Market Trends

Reputational Risk Management: An essential component of an ERM program

The breakout session devoted to managing reputational risk during the 50th IIS Seminar in London on June 23, 2014 drew a significant number of participants, as all the chairs around the table were occupied. It is a clear indication that the topic has gained momentum at a time when all insurance regulators are devoting more attention to the issue, in parallel with Europe Solvency 2, which calls for direct supervision of the management of risk to reputation at the board level.

Because reputation is the reflection of the trust and confidence of all stakeholders, it is essential for the insurers who promise a future contingent service in exchange for an immediate payment, to maintain a high level of trust. It may even be the only business when the industry might be confronted with a systematic risk as the downfall of one insurer could hinder the trust of the public on the whole industry. For example, while AIG’s recent troubles were not related to its insurance business the fact that it insured so many businesses sent ripples across the business insurance sector and may even serve to increase the flow of commercial dollars to insurance alternatives.

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Market Trends

Inflation and Insurance

Oct 03.2011 |

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Because of the long term nature of insurance contracts, pricing, reserving and investment policy are very sensitive to inflation trends and experience. We are currently living in a low and relatively stable inflation environment. The industry is generally able to adapt to inflation changes that occur in gradual cycles with limited peaks and valleys. It is the sudden movements that create the problems. Although the industry has survived through rapid movements and extremes in the past, most of the current generation of insurance people do not have experience with operating under high inflation conditions. As we anticipate an eventual economic recovery, we should expect a return of higher inflation rates. Depending on the progress of recovery, and government stimulus actions, we need to be prepared for a range of higher inflationary scenarios.


Because of the long term nature of insurance contracts, pricing, reserving and investment policy are very sensitive to inflation trends and experience.  We are currently living in a low and relatively stable inflation environment.  The industry is generally able to adapt to inflation changes that occur in gradual cycles with limited peaks and valleys.  It is the sudden movements that create the problems.  Although the industry has survived through rapid movements and extremes in the past, most of the current generation of insurance people do not have experience with operating under high inflation conditions.  As we anticipate an eventual economic recovery, we should expect a return of higher inflation rates.  Depending on the progress of recovery, and government stimulus actions, we need to be prepared for a range of higher inflationary scenarios.

 

The IIS Toronto Annual Seminar in June 2011 included a session titled:  “The Coming Inflation:  Threat or Opportunity.”  The follow material is drawn in part from the presentations during that session by Kurt Karl, Chief US Economist, Swiss Re; Martin Hegarty, Managing Director and Co-Head of Global Inflation-Linked Portfolios, BlackRock, US; and Todd Solash, SVP and Head of Retirement Services Product Life Cycle Management, AXA Equitable, US.  The panel was moderated by Ramy Tadros, Partner and Head, North American Insurance Practice, Oliver Wyman, US.

 

Inflation Trends

 

Consumer Price Indices are the most commonly cited measures of inflation.   Following relatively low levels (<5%) of US inflation in the post-World War II period, the Vietnam War and other factors helped push inflation higher in the 1960s (4-8%).  The oil crisis of 1974 helped push the rate above 10% and even higher in 1979-80.  Since 1985 the rate has been below 5%.   Other countries have had some very pronounced hyperinflationary conditions.  Insurers can adapt to a wide range of trends but are particularly vulnerable to sudden increases that have, in some instances, effectively wiped out particularly life and pension industries.

 

The early stages of the current global recovery brought concerns about a return of rapidly increasing inflation sparked by massive government stimulus programs.  As the pace of recovery has remained gradual, inflation concerns have diminished, replaced at times by deflation concerns. 

 

So, what drives inflation?  How did we get to where we are?  What do the drivers suggest about the future.  The bursting of a multinational housing bubble, most evident in the U.S., put housing prices in a steep decline from mid-2006.  Despite some turnaround in 2011, no sustained upward trend has yet been established.  Commercial real estate is in a similar position, following the housing trend.  Recovery is expected but the pace of increase remains slow and uncertain.

 

Increased consumer demand can be expected once job growth becomes stronger.  Again, the pace has slackened recently.  Consumer goods producers have continue to await signs of strengthened demand limiting job growth.  There has been some recovery of consumer credit but consumer outlooks remain hesitant.  Oil prices have recovered more than others pushing up inflation rates without much support in other sectors.  Lack of signs that these inflation drivers are poised to increase rapidly suggests that a spike in inflation is not likely in the short term.  Concerns about potential deflation persist but the indicators do not point to a rapid decline either. (See Panel Member Martin Hegerty’s presentation for details on inflation and deflation indicators.)

