Follow up to the letter: Insights from PRA thematic review of general insurance reserving and capital modelling

Following the publication of a „Dear CEO Letter“ in October 2022 as regards the consideration of rising claims (claims inflation) in the modelling of a (re)insurer’s capital needs and its assessment of reserve requirements – current and in the future (please refer to EventID 17794 in this context for more information), the Chief Actuary for General Insurance, Mr. Nylesh Shah, of the Prudential Regulation Authority (PRA) has published a „follow-up letter“. Therein, Mr. Shah outlines the key observations the PRA has made since then concerning the consideration of claim inflation on capital and reserve modeling and some notable issues to be taken into account in this context.
The key observations and remarks are briefly noted below
(1) Adequacy of claims inflation-related increases in reserves: The PRA notes that it has observed such increases but is concerned that the average increase may not be enough to support future claims in light of the expected economic inflation. According to the Authority, a sample of 16 firms has reported an average net-of-reinsurance claims inflation allowance of 5.9%, with a range from 0.6% to 9% which shows that firms do recognize that economic inflation will affect claim settlement costs, such as higher court settlement costs, larger compensatory claim settlements, and increased legal and medical expenses. However, claims inflation may impact firms differently and may even cause a delay of inflation-related consequences upon their operations, depending upon their type and scope of business. Therefore, it is crucial for firms to consider if claims inflation may lag behind economic inflation in their business and to closely monitor any inflationary trends so as to enable them to adjust their capital reserves accordingly and in-time.
(2) Premature release of reserves and underestimation of the impacts of inflation: The PRA has observed that many firms have been releasing reserves from previous years as potential risks in the industry have become less severe. Additionally, premium rates have increased in some sectors, leading to improved financial conditions of insurers. However, the PRA fears that firms might be releasing reserves prematurely, as uncertainties about long-term inflation trends persist. The PRA is also concerned about the risk of overestimating the benefits of market improvements and making inappropriate assumptions about claims inflation. Therefore, the PRA once again emphasizes the importance of accurately estimating future claims inflation and gearing up forces within firms to consistently assess and apply inflation risks. In this context, the PRA also notes that – „given the range of plausible claims inflation paths“ – it is crucial for firms to assess the adequacy of their risk management frameworks and validate their inflation risk models. Furthermore, the calculated Solvency Capital Requirement (SCR) must sufficiently cover this risk.
Finally, the Chief Actuary notes that there is a potential for economic inflation to have a greater impact on claims settlement costs than currently assumed. This, combined with the relatively small increases in reserves made by companies, poses a significant risk of having too little reserves to compensate for inflation. The year-end of 2023 is expected to be particularly challenging for reserving teams, so Mr. Shah, and effective communication and feedback among various departments will help to set appropriate reserve estimates. Establishing a consensus on the expected development of claims inflation, understanding how much inflation is already factored into settlement costs and case reserves, and reserving accordingly will be crucial.
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To conclude, the Chief Actuary notes that the PRA will continue to closely monitor reserve practices of insurance undertakings, particularly in view of the upcoming „mid-year reserving and capital assessment processes“.