inflation risk and p-c insurance: overview and outlook joint meeting of the underwriting, claims,...
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Inflation Risk andP-C Insurance:
Overview and OutlookJoint Meeting of the Underwriting, Claims,
and Emerging Issues CommitteesReinsurance Association of America
May 18, 2010 Philadelphia, PASteven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief EconomistInsurance Information Institute 110 William Street New York, NY 10038Office: 212.346.5540 Cell: (917) 494-5945 [email protected] www.iii.org
2
Presentation Outline
1. What Causes Inflation?
2. Inflation’s Past and Future
3. Inflation’s Effect on Property-Casualty Insurance Claims
4. P-C Premium Growth and Inflation
5. Underwriting and Inflation
6. Investments and Inflation
7. Inflation, Reserve Adequacy, and Impairment
Q&A
3
What Causes Inflation?
What Makes Prices Increase?
An increase in the prices of the components (e.g., materials and labor) of the things we buy, if the sellers of those things pass along their increased costs to buyers
Scarcity of supply in relation to demand. If there isn’t enough of a good or service to meet demand, the price of that item will tend to rise (and some buyers will drop out, creating a supply/demand equilibrium at a higher price)
Expectations. If sellers expect their costs to rise in the near future, they might raise prices now to avoid being caught. This includes the category of “bubbles.”
What Makes the Prices of Items orComponents from Overseas Rise?
A drop in the value of the U.S. dollar. The price of any component that we buy from overseas could rise for us if the U.S. dollar’s value drops in relation to the value of the seller’s currency. In effect, it takes more U.S. money to convert to the same price in foreign currency.
70
75
80
85
90
95
100
105
110
115
Jan00
Jan01
Jan02
Jan03
Jan04
Jan05
Jan06
Jan07
Jan08
Jan09
Jan10
Trade-Index-Weighted US Dollar Exchange Rate*
*The broad index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. Sources: US Federal Reserve, Board of Governors, at http://www.federalreserve.gov/releases/g5/current/ ; Insurance Information Institute.
Except in Times of Global Financial Crisis,The U.S. Dollar Has Weakened vs. Other Currencies
January 2000 through April 2010
Depreciation of dollar after Tech bubble
and post 9-11
Post-crisis depreciation of
dollarDollar appreciates in its role
as the global “reserve currency” is affirmed during
the global financial crisis
What Makes the Prices of Items orComponents from Overseas Rise?
New taxes, tariffs, or other charges (e.g., shipping) that increase the effective price of an item.
An increase in the price of the item in the selling country.
Inflation Rates for Largest European Economies & Euro Area, 2010F-2011F
1.3% 1.1%
2.6%
1.5%1.1%
1.6% 1.5%1.8% 1.6% 1.5%
0%
3%
6%
9%
Euro Area Germany UK France Netherlands
2010F 2011F
Source: Blue Chip Economic Indicators, 5/10/10 edition.
% Change from Prior Year
Annual inflation is below 2% across
most major European economies
Inflation Rates for MajorEmerging Economies, 2010F-2011F
2.8%
9.2%
5.0%
7.2%
5.0%
2.9%3.3%
6.6%
4.7%
7.4%
4.2%
3.1%
0.0%
2.5%
5.0%
7.5%
10.0%
China India Brazil Russia Mexico S. Korea
2010F 2010F
Source: Blue Chip Economic Indicators, 5/10/10 edition.
