Inflation risk: is it here to stay?
Due to its compounding impact over time, inflation risk is particularly concerning to captive managers and risk managers who are actively managing a captive’s legacy reserve position. Jesse Sommer and Margaret McGuire of Guy Carpenter investigate.
“The captive’s risk appetite and underlying structure are key factors in selecting the legacy solution that is most appropriate." Jesse Sommer, Guy Carpenter
Captive insurance companies, like traditional insurance carriers, keep a watchful eye on present and emerging risks that can threaten the adequacy of their legacy reserves. In recent months, one particular emerging risk has been gaining significant attention: inflation.
Economic inflation is one underlying driver and according to the US Bureau of Labor Statistics’ September 2021 report, overall, prices have risen 5.4 percent year over year, and 0.4 percent over the past month. If you exclude food and energy, the Consumer Price Index is up 0.2 percent from August, or 4 percent from a year ago, outpacing the Federal Reserve’s target of 2 percent, according to Forbes Advisor.
Medical inflation is another underlying driver as medical costs have been rising. In fact, national health expenditures are expected to grow 5.4 percent annually, reaching $6.8 trillion by 2028, according to CMS’ Forecast Summary 2019–2028.
Due to its compounding impact over time, inflation risk is particularly concerning to captive managers and risk managers who are actively managing a captive’s legacy reserve position. For example, Figure 1 (using NCCI payout factors) shows the effects of a 2 percent inflation shock on a sample portfolio. The “Net Impact (Percentage) percent” heat map demonstrates the degree to which expected reserves and post-inflation reserves can diverge.
While reserve increases are required for all years in this example, the greatest deviation from expected reserves appears to occur in years five through nine. It is this exposure to inflation that has motivated risk managers to explore solutions to manage their reserves today.
Figure 1: Median impact of inflation on sample workers’ compensation portfolio
How are some captive managers managing reserves?
Captive managers employ different strategies to manage reserves. Some take a passive approach: expecting that current inflationary trends are transitory in nature, and will have minimal impact on their long-term strategy.
Other captive managers take a more active role managing legacy reserves to hedge against inflation risk and other adverse developments such as increasing litigation risk. In these instances, companies have two options to consider:
1. Internally manage the claims by drawing resources from other areas to fund the increase in required reserves, or 2. Pursue third-party legacy liability solutions to mitigate or eliminate future adverse development
Legacy solutions can include loss portfolio transfers, adverse development covers and novations. The captive’s risk appetite and underlying structure are key factors in selecting the legacy solution that is most appropriate.
Novations can be secured for a collection of years or one year at time. Additionally, novations can include a “rolling” feature that annually allows a new policy year to be added to the existing novation structure as they mature. Each policy year’s liabilities would then “roll” off of the captive’s book on to the balance sheet of a third-party reinsurer after the policy year reaches a certain age/maturity. This approach removes legacy liabilities from the captive’s balance sheet altogether and eliminates inflation risk within aging reserves.
Alternatively, an adverse development cover can cap a captive’s total loss for specified policy year(s) and transfer remaining loss the captive may incur to a third-party partner. This approach limits a captive’s overall exposure to inflation risk for each legacy policy year, although it does not entirely eliminate the exposure for all of its legacy reserves. Some of the liabilities would remain on the captive’s balance sheet.
What are the benefits of managing reserves through a legacy liability transaction?
There are a number of benefits to actively managing a captive’s reserves with support from a legacy liability transaction. First, there is more certainty of results. The captive reduces or eliminates inflation risk from its legacy reserves. Should payouts exceed the captive’s expected reserves, they will not have a compounding effect on the operations of the captive, ultimately leaving its viability intact. A by-product of these transactions is that they concurrently address other exogenous risks associated with long-tail liabilities, be they social inflation, regulatory risk or others.
Second, the captive achieves economic finality, particularly with loss portfolio transfers, like novations, where the captive’s legacy liabilities are removed from their balance sheet. Additionally, once these risks are transferred, the captive is no longer responsible for posting collateral in support of this business to a third party. As a result, years of trapped capital are freed up, enabling the captive to use them to invest back into the business or assume more of its on-going risk.
Lastly, overhead expenses decrease as the captive may no longer be responsible for the management of claims in the subject accident years.
Where do we start to manage inflation risk?
The first step is to engage your actuarial team, or a third party advisor, to model the exposures of your portfolio, and evaluate reserves and the inflationary impact on future claims payouts to a number of confidence levels. With that information in hand, it can be helpful to involve a reinsurance broker to help you better understand the potential risks inherent within your captive portfolio.
Brokers can also provide a third party opinion of this exposure using in-house actuaries and modelling capabilities.
After you identify and define the risks, a legacy liability solution can be tailored to meet the captive’s risk appetite and corporate objectives.
Jesse Sommer is managing director of Guy Carpenter. He can be contacted at: email@example.com
Margaret McGuire is assistant vice president, treaty broking, at Guy Carpenter. She can be contacted at: firstname.lastname@example.org