Our industry is indeed in a moment of great uncertainty. As of April 2022, the financial markets have been buffeted by several trends in addition to the crisis in Ukraine. A consensus is building that their combined impact on inflation will be more than transitory. We now seem to be on the cusp of a new era of higher interest rates and, for a time, higher inflation. A key question is for how long?
Higher interest rates and higher inflation generally lead to both moderate claims inflation, and in the near term, depressed investment returns — although higher interest rates will increase yields for invested premiums, they will also lower the value of fixed-rate bonds. These factors in turn lead to higher pricing in insurance markets, particularly in specialty business lines where replacement costs are driven by the prices of commodities and labor costs — both of which are rising.
Inflation expectations always encompass uncertainty. We outline three potential scenarios.
Regardless of how long and intense this period of inflation turns out to be, we expect it to have an impact on the insurance marketplace.
In response to inflationary pressures, the Federal Reserve has begun tightening monetary policy and raising interest rates. Many in our industry have not experienced such conditions.
From 2008 to 2015, the central bank kept short-term rates just above 0% to spur growth and fortify damaged bank balance sheets.
From 2008 to 2015, the central bank, in response to the Great Financial Crisis – kept short-term rates just above 0% to spur growth and fortify damaged bank balance sheets. This significantly increased the money supply. Keeping rates so low for so long while growing the money supply raised the possibility of inflation.
By early 2016, the Federal Reserve began modestly raising rates, which appeared to be helping both to maintain economic growth and tame inflation expectations. Then, in March 2020, the global pandemic intervened to literally send everyone back home, close city centers, and shutter the economy as we knew it. The U.S. government injected a huge amount of money into the economy. The pandemic led to other economic turns as well.
The COVID-19 pandemic impacted mortality rates, mental and physical health and the worldwide economy. Now, with vaccination rates up and the pandemic hopefully waning, the economic aftereffects of the pandemic are becoming apparent.
As demand rises, there is supply-side impact as well.
Supply chain disruptions combined with reduced output levels at manufacturing facilities have decreased the supply of many industrial goods. The pulse of new and unplanned-for demand, along with the depressed supply, has shocked markets and led to significant upward pressure on prices.
This spike in demand has affected the auto, construction, and metal industries in particular.
The pandemic also brought a significant shift in the labor market. In the great resignation, as many as 4.5 million Americans left the workforce. With the economy opening back up and sparking more demand for labor, we are seeing modest to significant upward pressure on wages.
The combined effect of these economic and social forces would have been enough to push prices up. Then another unexpected event took place: Russia sent its armed forces into Ukraine.
The ongoing crisis in Ukraine is clearly taking an unimaginable humanitarian toll. However, Russia is also a major energy supplier to Europe, and Russia and Ukraine together represent an important percentage of global wheat harvests. This energy disruption has helped push the price of crude oil from the $70 per barrel in December 2021 to nearly $120 per barrel in early March 2022.
The capital markets have experienced significantly higher levels of volatility, higher credit spreads and now a flattening of the U.S. yield curve. The latter is often seen as a predictor of an upcoming recession. Clearly, any sustained period of higher oil prices will increase the likelihood of a recession and hurt risk asset investment returns.
Impact on claims: A potentially short- to medium-term pulse of higher inflation will likely have a significant impact on expected claims, particularly for specialty lines, such as aerospace, commercial auto, construction, energy, marine cargo and marine hull. Increases in material replacement and repair costs, including labor costs, should be expected to a significantly raise insurer projections of future expected claims.
Impact on investment returns: The first of a likely series of rate hikes by the Federal Reserve has lifted short- to medium-term interest rates. The resulting higher yields for new investments may well be offset by the expected losses due to further increases in rates over 2022. Increased interest rates improve reinvestment yields for new premiums, but also reduce the value of the existing bond portfolio. The extent of this reduction will depend on the investment strategy employed, realization requirements and the accounting treatment of the portfolio. Additionally, the specter of higher inflation could lead to lower than expected or negative equity returns. Low projected returns across both bonds and equities for 2022 and 2023 due to the expected future increases in interest rates would obviously depress the investment returns across the investment portfolio for insurers.
Impact on pricing: Insurers facing claims inflation and depressed investment returns will likely consider higher and differentiated renewal prices.
These increases will depend on the tenor of the claims exposure. For shorter claims, conditions might benefit to some degree from slightly higher investment return assumptions due to higher yields, Medium-term to longer claims will be exposed to the higher risk associated with greater investment losses from medium-term bonds, as well as potentially depressed investment returns overall.
Insurer's prices may well reflect and anticipate both the higher expected claims inflation and lower expected investment returns, driving prices higher. The extent of the increases will depend at least in part on the impact of inflation dependency of a given claims stream.
Most of the lines in this report are predicting a continued easing of price increases, as the hard market of the last couple of years abates. But upward price pressures remain.
In addition to keeping an eye on the economic trends outlined above, policyholders can and must analyze their risks carefully and consider which risks they are willing to self-insure or alter coverage to address exposure to higher loss possibilities. Additionally, policyholders should assess the level and size of coverage required as asset prices and replacement costs may have risen. Buyers should engage in discussions with their insurers early on to avoid surprises in this highly uncertain and volatile period.
Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).
Each applicable policy of insurance must be reviewed to determine the extent, if any, of coverage for losses relating to the Ukraine conflict. Coverage may vary depending on the jurisdiction and circumstances. For global client programs it is critical to consider all local operations and how policies may or may not include coverage relating to the Ukraine conflict. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal and/or other professional advisors. Some of the information in this publication may be compiled by third-party sources we consider reliable; however, we do not guarantee and are not responsible for the accuracy of such information. We assume no duty in contract, tort or otherwise in connection with this publication and expressly disclaim, to the fullest extent permitted by law, any liability in connection with this publication. Willis Towers Watson offers insurance-related services through its appropriately licensed entities in each jurisdiction in which it operates. -The Ukraine conflict is a rapidly evolving situation and changes are occurring frequently. Willis Towers Watson does not undertake to update the information included herein after the date of publication. Accordingly, readers should be aware that certain content may have changed since the date of this publication. Please reach out to the author or your Willis Towers Watson contact for more information.