% Change from Prior Year
Annual inflation is forecast to be above 3% across most major countries from which
we import
“Headline” Inflation Rates,* Emergingvs. Advanced Economies, 2002-2009
-2%
0%
2%
4%
6%
8%
10%
Jan
02
Jul 0
2
Jan
03
Jul 0
3
Jan
04
Jul 0
4
Jan
05
Jul 0
5
Jan
06
Jul 0
6
Jan
07
Jul 0
7
Jan
08
Jul 0
8
Jan
09
Jul 0
9
Advanced Economies Emerging Economies
*12-month change in consumer price index, monthlySource: International Monetary Fund, “World Economic Outlook” update January 2010
Japan is an Inflation ExceptionAmong Advanced Economies
Source : Ecowin & SCOR (2010)
196
201
206
211
216
221
déc
-06
févr
-07
avr
-07
juin
-07
aoû
t-0
7
oct
-07
déc
-07
févr
-08
avr
-08
juin
-08
aoû
t-0
8
oct
-08
déc
-08
févr
-09
avr
-09
juin
-09
aoû
t-0
9
oct
-09
déc
-09
99
101
103
105
107
109
111
113
115United States, Consumer Prices, All items, SA, Index,USD, 1982-1984=100Euro Zone, Consumer Prices, All Items, Total (ECB),SA, Index, EUR, 2005=100United Kingdom, Consumer Prices, By Commodity, Allitems (CPI), Index, GBP, 2005=100Japan, Consumer Prices, Nationwide, All Items,General, SA, Index, JPY, 2005=100
Now, Really, What Causes Inflation?
“Too much money chasing too few goods.” When the Federal Reserve and the “shadow” banking system provide more money than people need at current prices, prices rise to absorb the extra money. “Inflation is everywhere and always a
monetary phenomenon.” (Milton Friedman)
Inflation and the U.S. Monetary Base Have Roughly Moved Together (1975-2007)
-3%
0%
3%
6%
9%
12%
15%
18%
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
CPI-U % change in monetary base
Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt Insurance Information Institute (calculations).
% Change from Start to End of Year
The Monetary Base is coins, paper, and bank reserves—
money available for use.
17
But the U.S. Monetary Base Exploded in 2008 (Monthly, 1990–2010*)
*As of end of April 2010; seasonally adjustedNote: Recessions indicated by gray shaded columns.
Sources: http://www.federalreserve.gov/releases/H3/hist/h3hist4.txt National Bureau of Economic Research (recession dates); Insurance Information Institutes.
Billions
$250
$500
$750
$1,000
$1,250
$1,500
$1,750
$2,000
$2,250
'90 '93 '96 '99 '03 '06 '09
The 12-month increase, from mid-Sept 2008 to mid-
Sept 2009, was 108.5%.
The subsequent 6-month increase,
from mid-Sept 2009 to mid-March 2010,
was 16.7%.
What Does the Spike in the Monetary Base in 2008-09 Mean for Future Inflation?
-10%0%
10%20%30%40%50%60%70%80%90%
100%110%
75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
CPI-U % change in monetary base
Source: US Department of Labor, Bureau of Labor Statistics
So far, this hasn’t produced rampant inflation because banks have been reluctant to lend (and businesses reluctant to borrow).
But this could change at any time.
In 2008, Central Banks in Europe, the UK, andthe US Dramatically Expanded the Money Supply
Source : Ecowin
0
500000
1000000
1500000
2000000
2500000
300000026
/05/
2006
26/0
8/20
06
26/1
1/20
06
26/0
2/20
07
26/0
5/20
07
26/0
8/20
07
26/1
1/20
07
26/0
2/20
08
26/0
5/20
08
26/0
8/20
08
26/1
1/20
08
26/0
2/20
09
26/0
5/20
09
26/0
8/20
09
26/1
1/20
09
Mo
illio
ns
of
Do
llars
or
Eu
ros
0
50000
100000
150000
200000
250000
300000US Federal reserve Banks, Total assets or liabilities, dollars
Euro Zone, Eurosystem, Total assets or liabilities, EUR
United Kingdom, Bank of England, assets, GBP
-6%
-3%
0%
3%
6%
9%
12%
15%
2004:Q
1
2004:Q
2
2004:Q
3
2004:Q
4
2005:Q
1
2005:Q
2
2005:Q
3
2005:Q
