While the insurance-linked securities (ILS) industry cannot avoid inflationary effects completely, the structures utilised have some tools embedded that allow ILS managers to tame the effects of inflation on their portfolios, according to Dirk Lohmann, Chairman, Schroders Capital ILS.
In a recent paper, Lohmann gives an insightful overview of the threats inflation can pose to the global insurance and reinsurance industry, explaining how the inflation of values-at-risk and claims quantum can drive impacts to protection sellers, unless properly controlled.
But the industry has some tools at its disposal to counter the effects of economic inflation and specifically in the insurance-linked securities (ILS) market, embedded features in instruments such as catastrophe bonds can work positively to protect investors against inflationary effects.
Inflation implies a general increase in prices, something the world is currently experiencing across most economies.
Explaining why inflation matters to insurance, reinsurance and ILS markets, Lohmann sums it up well by saying, “One of the inherent challenges of selling insurance protection is that one must set a price for the costs of a future event.”
In setting that price it is critical inflation is accounted for and this means diligent underwriting, using the latest possible data and models available.
Luckily, “The insurance industry and ILS managers have different tools and features at their disposal that seek to compensate or mitigate the impact of inflation,” Lohmann says.
Insurance and reinsurance firms have their own sets of tools for managing and countering inflationary effects, and managing inflation driven exposure growth is one of the most critical areas they must focus on.
By controlling, or at least understanding and pricing for, inflation driven exposure growth, it means the value-chain can ensure the latest inflated prices and risk levels are factored into their modelling and so they are paid for increasing risk in portfolios.
But inflation is about more than just macroeconomic risk, for insurance and reinsurance markets, Lohmann rightly says.
So there are other factors the industry must also keep on top of, from changing building codes, to claims adjusting practices and litigation, so-called social inflation, as well as simple construction market trends and growth patterns.
Adjusting total insured values (TIV) for properties is one way insurance interests can keep track of inflations effects on their portfolios of risk, as well as controlling how exposed a policy is to replacement cost values, as seen in roofing, plus managing deductibles better as a percentage of TIV.
These help insurers to understand how their exposure may be rising from inflation, as well as providing ways to control that to a degree.
Which is critical for reinsurance and ILS market interests to understand, when it comes to underwriting protection for them.
Ensuring you have the latest exposure data is critical, as submissions can often lag, in terms of the freshness of data, meaning reinsurance and ILS underwriters must do their own analysis to factor in the effects of inflation and capture value changes.
Lohmann explains, “First and foremost, one needs be conscious of when the exposure data submitted for analysis was prepared. For an indemnity trigger catastrophe bond, or private collateralised reinsurance transaction, it is not uncommon for the exposure data to be captured three to six months prior to the inception date of the instrument. Then one must consider the time elapsed until the potential event may occur.”
Examples of where data may lag include a hurricane bond where the modelling data is as of the start of the year, but the main risk of loss is more than six months later. An underwriter or ILS manager must consider what inflation could do to the exposure in the meantime.
The age of exposure modelling data is another factor, with many of the industry’s main IED’s may not even be updated annually.
While the update frequency of many models and data sets the industry uses are improving, there is always work to do for an ILS manager or underwriter to ensure they have factored inflationary effects into their assumptions and as a result pricing of risks.
“Catastrophe models used by the insurance and capital markets are increasingly sophisticated, regularly updated and calibrated to reflect the latest scientific research on the physical perils and the damage that they can cause. Even so, a residual degree of model risk remains,” Lohmann said.
Adding, “This is why protection sellers receive a healthy multiple over the model expected loss value as compensation for the risk assumed. However, as we all know, a model’s output is only as good as the quality of the data it has as its input. Ensuring that the data used in simulating projected losses properly reflect the most current view of exposure (including potential effects of inflation) is critical to achieving a realistic view of the risk and rewards posed by a given transaction.”
Catastrophe bonds are one reinsurance or risk transfer instrument that have some features embedded to provide some inflationary certainty and to mitigate the negative effects of inflation, Lohmann believes.
“Tradable catastrophe bonds contain certain features that seek to preserve the risk-reward relationship during the life of the bond,” he points out.
These range from the annual reset feature, which allows models to be run against updated insured values and exposure to reset metrics and also the coupon paid, ensuring some level of control over risk-reward for ILS investors.
To growth limitation factors embedded into catastrophe bond terms, for indemnity deals, which limits growth retrospectively by comparing TIV at the time of a loss with the TIV at inception of the instrument, with potential recoveries able to be limited by a pre-defined percentage where growth is deemed too high.
In addition, the much-discussed floating rate nature of catastrophe bonds, as well as other insurance-linked securities (ILS) in note form, “means that, as central banks hike rates to combat inflation, their coupons will rise,” Lohmann further explained.
All of which means there are tools available to the ILS manager that can aid in controlling inflation, providing some protection against its effects, even in a macro-economic cycle such as we see today.
Lohmann concludes, “While these various tools and practices may not eliminate the risk posed by inflation to investors in ILS, they should tame them.
“We’ll have to leave the slaying of the inflation tiger to the central bankers.”