So far the dreaded H5N1 bird flu virus has not mutated into a more deadly form. But if experts are right and it does become a pandemic, life insurers and reinsurers would be hit the hardest, explains Lauren Kalinowski.

With another winter comes another flu season. Not usually something to celebrate, but since it is just a normal seasonal flu, many are breathing a sigh of relief. Last year, experts were anticipating that the H5N1 bird flu virus would have been detected in wild migratory birds over the North American major flyways by now and, even worse, that the virus would have mutated to enable widespread human-to-human transmission.

Thankfully, neither prediction has come true. The virus remains in a pandemic alert phase three, with no or very limited human-to-human transmission despite the spread of the virus in birds, according to the World Health Organization. Nevertheless, most experts believe that it is only a matter of time. They are convinced that the unprecedented 39 years since the last bird flu pandemic will have to come to an end. Such foresight, however, does not change the impossibility of accurately predicting the effects of such a pandemic.

Nevertheless, Fitch Ratings has made some assumptions in evaluating the result a potential pandemic might have on the insurance industry. Based on these results, life insurers and their reinsurers would be the hardest hit. A significant threat of widespread downgrades to either the life, non-life or reinsurance sector is not envisaged at present, however. Downgrades would be most likely if the virus mutates to enable human-to-human transmission and leads to a considerable increase in mortality claims or investment market losses.

History lessons

The US Department of Health and Human Services (HHS) and UK Chief Medical Officer have used historical data from past moderate and severe flu pandemics to estimate the number of potential illnesses and deaths if a pandemic were to occur. Results indicate that over 200 million people from the US and Europe combined could become sick and about 50% of them would be likely to need outpatient medical care. An indeterminate percentage of those could either be hospitalised or die, depending on the pandemic severity. According to the HHS, under moderate conditions, 209,000 could die in the US, and according to Fitch, 400,000 in Europe. Under severe conditions, the HHS has predicted up to 1.9 million people could die in the US.

Factors exist today that experts believe would mitigate the effects of a bird flu pandemic if it were to occur, including efficient global communication, government response systems, poultry surveillance, and advances in modern medicine. It is difficult to say what benefits, if any, these factors would have. To date, the US has committed over $1bn to vaccination research. In addition, over 140 million poultry in Vietnam have been vaccinated and tens of millions have been culled to help prevent the spread of the disease in birds this year. On the other hand, many factors exist that lead some experts to think a flu pandemic today would be just as severe as the pandemic in 1918, which took an estimated 20 million lives worldwide. Population density and the reduction in international travel time are two such factors.

The life of the party

Despite the impossibility of accurately estimating the effects of a potential bird flu pandemic on the industry, Fitch believes US and European life insurers and their reinsurers are likely to be the hardest hit. Under a moderate scenario, the life insurance industry could face mortality-related financial losses of more than $18bn in the US and £20bn in Europe. A severe pandemic could raise the death claims in the US to $155bn, according to the Insurance Information Institute.

Under the moderate scenario, it is not anticipated that the life insurance industry's capital will materially deteriorate, given that $18bn is only about 8% of the US life insurance industry's 2005 statutory surplus. That said, it is anticipated that industry earnings would be significantly affected with higher than normal mortality experience over the course of several quarters, depending on the length of the pandemic. Current expert thinking is that a pandemic could occur in one or more waves lasting about three months each.

Ultimately, primary carriers are responsible for claims if their reinsurers default. Fitch would not be surprised if some life reinsurers defaulted under a pandemic scenario given that over 44% of the industry's $3trn life insurance in force was reinsured in 2005. Cession rates are even higher (56%) for term life products as a result of the heavy regulatory reserve requirements, but lower for group life policies (11%). Also, several primary carriers - in some cases the largest in the industry - have no or little reinsurance.

Varying retention rates suggest that primary carriers and their reinsurers would be affected differently. Further, business diversification could protect some from complete financial hardship. Others have mitigated their mortality exposure. To date, the most effective, albeit expensive, way to limit exposure is by transferring the risk to the capital markets through various structured securities eg catastrophic mortality bonds. Looking ahead, it is expected that bond issuance activity will grow as reinsurers and primary carriers increase their focus on risk management and extreme tail events.

More exposures

No one would be immune to the havoc that would likely ensue on the global economy if a pandemic were to occur, including insurers' assets, which would be impacted by the volatility in the markets. Experts agree, however, that the markets and economy would snap back once the pandemic ended.

In addition to assets and the life insurance sector, if a pandemic were to occur with an estimated 25%-30% infectious rate, health insurers would inevitably be exposed to increased claims. However, trying to quantify the effect is difficult given the variability of health plans, government involvement, premium adjustments, vaccine potential, quarantine enactments, hospital stay durations, doctor visit frequency, the ages of those infected, projected death tolls, etc. As with the life insurance industry, a bird flu pandemic would be likely to cause a temporary earnings issue for the health insurance industry rather than a devastating capital issue.

US disability insurers and their reinsurers may also face increased morbidity experience. Short-term disability policies typically require an ill employee to be out of work for seven to 180 days. If affected individuals were to recover within a two-week period (current expert thinking is four to eight days), there is likely to be a slight increase in morbidity experience, which could be prolonged if quarantines are imposed. In Europe, sick pay typically covers only long-term illness. However, there is potential for some individuals both in the US and Europe to abuse disability policies by filing fraudulent claims if they are not sick but are afraid to go work.

Non-life and health insurers' exposure is likely to be significantly more limited. Most property insurance explicitly excludes damage from the spread of infectious disease, including business interruption coverage, which covers only physical damage or restricted access to buildings, not absentee employees. Travel insurance exposure might exist. However, if governments close borders or advise against travel, claims are likely to be mitigated.

As there appears to be little business interruption coverage for bird flu, businesses are being advised to revisit their business continuity plans. In the past year, some insurance companies - typically those with more sophisticated enterprise risk management programmes - have considered the impact a pandemic might have on their critical business processes and devised plans to address weaknesses.

Fitch considers business continuity planning as part of its ratings process. If an insurer's business continuity plan was found to be deficient, this could have a negative effect on the insurer and therefore on its rating too. For example, if staff were not available to write new business or process claims due to lack of business continuity planning during a bird flu pandemic, this could result in a downgrade.

Is the sky falling?

A severe bird flu pandemic could wipe out over two-thirds of the life insurance industry's capital. The adverse effects on the labour supply and consumer behaviour could impact the financial markets, which would have negative rippling effects. Although it sounds bleak, experts believe any effects from a bird flu pandemic would be relatively short-lived, including for the insurance industry, albeit some players might be more affected than others. Bird flu has not yet mutated to enable human-to-human transmission and with any luck, it may never. But if it does, families, communities, companies, industries and economies are resilient and will rebound.

Recent reports on avian flu include:

- The Insurance Information Institute's June 2006 update of Pandemic: Can the Life Insurance Industry Survive the Avian Flu?

- Fitch's March 2006 report: Bird Flu - Will It Ruffle The Industry's Feathers?