Inflation – friend or foe?
Amid the roll-out of mass vaccination in key markets, inflation concern has flared up since early 2021 alongside more signs of a global economic recovery. Reflecting this, 10Y US treasury yield has gone up to 1.75% at the end the first quarter from 0.912% at the end of 2020, although by the end of May this had retreated to around 1.60%. Implied inflation rate in the US (10-Year) has edged steadily higher in the months of 2020 (see Figure 1). Such concern is not limited to the US but has also been observed in other markets. As of 25 May 2021, there have been 19 rates hikes recorded globally (albeit predominantly in Eastern Europe and Central Asia), compared to a total of nine hikes for the whole of 2020. In the near-term, cyclical drivers of higher inflation include a low-base effect, on-going supply chain disruptions (think Ever Given), rising commodity and energy prices, and recovering job markets supporting private consumption, and an expectation of continuous large public spending including an impending US infrastructure boom. The earlier tweak to the US Federal Reserve’s policy framework could also signal higher inflation appetite of central banks. In summary, despite lingering burdens of a pandemic and uneven global recovery, it is now that expected short-term inflation will likely continue to trend upward.
Figure 1: 10-Year US breakeven inflation rate, %
Are we entering a period of persistently higher inflation?
Beyond cyclical rise in inflation, the outlook for long term inflation remains highly uncertain. In order to cushion the blow from COVID-19, central banks around the world took steps to lower interest rates and injected liquidity through another round of quantitative easing (so-called “QE 2.0”), thus inducing fears of inflation. However, earlier experience with “QE 1.0” in the aftermath of the 2009 Global Financial Crisis (GFC) had suggested something more benign. Global inflation has averaged 3.5% in the decade after the GFC, lower than the average of 4.6% recorded in the preceding decade between 1999 and 2008.
The idea that quantitative easing will inevitably lead to higher price pressure needs to be placed in the right context. The substitution of central bank money for other assets/debts works like an asset swap which will not necessarily inject additional liquidity into the economy. The transmission mechanism, through portfolio rebalancing, is inflationary to the extent that loans and funds start to shift from ultra-conservative assets into riskier assets. Empirical evidence shows this has been partly played out in the aftermath of GFC, but only to the extent of helping to counter the deflationary impact of the financial crisis.
Figure 2: Increase in money supply M2, in %
Source: CEIC, Peak Re.
This does not mean inflation is not a threat, either. There are some salient features of the current economic conditions that differ from the period of GFC, and could warrant heightened attention to the risk of higher inflation.
- The decade that came after the GFC was characterised by increasing globalisation, rising exports from China (and other emerging markets), lower oil prices, and other structural changes that are generally deflationary. On the other hand, the current market environment is characterised by de-globalisation, supply-chain disruptions and rising commodity/oil prices. In other words, more money is chasing fewer output this time.
- QE 2.0 has resulted in sharply higher growth of money supply M2 in the US (see Figure 2) now than in GFC, which means that additional liquidity is getting into the real economy, rather than largely staying within the financial sector. While the situation in Europe is less pronounced, it is on the same track. This reflects in part the different objectives of QE 1.0 and QE 2.0. During the GFC, the prime objective was to stabilise the financial sector and avoid a liquidity crunch from transcending into economic disasters. QE 2.0 on the other hand is mainly aimed at supporting demand for goods and services. Meanwhile, M2 increased rather stably in China, hinting at a different inflation outlook compared to the US and Europe.
- Inflation’s impact on the real value of debt is a strong incentive for policymakers to tolerate higher inflation going forward, now more relevant than a decade ago. As reported by the World Economic Forum, falling government revenues coupled with costly pandemic relief packages have resulted in an additional USD20 trillion of global debt, between the third quarter of 2019 and end 2020. The global debt-to-GDP ratio is estimated at a whopping 365% at the end of last year.
- Furthermore, the focus on infrastructure investment in the post-COVID-19 recovery could add to inflationary pressure. The US has set out spending significantly to revitalise America’s roads and bridges. At the same time, the G7 Group of advanced markets has endorsed a plan to set up an alternative to China’s Belt and Road Initiative. This new investment in infrastructure could potentially give rise to additional inflationary pressure.
While Asia, emerging Asia in particular, has been able to retain a sanguine growth outlook despite the pandemic, the risk of inflation is also high in this part of the world. Indeed, even before the onslaught of COVID-19, central banks in the region had tinkered with interest rate hikes as inflation risk loomed. To begin with, emerging markets have historically higher and more volatile inflation, partly reflecting less sophisticated central bank policy regimes, including a lack of an inflation-targeting frameworks. Many Asian emerging markets are also highly dependent on trade to support economic growth, which renders tightening monetary conditions to combat inflation (thus reducing external price competitiveness when their currencies appreciate) less palatable. On the other hand, large exchange rate depreciation could raise the risk of higher imported inflation. At the same time, inflation in emerging Asia is more vulnerable to shocks from volatile food and energy prices due to higher weights for these items in the consumer price index (CPI) baskets.
