Brace for the multi-faceted impact of inflation
With inflation here to stay, insurers should consider its impact on operations, product design, investment strategy and risk management.
Last year, inflation accelerated as pent-up demand clashed with widespread supply-chain disruptions.
This year, the war in Ukraine saw energy and food prices soar.
With limited spare energy capacity, oil prices surged past US$100 per barrel in February. In the same month, the UN FAO Food Price Index reached an all-time high and maintained an upward trajectory.
As the war drags on in Ukraine and lockdowns in China add pressures on global supply chains, wage-price spirals are beginning to be visible in certain markets. After decades of stable or even declining prices, inflation is a new phenomenon for many actors in the market and a key topic every insurer must understand thoroughly.
The impact of inflation on re/insurance firms
Inflation will affect the whole insurance value chain.
Rising inflation and interest rates will broadly increase the operational cost of insurance operations.
In P&C insurance, claims typically go up in line with soaring inflation although the specific impact will vary. For example, construction material price indexes could be more relevant to property insurance than consumer price indexes (CPI), a common measure of inflation. Supply chain disruptions and manpower shortages, therefore, will lead to major losses and increase costs for insurance companies.
Meanwhile, medical inflation, a key driver of health insurance, is expected to grow faster than CPI-based inflation affecting health insurance businesses.
Furthermore, some fixed benefit products in L&H business lines may become less attractive.
Longer tail businesses, in general, will be more severely affected. To the extent that higher CPI inflation feeds into higher social inflation, it will impact casualty and liability lines. High social inflation is already a key driver of liability claims, particularly in North America, as juries are proposing higher payouts attuned to an inflationary backdrop.
Meanwhile, higher interest rates could translate into better investment yields depending on insurers’ reinvestment cycle and portfolio mix depressing the values of bonds in portfolios managed by insurance companies in the short-term.
With potentially an increase in claims, it could hit both sides of the balance sheet creating a perfect storm for the sector.
Embedding higher inflation in new product developments
An all-consuming COVID-19 pandemic has channelled product development discussions over the past year on certain time-critical issues such as how to de-risk the supply chain and how to offer better protection against the side effects of vaccinations. It has impacted product development discussions that, in the coming months, will need to focus more on inflation assumptions and the sensitivity of insurance demand (and claims) to changes in assumptions.
Already, end-users of insurance products are seeking changes to products whether in terms of structure, coverage or distribution, especially as the world becomes more digitised.
Rising inflation will make it even more important for insurers to consider digitalisation to manage cost increases.
Emerging markets are the most vulnerable
Those insurers with operations in emerging markets should be most concerned.
Already, food and energy typically make up a bigger share of the consumer basket meaning that inflation risk is most acute in emerging markets. (However, a caveat is that food and energy producers or exporters, on the other hand, could benefit from higher international prices for produce.)
For emerging market economies dependent on food and energy imports, pressure on public coffers will increase. The state’s capacity to combat inflation is also relatively constrained in many places – even if central banks raise rates, they’re aware of the collateral damage to economic growth.
To make matters worse, limited social security systems in emerging markets means households remain exposed to rising food and energy bills.
As such, insurers operating in such markets face a twin challenge – higher inflation will affect operating costs while dampening household affordability will make it difficult to provide sufficient insurance acover.
Reinsurance is a tool that can help insurers managing exposures under a high inflation scenario. Excess of loss contract, for instance, helps transfer more of the frequency and severity risks to reinsurers.
In our recent renewal discussions, the focus has increasingly been on inflation assumptions and the use of indexes.
Yet, with underlying drivers remaining unchanged (increased severity of losses, including secondary perils, supply chain disruptions, retro squeeze and increase in interest rates), the hardening of prices could persist for a while.
There is a clear opportunity for the re/insurance sector to take the lead and help customers navigate these challenges through effective product design and improved transparency. Ultimately, we must work together to narrow the protection gap so that gains made in recent years are not lost.
