High Rates of Inflation Likely To Pressure Property-Casualty Insurers' Profitability

Even as insurance rates continue to harden, property-casualty insurance companies are likely to face headwinds to their profitability due to persistent high rates of inflation, two new reports suggest.

Describing 2022 as a "transition year" for the insurance industry with surging inflation and higher interest rates, a Swiss Re Institute sigma report, Stagflation: The Risk Is Back, but Not 1970s Style, says property-casualty insurers are likely to feel inflation this year through higher claims, in addition to some direct loss exposures in specialty lines.

At the same time, "Rising interest rates are a positive prospect for the whole industry and will likely benefit investment results, although volatile financial markets and widening bond spreads are expected to create accounting losses in 2022," the Swiss Re report (no. 2/2022) says.

In its own May 6, 2022, report, The Inflation Risks Facing the Insurance Sector: And What Insurers Can Do about It, Gallagher Re notes, "The debate has moved on from whether inflation will spike to how long it will last. Financial markets have begun to price in more pernicious longer-lasting inflation."

For property-casualty insurers, there is either evidence of inflation of underlying cost drivers or an increased risk of inflation taking hold, Gallagher Re reports. And, while higher interest rates are helping insurers on the asset side, the impact is slow and coming off a low base.

While the full impact of inflation on the global insurance industry has yet to be determined, Swiss Re suggests that higher inflation creates multiple challenges for insurance companies.

Claims inflation is the primary risk for property-casualty insurers, the Swiss Re report says, with increases in claims severity eroding insurers' profitability.

Meanwhile, inflation will lead to rising interest rates, which will have a positive impact on insurers' investment income. "Nevertheless, we believe that any gains in investment returns from inflation-induced higher interest rates will not be enough to offset higher claims, and that overall impact on P&C sector profitability will be negative," the Swiss Re report says.

There could also be what Swiss Re calls "ambiguous effects" on property-casualty insurers' balance sheets. A mismatch between the durations of assets and liabilities could lead to "unsynchronized exposure" of the balance sheet to varying interest rates over time, the reinsurer says.

"In the current inflation shock, characterized by particularly high construction and car part costs, we expect motor and property insurance claims to be most affected in the short run," Swiss Re says.

Automobile and car part prices are currently trending higher than general consumer price index (CPI) inflation in most advanced economies, the report says, mainly as a result of supply chain shortages that still exist as a result of COVID-19 lockdowns. In addition, car repair costs are also experiencing higher-than-average inflation due to high wage growth.

At the same time, rising construction prices that are also growing faster than CPI inflation are putting considerable pressure on property claims, Swiss Re says. "The current inflationary shock is primarily driven by supply disruptions for construction materials and labor shortages, but we see this as temporary and expect price rises to revert to the wider US CPI level over the next 2 years," the report says.

Over the long term, longer-tail property-casualty lines such as general liability, medical malpractice, and workers compensation will be most exposed to sustained high inflation across the economy, Swiss Re says. "This applies in particular to unanticipated inflation trends, while anticipated inflation levels should be considered in pricing of insurance contracts," the report says.

Other lines of business such as property and auto are also exposed to the long-term impact of inflation but less severely, Swiss Re says. "In these lines of business, claims are mostly settled based on the prices in the moment when the loss occurred, limiting the potential for inflation effects to accumulate over time," the report says. "Capping of total losses by policy limits and automated indexing would also help to lower the exposure of these lines to inflation."

The Swiss Re report suggests that claims inflation is likely to result in further hardening of property-casualty rates. "After 2 years of strong gains, we expect additional inflation to exacerbate the uptrend in premium rates in many commercial and personal lines, to catch up with rising loss costs," the report says.

The hardening should be particularly pronounced in commercial property-casualty insurance in advanced markets, Swiss Re says.

Gallagher Re's report similarly suggests that inflation will likely have an impact on all major classes of property-casualty insurance. In addition, ongoing social inflation will exacerbate economic inflation's impact, according to the intermediary.

Gallagher Re's report suggests several areas insurers should consider to mitigate inflation risks.

• Reserve risk
• Attachment points and deductibles on underlying insurance policies
• Attachment points on reinsurance treaties
• Reduced spending through structured solutions on shorter-tail treaties
• Understanding their portfolios

Gallagher Re notes that for insurers, lower reinsurance attachment points will provide greater protection from inflation, but there are a number of additional factors to consider. Meanwhile, retrospective covers could provide protection against reserve deterioration.

In addition, Gallagher Re recommends that insurers clearly communicate to reinsurers about how they are addressing inflation risk in their original portfolios.