4
2006:Q
1
2006:Q
2
2006:Q
3
2006:Q
4
2007:Q
1
2007:Q
2
2007:Q
3
2007:Q
4
2008:Q
1
2008:Q
2
2008:Q
3
2008:Q
4
2009:Q
1
2009:Q
2
2009:Q
3
2009:Q
4
Home Mortgage Consumer CreditBusiness Corporate
Households and Businesses Are Now “Deleveraging”: Low Inflation Pressure
Source: Federal Reserve Board, at http://www.federalreserve.gov/releases/z1/Current/z1r-2.pdf (latest data as of 5/14/2010)
Percent Change in Debt Held(Quarterly since 2004 at Annualized Rate)
66%
68%
70%
72%
74%
76%
78%
80%
82%
Mar 01
Jun 0
1
Sep 0
1
Dec 0
1
Mar 02
Jun 0
2
Sep 0
2
Dec 0
2
Mar 03
Jun 0
3
Sep 0
3
Dec 0
3
Mar 04
Jun 0
4
Sep 0
4
Dec 0
4
Mar 05
Jun 0
5
Sep 0
5
Dec 0
5
Mar 06
Jun 0
6
Sep 0
6
Dec 0
6
Mar 07
Jun 0
7
Sep 0
7
Dec 0
7
Mar 08
Jun 0
8
Sep 0
8
Dec 0
8
Mar 09
Jun 0
9
Sep 0
9
Dec 0
9
Mar 10
Conventional Wisdom: Inflation Won’t Threaten Until We’re At Full Capacity
Source: Federal Reserve Board statistical releases at http://www.federalreserve.gov/releases/g17/Current/default.htm 21
Recession began December 2007
Percent of Manufacturing Capacity
Hurricane Katrina
March 2001-November 2001
recession
“Full Capacity”
The closer the economy is to operating at “full
capacity,” the greater the inflationary pressure
But Some Industrial ProductionCapacity Has Vanished
Source: Wall Street Journal, Feb. 3, 2009
Some unused capacity is gone, and in other industries new capacity is needed, so the economy might be closer to full capacity than the industrial production numbers indicate.
If so, this might spur inflation sooner than expected.
23
Inflation’s Past and Future
Inflation Isn’t Double-Digit Now as It Was in 1974-81
-2%
0%
2%
4%
6%
8%
10%
12%
14%
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99 00
01
02
03
04
05
06
07
08
09
10F
Sources: US Department of Labor, Bureau of Labor Statistics; Blue Chip Economic Indicators (5/2010 issue) (2010 forecast)
If you started work in the insurance industry 27 years ago, you never experienced
annual inflation as high as 6%
Annual Inflation Rates (%)
25
A Closer Look: Annual Inflation Rates(CPI-U, %), 1990–2014F
2.92.3
1.62.2
3.42.8
1.6
2.32.7
3.4 3.22.8
3.8
-0.4
2.0 1.92.3 2.4 2.4
5.4
4.2
3.0 3.02.6 2.8
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10F
11F
12F
13F
14F
Sources: US Bureau of Labor Statistics; Blue Chip Economic Indicators, 3/2010 and 5/2010 issues (forecasts).
The Annual Inflation Rate (CPI-U) Has Been Below 4% Since 1992. The Compound Average Growth Rate of Inflation 1992-2009 was about 2.3%.
Annual Inflation Rates (%)
The recession and the collapse of commodity prices appear to have reduced inflation, at least for nowTwo years after the last
recession ended, prices started up again
26
Forecasts of Yearly U.S. Inflation Rates(CPI-U, %), 2010–2015F
2.0 1.9
2.3 2.4 2.4 2.5
1.7
1.1
1.5 1.6 1.7 1.8
3.23.13.13.12.8
2.4
0
1
2
3
4
2010 2011 2012 2013 2014 2015
Blue Chip AvgPessimistic
Blue ChipMedian
Blue Chip AvgOptimistic
Source: Blue Chip Economic Indicators Mar. 2010 and May 2010 issues.
Overall Inflation Is Forecast to Rise Modestly through 2015but Is Not Expected to Become a Major Concern
Annual Inflation Rates (%)
Even the pessimistic forecasts don’t see the CPI rising much above 3% in the next 5+ years
But Some Economists Say the Fed’s Inflation Target Should be Higher
Headline in Wall Street Journal Monday February 22, 2010:
Low Inflation Always Best? Some Urge a Policy Rethink
Higher inflation brings higher interest rates, giving the Federal Reserve “more room” to lower rates when it wants to stimulate the economy.
