Inflation In The Economy And Its Impact On Claims
By Eli B.Vine and Kathleen M. Klein
As inflation continues to run rampant throughout the United States economy, we have all experienced the effects of supply chain impediments, labor shortages, and increased costs in our daily personal lives. In our professional lives, these circumstances also warrant our attention. In that context, the question for insurers and claims departments is what adverse effects the economic inflation will have on claims and litigation, and perhaps more importantly, what insurers can do to mitigate these risks.
In the field of economics, inflation is typically defined as a general increase in the prices of goods and services in the economy over a given period of time. When prices rise, in general terms, purchases fall. Inflation tends to occur when prices rise due to increases in production costs or, alternatively, when the demand for a product exceeds it supply. Think of the empty toilet paper shelves in the early days of the Covid pandemic or current skyrocketing gas prices. Supply chain issues, surging demands for goods, increased production costs of goods, and trillions of relief fund dollars to fight COVID-19 via the American Rescue Plan of 2021 are all likely culprits of the current inflation in the United States. What does this mean for insurers?
As with most financial institutions, high inflation negatively impacts claims departments and the cost of litigation. What are those expected impacts?
Impact on Loss Reserves
Runaway inflation may adversely impact insurers’ liabilities. Insurers carry liability via loss reserves. A loss reserve is an estimate of an insurer’s liability on future claims it will have to pay out. If inflation is higher than the rate built into the loss reserves, then future payments will be greater than the insurer bargained for. While one would expect the impact of inflation may vary by line of business, an increase of just one percent in inflation can raise the property and casualty industry combined ratios by two to three points.
Impact on insurer liability is further exacerbated by the types of risks insurers cover. For example, claims on personal lines, such as personal automobile coverage, are known and can be estimated relatively accurately in a fairly short period of time. Payouts on these claims tend to be shorter in duration, again typically resulting in a lower risk to insurers in underestimating loss reserves. Other liability lines may have longer payout periods; sometimes they may not be known or resolved for years after they occur. The increased length of time for payouts, coupled with uncertainty over the nature and cost of future claims, can expose the insurer to a significantly higher risk of undervaluing current claims. In a period of economic inflation, these risks are magnified. Workers’ compensation insurance, for example, has potentially longer payout periods and may also be impacted by accompanying changes in wages, medical expenses, and other related costs.
Thus, the impact of inflation on loss reserves may be nominal in personal lines of business, where liabilities are shorter in duration. A one percent increase in inflation may only increase the combined ratio by less than one point. In contrast, for medical professional liability, where the liabilities are generally longer in duration, the same one percent increase may raise the combined ratio by more than five points.
Impact on D&O Claims
Another consideration in evaluating the impact of economic inflation and supply chain issues, is whether this environment could lead to a wave of Directors and Officers (“D&O”) claims and lawsuits. One can easily imagine securities class action lawsuits by plaintiff shareholders, directly relating to a company’s less than anticipated earnings due to inflation and the surrounding circumstances, and the drop in stock price that results. A recent example is the New York class action suit, Vinings v. Vertiv, where the company allegedly failed to disclose to investors the anticipated effects of material and freight inflation. The company estimated fourth quarter 2021 earnings at $0.28, but its earnings report ultimately indicated only $0.06 per share. Now that economies have largely reopened, but supply chains and production struggle to catch up, suits like this could arise as more companies struggle with the effects of inflation on their bottom line.
Impact on Present Value of Future Loss
How will economic inflation impact litigation itself? What about assessments of damages, when a plaintiff asks for compensation for future losses, like wages and future medical expenses. These claims can extend far into the future. While a detailed discussion of the methods of calculating the present value of future losses is beyond the focus of this article, the pieces of this analysis, like “discount rates,” are often hotly contested. We can be sure that vocational rehabilitation and life care planner experts will tap into favorable assumptions about inflation in their calculations of the current dollar value of future expenses.
Learning Point: What can claim departments due to combat the negative impacts of inflation? Maintaining claim reserves adequately, with an eye toward the potential exacerbating effect of inflation and the current economic environment, is one practical step. Another possibility is for claims departments to provide a systematic claims settlement strategy focused on curtailing excessive payout periods, or even a case by case or “soft” policy of advancing payout periods wherever possible, to help reduce the impact of long-term inflation risk. Proactive claims management and partnerships with outside counsel that explicitly acknowledge these risks and emphasize litigation goals in line with this strategy can move the ball forward on the micro level; consistency in this approach has the potential for macro effects. Finally, identification and targeting of emerging regulatory or legislative issues is always useful, to appreciate, act on, and ultimately attempt to influence long-term trends that will affect both the insurer and its insureds.