A closer look at inflation

Which inflation data are relevant for the valuation of the technical provisions of a non-life insurer? 

Inflation for a non-life insurer often deviates from the Con-sumer Price Index (hereinafter: CPI). This is because the compensated claims often have their own inflation pattern. Think of personal injury, where additions to the third-party liability coverage such as emotional damage have led to a different inflation pattern than the CPI. Also, construction materials or car parts show very different inflation percent-ages than the CPI. Moreover, in motor vehicle insurance portfolios, the fact that cars have increasingly had integrated technology in recent years caused that repairs became much more expensive. In other words, here too, different inflation patterns than the CPI.

From a macroeconomic perspective there are two important inflation figures: the CPI and core inflation. The difference between these two inflation figures is that core inflation – unlike the CPI – does not include inflation on energy and food. For the insurance claims payments, developments in wages and material costs are the most important factors, while energy and food prices only influence this in the somewhat longer term. It is therefore more obvious to take core inflation as a starting point for estimating the expected inflation for the claims burden. In the Autumn Forecast (December 2024), DNB provided insight into the expected developments in, among other things, core inflation. According to DNB, core inflation will amount to 3.2% over 2024, which is a decrease compared to 6.4% realized in 2023. Core inflation will remain stable in the longer term.

For 2025 and 2026, DNB also expects a core inflation around 3%. This core inflation and the expected developments therein are taken as a benchmark for the developments in inflation that are specific to an insurance technical portfolio. However, core inflation is not broken down into underlying cost categories. Since the CPI figures are broken down by Statistics Netherlands into categories, these will be applicable to specific insurance sector – provided they are corrected for expected effects based on core inflation. This workaround helps to estimate inflation figures per specific insurance sector.

Source: CBS

Building and contents insurance

According to the CBS figures, the input price index for construction costs of new build homes was 4.0% higher in October 2024 than a year earlier. This price index has been rising since mid-2024 due to an increasing component for wage costs and a stabilising component for material costs. On the other hand, the inflation development on upholstery and household appliances was -2.3%. This leads to an average inflation of 0.9% as of October 2024.

Motor vehicle insurance

For Motor Casco, an average inflation on the purchase of new vehicles and inflation for maintenance and repair of vehicles can be assumed, which amounts to 2.0% as of October 2024. For a Motor liability portfolio, a combined inflation must be taken into account, of which the material damage part (like for Motor Casco) is taken as the average inflation of new purchase and maintenance and repairs. For the personal injury part, the core inflation is a more obvious assumption, because this compensation consists of a mix-ture of loss of earning capacity (VAV) and compensation for other costs.

Other insurance sectors

For other sectors such as Liability (private or professional), Travel Insurance and Legal Assistance we see that a hodge-podge of item categories is reimbursed from here. There is both a wage cost aspect and reimbursement of various material items. That is why the use of the core inflation for 2024 is justified for such sectors.

Operating costs are also rising due to inflation. We can assume that these largely consist of personnel costs. These costs are directly linked to the collective labor agreement for the insurance sector. A best estimate for wage development in 2024 and 2025 is the CPB projection for the collective labor agreement wages of companies.

Upscaling to full year 2024 and 2025

The starting points discussed before result in an overview of the proposed inflation rates to be used per sector and for the costs (see next page). It should be noted that the presented inflation rates per sector are based on the figures as of October 2024, where the CPI is 3.5%. If we scale this generically with the ratio of the CPI position as of October 2024 to the annual projection of DNB for core inflation (3.2%), a more realistic picture emerges for the entire year 2024.

In fact we are not only looking for inflation, but actually for the ‘add-on inflation over 2024’. After all, the long-term inflation trend has already been implicitly incorporated into the modelling of the technical provisions, because it is included in the historical claim data. We assume the long-term inflation trend to be equal to the ECB’s aim to keep inflation at an average of 2.0% over the long term, except for Build-ings, Contents and Motor liabilty. For these sectors, we have specifically researched the long-term inflation trends and these are higher than the 2% target inflation of DNB (which results in lower additional inflation). For Buildings and Contents, we examined the CBS index for the development of construction costs between 2016-2021. For Liability, a sector average pattern of real inflation on personal injury and material damage was examined to obtain a weighted figure of 3%. By subtracting this from the figures for 2024, an additional inflation figure for 2024 per sector results. The inflation is only just above the CBS long-term inflation for the sectors Liability private and professional and Other. In cases with material impact for these sectors, this additional inflation can be applied in the modelling of the technical provisions.

