Report: The effects of inflation on insurance companies

Besides the glitches in global supply chains, the post-pandemic world has been facing a surge in energy prices following the resumption of economic activities. Such a situation has been compounded by the geopolitical scenarios triggered by the war between Russia and Ukraine, which is fuelling inflationary pressure worldwide. Moody’s has produced an analysis detailing how the current situation may impact insurance companies within EMEA. US insurers would do well to take heed. ,The rating agency has remained neutral on the creditworthiness of the insurance companies operating in the Mediterranean and in the Middle East, and believes that, although inflation may increase damage claims, the insurance sector will be fully able to offset such a trend, by increasing premiums and benefiting from improved investment yields such as an increase in interest rates.

A HIKE IN PRICES

In its report, Moody’s “considers a downward scenario of a high and prolonged inflation” as the main risk for insurance companies. “Such an event would increase credits more than usual, that would require prices to be raised. The insurance sector may not be able to sustain such pressure and profits may be curtailed”. Stubbornly high inflation might also slowdown economic growth and consequently the demand for insurance policies. According to Moody’s, if this leads to significant growth in the interest rates and a high market volatility, insurance companies may also experience a dent in capital and profit.

Within the main scenario Moody’s has envisioned, “non-life insurers would be able to offset the majority of the increases in accident-related expenditures by increasing prices and limiting the decline in their insurance-related performance”. At the same time, the report states that “the increase in rates would support the returns on investments, providing further compensation”. There would be no immediate upturn in the returns on investments for life insurance companies, as their assets have longer expiry dates, but inflation, according to the rating agency, does not have a significant impact on their credits. However, the increase in rates is beneficial to the economic capital of all insurance companies, especially life insurance firms, as the latter’s Solvency II assets requirements are affected by the variations in said rates.

A SHORTFALL IN DAMAGE-RELATED PROFITS

Significant and long-lasting inflation may lead to further increases in the field of damage loss. Such a trend is shooting upward due to frequently extreme weather conditions.

According to Moody’s, non-life insurers active in retail “may not be able to sustain price increases” to offset such trends, as the companies must usually contend with competition. On the other hand, those operating in the commercial milieu would have more opportunities to increase prices due to new business, but would also experience “more significant pressure to augment their reserves, in the face of outstanding accidents from the previous year, as inflation is fuelled by litigations and medical expenditure”.

At any rate, although non-life insurers active in the commercial field can still benefit from increased premiums, the climb in the prices for commercial non-life insurers is slowing down. Therefore, writes Moody’s, “it is possible that significant and lasting inflation, connected with the cost of accidents, may put a dent in profits over time”.

As a matter of fact, in the midst of a significant and enduring inflation, such insurance companies may be forced to amass further reserves, in order to deal with past accidents. In some sectors, as is the case with medical malpractice, many years may elapse between the submission of a claim and the moment the insurance companies must disburse payment or even prior to being informed of the loss. Therefore, according to Moody’s, such insurance companies should perform an estimate of possible accidents, while increasing their budget reserves. Since both medical and litigation expenditures are heavily affected by price hikes, even some incremental inflation can have an adverse effect on the damage reserves insurance companies can draw from. According to Moody’s, non-life insurers “currently hold prudent reserves, which have been developing favourably for over a decade. Therefore, most of them bank on reserves to absorb a certain inflationary impact. To conclude, in an extreme scenario, a marked and lasting inflation may have a negative impact on profits and possibly on equity”.

THE LIKELY FALLOUT

During an inflationary period, economic downturn or recession, many forms of insurance may experience a slump. “The risk of a sudden surge in interest rates may likewise go up”, another quote from Moody’s, together with the warning that “unlike more gradual climbs, such a development would be negative for insurance companies, as it would lead to a swift devaluation of their bond portfolios, affecting their capital and financial leverage metrics. A combination of slow economic growth, high inflation and rapidly climbing rates may also trigger a significant volatility within the financial markets, damaging both the return on investments and economic capital for insurance companies”. Although the rating agency has revised the initial growth estimates downwards, it forecasts “constant economic expansion for the EMEA region”. The report by Moody’s states that “We predict that the GDP of the Euro area will grow by 2.8% in 2022, slowing down to 2.2% in 2023, while remaining above the pre-pandemic levels”.

SUDDEN SURGES IN RATES MAY HAMPER CREDIT

Within a scenario of a high and prolonged inflation, there is an increased risk that central banks may opt to raise interest rates rapidly. Regardless of its speed, the growth in interest rates is, on one hand, positive when return on investment is concerned, while increasing the economic capital of an insurance company on the other, thus reducing the current value of future liabilities.

However, Moody’s report notes, “a sudden climb in interest rates, unlike a more gradual increase, may indirectly lead to a reduction in profits, to a worsening of “assets invested by insurance companies, even perhaps to an impact on their Solvency II coefficients”. Rising interest rates can gradually increase the return on investments for insurance companies, in line with the duration of their assets and liabilities. Furthermore, rising rates would entail an immediate reduction in the value of bonds, an important asset class for insurance companies.

A CAUTIONARY TALE

According to Moody’s, life insurance companies may incur further risks, as a swift increase may have the clients forgo their savings policies in favour of more profitable alternatives. “Higher redemption rates would increase the liquidity needs for insurance companies and may leave some players with no other option but sell their bonds at their new, lower value, in order to give capital back to their clients”. Although a decrease in bond value does not affect assets, provided an insurance company holds onto them until their expiry date, selling them at a loss prior to such date may very well have a negative impact. Moody’s has highlighted that life insurance companies are most vulnerable to such scenarios “as a substantial share of their portfolios consists of savings. A part of such products features no redemption penalties or has very low ones, if any”.