Inflation: Captive Insurers, Beware of What You Wish for

According to Merriam Webster's dictionary, inflation is "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services." Several years ago, we were obsessing about the possibility of persistent deflation. The Federal Reserve System (the Fed) routinely offered prognostications about the normalization of interest rates and core inflation moving closer to its preferred target of 2 percent. And then came the let down and rationalization about why things had not turned out the way the Fed had predicted. We offer this observation as a cautionary tale about the Fed's crystal ball.

Consumer prices in the United States increased 2.4 percent year-on-year in March of 2018, above 2.2 percent in February and marking a high water point. The initial report for April is due momentarily, and with the rise in gasoline prices, expectations are for the Consumer Price Index to come in higher than the March number. The Fed has announced that they are prepared to allow inflation to run above their preferred 2 percent target for a period of time to make up for the lower inflation rates of prior years.  The problem with this scenario, as we noted above, is the Fed does not have a stellar record when it comes to managing inflation. This all supports an argument for captive insurers to be somewhat wary of where short-term inflation may end up.

Keep in mind that we are talking about short-term inflation here, not the longer-term trend for inflation. In the previous Captive.com article Captive Insurance Industry Looks at What Is Next for Bond Yields, Inflation, we discussed the forces at work that may well keep long-term inflation in check. However, our crystal ball is no better than the Fed's, so the real question for captive insurers is, how would higher levels of inflation impact their operations? A corollary question is, does your captive do any inflation forecasting in its strategic planning, and what are the implications?

How does inflation affect an insurance company? An internet search on this question leads to links with article dates from 2012 and before. This alone should be pause for concern. We recommend the report The Effect of Deflation or High Inflation on the Insurance Industry, by the Casualty Actuarial Society (CAS). 

Early on in the report, the authors note that "while the general rate of inflation as measured by the Bureau of Labor Statistics and reported as a percentage change in CPI is one indicator of price increases, the effects on insurers may be dramatically different." This difference is driven by several factors, but in our mind, there is one that gets overlooked. Insurance is one of the few products sold where the cost of the product is not determined until years later. For captives writing short-tailed business, such as property coverage, this may be only 2–3 years. For those writing workers compensation, it may be 30–50 years. 

How does inflation factor into this equation? A captive will typically use an actuary to help it price the cost of its coverage(s). That cost, the premium, is intended to cover the expenses associated with all claims arising from the policy being underwritten and overhead expenses, and, for some captives, provide an incremental return on capital. When pricing products, actuaries will always factor in some sort of trend for inflation. But what happens if that trend factor is wrong, especially if it understates the true rate of inflation? The result is a decrease in the captive's underwriting profit or, in the event the captive was looking to write to a break-even point, an underwriting loss.

Willis Towers Watson produces an annual Claim Cost Index, and their 2017 report states, "Analysis of the annual changes in the Willis Towers Watson Claim Cost Index ... shows that the composite insurance inflation rate has outpaced the general inflation rate since 2013. The 2017 cost increases are preliminary, as many of the cost indices contributing to the Willis Towers Watson Claim Cost Index are not finalized."

The report continues, "A [property and casualty] insurer's claim settlements are directly affected by economic factors such as trends in the cost to replace damaged property, the cost of repair parts, the cost of medical services and drugs, and salaries and wages. In economic terms, claim costs for loss and loss adjustment expenses are the cost of production for the insurer. An insurer's major claim costs include physician services and other medical expenses; hospital care and rehabilitation; lost time and wages; automobiles, including repairs and parts; building materials and construction labor; and personal effects. The components for loss adjustment expenses are those incurred by insurance companies in settling claims (e.g., legal fees, and other legal and court costs)." Captive insurers are impacted similarly.

However, it is not only current claims costs that are driven higher. The CAS report comments, "In addition to the impact of inflation on the cost of future claims on current policies, property-liability insurers are also likely to experience adverse development on loss reserves if inflation increases. ... [L]oss reserves are commonly set based on the inherent assumption that the inflation rate experienced in the recent past will continue until these claims are closed. However, if inflation increases more than forecast, it will cost more than expected to settle these claims and loss reserves will prove to be inadequate."

So while captive insurers may be cheering the recent rise in interest rates, which will lead to higher investment returns, the devil is always in the details. If inflation rates rise faster and/or more than forecast, captive insurers may not like the results. Earnings from underwriting will certainly fall, and any incremental gain in investment income is likely to be swamped by the decrease in underwriting income. The result will be an overall decline in policyholder's surplus. Thus, captive insurers need to have an inflation risk mitigation strategy in place—do you?