For 2025, the projected core inflation of DNB is used to scale the sector-specific inflation figures. For the cost inflation, the projection of the CPB is used for both years 2024 and 2025. This results in the following inflation figures for 2024 and 2025 (with an assumption of 50%/50% for Injury and Material in Motor Liabilty):

Table 1: Inflation figures 2025

Table 2: Inflation figures 2025

Technical reserves Solvency II

We will explain here in more detail the impact on the claims provisions, the provision for claims handling costs and the premium provisions.  

Claims provisions

General insurers using the chain-Ladder modelling technique have to deal with the implicit model assumption that in the long run the inflation trend per calendar year in the claim amounts is roughly constant. From 2022 onwards, the data show clear deviation from this assumption, because for the various insurance sectors the inflation in these years was considerably higher than the long-term average. As the inflation for 2022-2023 was already processed in the current status of case reserves and claims payments, the status of the incurred claim amount (as a result of inflation in those years) is already higher than in the situation without inflation in 2022-2023. So no correction is required for the inflation for 2022-2023 on the ultimate claim projection. However, the inflation for 2024 and 2025 is not yet fully processed in the claim amounts. However, due to the reduction in inflation, no add-on is necessary for most sectors.

If it is material, an add-on for inflation should be applied for the expected claims cash flows starting from 2024 in the sectors Liability and Other for all outstanding claims.

These cash flows should be increased cumulatively for 2025 and beyond with the inflation add-on for 2024 and 2025. This is because we assume that, regardless of the year of the claim, any claim not yet settled will increase with the sector-specific inflation, whereby the effect in 2025 is cumulatively processed over the effect of 2024 in the cash flows of the claims reserve. All cash flows are therefore increased by the same factor. It must also be taken into account that the first cash flow takes place during the calendar year 2025. As a result, this cash flow will be exposed for less than 100% to the additional inflation of 2025.

It seems reasonable to assume that the payment patterns of the claims provision will not change significantly due to inflation. However, it is important to monitor per sector what the impact is of higher payments on the estimated settlement duration of claims. As of the end of October 2024, little insight can be provided into this. However, during the annual work for this, an adjustment can be made sector-specific in special cases, based on expert judgment, and it can be made clear whether the payment patterns on the diagonal have changed significantly compared to history.

Provision for claim handling costs

The provision for claims handling costs also uses an implicit cost inflation component. Here the adjustments needed for 2024 and 2025 can be made by increasing the modeled cash flows with the additional cost inflation. All future cash flows are increased with the additional inflation for 2024 and 2025, as is also done for the claims provision. In terms of inflation for claims handling, the expected development of the sector wages can be applied, because salaries are the main component in the costs for claims handling.

Premium reserves

The relevant factors in the premium provision are the expected claims ratio, the cost ratio, the reinsurance cover, the expected retention and the settlement pattern of future claims.

For the premium provision it is important that the Combined Ratio (COR) is adequately adjusted to inflation expectations. The expected future claim ratio is determined on the basis of a long-term average of the (annual) claim ratios, taking into account historical inflation and premium adjustments (general inflation correction method). However, at the end of 2024, two things must be taken into account:

• The additional inflation over 2024 and 2025, which increases the claim ratio;
• Premium adjustmens including inflation corrections, which will reduce the claim ratio.

By correcting the premium and claims base for both effects, a pure estimate of the claims ratio is created. The inflation over 2024 and 2025 can be processed as a product in the claims ratio, because the claims cash flows for both the unearned premium provision and the future premiums will not be paid out until 2025.

The same considerations apply to the cost ratio, except that a different inflation correction is applied here  than the one used for the claim amounts, namely the expected wage cost development (since wages are the main component in the (indirect) costs of insurers). For reinsurance, the inflation adjustments in the reinsurance premium and commission are processed in contractual percentages as determined upon renewal of the reinsurance contracts. For the reinsured claim amounts in the premium provision, the reinsured claims ratio continues to be determined by the gross claims ratio times the quota share percentage and by the long-term Excess of Loss results (corrected for historically adjusted Quota Share percentages and retentions). This ratio indicates the reinsured claims in relation to the gross claims. This gross claims has been adequately adjusted for inflation expectations, which means that the expected reinsured loss has also automatically moved along.

The economic circumstances in times of recession may also lead to higher cancellation. This underlines the importance for general insurers to perform an extensive sensitivity analysis on their assumptions regarding retention.

Similar to the claims reserve, it is possible that temporarily higher inflation has an impact on the run-off pattern of the premium provision. As with the loss provision, there seems to be no reason to adjust this pattern, but if it is done on the basis of expert judgement, it is advisable to include this in the premium provision as well.

[1] Source: StatLine – Nieuwbouwwoningen; inputprijsindex bouwkosten 2015=100 (cbs.nl)