Social inflation is the latest buzzword given to the phenomenon of unexpected
rising insurance claim costs because of societal trends and views toward
litigation. While social inflation as a concept is not new, it recently has
become very popular in the insurance press and now appears frequently in the
general press. Nearly every insurance company CEO is talking about social
inflation and how claims costs are increasing in ways that were not
anticipated.
First, let us set the scene before we jump into social inflation.
Reinsurers, through traditional reinsurance contracts, provide economic capital
support to ceding insurers by indemnifying ceding insurers for all or part of
their underlying policy liabilities. This allows ceding insurers to write more
business and maintain sufficient balance sheet surplus.
When entering into a nonfacultative reinsurance treaty, the reinsurer
"underwrites" the ceding insurer and the ceded book of business to
set the reinsurance premium. The reinsurer usually has a great deal of
experience across similar books of business of several ceding insurers, which
better permits the reinsurer to anticipate both premium flow and loss/expense
obligations over the life of the underlying policies ceded to the reinsurance
contract.
Reinsurance Underwriting Analysis
When underwriting a ceding insurer and its book of business, the reinsurer
will consider many factors in determining how it anticipates the ceded book of
business will develop over the life of the reinsurance contract. This is most
often an actuarial determination, with consideration given to factors such as
economic inflation, interest rates, historical loss experience, loss trends,
the competitiveness of the marketplace, the underwriting skill and experience
of the ceding insurer's underwriting personnel, historical and anticipated
profitability, and the legal and regulatory landscape. These and other factors
go into deciding whether to offer reinsurance terms and, if so, into developing
the reinsurance premium.
Of course, the reinsurer's underlying premise is to charge a sufficient
reinsurance premium to pay all of the reinsurance obligations and come out with
a profit. Thus, the analysis of the ceding insurer and its business, along with
the reasonableness and credibility of the likely economic outcome of the
reinsurance contract, is critical to the reinsurer. Much of this analysis
depends on the information provided by the ceding insurer. But, with factors
like social inflation, reliance on information from the ceding insurer is not
enough.
Anticipating how a book of business will turn out is key to profitability
for both the ceding insurer and the reinsurer. When actual experience turns out
to be way off the anticipated outcome, both the ceding insurer and the
reinsurer will lose. A bad outcome makes renewal of a reinsurance program, if
even possible, more difficult and more costly for the ceding insurer.
What Is Social Inflation?
There is no common definition of social inflation. It has been described
many ways, but there are some themes that run through all of the descriptions.
First, it concerns the rising costs of insurance claims. Those rising costs are
being fueled by trends in society like significantly increased jury awards
against corporate policyholders (what some call the "nuclear
verdict").
Second, these increased awards and settlements appear to be caused by some
or all of the following factors.
- More liberal treatment of claims
- Erosion of the tort reforms build into the legal system during the last
century
- Third-party litigation funding
- Erosion in the trust of corporate America
- Changing views of social responsibility and the righting of wrongs (see
the #MeToo movement)
- Populism
- Society's desensitization to large jury verdicts and settlements
A number of commentators have identified generational attitude shifts
concerning the responsibility for damages allegedly suffered at the hands of
corporate America. Jurors accept the litigious nature of our society and are
unfazed by jury awards and settlements in the tens of millions of dollars. The
average juror sees professional athletes and entertainers, as well as corporate
CEOs and billionaires, reaping enormous benefits from society. Commercials by
plaintiffs' law firms in nearly every market tout their ability to win
millions for their clients ("XYZ Law Firm got me $1.5 million when
insurance offered only $150,000").
When faced with a plaintiff's significant injury while sitting on a
jury, jurors have no qualms about righting what they perceive as a wrong done
to the plaintiff by rich corporations. Thus, the predictability of jury
verdicts has gone out the window as these so-called nuclear verdicts have
proliferated.
A number of commentators also think third-party litigation funding has
helped fuel the rising costs of claims. Litigation funding companies provide
significant resources to plaintiffs' attorneys in exchange for a percentage
of the recovery. This funding takes the burden off the plaintiff's attorney
to go out of pocket to retain experts, find witnesses, and develop
sophisticated trial presentations. With litigation funding, the plaintiff's
lawyer can afford focus groups, mock juries, and trial technology.
Without litigation funding, many of these claims would not have been brought
or would not have lasted as long as they have been lasting. Defendants up
against plaintiffs backed by litigation funding have had to bolster their legal
teams, making some cases much more costly to defend than in the past.
Defendants, faced with well-funded plaintiffs' lawyers with sophisticated
technology, have had to match those resources to even the playing field. No
doubt, this has caused a rise in claim costs.
