PRA Policy Statement 1/22: Insurance business transfers
We review the key amendments to the PRA’s Policy Statement 1/22 on insurance business transfers and consider the potential implications.
The economy and insurance industry have been transformed over the past few years by significant disruptors such as COVID-19, increased natural catastrophes like flooding and wildfires brought on by climate change, and the return of social inflation. The combination of these factors has contributed to a hardening property and casualty (P&C) marketplace, resulting in higher premiums, policy restrictions and/or exclusions, and even some carriers pulling out of certain markets or having insureds take on more risk through higher retentions. While COVID-19 and climate change impacts may be more easily isolated, the influence of social inflation is harder to measure and may be just as or more volatile.
Social inflation causes disruption to data, metrics, and forecasts. Many individuals in the insurance industry, such as risk managers, underwriters, brokers, actuaries, captive managers, or attorneys, have their daily decisions and tasks impacted by social inflation. Even C-Suite and company management become heavily engaged when social inflation distorts budgets and renewals of insurance exposures. Social inflation is a significant driver of higher losses with more uncertainty, which is shrinking profit margins for insurers and increasing premiums for insureds. Let’s examine social inflation’s causes and drivers, the impact to data, metrics, and forecasts, and strategies to best deal with and mitigate it in a COVID-19 environment and in the future.
Social inflation has been a buzzword in the industry connected with other terms such as nuclear verdicts, runaway verdicts, and even “superimposed inflation”; however, the phenomenon is not new to the insurance industry. Beginning in the 1970s, 1980s, and even 2000s, the insurance industry started to see claims settle for large amounts but only recently has the name social inflation gained more traction. Social inflation is sometimes loosely defined, but in simple terms it refers to all the ways in which insurers’ claim costs rise over and above general economic inflation and expected claim development. Some in the industry also include legislative and litigation developments, which impact insurers’ legal liabilities and claim costs due to societal trends and views toward increased litigation, broader contract interpretations, plaintiff-friendly legal decisions, and larger jury awards in the definition of social inflation.
Social inflation, while originating in the United States, is beginning to expand globally. Many insurance lines can be impacted by social inflation but the lines most affected are:
Even other lines such as workers’ compensation, via employer’s liability, can experience more generous and liberal awards.
The composition of jury pools is shifting to Millennial and Generation Z age groups from older groups. Each generation has its own general viewpoints and perspectives, which may influence how cases are viewed and verdicts are awarded. This shift could possibly contribute to social inflation. Other potential drivers include:
Many of these drivers share a common theme of insurance settlements being viewed as and becoming a “business.” Strategies that historically were used to control claim costs are no longer as successful or applicable. Societal views have shifted and continue to shift over time, making it difficult for the insurance industry to keep up with and proactively be prepared for new trends in insurance settlements.
One of the first telltale signs that social inflation is having an impact in the industry is the rise of combined ratios across various lines of business. As shown in Figure 1 and Figure 2, the combined loss ratios for both commercial auto liability and medical professional liability have been over 100% and generally increasing. In addition, insurance companies have been combatting rising combined ratios by increasing written premium and rate changes. However, combined ratios continue to climb even after these rate increases. This indicates that losses are growing faster than insurance rates, which is likely driven by social inflation. The increase in losses can be caused by higher frequency and severity trends directly from socially inflated claim values.
Data sources: National Association of Insurance Commissioners (NAIC) data sourced through S&P Global Market Intelligence, MarketScout Market Barometer.
Data sources: NAIC data sourced through S&P Global Market Intelligence. MarketScout Market Barometer.
The insurance industry relies on the theory of consistency when producing actuarial estimates and loss projections. This means that past loss experience is an indicative and reliable predictor of future losses. This would include losses being reported, reserved, and paid consistently over time. In addition, severity and frequency trends can be estimated and applied to historical losses in forecasting future losses. Social inflation presents a challenge to this theory by creating data that is not consistent with the past and may not behave similarly. In particular, claim patterns, claim severities, and large loss frequencies have deteriorated. This variability adds uncertainty to loss forecasts. While actuaries could overcompensate for the trends that are shown in historical data, this could also impose the dilemma that actuarial forecasts might be redundant or too high.