 

The consensus of the IIS panel was the maintenance of relatively low inflation (2-3%) for some time to come.  Governments seem sensitive to not overdoing economic stimulus efforts and central banks seem keen on moving quickly if inflation begins to rise, but remained mostly concerned about stimulating recovery and resolution of sovereign debt problems.

 

Inflation in Insurance

 

While general CPI measures of inflation impact insurance, it is important to look more particularly at how inflation affects aspects of insurance.

 

Claims Inflation

 

When considering how inflation affects claims, it is important to consider the particular inflation trends affecting claim costs.  Auto insurance claims may include such things as car parts, labor, medical costs and litigation costs.  Some of these are directly affected by price inflation changes.  Some might be considered social inflation cost changes, e.g., court-recognized changes to liability definitions, exposure under existing coverage for newly discovered risks.  Considering particular inflation and social inflation factors, claims inflation can advance more quickly than general inflationary indices.  Panel member Kurt Karl noted that between 1960 and 2008, liability insurance claim costs rose 2-3 times as fast as the prevailing CPI.

 

Impact on Pricing

 

Since insurance pricing provides coverage for future losses and loss settlements,  assumptions of future inflation must be considered.  In periods of relatively low and stable inflation levels, inflation factor requirements in pricing are not difficult to calculate.  The consequences of pricing errors are not large so long as inflation variation stays within a narrow range.  Unanticipated spikes in inflation can leave normal pricing inadequate to meet ultimate claim costs.  Attempts to anticipate spikes can run into resistance from insurance regulators when applied to rates subject to regulatory approval.  In the panel presentations, Kurt Karl noted that long-tail P&C lines are more exposed than short-tail, including general liability, medical malpractice and workers’ compensation.  He also noted the leveraged effect of inflation as increasing both frequency and severity in umbrella, excess liability and non-proportional reinsurance as deductible and layer limits are breeched.  Policy limits and inflation indexes can be used to protect against these effects.

 

Life Insurance Complexities

 

Panel member Todd Solash described the various interactive characteristics of life insurance and how they are affected by inflation trends.  Life insurance combines a long-term contract (30 years and more), dependent on interest rate and other investment trends, with operating cost inflation, benefit and return guarantees, and policyholder retention and benefit choices, driven in part by inflation and interest rate trends.

 

Financial models are used to determine the combined results as alternative assumptions are used for the various factors driving life insurance outcomes, often with non-intuitive results, e.g., product portfolios that benefit from increased lapse experience.

 

What next?

 

With current trends not suggesting big movements up or down it is easy to consider inflation an issue for another day.  There are plenty of more pressing issues to address.  This condition leaves the industry with few who would know an inflation threat in insurance terms if it started to appear.  Thus, the first task is to establish and maintain an early warning system.  Companies need people who are looking at the issue and who understand both what they are seeing and know how to initiate responses.

 

Because of the long term nature of insurance, response to rising inflation must begin before inflation increases are fully established.  This includes not only economic analyses of cost and interest rate trends.  It includes monitoring of social inflation trends of litigation results and regulatory changes that increase exposures.

 

In addition to monitoring, companies need to be prepared to act.  Does the actuarial department know how to translate higher inflationary trends into pricing, reserving and capital management analysis?  Are the regulatory lawyers ready to present the issue to regulators for needed pricing approvals.  It is easier to avoid inflation-based losses and convince others that action is required if a strong fact base is established early in an inflation acceleration scenario.

 

 

Considerations

1. What inflation trends most affect your lines of business?

2. Do you have an effective monitoring system to identify a significant risk of inflation change in time to take corrective action?


3. Do you have the skills and experience in place to cope with inflation change when it comes?

4. What tools are most effective in addressing inflation change?

 

 

Sources


See the IIS website for the inflation panel presentations in the “Seminars” section of the site.

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Economic Crisis

The Impact of the Economic Crisis on the Insurance Industry

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Considerations:

1. How have the economic crisis and aftermath affected insurance lines, e.g., higher claims, decline in sales, growth in sales, new products?

2. How has the experience in financial services affected the direction of insurance regulation? Is insurance regulation affected by mistaken assumptions about industry needs and norms, e,g., excessive restriction on the use of needed hedging facilities?

3. How will the recent experience change risk management practices in the industry?

4. Will problems in the derivatives markets reduce or change the use of capital markets for insurance activities?

5. What new market opportunities are created by the recent crisis?

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