In June 2023, the PRA published a “Dear Chief Actuary” letter providing feedback on how general insurers had responded to its October 2022 letter which focussed on the impact of claims inflation. The letter draws on findings from discussions with general insurers across personal and commercial lines and the London Market. The impacts of inflation have been an ongoing point of discussion for general insurers in recent years and are a key supervisory priority for the PRA in 2023. The June letter highlights that the uncertainties arising from the current inflationary environment and the risks of failing to adequately reflect these consistently across all functions within a firm remain a priority area of regulatory focus. In this article, KPMG in the UK consider the challenges for general insurers in adjusting to the evolving and uncertain impact as claims inflation flows into decisions on reserving, capital and business planning. We set out the key questions that actuarial functions and risk management teams should be considering and the challenge that the management team and, ultimately, the Board should be offering to ensure sustainability of business models.
Claims inflation — technical challenge and decision-making uncertainty
Claims inflation impacts all general insurers — but not in the same way
The PRA has identified a range of areas across modelling, capital management and governance that require further consideration by firms
It is critical to carefully challenge assumptions about the impact of claims inflation on reserving, capital, risk modelling, pricing and business planning — both for existing and future exposures
The first step is identifying the drivers of claims inflation for an individual firm, which will be different from the headline inflation rate and vary by geography and product line
Firms cannot necessarily rely on historical data and should assess existing modelling techniques to determine if they can still be relied on
There needs to be a holistic view of inflation, bringing together claims, reserving, capital modelling and underwriting/pricing functions as well as feeding into the business planning cycle
Identifying claims inflation
Expected claims ultimately drive many aspects of an insurance business — the reserves and capital held but also the rates to be charged for policies not yet sold and the assumptions underlying the business plan. Failing to appropriately assess the impact of inflation on future claim amounts then has potential to have widespread consequences. At the same time, though, understanding the drivers of claims inflation is far from straightforward.
While it is reasonable to assume a link to wider economic inflation in many cases, the underlying drivers for a given claim type are likely to be far more nuanced — perhaps most closely linked to the price of a particular material or to labour costs for a particular specialism. For London Market insurers, who may cover a diverse range of risk types and geographies within a class of business, identifying the drivers, let alone identifying suitable forecast indices, remains a significant challenge.
Given the potential for a lag between economic inflation and claims inflation, it is particularly important for those firms which may not yet see any evidence of claims inflation in data (e.g. writers of long-tailed liability lines) to be vigilant as this may simply be yet to emerge. Equally though, there may be classes of business for which claims experience remains relatively unaffected by wider economic factors so applying blanket assumptions to all classes is not appropriate. Where it is not evident in overall settled claims data, it may be useful to perform some more granular claims analysis in specific classes. The level of the analysis, however, must be balanced with the risk of spurious accuracy where inflation assumptions rely on economic forecasts which are themselves uncertain.
Allowing for inflation
Fundamentally, there is a question for actuarial teams as to whether current modelling approaches are fit for purpose in a less stable economic environment. In reserving, for example, standard techniques rely on an implicit assumption that the inflationary environment underlying the historical data is representative of the future. While that has been the case for the last two decades for reserving teams based in many countries, the last few years have exposed a gap in the tools immediately available to many reserving teams as these have not generally been easy to adapt when that implicit assumption no longer applies.
In 2021, when the high-inflation environment was still relatively new, it was too early for there to be any significant level of increased inflation in claims data so, in practice, it was relatively straightforward to assess forecast inflation and include a simple uplift to reserves. Even by year end 2022, it was more complicated to include inflation allowances due to the difficulty of quantifying the extent to which case reserves, plan loss ratios and other inputs to the reserving process already made allowance for inflation. This remains as complicated, if not more so, for year end 2023 and, even if inflation were to revert to a stable level, this will remain a challenge for some time as the impact of inflation over recent years works through claims data. Judgement will be required in determining to what extent the inflation captured in data from this period should be reflected in projections of future experience.
The PRA letter notes that Personal Lines insurers seem to be better placed to comment on drivers of claims inflation. They also have notably higher average inflation allowances in the data presented in the PRA letter (based on a sample of 16 firms). This may be expected as the most immediate inflationary impacts are likely to be seen in property-related lines e.g. in repair costs for motor and household claims. We may reasonably expect more of a delay before impacts can be seen in some of the more complex liability lines typically seen in the London Market. It is however also the case that Personal Lines insurers generally use reserving methods which, by default, separately consider claim numbers and the average cost of each claim and, as they are sensitive to movements in average costs, may well respond more quickly to inflation emerging in data.
The consistency and volume of Personal Lines policies creates greater opportunity for identifying inflationary trends than may be possible within a typical London Market reserving group which will likely include a diverse range of risks, with variations in risk type, geography, line size and layer. As a result, in contrast with Personal Lines insurers, London Market insurers typically consider developments of overall claim amounts and offsetting upward and downward movements between the number of claims and the cost of each may mask an overall inflationary trend. This, combined with the fact that the variation in underlying risks means that there may be a mixture of underlying drivers of inflation, makes it more difficult to detect an overall impact of inflation and respond to it. There may be a need to adapt approaches used or otherwise employ more advanced data analytics to identify underlying trends in diverse commercial books.
