Underwriting impacts: Today’s macro risk issues and how the industry needs to handle them

While the insurance industry will always face risks and challenges, the current risk environment may be the most challenging in 45 years, with multiple macro risk issues going on at the same time. These include a war in Europe, rising economic inflation, social inflation, a pandemic, social unrest, cyber risk, supply chain issues, workforce disruption, climate change impacts, and the threat of a recession, all occurring simultaneously. In addition, the industry is experiencing a nuanced, transitioning insurance market that many believe may well be moving from hard to softening. Although these issues may seem daunting, addressing them in a systematic way can enable carriers to manage effectively for long-term growth and profitability.

Using a data-based approach to deal more effectively with market cycles

Although the insurance marketplace is continuously competitive, market cycles are commonly referred to as hard and soft. A hard market is a sellers’ market that is generally characterized by reduced capacity, higher reinsurance costs, higher rates, reductions in limits, and tightening of terms and conditions. Soft markets are buyers’ markets, and generally exhibit rate reductions and loosening of terms and conditions.

In the last 45 years, four hard market periods took place, in approximately 1975-1978, 1984-1987, 2001-2005, and now. The rest of the time was either a soft or transitioning market. Some would say, and I generally agree, that we are currently in a transitioning market, as we are experiencing some moderation in rate increases and are seeing additional competitors enter the market.

Transitioning markets can be the most difficult to navigate as carriers attempt to balance rate adequacy with market forces in order to find the equilibrium pricing for each account. Carriers’ prudent goal is to optimize pricing so that they achieve adequate profitability and keep the business they like. It is especially difficult to reach equilibrium pricing when competition is moving the market from identifiably hard to possibly softening, as appears to be the case today. Effective methods are needed to help carriers navigate through all market conditions.

Carriers employ product segmentation strategies that enable underwriters to select and price business based on desirability characteristics. Segmentation works well regardless of market conditions by characterizing each business opportunity based on its measurable attributes, and understanding the correlations between those attributes and profit. These attributes often include territory and location; the size of the account; limits and attachment; coverage; class, commodity or industry; insured risk management/mitigation capabilities; construction occupancy protection exposure (COPE), as applicable; and the prospective insured’s financial and management experience and claims history.

Regardless of the exact attributes considered by a given carrier, segmentation helps to establish a data-based approach to risk selection. In addition to being important for carriers’ profitability, this data-based approach also helps them send their producer partners—brokers and others—the right signals about the opportunities in which each carrier is most interested, creating efficiency for brokers and carriers.

A cross-disciplinary approach to adjusting for inflation

Everyone in the industry has become increasingly aware of the challenges posed by inflation. For the last few years, headlines have mentioned social inflation, meaning the impact that non-economic influences have on the cost of claims. Typically, changes in legislative or judicial outcomes cause social inflation due to higher awards or settlements. Claims in the hundreds of millions of dollars, or even reaching a billion dollars, have been in the news recently.

During recent months, the industry has also been hearing about—and experiencing—economic inflation. While social inflation impacts are serious and increase the cost of insurance, economic inflation impacts both premium and claims. According to figures from the US Bureau of Labor Statistics, from 2016 to 2020, economic inflation hovered around 2%. Recently, however, measures of economic inflation have hit the 9% range—the highest since the early 1980s.

Inflation has meaningful influence on the values of future claims payments. Carriers receive premium today in exchange for a promise to pay an uncertain amount in the future. This uncertainty stems from several factors. In addition to the insurance risk and the uncertainty around the inherent amount of the claim, there is the financial risk: the impact of inflation on the actual amount of the claim at the time of payment. For property and casualty insurers, inflation leads to higher claims costs, thereby eroding profitability. When business is priced today, prudent actuaries will include provisions for anticipated future inflationary impacts.

While inflation impacts both first- and third-party lines, extended periods of accelerating inflation are especially problematic for long-tail lines of business. The cost to repair and replace automobiles, for example, is impacted by materials and parts increases, as well as increased labor costs. The same is true with building costs. Medical cost increases have a significant impact on bodily injury cases, as they increase the cost of care and the value of settlements.

Larger than anticipated inflationary increases may render carriers’ rates inadequate. When inflation was in the 2% range, carriers had more confidence that their trend assumptions were adequate. Current levels of inflation, however, introduce more volatility and uncertainty.

Underwriting managers’ roles in navigating market cycle and inflation risks

To underscore a key takeaway: to navigate the current market, it’s important to maintain appropriate rate increases to offset the potential impacts of inflation. It’s also critical to recognize that everyone working at an insurance carrier has a role in helping it achieve successful outcomes.

The role of underwriting manager is especially important because busy, highly motivated underwriters may find it challenging to step back and take an outside-in view of trends and market conditions. The manager should take a broader view and support the underwriter with that contextualization.