Insurance Risk Study - Aon

Managing Inflation Risk
Risk managers today recognize inflation as a potential
threat in the years ahead, but struggle to quantify the
risk and identify ways to mitigate it. The historical record
reminds us that periods of high inflation have occurred
repeatedly in virtually every economy. But during the
last 25 years, inflation has been contained at low levels
in the U.S. and other developed economies. As a result,
the time series available to measure inflation’s impact on
the current insurance industry will not serve us well in
anticipating the next potential inflation shock.
Inflation 1914-2009
20%
15%
10%
5%
0%
-5%
-10%
-15%
1910
Impact on Insurers
Periods of high inflation, and high inflation volatility in
particular, have generally preceded periods of rising
accident year combined ratios.
Inflation and Combined Ratio
14%
12%
10%
8%
6%
4%
2%
0%
1970
1975
1930
1980
1985
1950
1990
1970
1995
This lagged relationship between inflation and
combined ratios is driven by three factors:
> Lags between the incidence of inflation rate changes
and recognition in loss reserving systems and rate
indications
> Lags between attempts to raise rates and actual
rate changes due to regulatory and competitive
limitations
> Immediate impact on balance sheets
1990
Combined Ratio
Inflation
2000
2005
2010
125%
120%
115%
110%
105%
100%
95%
90%
Industry Balance Sheet Impact
Aon Benfield
In the table below we demonstrate the last of these
three effects for U.S. insurers using the 2009 industry
balance sheet and the sensitivity of bond holdings,
equity holdings and nominal loss reserves to changes
in inflation. We show that a 200 basis point increase
in inflation could result in a $70.9 billion impact on
surplus, a 13.7 percent decrease.
Impact of Inflation Increase on Industry Balance Sheet
Assets
Balance
($B)
Pre-tax
Sensitivity
%
After-Tax
Sensitivity
%
After-
Tax Impact
($B)
Bonds 866.3 -7.3% -4.7% -40.9
Stocks 227.0 -6.0% -3.9% -8.9
Other Assets 398.9 0.0% 0.0%
Total Assets 1,492.2 -5.1% -3.3% -49.7
Liabilities
Net Loss Reserves 564.0 5.8% 3.8% 21.2
Other Liabilities 411.4 0.0% 0.0%
Total Liabilitites 975.4 3.3% 2.2% 21.2
Surplus 516.8 -21.1% -13.7% -70.9
The primary drivers of these changes are bonds, stocks
and loss reserves.
Bonds — Changes in inflation affect bond yields
differently for bonds of different maturities. Overall, a
200 basis point increase in inflation would be expected
to decrease the value of the industry bond portfolio by
7.3 percent.
Stocks — Stock portfolios are often assumed to have
a high sensitivity to changes in bond yields. However,
since empirically 80 percent of changes in inflation
expectations ultimately flow through the S&P 500 as
higher nominal dividends, this significantly offsets the
effect of discounting these dividends at higher yields.
The overall affect is approximately a 6.0 percent decline
in the value of a diversified equity portfolio for a 200
basis point change in inflation.
Loss Reserves — The impact of inflation, particularly
when measured as changes in the broad CPI-U,
varies by line of business. Many short-tailed lines are
impacted directly, though modestly, as a result of
their quick settlement. In contrast, long-tailed lines
are impacted more significantly by components of the
CPI-U, which results in a more muted relationship to
general inflation. Overall, for the industry reserves, we
estimate a 5.8 percent increase in undiscounted loss
reserves for a 200 basis point increase in inflation.
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