The PRA has published its follow up letter to Chief Actuaries of general insurance firms and Lloyd’s Managing Agents regulated by the PRA. The letter provides insights from the PRA’s thematic review of general insurance reserving and capital modelling.
The PRA recently conducted a thematic review across the general insurance sector to assess how firms responded to their previous letter to Chief Actuaries on 20 October 2022 regarding claims inflation. Claims inflation refers to the increasing cost over time to settle general insurance claims. The PRA emphasises that claims inflation can have a varying impact on different firms based on their business models and risk profiles, and there is a risk of solvency coverage deterioration unless appropriate mitigating actions are taken.
The review involved discussions with various firms in the London market, retail, and commercial insurers to understand how they incorporate claims inflation into their Solvency II technical provisions and Solvency Capital Requirement (SCR) calculations for the 2022 year-end. The PRA focused on firms’ identification of claims inflation drivers, assessment approaches for claims inflation, and expectations for future claims inflation.
Firms are reminded to consider claims inflation when calculating technical provisions, as they must be based on up to date, credible information, and realistic assumptions. They should also account for the risk of further claims inflation in internal model (IM) SCR calculations and ensure that where the standard formula (SF) is used to calculate the firm’s SCR, that it remains appropriate.
The PRA provides feedback to the market based on its review, discussing key findings and observations in three specific areas: adequacy of reserve strengthening, mitigating benefits to firms’ reserves and capital, and financial resilience and governance challenges in responding to claims inflation.
In regards to the adequacy of reserve strengthening, the PRA found that the average increases in reserves related to claims inflation may not be sufficient to support future claims, particularly in relation to total economic inflation forecast to pass through the economy. Firms need to consider potential lagging effects of economic inflation on claim settlement costs, how this may increase claim settlement costs, and carefully assess whether such a lag may apply to their business.
The PRA also highlights that some firms may have been able to release from prior year reserves amid recent favourable conditions such as reduced downside uncertainties and increased premium rates in certain sectors. However, firms may be releasing reserves prematurely while uncertainties about long-term trends remain or may overestimate the benefits of market hardening in recent years by using inappropriate claims inflation assumptions, such as adjusting historical cash-flows to their present value to mitigate the impact of claims inflation. Underestimating future claims inflation impacts can lead to a firm overstating their profitability.
Furthermore, the PRA emphasises the importance of financial resilience and governance in responding to claims inflation. Given the potential for more economic inflation to affect claims settlement costs, there is a risk that the market may require further strengthening of prior years’ reserves. Strong interactions, communication, and feedback loops between functions within firms are essential to support reserving teams in setting appropriate reserve estimates.
The PRA concludes by stating that they will continue to monitor and review how firms incorporate claims inflation in their reserves, claims, capital requirements, and underwriting/pricing. They urge firms to review the findings and consider the impact on their firm during the mid-year reserving and capital assessment processes and beyond.
The PRA’s thematic review highlights the importance of addressing claims inflation adequately, considering its potential impact on solvency coverage, financial resilience, and risk management in the general insurance sector.