The current short-term consumer price inflation (CPI) spike is manageable for the reinsurance industry, but should inflation prolong it could weaken carriers’ credit profiles, warns Fitch Ratings.
Currently, CPI rates are approaching multi-decade highs in Europe and the U.S. The spill-over effect from the spike has the potential to inflate claims as repair costs for housing and vehicles trend higher.
Recent rate rises in the property space are compensating for upward pressure on claims inflation, and analysts at Fitch feel that at this time, a short-term CPI spike is manageable for the global reinsurance sector.
However, should CPI remain higher than expectations for two years or more, Fitch says that reinsurers’ credit profiles could deteriorate, and this is despite the ability to leverage a range of defence mechanisms.
According to the ratings agency, firms can navigate the CPI spike issue in both their underwriting and investments.
“The group of underwriting tools are more precise and minimise basis risk, but sometimes are hard to implement if competitive pressures are too strong,” says Fitch. “The investment tools carry a higher basis risk and may be expensive from a solvency perspective, but are available even in soft market phases.”
On the underwriting side, Fitch highlights basis risk (the risk of mismatch between claims inflation and the hedging instrument in place) and the pressure of competition.
Options available to reinsurers include hiking prices to offset claims inflation if competition allows, alongside the possibility to index terms & conditions of treaties to CPI to reflect the heightened exposure.
Additionally, Fitch notes that carriers are able to adjust their investment strategy to offset inflation risk.
As interest rates on financial markets mirror expectations on future inflation rates and the responses of central banks, Fitch explains that a rise in inflation expectations should therefore go hand in hand with rising interest rates.
“After decades of falling interest rates, some reinsurers have bond portfolios with a duration below the one of the corresponding insurance liabilities. This would allow them to reinvest quickly at higher rates, should rates start to rise, and would be a net positive for solvency capital,” says Fitch.
However, the data reveals that higher inflation has not necessarily led to a rise in interest rates.
By exploring 10-year government bond yields in countries like the US or Germany, the response of interest rates to the current multi-decade records in CPI has been muted at best, says Fitch.
Fitch finds that on average, the yields have regained the levels at the beginning of 2020, which is still very low in a historical context.
“This clearly shows that investors such as reinsurers cannot rely on higher interest rates to compensate for higher CPI,” says Fitch.
