue of at least the next decade. It's affecting a lot of our clients, not just those who are near the ocean, but it's affecting a lot of our clients. They're being driven across the world to assess and quantify their climate exposures going to be doing so even more here in the U.S.
And it's interesting, that Executive Risk Study that I referenced before in that report, we found that, or it's reported that confident leaders of large companies are spending upwards of 50 percent of their time or they're spending 50 percent more time on climate issues than other leaders. So, it is a topic that is in the C-Suite and it's one that is going to be around for a long time, I think. When we look at ESG, now, the ESG covers a lot of things, right? Environmental, Social, and Governance. So, we're advising our clients and what we're seeing more experienced risk managers do is build ESG measurements into their risk management program, building ESG issues into their risk register, their risk taxonomy, and they're also making sure that they're prepared for the underwriting questions that are coming up across all lines of business related to ESG. Just as every corporation in America is starting to get focused on ESG.
So, is every insurance company in the globe getting focused on ESG and the ESG exposures of their policy holders, but also just the ESG nature of their own portfolio of business. So, that's a topic that not only hasn't gotten away, hasn't gone away, it's also kind of picked up. And then lastly, supply chain. We're in earning season and you're hearing companies still refer to issues in supply chain, while it might not be as severe, supply chain issues might not be as severe as they were a year ago, they're still very prevalent. And our consultants in AGRC are working with a number of clients to help them assess their supply chain and their supply chain's exposure to risk. There's no panacea out there, Charles, to deal with supply chain issues, but there are things that people can do. I mentioned parametrics before, they can be a great tool to sort of bolster or deal with the risk that our clients’ supply chain face. So, there are more slivers of good news out there than perhaps I'm letting on.
Charles Philpott:
There you go. Well, there is so much to think about, and as I started the question of will 2023 be as busy as 2022? I think you answered it, yes. We've got a lot of ground to cover in climate change and ESG and supply chain, and I know the professionals at Aon are thinking about that every day. So, we usually use this next section to get to know our speakers. But since this is a takeover, I'd like to follow the same questions at Jen Bell asked our panelists on our first podcast. So, Joe, what are you most excited about as we finish this year?
Joe Peiser:
Charles, November, December, our busy time. They always have busy times in our business, busy times in our personal lives as the holidays come. But one of the things that I've always liked about our business are all the events that we have in November, December where we get together as an industry at parties, at charity events. There's quite a number of them, and it's just a great time to see folks in the business. And for the last couple of years, we haven't had those. They've been on the shelf because of the pandemic, but there's a lot that are scheduled for this year and they're all in person, and I'm really looking forward to that. Now, Charles, I'm going to turn it right back to you. What are you looking forward to the end of the year coming?
Charles Philpott:
Well, I'd have to agree with you all your comments. They're so true. I think what I'm thrilled about is Thanksgiving that comes immediately to mind, being with family, maybe some football, a few naps here and there. But seriously, in the spirit of giving thanks, I'd like to thank all of our colleagues for their incredibly hard work this year, helping us reshape Aon to help our clients make better decisions. You mentioned a lot of complex subjects today, and I'm just so excited to work for a company that has never been so relevant and so well positioned to help our clients solve for these problems. So, Joe, I know you listened to our last podcast, and you know this is coming, but one more to answer. What word would you use to inspire our risk manager clients as they think about these challenging times?
Joe Peiser:
I was waiting for this question, Charles and I have thought about it, and my one word is engagement. And I don't say that lightly. I talk with a lot of clients, and I've been very taken with a lot of comments from clients who say they've never been called into their C-Suite so often, and they're not getting called in just to hear about price increases that the CFO doesn't like. They're getting called in to the C-Suite to talk about risk issues, to talk about what's happening in climate, to talk about what's their perspective, what's the insurance perspective on diversity, equity and inclusion.
What are different ways to handle all the volatile risks that companies are facing? So, our clients, our risk management clients, are in the center of a lot of things that are being discussed in the boardroom. And in a lot of ways, I think this could be the golden age of the risk manager, and it's difficult. They got a lot on their plate. We can help them with as much as we can, but I think it's a great time to be in our business and it's a great time to be a risk manager.
Voiceover:
This has been the second episode in a special edition takeover series of the “On Aon” podcast around economic challenges. Thank you for listening. If you enjoyed this week’s episode, tune in next week for the third and final episode of the series. To learn more about Aon, its colleagues, solutions and news, check out our show notes, and visit our website at Aon dot com.