Higher inflation also lessens the debt burden (inflation pushes incomes up but debt payments are fixed)
Proposed inflation target: 4% (Current target: 2%)
Bernanke’s Recent Views onthe Fed’s 2% Inflation Target
A major inflation driver is expectations regarding the future rate of inflation Firms will raise prices if they expect their costs to
increase Workers will demand pay raises to offset expected
higher inflation Bernanke’s worry: If the Fed changes its target to a
higher inflation level, people might think that the Fed isn’t serious about inflation, and might bid prices up proactively
Bernanke: the Fed should maintain its 2% target in order to support current beliefs that the Fed will act to limit inflation to 2%
Source: http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm
29
So If Inflation Isn’t Threatening Now,Why Are We Worried About It?
Rising Claim SeveritiesCost of claims settlement rises across the board (property and
liability)
Rate InadequacyRates inadequate due to low trend assumptions arising from use of
historical data
Reserve InadequacyReserves may develop adversely and become inadequate
(deficient)
Burn Through on RetentionsRetentions, deductibles burned through more quickly
Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly,
tapping into reinsurance more quickly and potentially exhausting their reinsurance more quickly
30
Inflation’s Effect on Property-Casualty Insurance Claims
P-C Claim Severity Generally Has Risen Faster than the CPI
Resurgent Inflation Would Shift ClaimSeverity Upward for any Given Distribution
Source : SCOR
Loss distribution
Loss size ($)
Lo
ss
pro
ba
bili
ty (
%)
Claims before inflation resurgence
Claims after inflation resurgence
Source: Philippe Trainar, “Inflation risk: a long term Pressure scenario for insurance companies,” presentation at the Geneva Association’s Amsterdam Circle of Chief Economists, February 11, 2010.
32
Major Components of the CPI-U,by Weighting
42.0%
16.7%
14.8%
6.5%
6.4%
6.4% 3.7%3.5%
Source: BLS News Release, March. 18, 2010 “Consumer Price Index – February 2010”
P-C Insurance Doesn’t Pay for the Major Items in the CPI. It FactorsSlightly in Housing, Transportation; Significantly in Medical Care
Housing
Other
Transportation
Food & Beverages
Medical Care
Education & Communication
Recreation
Apparel
Nearly 2/3 of this is the rent homeowners pay to themselves for
living in their own home
Inside the Jan. & Feb. 2010 CPI:*Components Move Differently
*seasonally adjusted.Source: BLS
2.6%1.6%
0.4%
-0.2%
3.5%
19.1%
2.1%1.3%
0.3%
-0.1%
3.6%
14.4%
-2%
0%2%
4%
6%8%
10%12%
14%
16%18%
20%
Overall CPI "Core" CPI Owners'Equivalent
Rent
Food &Beverages
Medical Care Energy
Percent change fromsame month, prior year
The “Core” CPI Excludes Price Changes for Food and Energy, Which Are Generally Volatile. These Items Are Nearly ¼ of the CPI. The Largest Single CPI Component isan Estimate of What Homeowners Would Pay as Rent to Themselves as Landlords.
34
Weights of Selected CPI Components Owners’ Equivalent Rent 25.2%Food and Beverages 14.8%Energy 8.6%Medical Care 6.5%
When Prices for Some Items Drop, Check the Prior-Year Surge
Sources: Bureau of Labor Statistics; Insurance Information Institute.
3.8%2.3%
6.8%
10.3% 9.7%
-0.40%
1.7%
4.8%
-2.9%
-4.6%-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Overall CPI "Core" CPI HeatingEquipment
StructuralSteel
Products
ResidentialMaint &Repair
2008 2009(Percent)
Some Costs Related to Construction Spiked in 2008,Far Above the Overall Inflation Rate (CPI), then Retreated in 2009
35
Price Indexes for Elements ofProperty Claims Monthly, Jan 2008-Feb 2010
185.
5
186.
6
190.
1
193.
0
205.
0
206.
1
200.
4
194.
3
189.
5
189.
9
187.
4
186.
3
186.
3
187.
6
188.
9
187.
9 189.
9
189.
5
188.
8
189.
8
190.
2 192.
619
2.7
205.
4
201.
1
197.
