Economic Outlook: Sticky Inflation – Not All Inflation is the Same for P&C Insurers
There are growing signs of an inflationary slowdown in the global economy. Inflation is proving to be stickier than expected, while aggressive monetary policy tightening is beginning to take a toll on parts of the real economy.
The recent collapse of Silicon Valley Bank in the US has raised concerns about the health of small financial institutions, of which many have been impacted by losses on financial assets last year. Banks are also facing deposit outflows to higher-paying money market funds. This has led to tightening lending conditions (Figure 1) in the US as banks become more risk-sensitive, and are likely to impact private investment.
A higher cost of borrowing has also contributed to a contraction in the highly leveraged property sector, from America to the UK and New Zealand. At the same time, a number of low-income developing countries[1] are in a debt crisis, exacerbated by the sharp increase in global interest rates.
Declining asset prices, tightening credit conditions, and financial market volatility are in turn likely to weigh on consumer sentiment and business confidence into the rest of this year.
According to the UN Conference on Trade and Development (UNCTAD) Nowcast estimates, global merchandise trade is expected to have grown 2.3% quarter-on-quarter in 1Q 2023, after having shrunk in 4Q 2022.[2] On the other hand, manufacturing PMI contracted in the US and Europe, though having rebounded in China.
The mixed performance in the first quarter has raised some optimism that the global economy may avoid a contraction this year. However, when accompanied by high inflation and tight labour markets, this economic resilience may only further reinforce policymakers’ view that the current tightening cycle has more way to go. We think a broader economic slowdown is likely in the second half of the year.
In the Euro area, inflation ex-energy and food (core inflation) climbed to a new high of 5.7% year-on-year in March 2023. On wages, hourly labour costs accelerated to 5.7% year-on-year in 4Q 2022 (from 3.7% in Q3). The inflation outlook is further complicated by a surprise rebound in food prices in the EU and the UK in the past few months.
As underlying price pressures are still growing and inflation is far above central bank targets, monetary conditions are bound to remain tight until there is an appreciable slowdown in activity data and labour market conditions.
Specifically, on the impact of inflation on claims, it is important to differentiate the different types and drivers of inflation that are relevant to each individual line of business. For example, building materials/construction costs tend to see shorter-term spikes and are likely to have only a temporary impact on property claims and thus P&C profitability, particularly since premiums can adjust swiftly in the next annual renewal. However, labour and medical inflation could have a slower but longer-lasting effect on the long-tail lines of business including casualty, motor liability, worker compensation, and other liability lines.
The outcomes for insurers could be worse in a “stagflation” scenario – where persistently high inflation is accompanied by low real economic growth. We look back to the 1970s-1980s decade of high inflation in the US to observe the impacts on insurers. In this period, inflation was over 10% for a few years and Federal Reserve interest rates has risen to a peak of 21% in 1981.
This period was characterised by weak underwriting performance and low reserve levels for P&C insurers[3]. Claims predictability was a key challenge, affecting underwriting quality. For example, in motor insurance, the Insurance Information Institute noted that while the cost of car repairs rose 11% in the first 11 months of 1980 and medical charges went up 10.8%, the average premium increased only by 7.7%.[4]
Another interesting observation from that period is that certain coverages became completely unaffordable, leading to widening protection gaps. High inflation also gave rise to product innovation such as public entity risk pools, where government entities formed cooperatives to finance their liabilities.[5] Another feature of this period was a rise in fraudulent claims.[6]
While this may be the case under an extreme stagflation scenario, this is not our base scenario. We expect strong monetary actions to eventually tame inflation after a soft patch in growth during the second half. Inflation break-evens are suggesting that the market consensus is for inflation to normalise back towards 2% within 3 years.
We studied the relationships against a range of price indicators, including the headline HK consumer price index (CPI) and sub-indices, payroll indices, wage data, property price, construction materials cost, and household income data. During this period, CPI inflation in Hong Kong ranged from -4.0% to 6.6%, i.e., relatively stable compared to the double-digit inflation episodes of the 80s and early 90s. Hence, the study may not be reflective of the shifts in these relationships during very high inflation periods.
