Claims inflation: key questions for firms and actuaries after PRA’s letter
Claims inflation is high on the agenda for insurers and their regulator.
On 23 June 2023 the Prudential Regulation Authority (PRA) published its latest Dear Chief Actuary letter on the allowance for claims inflation. This was a follow-up to its previous Chief Actuary letter in October 2022 and highlights the PRA’s focus on how firms are adapting and planning for claims inflation.
The PRA is clearly concerned about the potential for adverse reserving outcomes due to claims inflation during 2023. This will be an area of focus for them in the second half of 2023 and in 2024.
More broadly, the latest intervention reminds firms about the appropriateness and consistency of their inflation assumptions used across the business and whether or not there is sufficient understanding of the uncertainty of these assumptions.
With the FCA warning firms about undervaluing cars or other insured items as part of their claim settlement process, firms and actuaries need to ensure that the overall level of technical provisions appropriately reflects the true final cost of settling their claims.
The trade press along with the FT and The Times picked up the story and the expectation that insurers may need to increase reserves in 2023 due to ongoing claims inflation concerns. Here is our assessment of the letter and the next steps for firms and actuaries to consider .
Following years of relatively stable low interest and inflation rates, as the world came out of the Covid pandemic and with Russia’s invasion of Ukraine in early 2022, bond yields and inflation increased significantly. It was clear, by October 2022, that there was a step-change in economic inflation and the impact on insurer profitability could be significant.
Additionally, Lloyd’s and the Institute and Faculty of Actuaries highlighted the risks, and some of the practical considerations, of high inflation in market alerts.
Actuarial Reserving relies on a number of assumptions and one that has become implicit in recent times is that inflation would be low and stable. But with the return of higher inflation the need to re-introduce inflation adjusted reserving techniques has risen up the priority ladder for reserving teams. This also brings with it the need to have access to appropriate data as well as the associated explanation of new key assumptions.
Year end 2022
The PRA reviewed how 16 firms were allowing for claims inflation at the end of 2022. A quarter of those firms were unable to provide the analysis that would allow the PRA to quantify the implicit and / or explicit allowance for claims inflation.
Amongst those that did provide enough information the additional allowance for claims inflation ranged, as a percentage of undiscounted net best estimates, from 0.6% to 9.0% with an average of 5.4%.
Although favourable Prior Year Development (PYD) is a normal occurrence, the PRA appear to have raised their eyebrows at the amount of firms’ favourable PYD especially as it exceeded the allowance for additional claims inflation for prior years and in total.
Also, the increase in technical provisions due to inflation was less than the reduction in technical provisions due to the corresponding increase in the discount rates.
Reading between the lines, one might detect a concern that insurers took the good news and didn’t adequately allow for the bad news.
Nature of claims inflation
Claims inflation differs from economic inflation for several reasons. The key assumptions for each reserving segment are by how much and for how long claims inflation will be above “normal” levels. This depends on the drivers of inflation for that reserving segment and the understanding of these drivers by the business.
The PRA highlighted that “Motor insurers were able to provide the most clarity and detail as to understanding the precise source of the claims inflation (car values, repair costs, replacement car costs, supply chain challenges, and care/medical costs).”
They contrasted this with some other lines where the identification of claims inflation was less advanced. This was often due to claims activity being less advanced than motor.
Internal feedback loops
An internal view of inflation which is shared across the business will be important to achieve. This is particularly so for claims and reserving but should also include other areas such as pricing and underwriting.
Inevitably there will be different viewpoints and assumptions, but understanding the differences will be key to the success of the business. Some companies convene an Inflation Committee to agree the assumptions around inflation and ensure consistency amongst users.
Impact on surplus capital
Surplus capital, the excess of Own Funds above the Solvency Capital Requirement ( SCR), is very dependent on the level of future inflation assumed in the technical provisions.
Surplus capital will be overstated if the inflation assumption is too low because:
- The technical provisions will be lower, and hence own funds will be overstated
- Future profitability will be overstated which will lead to lower premium provisions and an increase in own funds
- A lower reserve risk charge, as the quantum of reserves is lower, and hence the overall SCR will be lower
(The impact on the SCR for Internal Model firms may be slightly different depending on how the model works.)
