Escalating inflation adds another layer atop rising losses

The year-end loss reserving season was a bit different this year for Chris Gross, CEO of Gross Consulting. For the first time in a decade, he added an explicit adjustment to reserve estimates to reflect higher inflation expectations. Although the adjustment is subjective, he said, it will help prepare his clients for the future. At the very least, he offered, reserving actuaries should acknowledge the changing inflation environment in their actuarial reports.

From loss reserving to pricing and rating, changing inflation trends are having an impact on property-casualty insurance. “Inflation leaves its imprint on practically every aspect of the insurance industry,” said Jeremy P. Pecora, who spearheads the Willis Towers Watson Claim Cost Index.

For property-casualty insurers, soaring inflation is exacerbating already-escalating loss trends. Although economists in early 2022 were optimistic that accelerating inflation would subside by the end of the year, the fallout from recent world events is likely to pressure inflation upwards into 2023. Russia’s war against Ukraine and major COVID-19 lockdowns in China are affecting prices and global supply chains, fanning the flames of inflation and slowing the pace of economic growth in the U.S.

Said James Auden, managing director and P&C sector head for Fitch Ratings’ North American insurance rating group, “For actuaries, previous claims and loss payment experience may be less helpful in projecting future losses going forward in this environment.” Auden added that both economic uncertainty and inflation concerns “are key factors promoting demand for coverage and [the] likelihood that rising premium rates in many lines will continue into 2023.”

An economy in flux

P&C insurance experts began ringing inflation alarm bells about a year ago. While consumers started to tighten their belts in response to rising food and energy costs, insurers were already experiencing rising repair and replacement costs.

When inflation rates are stable and predictable, insurers can easily adjust. During transition periods when inflation shifts dramatically, factoring for inflation is like chasing a moving target. A shift in monthly inflation can be temporary or it could be a sign of more to come.

Inflation began climbing as the U.S. economy quickly recovered from the pandemic-driven recession in 2020 and intensified in 2021, said Robert P. Hartwig, clinical associate professor at the finance department and director of the Center for Risk and Uncertainty Management at the University of South Carolina. The Consumer Price Index (CPI) from 2019 to 2020 rose a barely perceptible 1.4%, but then jumped  to 4.7% in 2021, according to the U.S. Bureau of Labor Statistics (BLS). The development marked the fastest pace of increase in the general price level since the Great Recession of 2008.

From the post-Great Recession period until a year ago, a decade of tepid but predictable U.S. Treasury note and bond returns have challenged insurers’ capacity to bridge the gap between rising losses and collected premium.

The first two months of 2022 ushered in the fastest inflation growth since the early 1980s. Month over month, the CPI rose by 0.8% in February after a 0.6% increase in January, according to the BLS. In March, the CPI rose an additional 1.2%, fueled by the gasoline index, which rose 18.3% in March, along with other increasing energy component indexes. For the 12-month period ending March 2022, the all-items index escalated to 8.5%, marking the largest increase since the period ending December 1981, according to the BLS.

Much of the inflation surge stems from the fallout of the COVID-19 pandemic and associated lockdowns that began in March 2020. Hartwig said that the $5.7 trillion in relief and stimulus dollars, supply chain disruptions, labor shortages and energy market disruptions are all contributing factors. The Federal Reserve Board’s recent rate hike — with many more expected to come — represents the Fed’s primary response tool for combating rising prices, he added.

From the post-Great Recession period until a year ago, a decade of tepid but predictable U.S. Treasury note and bond returns have challenged insurers’ capacity to bridge the gap between rising losses and collected premium.

Anticipating the impact of future inflation is tough. Past high inflationary periods took place in different economic circumstances. For example, high unemployment and double-digit inflation defined a decade of misery from 1974 to 1983, Hartwig said. However, U.S. Treasury yields — pushed into the double digits by actual and anticipated inflation — allowed insurers to materially increase investment income. During the 1990s, the CPI hovered around 5% and was steady.

Globalization and the offshoring of production during the past 40 years resulted in increased efficiency. At the same time, U.S. dependence on other countries for raw materials and production capacity increased. Supply chains were stretched thin, assuring that major disruptions outside the United States would produce ripple effects on the U.S. economy. The Russian attack on Ukraine and renewed lockdowns in China are two recent examples; both have been pressuring prices in the U.S. by disrupting supplies of oil, grain, fertilizer and other materials that are necessary for everything from growing food to manufacturing semiconductors. The looming potential for World War III makes investors more nervous.

Such conditions make it more difficult to anticipate future inflation. Earlier this year, insurance economists were assuming that reinvigorated supply chains, higher interest rates and low unemployment rates would pressure inflation downward in the second half of 2022.

But that is changing.

Fitch revised its inflation estimate. Instead of inflation falling to 2.6% at the end of 2022, the rating company is now forecasting that inflation will decelerate to 4.5% by year’s end, eventually declining to 2.6% in 2023, according to the organization’s “Global Economic Outlook — March 2022.” The report noted that the forecast adjustment is due to “faster Fed rate hikes than anticipated, tighter financial conditions and the drag on real incomes from rising inflation,”  and the likelihood of less fiscal support than assumed in its December report.

Hartwig continues to readjust inflation as more information becomes available. In mid-February, before Russia’s invasion of Ukraine, he estimated that the annual inflation rate for 2022 would run about 5.5%. Today, that estimate is up sharply at 7.5%. Even before 2022’s inflationary surge, the insurance industry was already paying more for some specific vital goods and services, he said.

Rather than boost interest rates by 50 basis points in March as initially anticipated, the Fed prescribed a lower increase of 25 basis points with promises of six more rate hikes. The Fed anticipates that fighting inflation is becoming more complex, marking the first interest rate increase since 2018.

Growing Losses

Citing BLS data, Hartwig noted that from January 2020 to January 2022, the cost of new and used vehicles surged by 54.6%, putting significant pressure on the CPI. Auto manufacturer supply chain issues are expected to linger well into 2022. Personal auto insurance premiums, he said, which make up 1.57% of the CPI, are expected to rise by 3.5% to 5% in 2022 (see sidebar, “Auto — Personal and Commercial”). Property insurance costs have also risen significantly (see sidebar, “Property Coverage — Homeowners and Commercial”).

From 2015 to 2020, eight P&C lines measured by the Willis Towers Watson Claim Cost Index were above the CPI. The index, which Pecora said is frequently used in reserving analyses to adjust losses to present value, can be used as an indicator of the rate of change in claim severity. The index is based on several sources, including the CPI and producer price index (PPI), to reflect “insurance inflation.”

General inflation adds a layer of about 1.25% to 1.50% to insurance inflation, Pecora said. The index’s composite insurance inflation rate has been outpacing the overall inflation rate for each year from 2013 to 2021 (preliminary), excluding 2018.

This is where inflation comes into play as part of the actuary’s assessment of future average costs of claims; even if inflation is low, the average cost of claims generally goes up.