Bank of England flashes warning lights on inflation

As UK inflation stays stubbornly high, and the government’s pledge to halve the current rate by the end of the year looks increasingly futile, the Bank of England has responded by raising interest rates at pace that has created alarm among consumers, mortgage holders and businesses. It has also led the Bank itself to fire off warnings to insurers.

The latest red warning light to start flashing is over claims reserves, writes Contributing Editor David Worsfold.

Last week, the Prudential Regulation Authority (PRA) followed up its cautious advice about the potential impact of inflation on claims in October with a much starker warning.

Nylesh shahIn a letter sent to general insurers, Nylesh Shah, chief actuary for general insurance at the regulator, said there could be a “significant effect on the representation of a firm’s financial strength” if an insurer misjudges or under-estimates the impact of inflation on claims costs.

“There is a risk that persistently elevated claims inflation might result in a material deterioration of solvency coverage for some firms unless they take appropriate mitigating actions,” he wrote, pointing to the danger that some firms might dip too far into their reserves if premium income failed to keep pace with claims costs.

The October letter was a prelude to a thematic review of claims in the general insurance sector and this found firms reporting an average net-of-reinsurance claims inflation allowance of around 5.9% for predominantly personal lines insurers and 3.4% across all other firms.

Overall, the general insurance market has seen rates in most classes of business harden over the last two years. Some were encouraged by this trend to release reserves but premium rate increases are now lagging inflation, especially as we are now clearly in a higher for longer inflationary climate. Added to the impact of the general rate of inflation on claims, the PRA says insurers must take account of rising court settlements, which are out-stripping inflation.

Shah’s letter warns against relying on rising premiums to cover this gap: “The average increases applied may not be sufficient to support future claims in relation to the total economic inflation forecast to pass through the economy.”

This, he says, has created a risk that firms may be releasing reserves while uncertainty remains regarding long-term trends.

This warning to general insurers comes hard on the heels of warnings to insurers in the bulk annuity market, which have been ramped up steadily since the turn of the year, and especially in the wake of the short-term turbulence in the LDI (liability driven investments) market last autumn.

The bulk annuity market has boomed as increased UK interest rates have reduced the value of schemes’ liabilities and increased funding ratios, making bulk annuity buy-ins and buy-outs more affordable. Some of these deals are backed by funded reinsurance which increases insurers’ capacity to do major deals. Some estimates suggest could the total value of these deals could top £60bn this year.

It is these reinsurance arrangements that are causing most concern at the regulator. 

Charlotte Gerken, executive director of insurance supervision the PRA, said in a letter to insurers and in a recent speech that insurance groups relying on reinsurers to help meet a surge in demand for corporate pension deals risk creating a “systemic vulnerability” for the sector and restraining domestic investment.

“The effect might be to accelerate these transfers in the short run, but it would come at a cost of creating a systemic vulnerability in the form of a concentrated exposure to correlated, credit-focused reinsurers,” she wrote. 

She also highlighted the potential clash with government policy as assets ceded to reinsurers are not available for reinvestment in long-term UK investments, a key Treasury objective. In addition, the PRA has warned that some of the assets used to back these deals are not suitable for matching with the long-term liabilities of pension funds, while others could potentially be highly illiquid in stressed markets.

These are unlikely to be the last warnings ­or interventions by the regulator as inflation continues to cast its lengthening shadow across the UK economy.


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