Observations from our analysis were as follows:
(i) Non-life insurance expenses showed a strong correlation with Hong Kong headline CPI inflation (Figure 5). Breaking down the management expenses by specific business lines, MD&L expenses showed a strong correlation with headline CPI, while management expenses of A&H and GL were more closely related to the nominal payroll index (Figure 6). With A&H and GL being the largest general insurance business lines in Hong Kong, payrolls growth can be a major contributor to the overall expense ratio for insurers.
(ii) Relative to expenses, the relationship between non-life claims and CPI inflation is much weaker. This is understandable, as claims are affected by many other factors such as natural catastrophe losses on property claims. Moreover, the claims data are based on financial years while longer-tail business could be impacted by inflation in different years. Claims payout for a particular underwriting year could come through at a far-away future date, making it difficult to clearly draw relationships with macroeconomic indicators (which are strictly on a financial year base).
Nevertheless, we found notable correlations between claims under individual business lines with relevant price indexes.
A summary of the correlations analysis for Hong Kong non-life insurance:
For P&C insurers, different types of inflation have different impacts on profitability and pricing. Specifically for Hong Kong’s non-life insurance markets, we recognise a strong link between CPI inflation and the payroll index on insurance expenses (i.e. the expense ratio). The relationships between CPI and non-life insurance claims are not as well-defined given the significant impacts of non-macroeconomic factors and uncertain claim settlement periods. However, notable correlations do exist for claims under individual business lines, especially for motor, A&H, and GL, and the relevant price indexes.
While this analysis looked at correlations between inflation and claims, the impact of inflation on loss ratios would be a topic of further study.
[1] Financial Times: Quarter of emerging countries lose effective access to debt markets, 31 March 2023
[2] UNCTAD STAT NOWCASTS: https://unctadstat.unctad.org/en/Nowcasts.html
[3] Fitch Ratings, 28 October, 2021, Inflation, Rising Rates Fuel Downside Risk for US P/C Insurers
[4] The Christian Science Monitor, 29 January, 1981, The year looked good, but inflation buffeted insurance firms in 1980
[5] Risk & Insurance, Article by Pinnacle Actuarial Resources, November 15, 2022, A 1970s Liability Crisis Gave Way to Risk Pool Popularity. Could a Similar Wave of Innovation Be in Store?
[6] The Christian Science Monitor, 29 January, 1981, The year looked good, but inflation buffeted insurance firms in 1980
The recent collapse of Silicon Valley Bank in the US has raised concerns about the health of small financial institutions, of which many have been impacted by losses on financial assets last year. Banks are also facing deposit outflows to higher-paying money market funds. This has led to tightening lending conditions (Figure 1) in the US as banks become more risk-sensitive, and are likely to impact private investment.
A higher cost of borrowing has also contributed to a contraction in the highly leveraged property sector, from America to the UK and New Zealand. At the same time, a number of low-income developing countries[1] are in a debt crisis, exacerbated by the sharp increase in global interest rates.
Declining asset prices, tightening credit conditions, and financial market volatility are in turn likely to weigh on consumer sentiment and business confidence into the rest of this year.
The tightening cycle has more way to go
Despite monetary policy and geopolitical headwinds, global economic activity remained relatively healthy in the first quarter of 2023. Services activity, in particular, showed positive momentum in 1Q 2023 across the US and Europe, and significantly strengthened in China where a post-reopening rebound in services consumption is underway (Figure 2). Labour markets in advanced economies remained tight, with unemployment rates hovering at low levels.According to the UN Conference on Trade and Development (UNCTAD) Nowcast estimates, global merchandise trade is expected to have grown 2.3% quarter-on-quarter in 1Q 2023, after having shrunk in 4Q 2022.[2] On the other hand, manufacturing PMI contracted in the US and Europe, though having rebounded in China.
The mixed performance in the first quarter has raised some optimism that the global economy may avoid a contraction this year. However, when accompanied by high inflation and tight labour markets, this economic resilience may only further reinforce policymakers’ view that the current tightening cycle has more way to go. We think a broader economic slowdown is likely in the second half of the year.
