Mitigating the inflation threat to insurers 

This reflects positive developments on COVID 19, the build-up of household savings, government stimulus packages and the increased willingness of some central banks to tolerate an inflation overshoot².  Alongside higher inflation expectations, a potential inflation spike (to levels even higher than current expectations) is a growing concern especially for Property and Casualty (P&C) and health insurers.

Higher inflation can affect both sides of the balance sheet, impacting profitability and solvency:

In addition, regulatory capital frameworks typically do not include inflation stresses, meaning that insurers may have no clear yardstick to quantify this threat. Nevertheless, insurers can take action to understand the risk, and help to mitigate it via their investment strategy.

Rising inflation expectations have already impacted nominal yields as well as inflation markets. For example, the US 5 year yield has risen by 62bps in the three months to March 31, 2021 whereas the 1 year yield has risen by just 2bps, anchored by a dovish US Federal Reserve, the net result being a much steeper yield curve⁴.

At the same time risk assets – in particular equities and credit - have yet to respond to the risk of higher inflation.  How they perform may depend not just on the quantum of inflation, but also on the type of inflationary scenario we experience.  An inflationary growth scenario could be benign for risk assets, while stagflation would more likely be negative.  The impact may also depend on the type of exposures held – for example some investors believe value stocks would outperform growth in an inflationary scenario, as they are less impacted by higher discount rates (as earnings and dividends arise sooner).

Inflation-linked bonds – such as Treasury Inflation-Protected Security (TIPS) – have held up well compared to nominal treasuries, and offer contractual indexation to inflation (typically consumer prices).  However, there is a wide range of inflation indices (e.g. wage inflation), and bond indexation may not track closely e.g. in the case of claims inflation.

Gold is another asset which many investors consider as an inflation hedge – it certainly outperformed during the early stages of the COVID 19 pandemic.  However, even though it is perceived to offer general crash protection, it is volatile and its behavior is complex with its intrinsic value a subject of much debate.

Insurers tend to allocate significantly to fixed income, with duration in both assets and liabilities.  Some have chosen to go net short interest rate duration, in the expectation that higher inflation would benefit them via higher interest rates.  However, this is not a cost-free strategy given the steepness of the yield curve implies lower interest income from reducing asset duration.

Inflation-linked bonds are also considered due to their inflation indexation.  However, unless allocations are substantial, they are unlikely to offer complete protection against balance sheet risks arising from higher inflation (and also do not match claims inflation).

Another possibility is to alter risk asset exposure, for instance tilting away from growth stocks and towards value, or shifting geographic exposure, as not all regions are expected to be impacted equally.

At Mercer, we help insurers consider investment strategy in a way that brings together both sides of the balance sheet. Coupling strategic and dynamic asset allocation with stress testing through multiple inflation scenarios allows insurers to target the optimal risk-return trade-off while protecting against specific risks to profitability and the balance sheet.

Our dedicated insurance team is here to prepare you for the opportunities and challenges that lie ahead – and help you be there for your clients when they need you. Connect with us to explore what we can do for you today.

1 Future Inflation expectations implied by the inflation swap and bond markets

2 The return of the inflation menace?, Mercer, 2021

3 The Effect of Deflation or High Inflation on the Insurance Industry, Kevin C. Ahlgrim and Stephen P. D’Arcy, Casualty Actuarial Society, Canadian Institute of Actuaries, Society of Actuaries, 2012

4 Bloomberg