Impacts of inflation on insurance
Insurance practitioners are concerned about the impact of higher inflation on their business operations and financial results. Inflation as used by economists generally refers to CPI inflation, which contributes to overall claims inflation. Other socio-economic factors also contribute to claims inflation, for example changes in liability regimes. CPI inflation can also impact on other operating costs of insurers. Meanwhile, the impact of inflation on investment and solvency capital will depend on how fast market interest rates are aligned to higher inflation.
Claims inflation: change in the expected claims cost level of a like-for-like policy in an economy over time. It is measured by comparing the change in expected claims costs of insurance contracts over time.
Claim cost inflation: interchangeable with claims inflation
Claims severity: the monetary loss of an insurance claim
Claims escalation: total increase in claims costs per unit exposure
Claims frequency: rate or distribution of the number of claims within a given period of time
Social inflation: increases in claims inflation beyond those captured by CPI inflation, and could arise due to changes in law, regulation, moral standards etc. Technological advancements (e.g. advanced medical treatments) could also contribute to more costly claims.
Super-imposed inflation: interchangeable with social inflation
A. Operational cost (expense ratio)
Generally higher CPI inflation translates into higher wages and other operational expenses thus pushing up the expense ratio of insurers, particularly when premiums are not indexed to inflation or adjusted frequently.
B. Claims (loss/payout ratio)
Higher inflation typically will lead to higher P&C claims. The impact to primary insurers will come through both in terms of higher severity (e.g. medical cost inflation) and higher frequency (e.g. more claims burning through deductibles). Insurers can compensate by revising the price of their products, but typically after a time lag. The adjustment can be faster for short-tail non-life business that is renewed on an annual base, for instance.
The impact on fixed-benefit life insurance products like term life or critical illness (CI) insurance will largely be neutral, as payouts are defined at the inception of policies. Indemnity-type medical policies will be similarly affected as P&C products, but multi-year policies will be difficult to re-price swiftly.
C. Reserves and solvency
Rising (and unexpected) inflation implies higher cost of future claims, which could increase the risk of insufficient reserve (adverse loss development) for business from earlier underwriting years. Over time, higher claim payments and the need to strengthen reserve could dent insurers’ profitability. Meanwhile, investment income should improve if interest rates increase alongside higher inflation.
On a fully economic-based balance sheet and with no duration mismatch, the impact of rising inflation/interest rates will be neutral. Some accounting regime that requires mark-to-market of assets but not (fully) for liabilities could result in lower net worth from higher interest rates.
D. Value of insurance
Non-life insurance based on a fixed sum assured, particularly those priced on original acquisition cost, may not be sufficient to fully replace damaged property due to inflation. It remains the case that replacement value should fully reflect expected inflation to preserve the value of insurance.
In regard to life insurance, rising inflation tends to erode the value of benefits for long-term and fixed benefit policies like term life and CI insurance, thus reducing their value and attractiveness. It could discourage take-up of new policies if benefits (and guarantee returns, if included) are not increased to restore the real value of policy after inflation adjustment. Higher lapse and surrender could result if policyholders choose to switch out of existing policies to take up new ones with higher sum assured.
E. Investment returns
Over a short period of time, some asset classes are noted for their returns’ positive correlation with CPI inflation, for example, bills, TIPS (Treasury Inflation-Protection Securities) and real estate investment. Long-term bonds and equity generally fare less favourably in times of high inflation.
The longer term response of different asset classes to inflation is harder to assess. For instance, while equity reacts negatively to inflation and higher interest rates, stocks can outperform when corporate assets and earnings increase along with inflation. Nevertheless, given insurers’ preference for fixed income instruments, they should be able to benefit from higher interest rates over the long term.
For non-life insurance, higher inflation will likely result in higher combined ratio compensated by improving investment returns. The impact on life insurance will be harder to discern, with higher expenses offset by the extent the insurer is exposed to negative spread. Empirical evidence tends to suggest, based on data in the 1970s, an increase in inflation coincides with subsequent drops in underwriting profit, and dis-inflation coincides with improvements in underwriting profits. Performance in more recent periods is not discernible.
Most of the above also applies to reinsurers though the impact of ground-up inflation on reinsurance could be bigger due to the leveraging effect of excess of loss layers. As a result, it may happen that reinsurers’ appetite for quota share will increase during period of rising inflation, while capacity for excess of loss will decline.
Preparing for inflation
With inflation having a potentially tangible impact on all parts of insurance operation, insurers could conduct frequent scenario and stress tests to understand their vulnerability and sensitivity to changes in inflation and interest rates. There are options available in re-underwriting insurance and investment portfolio that could mitigate the impact of inflation.
