Navigating the “higher for longer” forecast for APAC inflation
Given the expectations of ‘stickier’ inflation dynamics in Asia Pacific, what proactive measures and reinsurance strategies should insurers be looking to pursue? Hui Yen Tai and Yuan Tian explore the challenges and opportunities.
With economies in Asia Pacific (APAC) experiencing their highest rate of inflation in over a decade during 2022, insurers in the region felt the effects across their business and began developing strategies to mitigate these impacts.
Such navigational strategies are crucial not only because a higher inflation environment affects underwriting, reinsurance, investment and capital movement in the Asian non-life market, but also because of likely duration.
Although economic inflation in Asia has been less severe compared to Europe and the US – and is currently showing signs of a slowdown – it's forecast to track at a higher baseline level over the short to medium term, which brings its own complexities.
Investment dynamics, capital and claims
Asian central banks have raised interest rates to combat inflationary pressure, although some have maintained a longer-term accommodative monetary policy, such as China, Japan and Vietnam. Rising interest rates have helped boost insurer investment income and somewhat counterbalance the impact of inflation on underwriting results. Some Asian central banks have since slowed increases and are expected to cut rates when consumer inflation moves to a target level, although this may take a while.
As the US Federal Reserve hiked its policy rate aggressively, Asian currencies depreciated across the board against the US dollar between the end of 2021 and the third quarter of 2022. This depreciation was a particular issue for companies with international business, where large currency movements resulted in capital volatility due to the mismatch.
Loss reserve positions are dependent on the degree to which future rates are in ‘excess’ of historical rates, the length of the claims patterns (that’s to say, the reserve duration) and the persistence of excess inflation into the future. As a result, policy reserves vary by line of business, with longer-tail classes being more sensitive to excess inflation. Gallagher Re analysis suggests that 5 percentage points of ‘excess’ inflation can lead to a ~60 percent change in ultimate cost for 10-year liabilities, compared to a ~30 percent change for five-year liabilities.
Reported capital was impacted negatively by market movements in 2022 from unrealised investment losses. However, markets have rebounded in 2023, boosting earnings for many APAC insurers because of higher reinvestment yields. This boost has been reflected in both reported and regulatory capital models that are based on market-consistent balance sheets. But in the APAC region, where solvency frameworks are mostly risk-based capital (RBC) or Solvency I regimes, the application may be inconsistent.
For example, in some markets in Asia, insurers can choose whether to apply explicit inflation discounting when reserving, which may lead to asset/liability mismatches if assets are valued on a market-consistent basis and liabilities are not. The adoption of IFRS 17 and the enhancement of RBC frameworks in several APAC markets, such as South Korea, Malaysia and Singapore, are expected to alleviate these impacts.
Against this backdrop of inflationary impacts, the global (re)insurance market is grappling with cautious capacity and capital availability.
Non-life insurance markets in the APAC region have been impacted by escalating reinsurance costs and stricter coverage terms, particularly in areas affected by meaningful natural catastrophe losses, such as Australia, the Philippines and Malaysia. Whilst risk-adjusted reinsurance rates have increased for both loss-free and loss-impacted portfolios, levels are more muted compared to the US and Europe, with inflation discussions also being less of a headline influence.
Nevertheless, cedants have confronted rising reinsurance rates, diminished proportional capacity, lower reinsurance commissions, increased retentions and more restrictive terms during renewals. Additionally, expense ratios have trended higher due to increased acquisition costs and reduced commission income from reinsurance.
Bearing in mind insurers’ varied inflationary challenges and any potential capacity constraints, what proactive measures and reinsurance strategies can be deployed to best manage them?
Undoubtedly, those insurers with strong risk management and nimble strategies have weathered inflationary pressures more effectively. Comprehensive risk management includes stress testing claims against inflation scenarios; assessing economic impacts; regular monitoring and pricing and reserve adjustments; and adjusting reinsurance coverage to current needs.
Also, the contract design for original policies needs to respond to inflationary pressure, with some insurers adopting innovative underwriting practices and refined policy responses, such as percentage deductibles and updated total insured values to allow for more precise pricing.
To manage reinsurance costs, increased retention levels and inflation uncertainty, prudent insurers have adopted several proactive measures, including structured reinsurance and multi-year arrangements that capture the benefits of time diversification. Retrospective solutions like loss portfolio transfers and adverse development covers, particularly on long-tail classes, are also effective in managing inflation uncertainty or boosting solvency levels.
Exploring both traditional and alternative risk transfer solutions can mitigate the issue of limited appetite in some markets, particularly related to frequency activity. Certain types of financial and insurance products directly address the impacts of inflation risk – for example, indexed property policies, offering options to adjust coverage limits based on inflation indices, while inflation-linked bonds provide returns linked to inflation rates.
Globally, cat bonds and parametric (re)insurance have gained traction, not necessarily due to their explicit coverage of inflation, but rather in response to capacity withdrawal and shifts in reinsurer appetite. Parametric (re)insurance in particular, which pays out based on predefined event triggers such as the magnitude of an earthquake, removes inflation uncertainty from capacity providers.
Given the expectations for ‘stickier’ inflation dynamics, cedants should consider tailored reinsurance solutions, both traditional and non-traditional, to help proactively manage inflation risks. Partnering with firms that have extensive market coverage, data-driven insights and customised strategies can assist with this.
Hui Yen Tai is regional director and APAC head of analytics, and Yuan Tian is executive director and APAC lead for strategic financial analytics at Gallagher Re.
The above is an excerpt from Gallagher Re’s recent blog focused on inflation in APAC, originally published on 9 October 2023. For the full blog, please visit: APAC Inflation: Higher for Longer?