The past week has seen the biggest tax cuts in 50 years, the Sterling fell to the lowest of 37 years against the Dollar and interest rates raised to a 14 year high of 2.25% with further expected hikes to come.
One of the biggest concerns is that a weak Sterling alongside tax cuts will exacerbate inflation as key commodities and other imports are priced in dollars. This means that prices will be pushed up for goods and services and drive UK inflation higher, even further.
So the question is: how does this period of raging inflation affect the various participants in the insurance industry? To answer this question, we need to consider it from the perspective of each party.
The P&C Insurer
Given that an insurer doesn’t manufacture the products which it supplies in a conventional manner using the same types of goods and services normally found in a supply chain, one could be forgiven for thinking that an insurer is free of the inflationary pressures which have such an immediate impact on other businesses.
Insurers in fact are impacted by four key indicators, according to McKinsey & Company: 1) general inflation, 2) claims cost inflation, 3) wage inflation and 4) interest rates.
Insurers face a difficult balancing act on claims and wage inflation vs. premium growth and rising interest rates. On one hand, premium levels rise alongside general inflation (albeit at a slower rate) and increased interest rates lead to higher portfolio yields and investment earnings. The flipside to that is managing claims cost inflation should it rise above premium growth, alongside higher ongoing trading costs such as: increased wages, overall operational costs and impact on expense ratios.
How does this work in practice? An insurer’s product is essentially a promise to place the holders of the policies which it has priced and issued up to several years earlier, back into the same position that they were in prior to the loss. The problem here is that the expected cost of the claim when the policy was priced and paid for could be much less than the resultant cost when the claim actually occurs thanks to the increased prices of materials and labour due to inflation. On short tail policies the impact is limited to 12 months of inflation at which point the insurer can reprice the policy. However, for the likes of long tail exposures on such policies as Latent Defects insurance, this could mean 10 years of unpriced inflation forcing an insurer to add significant IBNR provisions.
During this period, discipline will be applied in all functions of the P&C insurer and more specifically on: underwriting efficiency and product innovation, claims productivity and automation, investing in operational productivity, all overarched by strong management discipline.
The Insurance Broker
An insurance broker holds a relatively unique commercial position. They do not manufacture anything themselves but rather act as a conduit through which insurance policies are delivered. However, unlike a typical product reseller, they are governed by the law of agency which means they have a legal and regulatory responsibility to act in the best interest of their customers. Historically, an insurance broker has been a highly profitable and cash generative business with the principal costs being staff, offices and an IT platform. Whilst inflation would impact these costs, there is generally very little capex involved in establishing a brokerage and thus typically little debt held on the balance sheet, thus limiting the impact of the increasing interest rates.
Brokers should be aware though of inflation’s impact on their clients’ coverage. Many businesses have policies that were written years ago and may not reflect the current value of their assets. A broker can work with a client to update the policy so that it provides adequate coverage incase of damage or loss. Actionable ways that a broker can help their clients during this period:
1. Review coverage regularly and ensure that policy limits are adequate
2. Update policy limits as needed and review underinsurance risks
3. Obtain new quotes as needed, compare rates and potentially switch to a new insurer to obtain adequate cover
From a regulatory perspective, an MGA is considered to be an intermediary however, operationally, an MGA is more similar to that of an insurer. In the same way as a broker, normal operating costs will of course be impacted by the inflationary uptick. However, more importantly, whilst the MGA won’t feel the direct impact of either an escalating cost of capital or claims reserving increases that an insurer will suffer, the fact that an MGA generally has one or two insurers effectively supporting all of their products, the indirect impact is significant.
It is for this reason that an MGA’s ability to analyse and demonstrate robust performance is essential as increasing loss ratios and pressure on the bottom line will inevitably cause insurers to review their distribution strategies. An MGA must demonstrate that it has a road map to navigate future inflationary pressure by incorporating this into its underwriting footprint to maximise performance. The risk lies in that the capacity provider could seek to deploy its capital elsewhere otherwise.
Unlike the former examples of industry participants, insuretech is a term which captures abroad range of business types. Insuretech is a term used to describe the use of technology in the insurance industry. Insuretech startups use innovative technology to enable or disrupt the insurance market and create new opportunities for industry participants, businesses and consumers.
Generally, insuretech startups are considered “growth” companies. The strategy is to take external equity, debt and invest these, together with any revenues, to rapidly grow the business. The majority of insuretechs require external funding, primarily from Venture Capitalists, to fuel their growth.
So how do VCs view inflation in terms of their investment strategy? For one, valuations are impacted as expected future cash flows are discounted using a higher interest rate. On a broader level, investment selection is viewed in the lens of capital efficiency and the fundamentals of the startup in relation to inflation. Certain startups with strong IP and tech products could preserve financials in real terms given their ability to pass inflation costs and their relatively low cost of goods sold.
One cannot give a definitive view on inflation’s impact on the Insuretech without first specifying in which sector of the insurance space it operates. For the sake of this example, let’s look at insuretechs working on the distribution of commercial insurance products. We have already established that a conventional broker's main costs are their staff, offices and IT platform. Trading in a traditional manner, a broker will usually have a regional reach and a significant portion of their staff will be engaged in the process of transacting or advising their customers. However, according to the Chartered Insurance Institute's report on the Future of Commercial InsuranceBroking on average, staff spent 56% of their time on administration and only 44% of their time on client servicing.
One can see the efficiencies that can be brought into commercial insurance distribution through the application of technologies which alleviate the need for large numbers of sales and administration staff and the supporting functions such as expensive offices and large travel costs. Despite cutting key costs, by responding to customers' willingness to receive advice-led insurance solutions in an efficient, digital manner, these organisations can also enjoy a much wider reach. Through the replacement of conventional overheads with technology one is able to mitigate the primary inflationary pressure that would be suffered by a traditional commercial insurance broker operating in the equivalent space.
Commercial Customer Demand
The broad business environment is undoubtedly affected in this environment. A weaker Sterling makes it difficult for those businesses assembling products using items acquired from abroad to remain competitive in the domestic market. Manufacturing organisations will find the debt required to purchase the latest machinery more expensive and those offering professional accounting and legal services will see a significant increase in operational costs. Ultimately, for different reasons, this is going to leave most businesses less profitable than prior to the inflationary squeeze.
An interesting question to ask is how the insurance industry will be affected by the revised position of its customer base? It’s likely that all businesses will reconsider their expense base. In some industries, such as vehicle rental or haulage, insurance premiums will feature in the three most significant costs incurred by the business. For others, insurance may only be a nominal expense and something upon which limited focus is placed. Furthermore, the size of the business is likely to have an impact on the decisions taken by the respective boards with regards to risk. Larger organisations, such as those in the mid-market or corporate commercial sectors with significant balance sheets, will have the luxury of choosing whether the certainty provided by insurance justifies the additional cost. Smaller businesses are likely to be under much greater financial pressure and whilst they may see the importance of operating a comprehensive insurance program, they may simply not have the financial resources to do so. Therefore, it could reasonably be argued that the insurance industry servicing mid-market and corporate clients could well see an uptick in volumes from businesses seeking to flatten their risk curve in these uncertain times.