As the year draws to a close, insurers need to work out their year-end reserves. Jinit Shah and Shamsul Haque look at the impact of high inflation rates and what this means for the reserving process.

Since the start of 2022, the UK's heightened inflationary environment has posed a challenge for UK insurers when estimating claims liabilities. It can affect two main types of reserve:

The first is the case reserves on reported claims, which firms estimate individually for a particular claim. Claims handlers estimate a value for each reported claim, based on the claims handler’s knowledge. These reserves are reviewed periodically in light of new information including heightened inflation in the economy.

The second area is actuarial reserving, which captures both incurred but not enough reported (IBNER) and pure incurred but not reported (pure IBNR). Firms can estimate these components from both paid claims and the incurred claims data (including case estimates).

However, in high inflationary periods, the actuarial reserving process becomes more complex. This is because it's difficult to predict how long the high inflationary period will last and how that inflation will affect future claims payments.


Economic and claims inflation are not the same thing

Claims inflation is not the same as economic inflation. Each business class will experience different inflation since a variety of inflationary factors will affect every component of a claim. For example, as costs increase, economic inflation directly affects accidental damage claims on motor insurance. It may not directly affect a casualty class of business, however, although there are likely to be secondary impacts such as salary inflation. It’s also important to consider wider social trends, such as court awards in claim settlements, which can also drive claims inflation.

Firms need to understand, therefore, what drives the claims inflation for different business classes in order to set accurate claims inflation assumptions in the reserving process.

It’s also important to note the potential lag between headline economic inflation and observing the inflation within claims.


Lag – making the implicit inflation allowance not suitable

Using standard chain ladder approaches to implicitly allow for inflation won’t be appropriate for all business classes. When new claims paid and case reserves data become available, firms need to review that information more closely.

These issues are under greater scrutiny from the regulators, with the Prudential Regulation Authority (PRA) issuing two letters to chief actuaries of UK general insurers and Lloyd’s Managing Agents:

1 A thematic review of general insurance reserving and capital modelling (October 2022), in which the PRA looked at the impact of the high inflation in the economy

2 Followed in June 2023 by an additional letter to provide further feedback

In these letters, alongside other vital points, the PRA wanted UK general insurers to consider how their data reflects the high inflation environment, and the lag between economic inflation and claims inflation captured in the claims paid and case reserves data.


Claims inflation in the data and setting future assumptions

A periodic actual versus expected (AvE) analysis of the claims data is an imperative step in the reserving approach in the present environment. AvE analysis will identify the starting point of the new claims inflation embedded in the data and indicate how different the implicit inflation in the data is from the expected inflation and future inflation assumptions.

Considering the current economic situation, most of the UK insurers' claims data will most likely move through the following phases:

Presence of claims inflation in the data

Diagram showing the presence of claims inflation in the data

Phase 1

This represents the period where claims outstanding and settlement data wouldn't capture claims inflation, following the economy experiencing a shock of rapidly rising inflation. If the major driver of economic inflation indices is the same as the driver of claims inflation of a particular class of business, there'd be a minimal lag between economic inflation and seeing claims inflation in the claims data of that class. But, as we've seen, claims inflation doesn't necessarily flow directly from economic inflation.

A claims reserving exercise in this phase requires a full and explicit uplift adjustment applied in future claims inflation assumptions.

Phase 2

Here, firms risk double counting implicit claims inflation – which is newly embedded in the data – if they don’t appropriately consider an explicit uplift adjustment to set future claims inflation assumptions. This is because case reserves or settled claims may already include some of the inflation, but it isn't always straightforward to segregate what claims inflation is in those case reserves or paid claims data.

Phase 3

When the data includes claims inflation, implicit inflation alone might be sufficient to project the claims reserve.

Let's look back to the 2022 year-end reserving exercise and where we stand at the upcoming 2023 year-end reserving exercise.


Review of reserving approach for year-end 2022

Year-end 2022 was mixed in terms of the extent of the claims inflation reflected in the paid claim and case reserve data. Although some short-tailed businesses had started to see claims inflation in their data, this was minimal for most insurers, especially for long-tailed business classes such as liability.

Therefore, for reserving purposes, most UK insurers needed an explicit allowance for claims inflation at the end of 2022. For short-tailed perils, such as accidental motor vehicle damage, the paid claims data was already capturing some of the change in inflation – so there was more information on which to base assumptions.

Methods used for 2022 year-end reserving to allow for changes in inflation:

  • Greater reliance on average cost per claim (ACPC) methods for reserving short-tailed classes to identify claims inflation trends
  • Using an initial expected loss ratio (IELR), making appropriate allowance for historical and future claims inflation
  • Estimating an excess factor using a future cash flow approach and applying an inflation index to the future cashflows to derive the overall uplift
  • Using the inflation-adjusted chain ladder approach (in some cases)


Year-end 2023 reserving approach

For short-tailed perils

Almost two years have passed since the heightened inflation period began, and at the 2023 year-end, firms can expect to see claims inflation across most of the short-tailed perils for data for the entire year. Therefore, for reserving purposes, firms can identify the 2023 year-end as phase 2 for the short-tailed perils.

The most important thing to consider at the 2023 year-end is the double counting of the claims inflation already implicit in the data. Actual versus expected analysis will help understand the extent of the claims inflation already implicit in the data, and firms need to carry it out at least quarterly. In setting future claims assumptions in this reserving exercise, insurers may need to apply an explicit uplift but they must adjust it for the inflation already implicit in the data to avoid double counting.

Different reserving approaches may also need similar uplifts. For example, firms can apply an uplift factor in the ACPC method; they can use a cashflow approach to derive that factor. Similarly, firms can apply an uplift factor in the IELR or initial expected burning cost under the Bornhuetter-Ferguson method.

For long-tailed perils

The claims inflation lag is even greater for long-tailed perils, than short-tailed perils, due to reporting and settlement delays. As such, the claims paid data information will still include limited claims inflation information for long-tailed perils and it will remain challenging to identify the extent of claims inflation in the case reserve data. Therefore, we expect most actuaries to use a similar range of reserving approaches to last year.


Falling inflation may require a reversal process

UK inflation and other worldwide inflation have started to fall. As of August 2023, the Consumer Prices Index (CPI) has reduced to 6.7%. According to the Bank of England’s forecast, this CPI rate will fall further down to 5% by the end of 2023. It will most likely maintain this trajectory to reach the UK’s long-term inflation target of 2% CPI in the first half of 2025.

However, this forecast might add extra complexity to claims reserving methods. For example, firms might have to apply a reversal process of reducing inflation
 after phase 3, based on implicit claims inflation in the data and case reserves.


What insurers need to do now

The 2023 year-end reserving exercise for UK general insurers has become more interesting and challenging under the heightened inflation environment. To meet these challenges effectively, firms need to understand how claims inflation differs from economic inflation – while generally following the same trajectory.

It’s also important to understand the lag between the two, and how some aspects of claims inflation can vary significantly from economic inflation indices. As such, firms will see a degree of inflation in their current data, with further inflation crystallising in future claims settlements.

In practical terms, firms need to work out how to accurately capture their claims inflation in the 2023 year-end reserving exercise data and consider the outlook for 2024. This includes continuously monitoring their data using actual versus expected analyses to understand the extent of claims inflation, and how this might change over time. It also requires a robust and appropriate reserving methodology, in line with the class of business and data availability, to include an explicit inflation uplift assumption.

For more information and guidance, contact Jinit Shah.