Inflating the way to reserve deficiencies
The dog that hasn’t barked
Many market participants and analysts have been waiting for some time for casualty reserve releases to dry up and deficiencies to emerge. Yet, while there have been a few high-profile cases of the latter, so far we have only really seen some degree of the former across the market.
This seems at odds with both historical experience and the direct implications of a casualty market featuring long-run soft rates and coverage terms. The softening may not have been as material as for other markets (although we will only really know that with hindsight), however we do know that the inevitable impact of under-priced catastrophe business has been increased competition for casualty.
And we also know the proximate cause of both: too much capital lacking attractive alternative options.
Moreover, casualty lines always come with the seductive sense that “smart underwriting” can beat the market. No doubt it can, but fewer tend to succeed in that than believe they will when writing the business. This “problem you don’t know you have” issue is why it is “reserve shocks” even more than “cat. losses” that tend to be the source of market-wide hits to reinsurance industry capital levels.
Of course, we have been here before; however, this time the elephant in the room may prove to be remerging inflation The flip-side of “lower for longer” interest rates is that inflation has been lower for longer too. Exceptional monetary policy measures and historically record low central bank base rates have been possible in part because core inflation has been so weak. In effect re/insurers have been getting reserve release contributions rather than investment income.
For the US, the “Trump boom” may well be changing that. At the time of writing, 5-year treasuries are back up to 2.75% (still historically low but creeping towards the bottom end of normal). And with good cause: injecting a “huge” fiscal stimulus into an economy already at or near maximum capacity should really only have one inflationary outcome! The fact that US tax changes will also increase the US trade deficit (the POTUS’ apparent primary fixation) need not detain us here.
Euro area inflation is also returning. The Fed, the ECB and the BoE are all at various points along the journey to normalising policy and base rates. Japan remains an outlier but that reflects its long battle against structural deflation.
The cumulative global consequences of the eclectic set of Trumpian foreign and economic policy actions are difficult to predict (for oil prices, exchange rates, business investment levels etc.) but China seems to be responding by allowing some return to the debt-fuelled, investment led growth it had been so keen to dampen down. The implosion of a (very large) Chinese bubble may well be out there somewhere, with who knows what impact on global demand. But, for now, a return to relatively normal inflation levels seems not at all unlikely. Even a relatively modest increase in inflation can have a big impact on a line of business with a 10-year tail.
If casualty re/insurers agree, then that should now be showing up in their reserving levels; Yet, while non-cat results have shown weakening up to a point, the impact of reserve hikes doesn’t seem to be a common theme in reported results. It’s not difficult to suspect that there are some “rose—tinted” reserving calls being made.
If so, then to borrow from the Sage of Omaha: when inflation goes up we may well see who has been reserving naked.
The asset side of the balance sheet is also inflation sensitive of course. Rising central bank rates driving up bond yields sounds good in theory for longer tail carriers, but the expectation of that should push down existing bond portfolio values.
A twin inflation driven squeeze on balance sheets (asset values down, liabilities up) could be very painful for some. Yet the loss of industry risk capital that could represent is they very thing needed for pricing to improve.
Reinsurance and its pricing remain a strange old world!
Head of Analysis
Litmus Analysis Ltd