Other factors are court decisions expanding liability, a broader reading on
contract terms, and changes in laws and regulations that increase insurance
losses. While most social inflation articles do not spend much time on
legislative changes, certainly the reviver statutes for child abuse will
increase insurance losses where legacy occurrence policies may be called on to
defend and indemnify those revived claims.
The Effect of Social Inflation on Insurance Companies
Higher claim costs lead to higher insurance premiums. It is that simple.
Greater insurance premiums lead to greater reinsurance premiums. This is what
insurers are seeing in lines of business such as commercial automobile,
directors and officers, medical malpractice, and commercial general liability.
Moreover, unanticipated higher claim costs and significant jury verdicts may
cause some insurance companies to shut down lines of business or, in the
extreme situation, go out of business.
When insurance premiums rise, competition becomes fierce among those
insurance companies in the marketplace still willing to write the underlying
business. Yet, other companies, some new to the business, may undercut the
rising premiums to gain market share. A downward premium trend because of
competition in the face of social inflation could cause several new insurance
insolvencies.
The problem ceding insurers face is that it is very difficult to measure and
predict social inflation. This is because there is a behavioral element to
social inflation arising from generational and attitudinal changes in society
about fair compensation and righting wrongs.
Like other past trends, social inflation is something rating agencies are
looking at when evaluating the financial stability of insurance companies. For
public companies, rating agency commentary about how those companies are
addressing social inflation could cause negative sentiment among investors.
Moreover, if the rating agencies start downgrading insurance companies because
of social inflation, that will affect the ability of those downgraded insurance
companies to write business, obtain financing, and procure reinsurance.
An insurance company's response to social inflation may also trigger
regulatory inquiry or action. Obviously, a regulatory action could affect a
ceding insurer's ability to obtain reinsurance and continue writing
business and, under certain circumstances, could cause termination of a
reinsurance contract.
Why Should Reinsurers Care about Social Inflation?
Reinsurers are subject to many of the same issues that face ceding insurers
dealing with social inflation. The rising costs of insurance claims and
significantly higher jury verdicts and settlements directly affect reinsurers
because those changes alter the economic dynamics of the reinsurance contract.
Nevertheless, generally reinsurers are one step removed and have no direct
control over the policies issued or claims managed by ceding insurers. This
makes them even more vulnerable to social inflation of insurance claims.
With the very low interest rate environment we have had for the past several
years, reinsurers' margins are tied to positive underwriting results and
predicable claim developments. When unanticipated claim costs and expenses
occur due to social inflation, a reinsurer's ability to make a profit may
disappear. In fact, enough runaway verdicts on high-severity claims will cause
a reinsurance contract to go negative for the reinsurer.
Social inflation is similar to any emerging risk except that social
inflation is not an actual risk but a driver of the increased costs to address
risks. Like emerging risks, the effects of social inflation may skew
reinsurance contracts by significantly altering the economic underpinnings of
the reinsurance contract from when originally written.
This is especially true for legacy property and casualty reinsurance
contracts covering occurrence-based policies that are still running off. A
reinsurer may have a reinsurance contract with a ceding insurer that for years
or decades has been in the black with a loss ratio of 70 percent. Social
inflation can cause long-tail claims to resolve at much more expensive
settlements or jury awards than in the past, pushing the overall loss ratio for
the reinsurance contract to 100 percent or more. Additionally, legacy claims
filed under reviver statutes may reawaken dormant treaties.
Because of these economic considerations, reinsurers are watching carefully
for trends in monthly and quarterly claims and are working with their ceding
insurers to anticipate and mitigate the effects of social inflation. That is a
daunting task given the uncertainty and unpredictability of social
inflation.
What Can Reinsurers Do about Social Inflation?
As with all uncertainties, reinsurers need to monitor claims developments
closely and analyze the data to determine whether and how they will engage in
new reinsurance contracts covering lines of business affected by social
inflation. Unfortunately, there is not much a reinsurer can do about legacy
reinsurance contracts.
Reinsurers can, however, closely monitor claims and assist the ceding
insurer in the claims resolution process. Most reinsurance contracts allow
reinsurers to associate with the ceding insurer in the defense or control of
claims. Social inflation may prompt some reinsurers to invoke the association
clause and become more proactive with larger claims. More proactive involvement
by reinsurers, especially those with significant treaty participations, could
mitigate social inflation by speeding up the settlement process.
Conclusion
While social inflation and its effect on insurance claims is not new, it has
become a much more significant issue for ceding insurers and reinsurers in the
past several years. The unpredictability that social inflation brings to
insurance claims makes a challenging business even more challenging.