In April of 2022, the Bureau of Labor Statistics reported that inflation hit a staggering 8.5%. If current projections hold true, this year will have the highest inflation rate since 1981. COVID-19, supply chain problems, Russia’s invasion of the Ukraine, housing price increases, and more predictable market cycles are some of the driving forces behind such high inflation. In our line of work – insurance, risk management, and employee benefits – macroeconomic factors like these are seen in the challenges our clients face and they solutions they prioritize. To complicate things, the property and casualty realm is also subject to things like natural disasters, climate risk, changes in societal litigiousness, and ransomware/cyber risk. That said, we sat down with Peter Johnson, Spring’s Chief Property & Casualty Actuary, to discuss how this challenging environment interplays with his work in the captive insurance space.

Q: Is inflation having an impact on underwriting and pricing?

A: This is case-by-case between captives but as an overall average, yes. A captive in a strong surplus position and favorable historical loss experience will still be able to provide favorable pricing even when the industry is seeing high loss trend and rate increases. Higher frequency and/or severity trends are certainly still impacting pricing needs for certain lines, such as cyber and excess liability where experience isn’t frequent in nature and the credibility of a single company’s experience is low. Specifically for cyber, ransomware loss costs have grown exponentially over the last 3 years and rate increases are being observed by both commercial carriers and captives. Further for both cyber and excess liability where commercial market pricing issues exist capacity has also shrunk and captive are being looked to, to fill the gap.

Q: Is inflation currently impacting reserving and if not, do you think it will in the future?

A: In general, yes, for many casualty lines where loss trends are high or increasing, but this is also a case-by-case basis since captives with good data credibility and stable historical loss experience can respond to their actual loss development and may not have a need for much, if any, reserve increases due to inflation. Cyber liability, commercial auto liability and excess liability are three lines in the industry with increasing severity trends and captive reserving practices often consider industry trends when company experience isn’t fully credible by itself, so I would expect some reserve strengthening for these lines due to trend assumption increases. Supply chain issues have been an obvious issue in the used car market and depending on a captive’s auto exposure and experience, there may be both increasing auto rate levels and reserve levels for the captive.

Q: Some analysts have suggested that while commercial market insurers are concerned about inflation, the impact might be offset to some extent by the benefit of higher interest rates in their investment portfolios. Would you expect captives to realize a similar investment benefit? Would you expect it to be significant?

A: To the extent a captive’s investment portfolio is invested in higher yielding fixed income, securities or other investments that are inflation sensitive then yes, there would be some offset.

Q: Are there specific coverage lines in captives that will be more affected by inflation than others?

A: Cyber, excess liability/umbrella and auto liability have seen higher trends than workers’ comp. Geography is an important factor as well since certain areas have seen noticeably higher/lower trends than the industry average. For example, medical professional liability severity trends have increased, but this varies significantly by region. Some states are seeing double digit severity trends and rate increases while others are experiencing very modest increases. Difference in litigiousness and jury awards drive much of these state-by-state differences. Property is certainly impacted by inflation with increases in cost to build, but natural catastrophes such as hurricanes, wildfire and wind/hail have typically had more of an impact and to compound things the current supply chain and inflation issues immediately after a disaster can lead to even costlier natural disasters. According to NOAA National Center for Environmental Information 2021 came is second all-time with 2020 coming in first as far as the total number and total cost of these disasters.

Q: Would you anticipate any changes in captive strategies in response to inflation?

A: For captives with active investment advisors, I’d expect a response on the investment side depending on their current investment profile and the surplus and loss reserve position of the captive. There certainly could be a variety of responses on the insurance risk side, particularly if inflation is driving up claim severity and significantly changing the risk profile of a captive. Capitalization, limits, retentions, reinsurance, and pricing are all potentially impacted and would need to be considered.

Q: Is there any advice you’d offer captive owners regarding inflation strategy?

A: In general, it is important to sensitivity test your proforma projections every few years based on practical adverse loss outcomes and investment income scenarios. These financial projections can consider higher than anticipated inflation trends over a multi-year projection horizon. This will help determine appropriate captive capitalization levels, reinsurance, pricing, and risk margin to protect against possible adverse events.

Q: Any final thoughts on the subject?

A: Firstly, large jury awards remain top of mind for many company executives and boards. Although the impact on industry combined ratios is less obvious based on what I’ve seen, this continues to be a big concern and is part of the driving force behind pricing increases in the commercial market for certain liability lines.
Secondly, as carrier capacity presumably decreases and underwriting profit margins increase for certain carrier lines where rate level increases outpace loss trend, captives will continue to be utilized to insure more risk and recoup underwriting and investment income related profits otherwise going to commercial carriers.
There you have it. While there are many negatives that sprout from inflation, one positive is that it allows captives to continue to elevate their status as a strategic risk management and financial tactic for organizations of all kinds, and help companies better face the difficult economic climate.