At the beginning of 2022, society breathed a sigh of relief. After the third wave of vaccinations the coronavirus pandemic seemed to be over, as the death rate among infected people and the number of infections declined. But the respite was short-lived, and new challenges were already appearing on the horizon.
Causes of inflation in 2022
In response to the 2008 financial crisis, the central banks have circulated large amounts of money with negative interest rates over the past decade. Although inflation was widely expected, it did not materialise at first.
When the desire for consumption returned with the flattening of the Covid-19 pandemic, some parts of the economy were unprepared. The measures introduced to combat the pandemic led to supply chains being disrupted in many places and a lack of materials and consumer goods. In addition, many workers turned their backs on the economic sectors that were particularly affected by these measures. Demand for goods and services could not be met, and the first signs of rising inflation began to appear.
Lockdown measures are still in place in many Chinese cities. The Chinese economy is slowing and many supply chains remain disrupted. At the same time, the war in Ukraine led to economic sanctions against Russia, which in turn have led to rising energy and food prices. The reduction or stoppage of oil and gas supplies from Russia to the Western world has resulted in a massive increase in energy prices and a threat of shortages in gas and electricity supplies. The exclusion of Russia from trade with the West resulted in Russia restricting food exports. In addition, the Ukrainian Black Sea coast was mined, which further restricted the export of food from Ukraine. Inflation, which was already evident in 2021, received another strong boost. In response, the central banks abandoned the negative interest rate period and decided to raise interest rates – in some cases significantly.
What do life insurers and pension funds need to prepare for?
Inflation is a fact. Regardless of how inflation develops, life insurers and pension funds need to ask themselves the following questions:
- How susceptible is the insured portfolio to inflation in general?
- How high is the risk appetite?
- Are there any limits to how much inflation risk people are willing to accept?
- What will be the impact of inflation on capital requirements?
- Should countermeasures be taken by restricting sales or by specifically changing the portfolio mix with appropriate sales incentives?
Inflation risk in life and accident insurance products
Insurance companies may experience the inflation risk in various ways. By reviewing their own product range, insurance companies can gain an overview of their inflation exposure. Products that are actively sold can be controlled via product adjustments or underwriting.
Direct impact of inflation on insured benefits and claims
Inflation has a direct effect on insurance products through possible wage inflation. If salaries rise, the insured benefits rise as well, since they are directly dependent on the declared salary. Premiums increase at the same time, since they are usually determined using a salary-dependent premium rate in group life insurance, short-term disability benefit insurance and accident insurance. The inflation risk of higher benefits is thus offset by a higher premium.
Higher salaries may also be reflected in higher medical costs for accident insurance. This would be the case, for example, if salaries in the health sector were to rise.
Another direct effect of inflation is inflation-related adjustments of current pensions in accident insurance or in pension funds.
Since premiums for accident and group life insurance products (group insurance) are usually linked to the overall payroll as a premium rate, or value propositions are expressed either as absolute amounts or with a well-defined salary dependency, potential wage inflation seems to have very little negative impact on pension funds or life insurance. The same applies if the premium rate of a reinsurance contract is linked to disability benefits. In the individual life business, benefits are defined irrespective of salary, and any imminent inflation would therefore not have a direct impact on the expected claims burden.
On the other hand, excess-loss reinsurance products are particularly exposed to inflation. Wage inflation increases both the expected loss frequency and the loss amount, if the excess is not linked to inflation.
Indirect impact through interest rate increases
- Central banks typically respond to inflation with higher interest rates.
- All life insurance products with savings components and accident and life insurance products with annuity benefits are dependent on interest rates. In the case of current pensions in particular, it is important to review the risks of the potential inflation adjustment of annuity benefits and secure their financing.
What can we learn from the past?
The financial crisis of 2007 and 2008 and the economic development in the following years had very different effects on the economic situation in the individual countries. For example, France, Spain, the UK and the US were hit by a severe recession, while Belgium, the Netherlands, New Zealand, South Africa and Switzerland experienced only a mild recession. There was no recession at all in Germany or Australia.
It can be said that there were no general correlations between the burden of disability insurance claims and the economic situation in a country. However, in some countries the claims experience in the disability business did correlate with the economic situation. For example, the likelihood of becoming disabled and the probability of ending a disability claim strongly depend on the definition of benefits or the interaction with the social security system. These differed depending on the country.
While the incidence of claims in some industrial segments and markets was heavily dependent on the economic environment and unemployment in particular, and therefore rose after the financial crisis (e.g. France, the Netherlands, the US, New Zealand), a delayed rise in the incidence of claims as a result of the economic downturn was recorded in certain markets. In other countries, there was no correlation between the economic market environment, especially unemployment, and disability claims.
Overall, however, it was noticeable that in an international context the claim termination rates reacted more quickly to the financial crisis than the disability rates. In general, it was observed that claims were reactivated less quickly and thus the duration of benefits was extended, which increased the overall claims burden.
It was also noticeable that group business was more sensitive to the economic environment than individual business. However, this may have been due to the disproportionate exposure to the financial industry in group business for the portfolios under review. Since it is difficult to predict which industrial segments will be hit more severely in the next economic crisis, in group insurance it may be advantageous from a risk perspective to split a portfolio as evenly as possible into industrial segments. Insurance companies achieve such balanced portfolio distributions by applying the corresponding underwriting guidelines and price differentiation.
Outlook: Risks and opportunities for life insurers
Inflation is not only an unpredictable risk, it can also be an opportunity, especially when associated with rising interest rates. Building up new business with the corresponding reserves will benefit from this.
Higher interest rates will also ease the situation in the second pillar. The politically fixed conversion rate for mandatory benefits would cause fewer or no technical losses in the event of future retirements if the interest rates earned on bond loans were higher than the technical interest rate implied by the conversion rate. The redistribution of investment income from the active population to pensioners would thus be reduced or even stopped.
On the other hand, inflation can have a negative impact on an investment portfolio, for example due to increased mortgage interest rates. If mortgagors are no longer able to afford the new higher mortgage rates when renewing their mortgages, this can trigger a real estate crisis, which will ultimately result in the devaluation of properties. This would initially affect investment properties such as those found on the balance sheets of insurance companies and pension funds. A real estate crisis could destabilise other sectors (e.g. banks, the construction industry) and lead the economy into a recession. This calls for good asset and liability management.
Higher inflation has a different impact across different industrial segments. Given that there is some correlation between increased inflation, unemployment and the disability claims burden, the insurance industry would be well advised to use active underwriting in order to aim for a balanced portfolio by industrial segment. This is the most effective way of reducing an economic downturn on the claims experience of a portfolio of disability policies.
Inflation outlook (reference to Sigma March 2022)
- Bruno Catarino, Actuary SAA, CERA, MSc Math. ETH, Head of Product & Pricing at elipsLife Switzerland/Liechtenstein
- Claude Schwarz, Actuary SAA, Dipl. Phys. ETH, Director at Swiss Re