How Inflation Impacts Reinsurance

The key economic theme which has dominated virtually all of the economic discourse in 2022 has been inflation. Countries around the world have seen inflation rise to record levels. Countries like the United States have taken stringent measures to combat inflation.

A record number of interest rate hikes have been undertaken by the American central bank in order to slow down inflation. However, it seems like the efforts are not bearing fruit. Even after the rate hikes, inflation continues to remain persistently high and is impacting almost every sector of the economy. As a result, most economic pundits in the world believe that we are going to live in an era of persistently high inflation for a while.

The reinsurance sector is not immune to inflation either. The reinsurance industry has witnessed a severe impact due to inflation.

In this article, we will have a look at the various ways in which inflation is impacting the reinsurance sector.

• Leads to Increased Loss Pay-outs: The business model of reinsurance is based upon taking money in the form of premiums and then paying out a smaller sum in the future in the form of claims.

  On average, reinsurance companies pay out claims 2.9 years after they begin taking premiums from the customers. This means that the real value of the money taken in the form of a premium keeps on decreasing if inflation is high. As a result, the loss value of the claim made is higher. As a result, insurance companies have to make higher payments.

  Persistently higher inflation leads to higher payouts. Over time, this can have a detrimental effect on the health of a reinsurer. Even if they are able to predict the magnitude of events and the losses in terms of lives and property loss, they are unable to predict the monetary loss because of increasing inflation.

• Leads to Higher Premiums: The immediate effect of increasing inflation is that insurance companies witness their profit margins reduce. These companies have to pay out increased claims in the short term. However, over time, the reinsurance companies are forced to increase their premiums in order to recoup the losses.

  Now, firstly there is a time lag between inflation and increased premiums which means that the margins have already taken a hit.

  Secondly, companies in the reinsurance market have to deal with other insurance companies who are very savvy when it comes to understanding how premiums are calculated. Also, the market for reinsurance is globalized to a large extent. All of this means that the market for reinsurance has cut-throat competition. Hence, raising premiums can be very difficult due to competitive forces.

  The end result is that even though premiums are raised across the industry, they are not raised in the same proportion as the rise in claims. Also, if reinsurance companies insist on raising premiums while ignoring the competition, many of them end up losing a significant chunk of their revenues.

• Inflation is Difficult to Plan For: Another problem with inflation is that it is very unpredictable. Economists all over the world are not able to accurately anticipate inflation numbers. For instance, right now the Fed has raised interest rates many times.

  Theoretically, the rising interest rates should have countered inflation and the rate should have fallen drastically. However, in the short run, there has been no significant impact on inflation. Inflation has stopped increasing. However, it is not reducing as well and as a result, has become stagnant. This unpredictability makes it very difficult to adjust premiums proactively. As a result, reinsurance companies have no option but to play catch up with inflation numbers.

• Inflation Causes Reinsurance Investments to Lose Value: Reinsurance companies all over the world use financial markets in order to earn an income from the additional cash that they have on hand. Now, it is no secret that interest rate changes can cause corresponding changes in the values of many financial assets.

  Stocks, bonds, bullion, and almost every other financial instrument lose value when interest rates begin to rise. This means that the investment value of the holdings held by insurance companies also starts to go down. This can be very problematic given the fact that most reinsurance companies are also witnessing escalating costs of claims simultaneously. Reinsurance companies need to take additional steps in order to ensure that their portfolios do not lose value during inflation.

• Inflation Causes Reinsurance Companies to Take More Risks: As mentioned above, inflation causes the base interest rates to change. This means that companies have to offer a higher return to attract investors. If the return offered is only marginally higher than the debt instruments, then most investors will avoid taking any risks and will stick to debt. As a result, almost all companies take higher risks to offer a better return on their equity shares. Now, this means that no matter which company the reinsurance company chooses to park its additional funds, it will end up taking a higher risk.

The fact of the matter is that inflation is one of the biggest issues which insurance companies across the world are facing as of now. Along with increasing premiums, reinsurance companies will also have to cut costs, or else they will witness a drop in the number of customers as well as the revenue generated by the firm.

Authorship/Referencing - About the Author(s)

The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.