Figure 1: US Bank loan officer survey on credit standards for firms: net tightening in lending conditions |
Figure 2: Services PMI: 1Q rebound across major economies |
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Source: CEIC, Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Conditions |
Source: CEIC, US ISM, China NBS, S&P Global |
Services inflation is persistent
Inflation in advanced economies remains stubbornly high, despite declining energy prices and easing factory gate inflation. In particular, services inflation is still accelerating, driven by wage pressures. Figure 3 shows the trend for goods and services inflation in the US. Median wages in the US have been growing at a rate of over 6% year-on-year for over a year (Figure 4), impacting the labour-intensive services industry.In the Euro area, inflation ex-energy and food (core inflation) climbed to a new high of 5.7% year-on-year in March 2023. On wages, hourly labour costs accelerated to 5.7% year-on-year in 4Q 2022 (from 3.7% in Q3). The inflation outlook is further complicated by a surprise rebound in food prices in the EU and the UK in the past few months.
As underlying price pressures are still growing and inflation is far above central bank targets, monetary conditions are bound to remain tight until there is an appreciable slowdown in activity data and labour market conditions.
Figure 3: US Personal Consumption Expenditure Price Index %YoY: goods disinflation versus services inflation |
Figure 4: US median wage growth: wage pressures are persistent |
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Source: CEIC, US Bureau of Economic Analysis |
Source: Current Population Survey, Bureau of Labor Statistics, and Federal Reserve Bank of Atlanta Calculations. |
What does high inflation mean for P&C insurance markets?
Conventionally, periods of high inflation adversely affect insurers’ near-term combined ratios (i.e., increase losses and expenses) and reduce profits. Higher interest rates could lead to reduced inflows of new capital while insurers’ investments could benefit from a higher return (allowing for reinvestment). This is largely in line with recent observations, where capacity has been constrained by tighter monetary conditions, although near-term investment losses were also a key consideration. Such an environment favours insurers with higher operations efficiency and well-diversified investment portfolios.Specifically, on the impact of inflation on claims, it is important to differentiate the different types and drivers of inflation that are relevant to each individual line of business. For example, building materials/construction costs tend to see shorter-term spikes and are likely to have only a temporary impact on property claims and thus P&C profitability, particularly since premiums can adjust swiftly in the next annual renewal. However, labour and medical inflation could have a slower but longer-lasting effect on the long-tail lines of business including casualty, motor liability, worker compensation, and other liability lines.
The outcomes for insurers could be worse in a “stagflation” scenario – where persistently high inflation is accompanied by low real economic growth. We look back to the 1970s-1980s decade of high inflation in the US to observe the impacts on insurers. In this period, inflation was over 10% for a few years and Federal Reserve interest rates has risen to a peak of 21% in 1981.
This period was characterised by weak underwriting performance and low reserve levels for P&C insurers[3]. Claims predictability was a key challenge, affecting underwriting quality. For example, in motor insurance, the Insurance Information Institute noted that while the cost of car repairs rose 11% in the first 11 months of 1980 and medical charges went up 10.8%, the average premium increased only by 7.7%.[4]
Another interesting observation from that period is that certain coverages became completely unaffordable, leading to widening protection gaps. High inflation also gave rise to product innovation such as public entity risk pools, where government entities formed cooperatives to finance their liabilities.[5] Another feature of this period was a rise in fraudulent claims.[6]
While this may be the case under an extreme stagflation scenario, this is not our base scenario. We expect strong monetary actions to eventually tame inflation after a soft patch in growth during the second half. Inflation break-evens are suggesting that the market consensus is for inflation to normalise back towards 2% within 3 years.
Inflation impact on non-life insurance in Hong Kong
In order to better understand the potential impact of high and rising inflation, we looked into the relationship between inflation and claims and expenses for the Hong Kong non-life insurance market. Our analysis uses data from the Insurance Authority (IA) starting 1999, for four lines of non-life businesses, namely property damage (PD), motor damage and liability (MD&L), accident & health (A&H), and general liability (GL).We studied the relationships against a range of price indicators, including the headline HK consumer price index (CPI) and sub-indices, payroll indices, wage data, property price, construction materials cost, and household income data. During this period, CPI inflation in Hong Kong ranged from -4.0% to 6.6%, i.e., relatively stable compared to the double-digit inflation episodes of the 80s and early 90s. Hence, the study may not be reflective of the shifts in these relationships during very high inflation periods.
