The sizable gap between interest rates and inflation in many economies could represent a potential wild card that many in the industry may not have considered, Stuart Shipperlee, managing director of Litmus Analysis, an advisory firm specialising in ratings and credit risk, told Monte Carlo Today.

Shipperlee explains that the drop in capital many reinsurers have experienced due to unrealised losses on their investment portfolio, triggered by rising interest rates, is not viewed as a problem by most, including the rating agencies, because it is seen as “transient”. It will become a reality only if they sell down their bond portfolio, which is unlikely, given the realised losses they would then incur.

“The elephant in the room is inflation,” Shipperlee said. “There is a lot of detailed analysis going into that and how it should be reflected in pricing. But there is an unusual disconnect between interest rates and inflation. This means that, ideally, carriers should be pricing in the impact of inflation on their legacy business and reserves.”

Inflation is forecast to reach close to 10 percent in the UK, maybe higher, and 7 to 8 percent in the US and Europe. Yet interest rates are forecast to remain at around 2 to 3 percent. Shipperlee explains that, historically, when inflation has risen, so have interest rates. This has meant that higher bond yields can be used, in part, to offset inflation.

“So reinsurers must increase prices to take into account not only future claims, based on inflation, but also their legacy business. That is the wild card,” he said. “It should not affect capital but it certainly might impact performance.”

The problem is exacerbated by the fact that reinsurers are limited in their ability to buy bonds at higher yields because, to do so would mean selling off their existing portfolio at a loss—realising those investment losses in the process.

“If interest rates were higher, investments have the potential to at least partly offset inflation. That is not the case now and I am not sure everyone has fully understood the consequences of that,” Shipperlee said.