Managing inflation risk on both sides of the balance sheet
Central banks have hiked their base rates in response to inflation. For insurers, both sides of their balance sheet have been left exposed to risks, impacting profitability as the cost of claims increase and the value of investments fall. While geopolitical tensions and inflationary pressures continue to pose a threat to the global economic landscape, how can insurers mitigate the risk of inflation-driven exposures?
A report by the World Economic Forum in partnership with Marsh McLennan and Zurich Insurance Group warned that "continued supply-driven inflation could lead to stagflation", the "socioeconomic consequences of which could be severe".
However, the International Monetary Fund (IMF) forecasts global inflation to decline from 8% to 6.5% in 2023 and to 4.1 percent by 2024. While this might be the case, at present inflation one of the biggest concerns of the global economy.
According to Thomas Holzheu, chief economist Americas at Swiss Re Institute, this period of high inflation has been driven by several factors.
“The first phase of the high inflation environment was driven by high durable goods prices, as Covid-19 related lockdowns shuttered the services sector and fiscal stimulus supercharged household demand, which outstripped pandemic-hampered supply.
"This was later exacerbated by the war in Ukraine, which boosted energy prices sharply in the spring and early summer of 2022, further underpinning high goods inflation in Q2 and Q3 2022.
"However, as supply chain conditions improved and firms restocked inventories, goods disinflation began to take hold in Q4 as households increasingly reverted their spending patterns toward services amid reduced Covid-19 fears.”
While inflation remains high, Dr. Thomas Sepp, chief claims officer at AGCS Sepp, believes updating insured values is vital.
“Determining and updating insured values is a pressing concern for everyone," he says: "insurers, brokers and the insureds.
There is some discussion in the market as to whether specific clauses addressing the risk of undervaluation should be brought back into wordings if asset values are not updated.
"It is important that businesses regularly monitor and adjust the value of assets, as well as the implications for the costs of replacement or business interruption, in order to ensure they are fully reimbursed post-loss.
“The insurance market has already seen a number of claims where there has been a significant gap between the insured’s declared value and the actual replacement value.
"For example, in a claim for a commercial property destroyed in the 2021 Colorado wildfires, the rebuild value was almost twice the declared value, due to a combination of inflation, demand surge, and underinsurance.
"However, in a high inflation environment, and with the growing complexity of large losses, insurers risk underpricing exposures where they rely on declared values that do not truly reflect the reinstatement costs."
Sepp explains that collaboration with clients and brokers is key at the renewal stage.
“We need to work intensively with clients and brokers at renewal stage to build awareness and preparedness for updating asset values," he says.
"Values are expected to increase because of inflation, but if there is a drop in values there will have to be plausible reasons – such as an exit of a market or a site closure.”
As underwriters look to manage inflation exposures, some are considering whether to highlight specific clauses to address the risk of undervaluation, according to Sepp.
“There is some discussion in the market as to whether specific clauses addressing the risk of undervaluation should be brought back into wordings if asset values are not updated,” he says.
“Clearly, we also need to manage our own inflation exposures in underwriting. Essentially, this means factoring-in rising claims costs in our underwriting practice."
Navigating a Changing Landscape
Insurers are having to adapt to a changing risk landscape, with two major risks being climate change and cyber crime. And in the case of cyber, the associated risks can be difficult to quantify.
“Cyber risks are difficult to quantify due to a lack of standardized data and modelling constraints,” says Holzheu.
Insurers need to be constantly reassessing their internal approaches to new forms of risk to best serve their clients.
“Future risks are typically inferred based on backward-looking data, but this approach is of limited value in the rapidly changing environment of cyber risk.
"Introducing cybersecurity standards can improve data in terms of breadth and transparency and allow meaningful risk insights and enable more accurate pricing and modelling.
“Re/insurers must also invest in the cyber workforce, to help strengthen the actuarial and technical skills needed for the forensic analysis that is part of underwriting and claims management cycles.
"Meanwhile, the high degree of uncertainty regarding expected losses and the evolving nature of the risk challenges the insurability of peak and accumulation risks.
“Re/insurers should update policy language for clarity and consistency. The relative youth of the cyber insurance market and complexity of the risk are reflected in a lack of standardization around exclusion clauses and terms and conditions.
“Finally, there is also need and scope for new types of public-private risk sharing mechanisms. Public and private sector collaboration is also key to mitigating cyber threats to critical infrastructure."
According to Hetul Patel, chief actuary at Liberty Mutual Re, insurers need to ensure they are adapting their processes to meet clients' needs as the risk landscape changes.
“Insurers need to be constantly reassessing their internal approaches to new forms of risk to best serve their clients," Patel says.
"The increasing risk of cyber-attacks and natural disasters in the current landscape, where inflation is making it harder for businesses and individuals to fund proper protections, cannot be ignored.
"This is why it is important that both insurers and reinsurers are as ready as possible for any eventuality.
"For example, on the risk of cyber-attacks, the industry must aim to put in place processes which can measure cyber hygiene for organisations, as well as assist in implementing measures such as tabletop drills and clear practices for insureds to follow should a cyber event occur."
The high inflation environment is having an impact across “most lines of the insurance industry in the short to medium term,” according to Sepp.
