Insurers Confront Inflation for the First Time in Ages
Inflation across the economy could eat into investment margins that have dropped incrementally for the past decade from low interest rates. The open question is: Just how long could it be?
- Terrence Dopp
- December 2021
- Rising: Inflation was up 6.2% in the 12 months ended in October, marking the highest increase in decades.
- Falling: Investment returns on life and health insurers’ portfolios dropped slightly in the decade since 2011, leaving the prospect that inflation could eat up any gains.
- Question: Timing. Will it be a blip as the world shrugs off the COVID-19 pandemic and lingering issues, or is it a pattern that may hold for a while?
The dreaded “I” word is creeping up as a real concern for insurers after decades in the rearview mirror.
The largest unknown for life insurers, and the broader economy, is whether the period of global inflation is a temporary blip that disappears following a once-in-a-generation health crisis, or will it linger?
Numbers tell the story.
The Consumer Price Index for All Urban Consumers tracked by the U.S. Bureau of Labor Statistics rose 6.2% before seasonal adjustments for the year ended in October—the highest in more than three decades. In October alone, it was 0.9% higher. Going a step further, food and shelter combined were more than half of the increase, with food alone rising 0.9% in October. The energy index increased 4.8% over the monthly period and 30% over the preceding 12 months, the BLS said.
“Inflation is already hitting the consumer and corporations, and if it continues to grow or persist unabated, it's going to impact retail spending, consumption and, ultimately, the credit markets as a last order of impact,” said Anthony McSwieney, a senior financial analyst with AM Best. “When it hits credit, it hits insurers' balance sheets.” In other words, inflation at the extremes could eat away at investment returns at the same time it pushes up the value of claims paid. For life insurers, this comes at a time when they find the mixed blessings of the highest sales since 1983 at midyear, as well as years of tightening spreads due to low interest rates.
Spreads are at extremes. We have seen them this low before, but there are things in the macroenvironment that we’ve never seen before in our lives.
Strategic Asset Alliance
The total U.S. life/health industry's admitted assets at the six-month point of 2021 were up 3.7% over the previous year's period to $8.45 trillion, according to a 2021 Best's Rankings report. Another set of AM Best data, which runs from 2011 through 2020, shows a competing issue: In all, investment returns were smaller at the end of the period than when it started. In 2011, the industry had a cumulative pretax investment return of 5.8% and gross yield of 5.53%. By 2020, despite some annual fluctuations, the trend line saw those figures drop to 4.7% and 4.5%, respectively.
In 2020, the highest-performing asset class was common stock with a return of 6.2% followed by contract loans and premium notes at 5.92%. On the other end was predictably cash and short-term investments with a 1.07% return, and other classes fell somewhere between them.
At Prudential Financial Inc., Chief Investment Officer Timothy Schmidt said credit, alternative assets and the commercial mortgage portfolios all outperformed expectations. Fiscal and monetary measures implemented by Congress and the Federal Reserve during the pandemic prompted “confidence and liquidity” that pushed equities higher and spreads tighter, he said. Schmidt said low Treasury rates mean all-in yields remain a challenge for insurers broadly, but the company doesn't anticipate any significant reallocation for its portfolio.
Prudential of America Group led the list of U.S. life/health insurers with the largest total of admitted assets at $687.64 billion, up 1% through the first six months of 2021, according to AM Best data.
“Currently the most pressing issue is the debate on the transitory nature of inflation—specifically, how deep and prolonged it will be and whether it, or the Federal Open Market Committee's (FOMC) response to it, will derail the global economic reopening,” Schmidt said in an email.
Other issues on the horizon include the evolution of environmental, social and governance-based investing, known simply as ESG, and the decarbonization of the economy. Both will challenge asset owners to balance those priorities with attaining the investment returns expected by investors, Schmidt said.
He said Prudential's diversification also will be a positive for the company in that it has exposures to asset classes that outperform in inflationary environments, Schmidt said.
Concerns over the impact of inflation go beyond just Prudential. Inflation is a concern everywhere, and one that has several facets that go beyond just investments.
In Europe, German commercial line affiliates of Munich Re and Hannover Re both cited inflation as a factor—along with COVID-19 and recent catastrophe losses—in what they expect to be a hardening reinsurance market. The eurozone saw a recent inflationary rise, which Munich Re said has the potential to cause higher claims costs at the same time interest-rate levels remained virtually unchanged. “Taken together, these two factors are producing an upward pressure when it comes to insurance prices,” Munich Re said.
The economic effects of inflation could go beyond numbers in a ledger.
On the brokerage side of the industry, Brown & Brown Inc. Chief Financial Officer R. Andrew Watts said consumer behavior carries the most risk for his company in an inflationary environment. Recently, during a quarterly earnings presentation, Watts said that, in isolation, there's a case for inflation to be viewed positively for a company like Brown & Brown. Yet it also could prompt customers to cut costs.
“The one thing that is a variable that happens is how the buyer of insurance modifies how they think about their total cost of insurance,” Watts said. “If their costs are going up, etc., and they're trying to manage their way through, they may evaluate their deductibles, their aggregates, etc., inside of this. So there's just—there's always a lot of moving factors just to kind of keep in mind.”
Inflation is already hitting the consumer and corporations ... and, ultimately, the credit markets as a last order of impact. When it hits credit, it hits insurers’ balance sheets.
While signs are mixed, not everything points to a pattern of sustained high inflation.
U.S. gross domestic product growth slowed to 2% in the third quarter as a combination of supply chain issues and the delta variant of the coronavirus cooled economic reopening. Excluding food and energy prices, the personal consumption expenditures index from the U.S. Bureau of Economic Analysis increased 4.5% in the third quarter, a moderation from the previous one. The question is whether this softening of inflation will pick up steam as the supply chain issues that have bedeviled retailers begin to subside and economic activity nears pre-pandemic levels.
AM Best Director Rosemarie Mirabella said inflation may prove to be a pick-and-choose phenomenon in terms of what issues persist and which aspects abate in a relatively short time frame. For instance, those costs pushed higher by supply chain issues could recede as the backlogs clear. Higher costs to businesses and consumers prompted by increasing wages, though, could remain an issue longer term, she said.
“Inflation's been pretty modest every year I believe from 2011 to 2019 pretty much,” she said. “[The current uptick in inflation] is not good, but the question is whether this is sustainable.”
Alton Cogert, president and chief executive officer of Strategic Asset Alliance, said he doesn't see too much of a fundamental shift in how companies invest their money. Portfolios remain a mix of traditional investments such as corporate fixed income, real estate, bonds and equities. What has changed is the movement toward private equity in the recent past as well as so-called alternative investments such as private debt and direct mortgages to hunt for yield. Going forward, he anticipates smaller and midlevel insurers will move increasingly into that space.
On the positive side for insurers, Cogert said he doesn't see any great jump in credit impingements or corporate defaults happening soon. However, he said the current investment environment is “unique” because COVID-19 lingers, the U.S. is experiencing a record $29 trillion debt and climate change presents both opportunity and peril.
“Spreads are at extremes. We have seen them this low before,” said Cogert, whose company advises insurers on their asset management plans. “But there are things in the macroenvironment that we've never seen before in our lives.”