A. Shorten the tails
Shortening the duration of investible assets and adopting “inflation immunised investment portfolio” can help to lower the price sensitivity of an investment portfolio to rising interest rates. Similarly, the longer the duration of insurance liabilities (e.g. some workers’ compensation policies), the more exposed insurers are to rising inflation. As such, efforts to shorten liability duration and adjust rates and premiums frequently could help.
B. Indexing to inflation
Insurance premiums (or sums insured in property insurance) that are indexed to CPI inflation and/or wages, depending on the business lines, could shield a portfolio from higher claims due to inflation. For example, liability businesses related to workers’ compensation can be linked to wages instead of CPI inflation. Policy deductibles could be made variable rather than fixed, and inflation adjusted; similarly reinsurers could opt to index retention level to inflation to manage frequency risks. Finally, having a cap for policies that index benefits for inflation to limit exposure during hyperinflation could also be a prudent policy.
C. Portfolio adjustment and terms and conditions
Some investors have taken the option to over-weight assets that historically perform well in high inflation, for example short-term bills, TIPS-like instruments, real estates and infrastructure. Real estate and infrastructure usually have inflation-linked revenues thus making them more resilient against rising inflation. In comparison, equity and Treasury are more likely to underperform (in the short-term at least) in a high-inflation scenario.
For life insurance product pricing, using real interest rates rather than nominal interest rates for guarantees could help to retain the value of future payout to policyholders. This could help to maintain the attractiveness of products and limit lapse and surrender. For indemnity-type products, implementing premium revisions quickly alongside inflation could help to mitigate negative impacts.
Primary insurers could make use of reinsurance to mitigate inflation risk through either proportional quota share (where both severity and frequency risks are shared with reinsurers) or non-proportional excess of loss treaties (where the reinsurer will face higher frequency risks). As a result of the leveraging effect of inflation, reinsurers underwriting excess of loss contracts (with fixed deductibles like umbrella, excess liability, and non-prop reinsurance) could see claims increase in multiples of underlying (CPI) inflation.
While most analysts would concur to the projection of a short-term spike in consumer price inflation, the outlook for medium- and long-term inflation remains a matter of conjecture. However, it is prudent for market practitioners to have a clear picture of the potential impact of inflation on their financial performance, and prepare actions in advance. Adjustments in product designs, portfolio compositions, terms and conditions, and investment strategies could be considered to mitigate and manage future inflation risks. With higher inflation, risks could burn through reinsurance retention more quickly. In consideration of such an outcome, insurers can consider to engage their reinsurers in discussion about a suitable structure that works equitably to manage inflation risk.
To the extent that higher inflation reflects improving
economic growth and confidence, it will help to bolster underlying demand for
insurance, both P&C and life & health. The fading of “lower for longer”
interest rates will also breathe new air into insurance investment.
Furthermore, it will help to alleviate the issue of “financial repression”,
where low interest rates disadvantage people who rely on savings, like
pensioners, and distort resource allocation in favour of government (or government-designated)
 “Inflation” in this article refers to price changes as measured by Consumer Price Index (CPI). This typically measures changes in price levels of a basket of commodities and services over a period of time. Statistical authorities may adjust CPI for quality improvements (for example a computer sold at a stable price but packed with more functions and capacity). CPI inflation is only one factor driving insurance claims inflation – these other factors like litigation costs are not typically what economists call “inflation”.
 The breakeven inflation rate measures what market participants expect inflation to be in the next 10 years, on average. The measure is derived from 10Y US Treasury Constant Maturity Security and 10Y Treasury Inflation-Indexed Constant Maturity Security.
 “Higher inflation” in this paper refers to accelerating rate of increase in inflation indexes, over a period of several years.
 See for example Valentin Jouvanceau, “The Portfolio Rebalancing Channel of Quantitative Easing”, Working Paper 1625, July 2016, GATE Lyon Saint-Etienne. Giovanna Bua, Peter G. Dunne, “The Portfolio Rebalancing Effect of the ECD’s Asset Purchase Programme”, International Journal of Central Banking, December 2019.
 See “This chart shows how debt-to-GDP is rising around the world”, The World Economic Forum, 14 December 2020.
 It is yet to be established whether inflation is uniform for claims of different size. It is possible that larger claims, with a higher proportion of medical/rehabilitation cost component, for instance, could be more sensitive to inflation.
 It should be noted that if interest rates increase only with a lag to rising inflation, the drag on profitability will be more significant. Furthermore, insurers will be able to benefit from higher interest rates from fixed income investment only when their existing portfolio matures and they get to reinvest.
 TIPS refers to Treasury Inflation-Protected Securities, which are indexed to inflation in order to protect investors from a decline in purchasing power due to higher inflation.
 Rising inflation, if accompanied by higher interest rates, could help to alleviate the negative spread problem of legacy life policies that came with high guaranteed rates. This will be significant in reducing the stress of some insurers that have policies written in prior years with high guarantees, particularly in Japan and Europe.
 See The impact of inflation on insurers, sigma no.4/2010, Swiss Re.