September 10th, 2009

Inflation Threatens Long-Tail (Re)insurance

Posted at 6:01 AM ET

small-lewinDavid Lewin, Managing Director
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Interest rates are low right now, so monetary inflation is not an issue in the short term for the (re)insurance market. Look into the future a bit, however, and you can see how monetary inflation could turn into a threat. In two to five years, the effects of such measures as “quantitative easing” (i.e., a government’s pumping money into a financial system to attain near-term stability) will be visited upon long-tail (re)insurers. Further, other inflationary factors will continue to increase the cost of writing this type of business. Legal inflation, medical inflation, social inflation and emerging risk inflation are poised to drive the cost of underwriting long-tail risks ahead of monetary inflation. Planning for these elevated costs now can make a profound impact on future profitability.

How do we know that higher inflation is on the horizon? Fiscal and monetary discipline in larger economies - such as the United Kingdom, France and Germany — could be compromised by weaker countries and exacerbated by quantitative easing. Further, when you compare nominal spreads on government bonds with those of inflation-linked government bonds, you can see that a substantial increase in all-price inflation is coming within the next five years.

For long-tail (re)insurers, this is problematic … unless they have enough time before claims have to be paid to invest premium and reserves. Instruments that are pegged to inflation can be used to offset the cost of inflation-affected claims. Excess of loss reinsurers can take advantage of index clauses in long-tail excess of loss contracts to secure an additional buffer of protection: the deductible is adjusted upward based on an index reflecting normal monetary inflation (e.g., retail prices or average wages and salaries) in the country where the loss occurs.

But, there are other forms of inflation that may be more difficult to hedge.

Legal inflation results from the impact of legislation and judicial decisions on settlements, judgments and jury award limits. Legislation also may encourage judges to devise new types of award, as is the case with the UK Courts Act 2003, which allows damages for future pecuniary loss in bodily injury cases to be compensated by a Periodic Payment Order (PPO). The net effect is higher claims, which translates to higher costs for carriers.

Changing attitudes and demographic and political developments have also caused a form of inflation. Improved standards of living have pushed peoples’ quality of life expectations upward, making it more expensive to restore a victim to his state immediately prior to the loss occurrence. Economic difficulties in conjunction with an aging population have made it increasingly difficult for governments across Europe to fund pensions and long-term medical care. As a result, they are interested in shifting the burden from state healthcare providers to the private insurance industry. At the same time, medical costs have been surging — at roughly twice the rate of the all-items price index over the last five years.

Rising interest rates over the next two to five years will probably result in monetary inflation, which in itself would make it more expensive for (re)insurers to pay claims. The additional inflationary factors, however, may not grow as fast in the next five years as they have in the past five years. This could narrow the divergence between the base indices typically used in XOL reinsurance contracts and the more specific cost of care indices, which some reinsurers currently argue should replace them. In the long run, a standard monetary inflation base index may not prove to be so wrong after all.

Statements concerning, tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice which we are not authorized to provide.

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