Actuaries sort data and monitor loss development through loss triangles in order to project the future. As part of this process, actuaries examine age-to-age factors that show how claims develop between 12 months and 24 months of reported losses for the same year, for example. Hence, it normalizes frequency, severity, and exposure trends because each year’s development is measured against the respective starting base for that year, being 12 months of reported losses. A three-year moving average of the factors smooths the variations within each individual year and might add more credibility in projecting future development.
In both commercial auto liability and medical professional liability, as shown in Figure 3 and Figure 4 respectively, the three-year average is increasing down the 12-to-24-month age-to-age column. This indicates that development is changing and becoming higher with each new year. Therefore, if more recent losses are developing at higher rates than in the past, then forecasts based on the past and the theory of consistency could be too low. This would also explain why there is a trend in the combined ratio despite taking rate increases. The pace at which losses are growing is quicker than what is being forecasted based on the past history.
Data sources: NAIC data sourced through S&P Global Market Intelligence.
Data sources: NAIC data sourced through S&P Global Market Intelligence
While it is true that unexpected loss development can also be related to factors other than social inflation, insurance professionals usually can better isolate those causes, leaving the unexplained piece likely due to the variability caused by social inflation. For example, the increase in accidents from distracted drivers and the increase in the cost of components and repairs to automobiles can be determined based on other subsets of data and industry statistics.
The impact of social inflation also brings to light the question of data reliability and quality. As long as the weaknesses and strengths of the data are understood by the user, then reasonable forecasts can still be completed. However, there may be added uncertainty. There is no doubt that social inflation has disrupted data, which adds to the complexities of using data for benchmarking, underwriting, forecasting, budgeting, and premium renewals. Some insurance companies or self-insureds may elect to account for this disruption by incorporating more conservatism and maybe even including additional contingencies.
With the disruption caused by social inflation, insurance professionals are advised to develop key strategies that will keep their companies sound into the future. Many of these strategies begin with recognizing there is increased uncertainty in today’s insurance environment, and this may continue going forward due to social inflation. The following are 10 considerations when developing these strategies:
Social inflation was highly prevalent in 2019 with numerous high verdicts but was dampened in 2020 when the COVID-19 pandemic started. During the pandemic, many court cases were delayed. Those that did move forward became virtual, which may have impacted how the cases were resolved. Virtual courtrooms did not always allow for a jury trial, which plaintiff's bar dislikes because jury trials tend to result in higher awards. In addition, because the trial process was extended, some plaintiffs attempted to settle earlier, which may have led to lower-than-expected claim amounts.
In addition to a slower litigation process, government-mandated lockdowns reduced insurance exposure. For example, auto exposures plummeted because there were fewer drivers on the road. Jury attitudes also might have shifted during the pandemic. Healthcare workers were viewed as heroes and, as a result, very few medical malpractice claims were filed. There were also temporary immunities offered to healthcare workers. On the flipside, public distrust might have increased during the COVID-19 pandemic. There were more reports of public outrage and increased pushes for social justice reforms occurring simultaneously. This increased awareness of the public good could help reignite the high jury awards. Also, will people need to brush up on their skills such as driving or performing surgeries as daily activities resume? This could lead to new claims and higher risks.
Social inflation is similar to any emerging risk, and it will take time to determine the full impact. Many in the insurance community believe that social inflation will return to pre-pandemic levels. The fear is the unknown, but an even bigger fear is the long-term risks that social inflation could have on the insurance industry such as insurance companies going out of business, lack of coverage, and out-of-reach renewals. It is clear though that everyone in the industry should pay particular attention to trends in liability court awards, factor them into business decisions, and be prepared with a strategy to best mitigate social inflation. Leverage relationships with business partners and be willing to quickly adapt business plans.