4
180
185
190
195
200
205
210
Jan
08
Feb
08
Mar
08
Ap
r 08
May 0
8
Ju
n 0
8
Ju
l 08
Au
g 0
8
Sep
08
Oct 08
No
v 0
8
Dec 0
8
Jan
09
Feb
09
Mar
09
Ap
r 09
May 0
9
Ju
n 0
9
Ju
l 09
Au
g 0
9
Sep
09
Oct 09
No
v 0
9
Dec 0
9
Jan
10
Feb
10
Sources: Bureau of Labor Statistics; Insurance Information Institute calculations.
Price Index
Construction materials prices spiked through the first half of 2008, returned to pre-spike levels by Spring 2009, but prices for construction materials are
climbing again.
Up 10.7% Jan-July
2008
36
Material and Supply Inputs to Construction Industries
Annual price increases,2008 over 2007: +8.2%2009 over 2008: -3.9%
Up 3.4% Mar 2009-Feb 2010
Inflation in Legal and Auto Repair Costs Affects P/C Claims More than the CPI Suggests
Sources: BLS; Legal services and motor vehicle body work are avg. monthly year-over-year change from BLS;Tort costs is 2009 Towers-Perrin estimate.
-0.4%
1.8%
2.7%3.0%
4.1%3.8% 3.9%
-1%
0%
1%
2%
3%
4%
5%
Overall CPI "Core" CPI LegalServices
US TortCosts
MotorVehicleParts &
Equipment
MotorVehicle
Body Work
MotorVehicleRepair
(Percent)
Repair Parts/Labor and Legal/Tort CostsAre Major P/C Insurance Cost Drivers.
37
In the UK, the Household Rebuilding CostIndex is Also Higher Than the British CPI
Source : Association of British Insurers
Annual Change in the Household Rebuilding Cost Index and Retail Prices Index
0,00
1,00
2,00
3,00
4,00
5,00
6,00
7,00
8,00
9,00
10,00
janv-9
8
avr-
98
juil-
98
oct
-98
janv-9
9
avr-
99
juil-
99
oct
-99
janv-0
0
avr-
00
juil-
00
oct
-00
janv-0
1
avr-
01
juil-
01
oct
-01
janv-0
2
avr-
02
juil-
02
oct
-02
janv-0
3
avr-
03
juil-
03
oct
-03
janv-0
4
avr-
04
juil-
04
oct
-04
janv-0
5
avr-
05
juil-
05
oct
-05
janv-0
6
avr-
06
juil-
06
oct
-06
janv-0
7
avr-
07
juil-
07
oct
-07
janv-0
8
avr-
08
juil-
08
oct
-08
janv-0
9
Annual In
crease
(%
)
HRCI RPI
Household Rebuilding Cost Index
British CPI
All Segments of French Motor Insurance CostsHave Grown Faster than the CPI for Over 20 Years
Source : Fédération Française des Sociétés d’Assurance
Average cost of motor insurance
100
120
140
160
180
200
220
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
100
= 1
987
Liability for materials
Theft & FireGlass breakage
Accidental damagesCPI
Most segments of French home insurance costs have been growing more rapidly than the CPI for more than 20 years
Source : Fédération Française des Sociétés d’Assurance
Average cost of home insurance ("multirisque habitation")
50
100
150
200
250
300
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
FireWind, Snow, HailTheftWater damagesLiabilityGlass breakageCPI
Of Course, The Prices of Some ThingsP-C Insurers Pay For Have Dropped
80
90
100
110
120
Dec
03
Dec
04
Dec
05
Dec
06
Dec
07
Dec
08
Dec
09
Plywood & Engineered Wood
Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted
Index Price Change from Prior Year2004 7.0%2005 -1.7%2006 -5.3%2007 -5.0%2008 1.3%2009 -5.4%
42
Inflation’s Effect is Unusually Strong with Health Care Costs
This Isn’t Just a U.S. Phenomenon
Medical Cost Inflation Has Outpaced Overall Inflation for Many Years
80
140
200
260
320
380
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
Inde
x V
alue
(198
2-84
=100
)
All Items Medical Care
Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjustedhttp://www.bls.gov/news.release/pdf/cpi.pdf
Since 1982-84, (index =100) the cost of medical care has more than tripled, while the overall cost of living merely doubled
French Health Insurance Tells the Same Story (as Does Many Other Countries)
Source : INSEE
100
105
110
115
120
125
130
135
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
100
= 1
998
CPI
Health Insurance CPI
P-C Claims Tend to Be for Intense Medical Activities,Whose Costs Grew Faster than Medical Care in General
100
120
140
160
180
200
220
97 98 99 00 01 02 03 04 05 06 07 08 09
Hospital Services Medical Care
Source: Department of Labor (Bureau of Labor Statistics); not seasonally adjusted; medical care costs re-indexed to 100 in 1997 by III calculations
From 1997 to 2009, hospital services costs grew 107% while the cost of medical care overall grew 60%.
