Inflation Risk in Casualty Pricing
The typical approach to pricing a contract or policy is to calculate the required premium to cover all the expected cost components. In this article, we discuss how claims inflation should be considered within the two main premium components, the expected claims cost and the cost of capital.
Expected claims cost
If we consider a burning cost approach to estimating the claims cost component of the premium, the underwriter will use the observed historical claims experience to price the business. The historical experience will need to be 'on-levelled' to allow for trends in claims frequency and severity.
The past inflation rate should be the actual observed general inflation rate, plus an allowance for superimposed inflation (SII). It is common practice to make a constant SII assumption, whereas it is generally accepted that SII comes in cycles. Although past SII is theoretically observable from the data, estimation is notoriously difficult, due to the 'noise' of random fluctuation in claims experience.
It is difficult to know where one 'is' in the SII cycle. Even if legal changes are designed to reduce claims costs, there may be a honeymoon period of lower SII, only to be followed by a renewed bout of claims inflation if claimants and plaintiff lawyers challenge the new regulations.
In addition to the cost of settling the claim, the insurance company will incur direct claims handling expenses which are also subject to inflationary pressure from wages growth which tend to increase with gross domestic product growth. Inflation is a macro-economic phenomenon, and the results for some lines of business are correlated with the general state of the economy (e.g. credit insurance).
Cost of capital
Suppose that the claims cost component of the premium allows for anticipated inflation only, and that unanticipated inflation is to be allowed for in the cost of capital. Regulatory and rating agency capital may or may not incorporate inflation risk, depending on the jurisdiction.
The peak risks for a casualty insurer will likely include claims inflation. When modeling the claims inflation peak risk to determine economic capital, a key assumption is whether central banks worldwide will maintain their long term inflation targets. Alternatively, the insurer may need to form a view as to the central bank's commitment to rein in any unanticipated spike in inflation.
If stable low long term inflation can be assumed, the appropriate inflation model for the cost of capital calculation is one that assumes a short term spike in inflation lasting one or two years with the inflation reverting to the long term average over the following few years.
Interest rates and credit spreads may also be components of the economic capital requirement calculation, and the question arises whether there should be a model link between interest rates and inflation. It is reasonable to assume that there is a correlation between interest rates and inflation, but there are divergent views on the appropriate linking model, so the insurer might choose to ignore this aspect for simplicity.
Insurance companies receive a fixed premium at early durations but pay an uncertain, inflation impacted, claim payments at later durations. This inflation risk is a challenge for insurance companies to manage.
It is difficult to hedge general inflation satisfactorily, and even more difficult to manage the 'basis risk' between general inflation and insurance claims inflation. Furthermore, inflation tends to be systemic across lines of business and geographical boundaries, and hence difficult to diversify away.
The claims cost should allow for claims inflation at the expected, anticipated level, though care needs to be taken to make sufficient SII allowance when on-levelling the observed claims experience to the current accident year and when projecting it into the future to the expected year of payment. The cost of capital calculation can make allowance for the unexpected, unanticipated level of claims inflation. The systemic nature of inflation risk means that an unexpected surge in claims inflation will also hurt competitors. This will tend to lead to a hardening of premium rates, allowing the insurance industry as a whole to recoup its losses.
Published February 2011
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