Peter Johnson, chief property and casualty actuary at Spring Consulting Group, on how this challenging environment is affecting the captive insurance industry

Peaking in June 2022 at 9.1%, the annual 2022 inflation rate leveled out at 6.5% at the close of the year. This is significantly higher than the average inflation rate for the last ten years, which stands at 1.88%, as reported by Forbes. The Covid-19 pandemic (especially the stimulus packages), supply chain problems, widespread worker shortages, Russia’s invasion of Ukraine and resulting oil price surges, the housing market and more predictable market cycles are some of the driving forces behind such high inflation.

Is the worst over? Possibly, but a recession is still a very real threat. The International Monetary Fund (IMF) projects that the 2023 inflation rate will decrease to 3.5%. So, while we hope to see egg prices come down, any overarching trends in the right direction will be gradual and precarious and, unfortunately, not all sectors will be equally impacted.

In our line of work – insurance, risk management and employee benefits – macroeconomic factors like these are seen in the challenges our clients face and the solutions they prioritise. To complicate things, the property and casualty realm is also subject to things like natural disasters, climate risk, changes in societal litigiousness and ransomware/cyber risk. That said, we sat down with Peter Johnson, Spring’s chief property and casualty actuary, to discuss how this challenging environment interplays with his work in the captive insurance space.

Captive Review (CR): Is inflation having an impact on underwriting and pricing?

Peter Johnson (PJ): Yes, we have seen substantial rate increases in the commercial market over the last few years for many liability lines. For example, the supply chain issues that drove up the prices for vehicle repairs and replacement had a direct impact on auto insurance claim severity and created a rate increase need for auto insurers to cover the cost increases. For many companies, these rate increases came in conjunction with increased underwriting scrutiny, forcing up retentions and coverage reductions. Captives were able to step in and offset many of these issues by providing more favourable pricing and better coverage terms.

CR: Some analysts have suggested that while commercial market insurers are concerned about inflation, the impact might be offset to some extent by the benefit of higher interest rates in their investment portfolios. Would you expect captives to realise a similar investment benefit? And, if so, would you expect it to be significant?

PJ: To the extent a captive’s investment portfolio is invested in higher yielding fixed income securities or other investments that are inflation-sensitive, then yes, there would be some offset. In general though, inflation for certain risks is so high that investment income is not able to make up much of the gap and rate increases are required to support the increasing claim severities.

CR: Are there specific coverage lines in captives that will be more affected by inflation than others?

PJ: Cyber, excess liability/umbrella and auto liability have seen higher trends than workers’ comp. Geography is an important factor as well since certain areas have seen noticeably higher/lower trends than the industry average. For example, medical professional liability severity trends have increased, but this varies significantly from region to region. Some states are seeing double-digit severity trends and rate increases while others are experiencing very modest increases. Difference in litigiousness and jury awards drive much of these state-by-state differences. Property is certainly impacted by inflation with increases in cost to build, but natural catastrophes such as hurricanes, wildfire and wind/hail have typically had more of an impact. To compound things, the current supply chain and inflation issues immediately after a disaster can lead to even costlier natural disasters. According to the National Oceanic and Atmospheric Administration’s (NOAA) National Center for Environmental Information, natural disasters cost the US $165 billion in 2022.

CR: Would you anticipate any changes in captive strategies in response to inflation?

PJ: For captives with active investment advisors, I’d expect a response on the investment side depending on their current investment profile and the surplus and loss reserve position of the captive. There certainly could be a variety of responses on the insurance risk side, particularly if inflation is driving up claim severity and significantly changing the risk profile of a captive. Capitalisation, limits, retentions, reinsurance and pricing are all potentially impacted and would need to be considered.

CR: Is there any advice you would offer captive owners regarding inflation strategies?

PJ: In general, it is important to sensitivity-test your pro forma projections every few years based on practical adverse loss outcomes and investment income scenarios. These financial projections can consider higher than anticipated inflation trends over a multi-year projection horizon. This will help determine appropriate captive capitalisation levels, reinsurance, pricing and risk margin to protect against possible adverse events.

CR: Any final thoughts?

MG: Having conversations early as well as reviewing coverage terms and conditions is very important for managing risk in a high inflation environment. As carrier capacity presumably decreases and underwriting profit margins increase for certain carrier lines where rate level increases outpace loss trend, captives will continue to be used to insure more risk and recoup underwriting and investment income related profits otherwise going to commercial carriers. While there are many negatives sprouting from inflation, one positive is that it allows captives to continue to elevate their status as a strategic risk management and financial tactic for organisations of all kinds and help companies better face the difficult economic environment.