Index
In France, since 2001 a growing gap between the growth rateof the cost of severe injuries and inflation/GDP growth rate
Source : SCOR Global Life (2009)
Average cost of severe French bodily injuries
100
110
120
130
140
150
160
170
180
2001 2002 2003 2004 2005 2006 2007
100
= C
ost
in
200
1
Average costsInflationGDP at current prices
The Rising Cost of Medical Care AffectsP/C Claims More than 2009 CPI Implies
Sources: BLS; medical care changes are avg. monthly year-over-year change from BLS; BI and no-fault figures from ISO Fast Track data for 4 quarters ending 09:Q3. WC figure is I.I.I. estimate based on historical NCCI data.
-0.4%
1.8%
3.1%
4.3%
5.5%6.2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
Overall CPI "Core" CPI Medical Care PP AutoBodily Injury
Severity
WC MedSeverity
PP Auto No-Fault Claim
Severity
(Percent)
Healthcare Costs Are Major P/C Insurance Cost Drivers.They Are Expected to Increase Above the Inflation Rate (CPI) Indefinitely
47
The “core” = the overall CPI after removing the effect of price changes in food and energy
Shifting Legal Liability & Tort Environment
48
Tort Costs Might Spike Again; but This Isn’t the Conventional Sense
of Inflation
The Frequency of Million-Dollar Verdicts*Was Increasing With Moderate Inflation
29%
37%
48%
59%
33%
51% 57
%
65%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Business Negligence Government Negligence Medical Malpractice Products Liability
2001-2003 2004-2005 2006-2007
*Verdicts of $1 million or more.Source: Jury Verdict Research; Insurance Information Institute.
Across all liability types, million-dollar-plus awards rose from 13% of all awards from
2001-2003 to 17% in 2006-07.
In the 1990s and Since 2003, Tort SystemCost Growth Has Moderated vs. Inflation
-6%
-3%
0%
3%
6%
9%
12%
15%
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Rate of Tort System Cost GrowthCPI
Sources: US Bureau of Labor Statistics, Tillinghast-Towers Perrin, 2009 Update on U.S. Tort Costs; Insurance Info. Inst.
Without these two high-growth years, tort cost
growth this decade would have been close
to the CPI
Growth Rate
51
So P-C Insurance Claim Costs Increase Faster Than Inflation.
But Why?
7 Reasons Why P-C Insurance Claims Often Rise Faster than Inflation
1. They contain at least an element of moral hazard, if not also a fraud/abuse dimension that isn’t present in prices generally.
a. This is reinforced by “bad faith” laws and/or consumer attitudes (surveys show that many people believe that it’s okay to inflate an insurance claim). So to avoid “bad faith” outcomes insurers pay some claims they might otherwise challenge
2. When deductibles apply, they tend to stay fixed (in dollars) over long periods of time, even though the price of the insured item increases (so that a larger percent of the damage is covered as time goes on)
Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)
3. P-C insurance sometimes pays for open-ended items (e.g., additional living expenses, liability defense costs) which can, through the quantity of the item purchased, inflate the insurer’s claims spending.