From a business model perspective, this will lead to concerns about the sustainability of planned business growth and any dividend plans.
The challenge for 2023
The PRA “anticipate 2023 year-end to be more challenging for reserving teams”. It is likely that one of the challenges will be the PRA seeking a degree of comfort that the reserves have appropriately allowed for claims inflation.
Reserving teams should consider the refinements needed to their toolkit to enable them to demonstrate this grip. For example, do they need to:
- Develop inflation adjusted techniques or frequency / severity analysis?
- Develop enhanced monitoring such as Actual v Expected or case reserve adequacy tests?
- Undertake inflation sensitivity analysis to demonstrate to stakeholders and boards the potential outcome if claims inflation behaves differently to that assumed
Given that 2023 will be the first full year of IFRS17 disclosure, this additional focus will require good planning of the decision journey up to year-end.
Impact on future business
The PRA acknowledges that some firms have evolved their practices over the last 6 months or so to understand the impact of claims inflation on pricing and underwriting including:
- considering the impact by head of damage or layers of coverage
- looking at calendar year effects for future underwriting years
However, it also noted that there were areas where more work was needed including the quality of inflation monitoring and the frequency of updating claims inflations assumptions. Firms may question whether an annual assessment is too infrequent in the current market.
Internal model considerations
Given the change in inflation over the last year, the PRA is keen for firms to ensure that their internal model assumptions and parameterisation remains valid. The PRA has clearly been discussing the appropriateness of Economic Scenario Generator (ESG) assumptions with Internal Model firms.
Uncertainty around claims inflation
Over recent months, CPI has been stickier than expected and the government’s goal of getting inflation under control by the end of the year is looking less certain.
Given how claims inflation arises and some of the time lags in its emergence there are still areas of uncertainty as to how inflation will emerge over the coming months and years.
The role of stress and scenario testing is key to help the business understand the potential impacts of inflation
A good range of stress and scenario tests will cover:
- A broad range of outcomes from a mild plausible scenario to a severe outcome
- Different timeframes from instantaneous shocks to a drawn-out inflationary spike
- The specifics of the business concerned rather than a generic scenario that has little relevance to the business
FCA intervention on claims settlement values
Whilst the PRA is warning about the allowance for inflation in reserving, an additional pressure on reserves may come from FCA intervention. The FCA has warned firms that they are concerned that insurers are under-valuing cars and other insured items as part of the settlement process and has publicly intervened with some firms.
Firms would be well advised to include a review of their approach to their settlement process and the valuations attributed on individual claims. As part of the broader feedback loop, claims would be expected to assist the reserving teams in understanding the impact of any shock due to changes in settlement practices to reflect such regulatory feedback.
Next steps for firms
Given the PRA’s deepening focus on claims inflation, there are several activities that Chief Actuaries and firms may wish to consider when developing their response to the regulator’s latest letter:
- How has the reserving team developed its understanding, monitoring, outlook and impact analysis of the change of claim inflation for each reserving segment?
- What sensitivity analysis does the reserving team give to enable stakeholders to understand the risks associated with claims inflation?
- Is there an effective feedback loop within the business, particularly between reserving and claims, that enables a coherent view of claims inflation, by line of business, to exist?
- Is the external reserve review giving adequate challenge and benchmarking to the impact of claims inflation? Is there other market (external) data available that may help validate the assumptions being made?
- Does the view of inflation for claims reserving invalidate any of the assumptions used in the capital models, including the standard formula?
- Is the Stress and Scenario testing and other Capital planning tools sufficient to assess the impact of significant claims inflation? What scenarios would help the business to understand the risks better?
- What actions does the business need to take to mitigate inflation risk for new business? This may include activity in pricing, underwriting and reinsurance.
- How are the board and senior management involved in challenging the assumptions around claims inflation?
In addition, understanding the approach by claims to cars and insured items’ valuations and whether is it delivering good customer outcomes would be a useful exercise to complete.