Articles - Inflation risks as changeable as the British weather

When the clock hands on Big Ben ushered in 2021, it was under a dark cloud of post-covid recessionary risk. By the time schools broke for the summer, those recessionary clouds had broken. Gloomy economic forecasts had given way to much brighter and sunnier expectations. And now, as we head toward December’s festivities, with temperatures falling and frost forming, we find that inflation thermometer rising faster than anyone, economists and central bankers included, expected.

 By Ed Harrison Senior Consultant at Lane Clark & Peacock

 Inflation is by no means a new risk to insurers, but with the forecasts changing as fast as the British weather, insurers need good risk management processes in place to help pick their inflation sunblock or umbrella!

 Managing inflation in a joined-up way
 Whether it be pricing, reserving, capital modelling, risk or investment, the key business functions at most insurers have existing processes in place to consider inflation risk. However, these processes are sometimes developed by each department in isolation. The end result can be a siloed approach to managing inflation, where each department’s approach meets its own needs, but the overall picture presented to the board appears muddled and incomplete.

 A much better approach is to have centrally-coordinated response to inflation risk, taking into account views from across the business and applying inflation assumptions/mitigations consistently in each area.

 This observation isn’t new, but developing a joined-up approach to managing any business risk (inflation or otherwise) can be surprisingly challenging. From the perspective of inflation, this article considers some of the key changes that can help with developing a firm-wide inflation management process.

 Reserving – putting a number on the best estimate
 From a reserving perspective, inflation can be a tough nut to crack because traditional reserving techniques, such as the standard chain ladder, capture inflation only implicitly. This means that loss ratios and reserves can be estimated without the reserving team having to form a clear view of underlying inflation on the various classes of business.

 The most common way of providing quantitative analysis of inflation as part of the reserving process is via “what-if” inflation scenarios or sensitivity tests that superimpose an additional future inflation allowance on top of what’s implied by the chain ladder. Although this approach is useful, it does still leave the business without a clear view of what the core reserving inflation assumptions are.

 A better approach may be to adopt methodologies that use explicit inflation assumptions, for example the inflation-adjusted chain ladder. If there isn’t appetite for this, then a good intermediate step is to at least “put a number on” the implicit inflation assumptions that form part of the reserving process. This could be via analysis of the data to which these models are fitted, or by looking at other relevant data such as price indices over recent history.

 Capital – highlighting the downside risks
 Capital models commonly use ESGs (economic scenario generators) to provide inflation stresses to earned reserves and unearned business. The recent Lloyd’s thematic review highlights some of the limitations of this approach. These are particularly applicable on business classes which have specific inflation drivers beyond baseline price inflation as measured by RPI or CPI, for example US casualty or UK motor insurance.

 To accurately model adverse inflation risks on classes with specific drivers, the “underlying” price inflation and the class specific “excess” inflation are best modelled separately. For example, on US casualty, in addition to using the ESG to stress price inflation, a second stochastic driver may be needed to properly allow for social inflation.

 Risk team – the holistic view
 Overall responsibility for coordinating and embedding a holistic view of inflation risk logically sits with the risk function, because of its role in monitoring business-wide risks and drawing together analysis from across different departments.

 A key first step is for risk teams to ensure inflation risk is on the radar. Often, inflation risk is embedded into monitoring KPIs for underwriting, reserving, and investment risk. A “quick win” for risk teams is to capture inflation risk on a standalone basis as part of regular risk monitoring and reporting.

 A good risk team will support the day-to-day monitoring with two key activities:
 1) Articulating how inflation risks could impact the business over the planning period.
 2) Horizon scanning for new inflation risks to incorporate into modelling.

 Both of these activities can be built into a firm’s ORSA process. A good ORSA should incorporate stress/scenarios that illustrate how inflation could affect the business plan over the full time horizon, considering its impact on all aspects of the business. The same report can provide a qualitative overlay of future inflation risks.

 Finally, best practice will also include managing inflation as part of an ERM process. For example, although there may be significant risks to reserves associated with inflation, these might already partially offset by the way the existing investment portfolio responds to inflation. Modelling undertaken by the actuarial, investment and risk teams jointly may also identify whether there are capital efficiencies to be gained from further inflation hedging the investment portfolio.

 In summary…
 Inflation isn’t new, but the risk it poses to insurers is higher now than it has been at any time in the past decade. With inflation risk on the increase, it’s more important than ever to have a clear view on inflation at board level, supported by rigorous analysis within the business and a plan for managing the risk going forward.

 Firms who successfully embed a coordinated approach to managing inflation risk will be best placed to confidently write business in classes with more uncertain inflation or a higher than usual inflation risk. Firms who do not do this risk seeing inflation rain on their parade.

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