November 19th, 2009

Inflation: Not All Bad News for European (Re)Insurers

Posted at 1:00 AM ET

carrington_george_bioGeorge Carrington, Head of International Casualty Specialty Practice

Inflation is always a major risk factor for the casualty industry. For the past seven years, monetary inflation has been low across most of Europe, and this has helped keep interest rates low. For casualty insurers, this can lead to a challenge, because the key cost-drivers of long-tail liability claims — salaries and wages, pensions and most notably medical care costs — have been growing much faster than monetary inflation.

Low interest rates mean low discount factors for lump-sum third-party claims payments and low investment returns on premium and loss reserves. Inflation rates applicable to the key casualty claims cost-drivers have outpaced monetary inflation rates, and this has caused pain to casualty insurers and their reinsurers. Reinsurers in particular have been arguing that the base reference indices used in excess of loss reinsurance contract Index Clauses, usually adjusted on average industrial wages and salaries but sometimes simply adjusted on retail prices, have not kept pace with the true rate of third-party bodily injury claims inflation, which is heavily influenced by “social inflation,” a mixture of social, legal and medical costs inflation.

Now, however, the picture is changing. The monetary inflation rate is expected to accelerate in Europe in the next three to seven years, largely because of “quantitative easing,” the process by which governments have been pumping money into their national economies to provide stability in the near term. The effects of this widespread fiscal and monetary strategy are expected to stave off economic depression in the short term but create underlying weaknesses that will push monetary inflation higher in the medium term. Interest rates will then have to rise to bring monetary inflation back under control.

A rise in interest rates, of course, will enable long-tail (re)insurers to enjoy greater cash flow benefits. The effect of this will be not only to increase investment returns on premium and loss reserves but, importantly, to narrow the gap between monetary inflation and social inflation. Index Clauses in reinsurance treaties will be triggered more quickly, allowing reinsurers to adjust their deductibles and build back the claims buffer that has been almost without value to them in recent years.

As austerity measures in a number of countries take hold, the key base index of wages and salaries is unlikely to rise in the short term, but we may expect a bounce-back in the medium term that will be accompanied by an increase in monetary inflation.

The signs suggesting a rise in monetary inflation are grounded in the fact that the fiscal and monetary discipline of Europe’s largest economies - such as France, Germany and the United Kingdom - could be compromised by quantitative easing - as well as by the actions of the continent’s weaker economies. All of this is evident in the difference between spreads on government bonds and spreads on inflation-linked government bonds. Implied forward inflation rates show mid-single-digit inflation beginning in roughly the next three years and increasing throughout the decade to follow.

Given sufficient time, thanks to the use of Index Clauses and higher interest rates to offset inflationary factors, the prospect of inflation becomes considerably less daunting. The rate of social inflation, for which there is no available market index and which cannot be mitigated to the same extent as monetary inflation because of the unpredictable advance of legislation and healthcare-related technological developments, will no longer be so markedly out of sync with monetary inflation. Consequently, the loading factors applied by reinsurers to account for social inflation should be reduced.

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