Insurance carriers must stay alert to inflation risk

In the wake of the global pandemic has come inflation, and price indices have jumped in most developed economies in the first half of 2021.

Many economists, including those at central banks, are hoping the rising inflation seen in the US and Europe will be transitory – a passing wave that will soon ease.

Even in the short term these inflationary impacts have put the squeeze on short-tail insurance lines.

Dan Brandt, partner at TigerRisk, believes the industry needs to be alert to this risk, as if these higher inflationary trends prove to be lasting, the effects will be felt on the bottom line across the industry.

“Transitory inflation is pretty painful to short-tail lines,” says Brandt. “If you look at the second quarter for big auto – new cars are more expensive, repairs are more expensive – so auto insurers are feeling the pinch. But if it’s not transitory and we have elevated and prolonged inflation, that is when long-tail lines get hit.”

Sustained higher inflation naturally increases the cost of future payouts. The further in the future the payouts, the larger the inflationary effect. The knock on effects would hit reserves, asset prices and market pricing. Insurers with stressed cash positions that need to liquidate fixed income assets to raise cash reserves may find they are selling at weak market prices should we ultimately see interest rates increase in response to sustained inflation. Those that book their fixed income assets at face value, rather than marking to market, may have to book immediate losses.

Inflation is not a new concept for reinsurers and while pricing effects are often the focus of inflation discussions, the impact on held reserves, cash position and asset valuations are equally as important and can result in additional reinsurance solutions.

“If inflation turns out to be 5 percent above expectations, the reserves on homeowner lines are going to go up by 9 percent. In the case of workers’ compensation that 5 percent difference would mean those reserves would go up by 22 percent,” Brandt says.

The longer the tail on any insurance line the greater the effect of any sustained inflation in raising the cost of payouts and eroding the value of assets. “Time really exacerbates the impact,” says Brandt.

If recent upticks in inflation turn out to be lasting, the speed of reaction by central banks will be a crucial factor for insurers. Rising interest rates are largely benign for insurers, Brandt says, but only if the shifts are incremental.

In the long run, higher inflation will feed through into pricing, but the ability of insurers to raise prices would depend on two key factors. Firstly, the regulatory environment – this would be particularly significant for US insurers operating with admitted rates for which any rises need approval at state level. The second will be market competition, and here new entrants and new capital may play an important role.

“Looking forward a sustained period of higher inflation could have a meaningful impact on carriers’ quarterly and annual results. This uncertainty should move insurers toward a more holistic view of the impact inflation – not only focused on go forward pricing but on their held reserves, cash position and asset valuations as well.”