Many actuaries in the insurance profession have only known low and stable inflation in their careers to date, meaning their techniques for estimating its effect on claim reserves haven’t needed much, if any, updating.
But a headline U.S. inflation rate that reached 9.1% in June 2022 is changing all that. The combined effects of the Ukraine conflict and post-COVID supply chain disruption have hit across the board creating inflation rates not seen in 40 years.
Insurers that can tell a credible story to stakeholders about the impact of inflation on reserves and give reassurance that they are on top of the issues should be better able to calm any market jitters – not to mention reduce the potential for damaging claim reserves mark-ups down the line.
A key aspect of better quantifying the inflationary impact on reserves will be an ability to reflect the varying effects of:
If we consider the broad categories of property and casualty (P&C) insurance, general liability (GL) coverages are principally prone to allocated loss adjustment expense (ALAE) inflation due to supply chain, legal and other operational pricing pressures. Indemnity coverages such as auto – where supply chain issues for replacement parts have been particularly acute – also have both bodily injury and property damage components and will therefore also be susceptible to medical inflation.
In both categories, reporting lag and accident year will also need to be taken into account, as not all the inflation impact will be on a calendar year basis. Linked to these timing issues, more recent accident/underwriting years will generally have a higher level of impact as there are more future years for the claims to pay out. Accordingly, lines of business with longer pay-outs, such as GL and workers’ compensation, will generally be more heavily impacted.
And while mainly an issue for commercial insurance, coverage layers will also be an important calculation component, as inflation will not only make claims more expensive generally but push more claims into higher excess layers.
We are working with several insurers to help them address the revived reserving challenges of higher and less predictable inflation. While the exact methods used vary by company, the objective is the same: to synchronize what the reserving methods employed would have told a company with the impact of inflation.
Our starting point is to estimate the implied inflation level in the reserve patterns and triangles based on an inflation dependency by segment that is validated by our in-house economists against external data. By restating the historical triangles as if at prevailing inflation rates, we can start to see how the patterns diverge from the actual.
To these triangles, we can then apply and project estimates of future losses on a nominal basis using various inflation forecast scenarios. These provide the basis for comparisons to the unadjusted accident year and underwriting year results.
Of course, any projection of the future is going to be educated guesswork. So, a further component of looking at inflation impacts is sensitivity analysis. The key questions to answer, or at least consider, are:
Having lain relatively dormant for so long, inflation is back, front and center, and is on the agenda of reserving departments. Taking informed action now should help insurers avoid getting burned in the longer run.
Beyond reserving, the strategies for addressing inflation should impact every step of the insurance cycle, from pricing, claims, reserving, capital, investment, and financials. An ideal roadmap to addressing inflation would start with an examination of the implicit consideration of claims inflation, followed by an examination of the explicit drivers as indicated above. These reviews would inform a holistic view to examine the impact of inflation on each component of the enterprise and ultimately would produce a set of reporting and monitoring that will better enable the insurer to weather the storm.
