Inflation and captive analytics

While US inflation rates have slowed in recent months, the 2022 annual rate is almost certain to at least double the country’s historical average. Apart from a select few outliers, the global economic landscape doesn’t appear to be much different. Economists are currently expecting US inflation to return to a state of relative normalcy by the end of 2023. Until then, risk-bearing entities such as captives must contend with the impact of high inflation.

The consequences of a historically high inflationary environment are far-reaching, and insurance costs are no exception. No matter where a captive’s retained risk comes from, the dramatic increases seen in recent years on materials, medical treatment, and numerous other areas are driving the cost of claims higher than anticipated. Alongside this, the financial implications on items such as property values and wages mean that risk-related strategies must evolve quickly to assess a reasonable level of impact on captives’ exposures.

With that in mind, below are a few tips for captive decision-makers to consider when reviewing or discussing their actuarial analytics in 2023:

Benchmarking databases

Benchmarking databases can serve as a highly useful baseline measurement to determine the financial implications of items such as inflation. Often, such indices are contemplated within a captive’s actuarial report. Identifying these indices and the sources used can lead to more effective communication with your actuary about whether the chosen indices are adequately reflecting the rapidly changing environment and if any company-specific adjustments are needed.

Consider the following list of sample indices that could be involved in such a conversation:

Actuarial analyses using such information typically condense the supporting indices and trend factors into a single exhibit, such as in Table 1. Note that these index amounts are shown for illustrative purposes only and do not represent actual benchmark data.

Table 1: Indices and trend factors used in actuarial analysis

In Table 1, the indices relating to exposures and claim costs diverge over time, but that’s not always the case. Depending on the current economic environment, these indices could be increasing at the same or similar rates. Understanding the impact these two scenarios can have on future loss estimates allows a captive decision-maker to more easily isolate the cause of an unanticipated increase, such as deteriorating loss experience or pure inflation.

Changes in estimates of historical loss experience, on the other hand, can be more difficult to isolate the cause of and may require detailed discussions with the captive’s actuary.

Good communication

Frequent, transparent communication between the captive and its actuary on the unique situation presented by each captive’s risk portfolio is highly recommended. These types of discussions can provide an actuary with very valuable qualitative context for the quantitative information they see in the datasets received.

As an example, consider a captive which retains some level of workers’ compensation risk for a restaurant chain. During the COVID-19 pandemic, the average hourly earnings of the chain’s numerous employees grew significantly, but the number of employees was relatively stable.

If you were a decision-maker for such a captive, how would you convey this information to your actuary, and what types of adjustments might you enquire about in the ensuing discussions?

Similarly, what if the captive in this example retained some form of liability risk and used non-inflationary exposures? How might your approach differ in this scenario?

Other factors

For actuarial analyses involving premium determinations, captive owners should understand both the types of captive expense and the associated estimates included in the actuarially derived premium estimates. If these amounts could be impacted by a high inflation environment, potential adjustments should be identified and provided to your actuary to ensure premiums are not at increased risk of insufficiency.

Economic inflation can, to some degree, be understood and accounted for when using robust sets of historical benchmark data and an understanding of current trends. Unfortunately, the same cannot necessarily be said for social inflation. A rise in the frequency and volume of jury awards, for example, can be difficult to predict but very impactful on a captive’s retained losses.

Determining the ways in which social inflation could factor into your captive’s risk portfolio and discussing these with your actuary could result in a more holistic determination of future loss and premium estimates. This discussion might include qualitative commentary on the events which could lead to a nuclear verdict, as well as their potential likelihood.

Ultimately, a captive’s performance in volatile economic environments relies heavily on the engagement level of the captive owners and the third-party providers they’ve selected. Fostering a high level of engagement isn’t always easy, and it certainly can’t happen instantaneously.

By using the tips listed above, captive owners can begin or continue the ongoing process of building the necessary relationships with their service providers. More than anything, encouraging and maintaining a consistent level of engagement and communication on both sides of the captive team should be the priority, as achieving this is one of the most consistent attributes of financially healthy captives.

Michelle Bradley is a consulting actuary at Sigma. She can be contacted at: mb@sigmaactuary.com" mb@sigmaactuary.com

Enoch Starnes is an actuarial consultant at Sigma. He can be contacted at: enoch@sigmaactuary.com" enoch@sigmaactuary.com