4. For claims that involve health care of severely-injured people, the cost of hospital services has far outstripped the CPI
Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)
5. In some cases, competitive price forces don’t operate as strongly on insured goods and services (vs. non-insured goods and services); for example, they might
a. Be protected from international competition You can’t outsource repair of a car or a building to a
lower-labor-cost country
b. Be affected by the changing social value of life & suffering
The cost of pain medication for people with chronic pain is far outstripping general inflation
c. Concern services where productivity gains are limited
Examples are defending lawsuits, repairing roofs, clearing debris, etc.
Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)
5. for example, they mightd. Be confident that they car raise prices without fear
of a drop in demand for their services If your property is damaged you generally must get it
repaired or replaced
e. Be affected by shortages of particular skilled labor despite general conditions of high unemployment
If might be difficult to find and keep mechanics with the training and experience to fix today’s complex modern cars
f. Be affected by the cost of acquiring expensive new diagnostic equipment and the “need” to use it (and charge for its use) perhaps more often than necessary
56
6. Demand Surge. In catastrophe (and some other) situations, demand for materials and labor is highly concentrated, pushing up prices for scarce resources.
7. Cost-shiftinga. The “deep pocket” principle: as long as an
insurer “can afford it,” some Courts will extend their liability (judicial cost inflation)
b. Medical care providers charge higher rates for patients not covered by Medicare or Medicaid
Why P-C Insurance ClaimsOften Rise Faster than Inflation (cont’d)
P/C Premium Growth and Inflation
57
Mainly Driven by the Industry’s Underwriting Cycle,
Not the Economy
58
-5%
0%
5%
10%
15%
20%
25%
71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
CPI-U NPW Growth
P-C NWP Growth Generally Matchesor Exceeds Inflation 1971-2009
(Percent)1975-78 1984-87 2000-03
Shaded areas denote “hard market” periodsSources: A.M. Best, ISO, Insurance Information Institute
59
Underwriting and Inflation
60
Other Underwriting-RelatedEffects of Higher Inflation
Rising Insurable ValuesPremium volume and agent commissions will rise even if rates
are flat
Increased Political Response to Rate Increase RequestsRegulators might reject rate increase proposals to curry favor
with insurance consumers
Lower Profits Due to Reserve Strengthening
Burn Through on RetentionsRetentions, deductibles burned through more quickly
Reinsurance Penetration/ExhaustionHigher costs risks burn through their retentions more quickly,
tapping into reinsurance more quickly and potentially exhausting their reinsurance more quickly
An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines
Short tail LoBs (mainly property insurance) can quickly adjust to an increase in the rate of inflation
–Policy periods generally last six months to a year, or may be on a reporting form, so they adjust premiums frequently
–Claims tend to be paid soon after they’re reported, so an inflation spike won’t affect them as much
–Their asset durations match their liability structure, so investment income may increase rapidly with interest rates
An Inflation Spike Would be More Costly for“Long-tail” than “Short-tail” Insurance Lines
Long tail LoBs have more difficulty with resurgent inflation
–Claims tend to be paid long after they’re reported, so an inflation spike would magnify claims
–Their asset durations match their liability structure, so investment income may increase gradually, while values of existing assets would decline with an inflation spike
–Needed reserve strengthening would sap profits, making it difficult to earn their equity cost of capital
Investments and Inflation
63
Interest-Based InvestmentsBenefit from Higher Inflation
64
Distribution of P/C InsuranceIndustry’s Invested Assets
Sources: NAIC, via SNL Financial; Insurance Information Institute calculations.
Invested assets totaled $1.245 trillion as of 9/30/09
Insurers are generally conservatively invested, with more than 2/3 of assets invested in bonds as of 9/30/09
Only about 17% of assets were invested in common and preferred stock as of 9/30/09
Even the most conservative of portfolios was hit hard in 2008
Portfolio Facts
7.3%17.0%
1.2%
5.7%
68.7%
Bonds
StockMortgages & Real Estate
As of September 30, 2009
Cash and Short-term
Investments
Other
Bond Yields Tend to Follow Inflation,but the Relationship is a Loose One
-2%
0%
2%
4%
6%
8%
10%
90
91
92
93
94
95
96
97
98
99 00
01
02
03
04
05
06
07
08
09
10F
11F
12F
13F
14F
CPI-U % Change U.S. Treasury 10-Year Note Yield
Sources: US Bureau of Labor Statistics (history); Blue Chip Economic Indicators, 10/09 and 2/10 issues (forecast)
Forecast
2%
3%
4%
5%
6%
7%
8%
9%
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
10F
11F
12F
13F
14F
P-C Inv Income/Inv Assets 10-Year Treasury Note
P/C Investment Income* as a % ofInvested Assets Follows 10-Year U.S. T-Note
*Not including realized capital gains/lossesSources: history: Board of Governors, Federal Reserve System; A.M.Best; Insurance Information Institute.forecasts: Blue Chip Economic Indicators, 10/2009 issue
P-C investment yield historically tracks 10-year Treasury note quite closely
The midpoint of the Blue Chip forecasts indicates that T-note
yields might spike in 2012.
