Updating Your Inflation Forecasts

With very low inflation currently at hand, one might question the reason to feature the topic in this magazine at the moment. Still, there are good reasons for not losing sight of inflation and its eventual impact on our underwriting results.

Before going into these reasons, let’s make sure we are all on the same page. Insurers are interested in the change of claims severity over time. Claims severity is influenced by consumer price index (CPI) inflation and social cost escalation. In this article, we will look at both.

HOW INFLATION AFFECTS SEVERITY

For an underwriter, it is crucial to have a good estimate of the increase in claims severity from the time when the business is underwritten to the point when it runs-off. This estimate is of course much harder to come up with for a casualty underwriter, due to the long-tail nature of the underlying business. Inaccurate estimates for future CPI inflation and social cost increases can have a significant impact on the underwriting results of the business.

To illustrate this, I have picked three lines of business: personal auto, general liability (GL) on a claims-made basis and product liability with occurrence trigger. If we assume an additional one percentage point of annual claims severity inflation compared to the initial underwriting estimate, the nominal ultimate claims value will increase by 2% for personal auto, 4% for GL and a substantial 5% for product liability.

In other words, even if the estimates are largely accurate, a one-percentage-point difference can have a significant impact. If the forecast is less accurate and annual claims inflation ran five points above our estimate, the ultimate claims value would increase by 12% (personal auto), 21% (GL) and a whopping 29% for product liability. The example above illustrates the importance for underwriters of having accurate forecasts for CPI inflation and social cost escalation.

For reinsurers, the above effect is even more pronounced. Non-proportional reinsurance treaties with fixed deductibles absorb all adverse claims severity due to inflation, once a claim has reached the deductible.

The next question then is, what are the current forecasts for CPI inflation and social cost escalation?

CPI INFLATION

Let’s look at CPI first. Forecasts for the next 12-24 months regarding CPI inflation are low. Bank of Canada’s core CPI (see boxed text) is estimated to go up by 1.2% for 2009 and by 1.4% in 2010. This is a typical pattern for a recession, which normally triggers a period of between two and three years of falling inflation. The main reason is that existing overcapacity causes demand to be lower than supply. In addition, rising unemployment reduces inflation pressures from wage increases. The current short-term trend is a continuation of a long-term pattern of falling inflation. This has been observed over the last 20 years and has helped casualty results in the past.

Therefore, there is only one way the CPI inflation can go, and that is up. But how far up will it likely go? Most economists believe inflation to be “mean-reverting,” which is to say it will return to 2-3% after a period of lower or higher inflation. This belief is mainly based on the assumption that central banks will be able to manage CPI inflation. This is something they closely monitor and upon which they would intervene in the case of increasing inflation. Bank of Canada’s (BoC) target is to keep CPI inflation below 2%.

A common counter-argument is that the current budget deficits in most countries, coupled with the stimulus packages, will lead to above-normal inflation going forward. While the amount of money in circulation is certainly higher than normal, central banks will most likely take part of it out of the system again as soon as the economy recovers. The same applies for the stimulus packages, which will run out and not be replaced when robust growth has kicked in.

However, while the majority of economists see the danger of high inflation as limited as long as central banks stay independent, there is a group with a different view. This group foresees the supply of oil will not be able to keep up with demand when the world economy rebounds. This could lead again to triple-digit oil prices and high inflation for prices of all goods.

SOCIAL COST INFLATION

What about social cost escalation? Not surprisingly, from an insurance perspective, social cost has a high correlation to health care cost. In Canada, health care costs are currently growing faster than the CPI and population growth. According to the Canadian Institute for Health Information, these costs are forecast to equal about 11% of Canada’s GDP in 2009 — a new record. Besides health care costs, legal changes are another driver of social cost inflation. Examples of this are currently in several provinces in the motor line of business.

PROTECTING AGAINST INFLATION

Faced with the need for long-term forecasts, which are by nature very difficult to get correct, what can insurers do to protect themselves? The good news is, CPI inflation can be hedged relatively easily through government or corporate bonds whose principal or interest payments are linked to the CPI (TIPS, CIPS or inflation-linked structured notes). Empirical analysis shows that commodities and treasury bills are also good CPI inflation hedges.

It is much more difficult to protect against social cost inflation. Equities are a possible hedge since the increased social costs will flow back to companies as revenues. However, there is an enormous amount of basis risk in this and it will potentially work only over the very long term (maybe too long term).

One hedge against both CPI and social cost inflation is, of course, reinsurance. Non-proportional treaties give a 100% protection against adverse claims severity developments for larger claims hitting the cover.

———

There is only one way the Consumer Price Index inflation can go and that is up. How far up will it go?

———

What Is The Cpi?

The Consumer Price Index (CPI) provides a broad measure of the cost of living in Canada. Although there are other ways to measure price changes, the CPI is the most important indicator because of its widespread use, for example, in calculating changes in government payments such as the Canada Pension Plan and Old Age Security.

Through the monthly CPI, Statistics Canada tracks the retail price of a representative shopping basket of about 600 goods and services from an average household’s expenditure: food, housing, transportation, furniture, clothing and recreation. The percentage of the total basket that any item occupies reflects typical consumer spending patterns.

Besides this “total CPI,” Bank of Canada also uses the “core CPI,” which excludes eight of the most volatile components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, intercity transportation and tobacco products), as well as the effect of changes in indirect taxes on the remaining components.

Source: Bank of Canada website