Inflation reservations

Andrew English

Any return to high rates of inflation would be a challenge to writers of long-tail reinsurance business, especially when it comes to reserving. New modelling techniques will help to cope with this uncertainty, says Andrew English of EMB

What difference would a sudden surge in inflation make to reinsurance? Rolf Tolle, until recently Lloyd's franchise director, recently raised the issue and warned against complacency. At a time when some companies are bolstering profits by releasing reserves, he pointed out that a resurfacing of inflation would pose a real reserving challenge to anyone writing long-tail business.

Unexpectedly high inflation of the type last experienced in the UK in the late 1970s and early 1980s can wreak havoc with loss experiences. Although Tolle was talking about reserving, the potential consequences apply equally to pricing and capital modelling, making this a pretty fundamental issue for reinsurers.

It is not, though, the rate of price increases on its own that matters. If you know that inflation is going to be 15% a year, you can factor this assumption into your pricing and reserving. Unpredictability is the main enemy.

Some economists believe that deflation is the main threat while others, like Hank Greenberg and Joe Plumeri speaking in London earlier this year, fear hyperinflation. Furthermore, whereas high inflation is normally offset to a large extent by greater returns from bonds and other investments, this is by no means certain today. How do you reserve or price long-tail business under such uncertain circumstances?

One solution recently introduced to the (re)insurance industry is known as relative entropy, which seeks to measure the value of human judgement and apply it to actuarial models. More on this later but, first, it is important to define inflation. The Retail Prices Index (RPI) is a good illustration of how a commonly accepted measure can be misleading, whether applied to individuals or to (re)insurers. Inflation as measured by RPI may have fallen to close to zero but that is no consolation to the parent whose children's school fees have gone through the roof. Similarly, certain types of claim are more prone to inflation than others and there can be spectacular variations between layers.

Sliding scale

The 2007 International Underwriting Association-Association of British Insurers UK Bodily Injury Awards Study, (IUA_ABI) for example, found that awards had been subject to claims inflation of 6.5% a year over the previous decade - a significant but manageable increase. (The IUA-ABI study found that claims experience overall had risen by 9.5% a year because of an increase in frequency and severity.) Yet for reinsurers above £250,000, the annual percentage was 20% - and more for the biggest claims. In other words, inflation at the higher layers was well above average. This highlights the need to understand how inflation affects your own business, rather than just the market as a whole, and to have detailed understanding of your data and what is driving claims experience.

The current uncertainty about inflation has led to dusting down and updating of ideas considered during the tumultuous 1970s. These essentially involved either adjusting data to remove the effects of known past inflation, or else explicitly modelling and estimating the impact of past and future inflation as part of the modelling process. So far so good, yet how do you make assumptions for future inflation?

In these circumstances, it is often imperative to treat each large claim individually: assess the likely rate of inflation based on the characteristics of the case and do not rely on aggregations or averages. Methodology that implicitly assumes future inflation to be the average of recent past experience could be misleading. Inevitably, management will have to take a view on what they consider most likely and this will influence the distribution of probabilities.

Liability claims will be driven mainly by wage inflation, potentially aggravated by legislative, regulatory and judicial developments; property damage largely by the costs of raw materials and wages; motor by personal injury trends - a complex subject in its own right.

Drawing the line

When it comes to the size of claims, losses may go through some layers regardless of inflation and they will be unaffected by your calculations. Other excess-of-loss layers, by contrast, could change fundamentally. For example, 10% inflation on a £1.1m XL claim that kicks in at £1m will double the loss to the reinsurer - a point that is sometimes overlooked. While many excess-of-loss reinsurance policies will have indexation clauses, any contracts that rely on large aggregate deductibles to place themselves as extreme event covers are most vulnerable to unanticipated inflation.

With this level of uncertainty, there is inevitably a high margin for error. There is also the danger that reinsurers under pressure to declare improved results may fail to exhibit the extra caution that any volatile situation demands; and they may use the reserving process to bolster profits.

It is helpful to use the type of simulation techniques employed in economic scenario generation and capital modelling to quantify the impacts of uncertain future inflation. One valuable new modelling technique is known as relative entropy, a concept familiar to scientists but now receiving wider business attention.

Essentially, it quantifies human judgement (such as the view the board or external economic advisers take on likely inflation trends) and lays it over conventional models. The human element is weighted in order to influence outcomes. This weighting diminishes the further forward you go, reflecting the increased difficulty in forecasting far-future developments. This technique has the valuable quality of allowing human judgement free rein, though in a controlled manner.

Whatever approach reinsurers take to reserving, it is clear that they will need to pay even more attention than usual to claims development, being especially alert to trends that diverge from the expected. When they are in doubt, they should err on the side of caution. Under-reserving, so often the Achilles' heel of our industry, could come back to haunt us.

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