Inflation’s Effect onP-C Claim Reserves
67
Will Impairments RiseIf Reserves Are Deficient?
68
$2.3
-$2.1
-$8.3
-$2.6-$6.6
-$9.9-$9.8
-$4.1
$1.0
$11.7
$23.2
$13.7$9.9
$7.3
-$6.7-$9.5
-$14.6-$16.0-$15.0
-$5.0
-$20
-$15
-$10
-$5
$0
$5
$10
$15
$20
$25
$3092
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
10F
11F
Pri
or
Yr.
Reserv
e R
ele
ase ($B
)
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Infla
tion
(CP
I-U)
Prior Yr. ReserveDevelopment ($B)Inflation
Strengthening and Releasing P/C Reserves Appears Unrelated to Inflation
Reserve Releases Are Expected to Taper Off in 2010 and Drop Significantly in 2011
Note: 2005 reserve development excludes a $6 billion loss portfolio transfer between American Re and Munich Re. Including this transaction, total prior year adverse development in 2005 was $7 billion. The data from 2000 and subsequent years excludes development from financial guaranty and mortgage insurance. Sources: Barclay’s Capital; A.M. Best, BLS
69
Reasons for US P/C Insurer Impairments, 1969–2008
3.7%4.2%
9.1%
7.0%
7.9%
7.6%
8.1% 14.3%
38.1%
Source: A.M. Best: 1969-2008 Impairment Review, Special Report, Apr. 6, 2008
Deficient Loss Reserves and Inadequate Pricing Are the Leading Cause of Insurer Impairments, Underscoring the Importance of Discipline.
Investment Catastrophe Losses Play a Much Smaller Role
Deficient Loss Reserves/Inadequate Pricing
Reinsurance Failure
Rapid GrowthAlleged Fraud
Catastrophe Losses
Affiliate Impairment
Investment Problems
Misc.
Sig. Change in Business
P/C Insurer Impairments, 1969–2009p8
15
12
71
19
34
91
31
21
99
16
14
13
36
49
31 3
45
04
85
56
05
84
12
91
61
23
11
8 19
49 50
47
35
18
14 15
71
1
5
0
10
20
30
40
50
60
70
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
p
Source: A.M. Best; Insurance Information Institute.
The Number of Impairments Varies Significantly Over the P/C Insurance Cycle, With Peaks Occurring Well into Hard Markets
5 of the 11 are Florida companies (1 of these
5 is a title insurer)
71
P/C Insurer Impairment Frequencyvs. Inflation, 1970-2009p
-2%
0%
2%
4%
6%
8%
10%
12%
14%70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
09
Inflatio
n (C
PI)
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
1.6
1.8
2.0
Imp
airm
en
t Rate
Inflation P/C Impairment Frequency
0.36% 2009 impairment rate is III estimate based on preliminary A.M. Best data.Sources: BLS, A.M. Best, Insurance Information Institute
The Highest Impairment Rates Appear Affected by Inflation,But the Correlation Isn’t a Strong One
What Can Insurers Do?
72
Re-Ignited Inflation is An Economic Catastrophe (Like a Major Hurricane?)
Hold more capital to cover the uncertainty of re-emergent inflation
Go more heavily into inflation-indexed investments
Improve the quality of data used for reservingUnderlying trends & elasticitiesTailored inflation indexes?
Regulators Must Be Part of the Discussion
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