“Inflation is a concern for liability claims, such as directors and officers (D&O), professional indemnity and general liability," Sepp says, "which are already experiencing rising defense costs and social inflation in the US, driven by higher jury awards for personal injury claims and shifting societal attitudes."
Patel also takes the view that the impact can be felt across most lines of the insurance industry, and explained that there is a less of an impact on lines exposed to economic activity and the geopolitical environment.
“In property, material cost inflation, supply chain delays and labor scarcity are increasing property repair and replacement times and costs, compounding property claims that were already increasing in frequency and severity impacted by climate change," he says.
“In casualty, wage and medical cost inflation are driving up liability claims with labor shortages and workforce reductions increasing strain on existing employees.
"Similarly, for commercial auto, the supply chain delays have increased the wait time for replacement parts, keeping vehicles out of commission for longer.
“So far, we have seen only a limited impact on lines exposed to economic activity and the geopolitical environment i.e., surety, trade credit and political risks.
"However, these businesses are facing challenges in other ways. For example, where economic volatility has presented challenges in forecasting and business planning. Surety has also been impacted as rising interest rates can affect investment in construction projects and financial volatility can increase project cancellation risks."
Social inflation is particularly an issue in the US, which according to Sepp could be further driven by lawyers’ higher salaries and hourly rates.
“In addition, we are also seeing the beginning of cost increases in professional services such as legal fees. Annual US legal services inflation is already at four percent in 2022. Higher salaries and hourly rates of lawyers could also further drive up defense costs.”
For many insurance companies, gaining a competitive advantage is one of their key priorities, especially considering the current economic and political environment, and utilizing technology is one way they can do that.
“Technology is ever evolving and we as an industry are starting to see more innovative and effective uses for it," he says. "It can help insurers get a better all-round grasp of the problems their clients are facing and can assess data to provide a fairly comprehensive view of possible risks.
"At Liberty Mutual Re, we have adopted several technological strategies to deal with the inflationary issues – using both internal and third-party vendor tools. The use of these technologies gives us a good level of underlying comfort that we are getting our arms around the problem and providing better support to our clients.
“Companies can also look closely at their own data to assess how exposures have changed over the years, and to make forecasts about regional directions and velocities of travel."
As claims inflation continues to be a top concern for insurers, technology can play a significant role in improving efficiency in claims handling.
“Technology can help insurers develop more granular and accurate rates, for example, telematics in driving, reduce operations and claims processing costs and improve marketing strategies," he explains.
Re/insurers must also invest in the cyber workforce, to help strengthen the actuarial and technical skills needed for the forensic analysis that is part of underwriting and claims management cycles.
“Insurers use new data sources and advanced machine learning algorithms to analyze large amounts of data and identify patterns that can help predict future risks.
"This can include data from IoT devices and sensors to gather real-time information about potential risks, such as weather patterns and traffic conditions.
"In motor insurance, insurers use telematics to monitor driver behavior and identify high-risk drivers, allowing them to adjust pricing and underwriting."
While progress has been made in cat modelling, Sepp explained cat models can be further improved to help build a better picture of catastrophe losses.
He said: “Progress in cat modelling has been made, for example, with high-resolution risk-based flood rating models.
"In general, cat models can be further improved to account for the multiple factors that drive the physical and financial loss outcome. This includes climate change effects, impacts of urban development, more granular micro data on environment and building structures."
There are various ways insurers can protect against high inflation – for instance, investing in inflation-linked securities and reducing the duration of their bond portfolios.
“Inflation-linked securities (bonds and swaps) are perhaps the most straightforward way to protect against high inflation," says Holzheu. "They can play a role in asset allocation, but it is limited due to the size of the market and type of inflation protection offered.
“Treasury inflation-protected securities have an outstanding market value of $1.9 trillion at year-end 2022 – a small share of the US fixed income market.
"Moreover, hedging against consumer price inflation might not accurately reflect the claims inflation risk of property and casualty business, which tends to be more driven by healthcare and wage inflation and recently the price surges for used cars and construction costs.
“Insurers can also protect against inflation by reducing the duration of their bond portfolios – or holding more cash and short-term securities – enabling them to reinvest relatively quickly at higher nominal rates if interest rates increase with a surge in inflation.
"US P&C insurers decreased the duration of their bond portfolios in the two decades between 2002 and 2021, which has turned out to be a benefit enabling quicker portfolio reinvestment at higher nominal yields."
Patel has an optimistic view of the economic outlook over the next year and even more so for the next decade.
“Generally, optimism in the industry is growing, and we are cautiously positive as we look to the next year and the decade beyond. It is, however, vital that insurance companies are clear about what scenarios may play out given the current economic state.
"Companies should be looking to mitigate the risk to their investment portfolios as we start to see gentle easing of inflation. The first possible scenario we see is one where the economy experiences a soft landing and the second is a less rosy outcome where efforts to rein in inflation leads to a recession.
“We are cautiously leaning towards the first scenario, and the way the economy is evolving with inflation having cooled and continuing to trend in the right direction is encouraging.
“While no industry can predict the future, an insurer’s job is to be aware of the risk and to make sure its portfolios are prepared for this challenge and others which may be on the horizon."