Observations from our analysis were as follows:
(i) Non-life insurance expenses showed a strong correlation with Hong Kong headline CPI inflation (Figure 5). Breaking down the management expenses by specific business lines, MD&L expenses showed a strong correlation with headline CPI, while management expenses of A&H and GL were more closely related to the nominal payroll index (Figure 6). With A&H and GL being the largest general insurance business lines in Hong Kong, payrolls growth can be a major contributor to the overall expense ratio for insurers.
Figure 5: HK non-life management expenses versus CPI inflation |
Figure 6: A&H management expenses versus Nominal Payroll Index |
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Source: CEIC, Insurance Authority, Peak Re |
Source: CEIC, Insurance Authority |
Nevertheless, we found notable correlations between claims under individual business lines with relevant price indexes.
- Accident & health claims growth showed a material correlation with median household income growth, compared to any other price indicators in our analysis (such as medical inflation). As such, A&H claims may be better related to the lifetime impact of an injury on the household income rather than the specific medical costs for an injury.
- General liability claims growth showed the strongest correlation with the growth of wages of “managers and administrators”. While this is to be expected, the correlation has broken down since 2021, which may be explained by pandemic-related court delays impacting liability claims settlements.
- Motor claims data, which included both motor damage and liability claims, interestingly, showed shifting correlations – sometimes better correlated with motor inflation (i.e., the “motor vehicle purchase and repair” component of CPI inflation) and sometimes better correlated with medical inflation (Figure 7). Recently the correlation with motor inflation is stronger than with medical inflation. This could likely reflect the higher impact of motor parts costs over 2021 due to supply chain disruptions, while medical inflation in Hong Kong remained benign during this period.
- Finally, property damage claims showed a weak relationship with both, construction materials costs and housing inflation. It is likely that the impact of non-macroeconomic events, such as natural catastrophes (mainly typhoons), on property damage claims overwhelmed the impact from macro factors. The relationship has further broken down in 2021, which could be the result of a slowdown in construction activities during the pandemic years (Figure 8).
Figure 7: Motor claims growth 3Y rolling correlations with motor inflation and medical inflation |
Figure 8: Property claims growth versus building materials cost index |
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Source: CEIC, Insurance Authority, Peak Re |
Source: CEIC, Insurance Authority, C&SD |
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Summary
Pockets of the real economy have started developing cracks from the effects of persistently high inflation and monetary policy tightening. While economic data are resilient so far, we expect growth to slow later in the year, while services inflation could take longer to cool.For P&C insurers, different types of inflation have different impacts on profitability and pricing. Specifically for Hong Kong’s non-life insurance markets, we recognise a strong link between CPI inflation and the payroll index on insurance expenses (i.e. the expense ratio). The relationships between CPI and non-life insurance claims are not as well-defined given the significant impacts of non-macroeconomic factors and uncertain claim settlement periods. However, notable correlations do exist for claims under individual business lines, especially for motor, A&H, and GL, and the relevant price indexes.
While this analysis looked at correlations between inflation and claims, the impact of inflation on loss ratios would be a topic of further study.
[1] Financial Times: Quarter of emerging countries lose effective access to debt markets, 31 March 2023
[2] UNCTAD STAT NOWCASTS: https://unctadstat.unctad.org/en/Nowcasts.html
[3] Fitch Ratings, 28 October, 2021, Inflation, Rising Rates Fuel Downside Risk for US P/C Insurers
[4] The Christian Science Monitor, 29 January, 1981, The year looked good, but inflation buffeted insurance firms in 1980
[5] Risk & Insurance, Article by Pinnacle Actuarial Resources, November 15, 2022, A 1970s Liability Crisis Gave Way to Risk Pool Popularity. Could a Similar Wave of Innovation Be in Store?
[6] The Christian Science Monitor, 29 January, 1981, The year looked good, but inflation buffeted insurance firms in 1980
