Managing the risks associated with global inflation must be as nuanced as the drivers of inflation itself.
With prices climbing at their fastest pace in decades, the current inflationary period is one that many industries have not faced in almost a generation. That includes insurance, which for years has had its eye on inflation as a possible business risk and now finds itself rushing to address the consequences.
Many countries around the world are seeing the prices of goods and services rise at startling rates. In the United Kingdom, for example, February’s inflation rate as measured by the consumer price index (CPI) rose 6.1% from a year ago. The CPI in the United States reached 7.9% in February, the highest one-year increase in 40 years. Inflation in both countries is projected to remain high, and even rise, in the coming months 1 ,2.
The immediate upshot for insurers is that many are being pressed to deal with serious inflation after having gotten out of the habit of assessing and mitigating the risk. It’s a critical issue: Unlike other business risks insurers face, unexpectedly high inflation can impact multiple areas of their balance sheets.
To complicate matters, some experts believe there are several influencing factors, including the pandemic and geopolitical tensions, that require different thinking about managing inflation — ones that shift from a “detect and repair” approach to “predict and prevent” and engage teams across the full enterprise.
What follows are four key questions insurers should ask themselves to effectively manage inflation risk in this new environment.
1. What are the underlying drivers of inflation risk for my portfolios?
The most direct effect of inflation on insurance is upward pressures on claims settlements, potentially leading to outcomes beyond the range established when selling insurance policies.
However, general economic indicators of inflation (e.g., CPI and the retail price index, or RPI) do not always directly feed into claim costs, where the susceptibility can vary significantly across lines of business and product features. Liability coverage for wage or medical expenses, for instance, may not necessarily move in line with consumer prices. In recent years, property damage has diverged between RPI and the rising cost of auto repairs because of the use of new technology and rising sticker prices of secondhand cars (due to pandemic-related supply issues).
In certain classes of business, factors driving up claims costs can even be unrelated to the general economic environment. Recently, legislative and litigation developments that impact insurers’ legal liabilities and claims costs have been driving social inflation, particularly in U.S. casualty insurance.
These trends suggest that insurers should focus analysis and risk aversion on the key cost drivers related to inflation specific to the business written at the portfolio level, rather than take a broad-brush approach based on generic benchmarks.
2. Is there a process in place to model claims inflation coherently throughout the business?
It is not uncommon for insurers to apply implicit inflation assumptions for important business processes such as reserving, capital management and pricing for some lines. But when inflation is recognized as a key emerging risk for a wide range of business lines, a more precise response is needed.
In this unsettled economic environment, a robust process to explicitly model claims inflation that is embedded with business-as-usual processes could help insurers remain competitive. For certain types of insurance businesses, there is clear evidence of frequency and severity trends behaving differently. For that reason, modeling these trends separately may be more appropriate where credible data allows. The entire approach needs to be predictive — rather than simply relying on historical averages — to meaningfully help insurers navigate today’s dynamic risk landscape.
Most important is a single enterprise-wide process, as opposed to different versions of the same truth across underwriting, pricing, reserving, planning, strategy, risk management and capital modeling. It is perfectly reasonable to have different inflation assumptions for underwriting and reserving purposes, but a consistent underlying approach to inflation estimates and differences will enable timely and effective feedback among business teams.
3. Do I understand the full impact of inflation risk on my financial statements and operations?
Just as there are numerous assumptions about inflation itself, there are also multiple ways in which higher inflation can affect an insurer’s financial statements, impacting both profitability and solvency.
The rising cost of claims, for instance, can erode underwriting profit in the current year and increase liability through reserve deteriorations (or money set aside for a claim that is reported but not settled). Reinsurance costs would likely rise, reflecting the increased costs to reinsurers. Further, the value of investments may fall in both nominal and real terms, reducing investment income and available capital. Higher-than-expected inflation in wages or the retail rental market can lead to increased operational costs’ impacting profitability and cashflows. Further, prolonged wage inflation could lead to staff turnover. Significant general economic inflation may also have an indirect impact on insurers’ income due to changes in customers’ spending behavior.
A comprehensive set of scenario and stress tests can support insurers’ own risk and solvency assessments and fully assess the potential impact of inflation risk to insurers. As with inflation modeling, these assessments should not be performed in silos by a single team; all relevant business teams, such as risk, actuarial, claims, underwriting, investments, finance and operations, should be involved.
4. What are other mechanisms to effectively mitigate inflation risk?
Inflation risk can have a profound impact on insurers’ businesses. Fortunately, several levers can be pulled for effective mitigation. Working across the entire business and partnering with underwriting, claims, finance, investment management, capital management and operations allows the business to plan and implement strategies to limit or avoid the worst outcomes.
There are always tradeoffs in terms of management time, implementation costs and lost opportunities. But businesses that ride the inflation wave strategically will be positioned to support their clients through the pain and out through the other side. Here are some practical inflationary strategies:
Underwriting:
- Premium prices can be adjusted to appropriately allow for modeled claims inflation.
- Contract wordings may be refined to dampen the inflationary effect of certain contract features.
- Portfolio-level decisions could also be taken to manage exposure to areas of business most susceptible to inflation risk.
Claims:
- Maintaining claims reserves adequacy appropriate to the emerging inflationary environment provides valuable management information to support strategic initiatives, as well to support regulatory and reporting requirements, and it provides confidence to customers.
- A systematic claims settlement strategy to curtail excessive tail development may help reduce the exposure to long-term inflation risk.
- Proactive claims management actions targeting emerging regulatory or legislative issues could prevent excessive social inflation.
Investment:
- Appropriate investment hedging tools, such as inflation-linked bonds or commodities, can be used to neutralize the impact of inflation on the balance sheet. However, it is important to consider the type of underlying inflation driver (e.g., growth vs. supply shortage) as well as the duration of insurers’ liabilities for an effective hedging strategy.
Reinsurance:
- Varying reinsurance covers can be effective in transferring different types of claims inflation; individual excess of loss cover, for example, can limit exposure to material claim severity inflation.
- Aggregate covers can be more effective in managing inflation associated with claims frequency.
- Loss portfolio transfers may also be a viable option to manage expected longer-term inflation risk.
Operations:
- Proactive management of large infrastructure and salary spends through continuous cost management initiatives can help in mitigating inflation shocks.
- A robust operational resilience plan is also important during high economic uncertainty.
The strategies above are multidimensional and broad. Thus, the solutions depend upon the circumstances of each individual insurer. But the most important takeaway is for insurers to be proactive. Managing the balance of risk acceptance against risk management will be a core determinant of success.
For further information, please contact:
Lauren Cavanaugh, FTI Consulting
lauren.cavanaugh@fticonsulting.com
1: “There’s more inflation coming, as the Federal Reserve Starts raising interest rate.” CNBC.com, Mar. 10, 2022. https://www.cnbc.com/2022/03/10/theres-more-inflation-coming-as-the-federal-reserve-starts-raising-interest-rate.html
2: “Will inflation in the UK keep rising?” Bank of England. Feb. 3, 2022. https://www.bankofengland.co.uk/knowledgebank/will-inflation-in-the-uk-keep-rising