Developing a cross-functional approach
As the high-inflation environment persists, there is a need to develop a consistent view of inflation — both best estimate and a range of future scenarios — to inform decisions across the business e.g. underwriting, reserving, capital modelling, business planning, reinsurance purchasing. Firms will also need to be able to explain and justify any inconsistencies in assumptions where these occur. Developing a more sophisticated view of inflation and its impacts across the business will require input from a wide range of functions.
Deriving robust inflation assumptions, which can be clearly articulated and justified, will likely require a combination of qualitative and quantitative approaches. For example, a first step may be developing a qualitative understanding of the drivers of claims experience and emerging trends through discussion with claims and underwriting teams. It may then be possible to identify appropriate economic indices which reflect these drivers, such as wage inflation indices for specific industries. While many indices may only be captured historically, analysis can be performed to understand the extent to which these drivers track widely available forecasts, such as CPI forecasts from central banks, thereby allowing class-level indices to be constructed. In parallel, close monitoring of claims metrics and emerging claims data will be essential for validating these assumptions.
Beyond the immediate issue of allowing for the current economic climate in actuarial models, there are broader reasons for developing a deeper understanding of claims inflation and its drivers as well as improving collaboration between functions. In particular, as actuaries are increasingly drawn into the assessment and modelling of climate risk, it is increasingly necessary to understand how claims costs will respond both to the changing climate itself and to the economic impacts of transitioning to a net zero economy. Ultimately, this requires actuaries to develop their understanding of what actually drives claims experience, where this links to broader economic factors or societal trends and how this can best be reflected in modelling.
Meeting the PRA's supervisory expectations
The PRA will continue its supervisory focus on general insurers' approaches to claims inflation and the extent to which its findings have been taken on board. Firms should be ready for scrutiny of their assumptions and modelling techniques as part of supervisory conversations. The PRA is likely to look particularly closely at firms that continue to report little in-built claims inflation or place reliance solely on historical data and existing modelling techniques. Supervisors may also question the appropriateness of any releases of prior reserves and firms seeking to benefit from a hardening market in recent years should be prepared to explain their approach and future business planning.
Firms should be ready to explain to their supervisory contact their organisational and governance response to claims inflation. The letter has made it clear that the PRA will be looking for a joined-up approach across teams (reserving, claims, modelling, capital, pricing, underwriting) and consistent assumptions on both the liability and asset sides of the balance sheet. Regulatory expectations include effective second line questioning of assumptions and scrutiny of whether underwriting practices and business planning continue to be within the firm's risk appetite.
The PRA is concerned misjudgements on the flow-through of inflation may potentially lead to material deterioration in firms' solvency coverage and expects firms to review either the appropriateness of the Standard Formula or of internal model assumptions. The PRA expects the findings outlined in its letter to be reviewed by all firms. Ensuring firmwide discussion, including with the Board and other relevant stakeholders and appropriate challenge will be essential to ensuring a robust response.
Next steps for firms
Consider how to incorporate the PRA's findings into mid and end of year reserving and capital exercises
Assess modelling techniques and how to account for inflation now and under a range of future economic scenarios
Prepare to engage with supervisory teams, ensuring assumptions, approach and level of oversight can be clearly communicated and evidenced
Take particular care to document approach and rationale if intending to release prior year reserves
Assess the appropriateness of the standard formula or the assumptions within internal models
Assess the adequacy of risk management and control frameworks
Ensure there is a holistic view across teams and that the approach has been communicated to, and challenged by, the Board
Challenging assumptions — questions to ask
Have the firm-specific drivers of claims inflation been appropriately identified? Are there any relevant indicators (e.g. material or labour costs) that can be compared against the assumptions made by the reserving team?
Is there an appropriate feedback loop between reserving and claims? How frequent are the interactions and how has the MI been used?
Has claims inflation been considered at the appropriate level of granularity in terms of product lines and geography?
What is the appropriate time horizon for considering the impact of inflation? Does this align with the claims tail for liabilities?
What is the interaction between inflation, monetary policy and economic outlook assumptions? Does this appropriately flow through into reserving, capital, underwriting and business planning?
Have we applied the same assumptions around impact and uncertainty to both assets and liabilities?
How is the uncertainty built into stress and scenario testing? Does the ORSA continue to appropriately reflect the range of possible scenarios?
What are the possible management actions if future events deviate from our assumptions?
Does our governance continue to be effective? Is a cross-functional `Inflation Committee' warranted?
What is the impact of inflation on our risk mitigation techniques, including reinsurance and hedging arrangements?
Do our arrangements with third party claims administrators continue to be appropriate?
Have we taken into account likely policyholder behaviour in light of the cost pressures across the economy? Do our business plan assumptions around demand and response to changes in pricing continue to hold?
How we can help
KPMG professionals have a wealth of experience in supporting insurers in developing effective reserving, modelling and risk management capabilities. If you would like to discuss further, please do not hesitate to get in touch.