Recent inflation trends have significantly increased during the post pandemic economic recovery. Whether this result is a "bounce back" effect or a longer-term trend is yet to be determined, says Willis Re's Strategic & Financial Analytics in a note released earlier this week.
However, the negative impact of rising inflation on the insurance industry’s financial position is leveraged and multi-faceted affecting both profitability and capital position, says the note which is titled “Global (re)insurance: Underlying profitability improves at H1 but inflation and rate deceleration remain concerns”.
The note outlines the potential impact of inflation on a company’s profitability and capital position.
From an underwriting perspective, during times of unanticipated inflation, there is usually an increase in loss ratios given the typical lag in pricing response. In the current pricing cycle, companies appear to be proactively taking pricing action, but it remains to be seen whether it is sufficient.
For reinsurance, it is important to note that loss trend on excess of loss layers is higher than ground-up trend. This effect increases the relative value of excess of loss reinsurance as an inflation hedge. On the positive side, overall premiums increase with inflation sensitive exposure bases (e.g. sales, payroll) as well as real economic growth.
With respect to carried reserves, if inflation spikes above the historical trends reflected in the actuarial reserving data, losses will tend to ultimately develop greater than currently booked. The impact of inflation on long-tail reserves is greater as more of incurred losses in older years will be paid out with newly inflated costs.
Also, writing long-tail business accumulates reserves to a multiple of current premiums magnifying the risk of adverse development. In addition to reserve uncertainty, the economic value of holding reserves has been pressured as recent interest rate increases have lagged the rising trend in inflation making reserve transfer solutions (ADC/LPTs) potentially more attractive.
On the asset side, as inflation rates (or fears) increase, interest rates typically go up. As noted, currently interest rate increases have been more moderate than inflation, but they have increased from their 2020 lows. Given insurance companies hold large bond portfolios whose market prices go down as interest rates go up, this poses a significant risk to their asset values.