Social Inflation in General Insurance – why the past is no longer the key to the future

As with almost all facets of society and the economy, Covid-19 is the most high-profile issue facing General Insurance (‘GI’) companies today. However, even before the pandemic emerged, the sector was starting to feel the effects of trends that have been driving increased claims and, as a result, a growing disconnect between past experience and future expectations.

One such trend, and the subject of this article, is that of ‘social inflation’, which has recently received a lot of coverage within the industry. For those less familiar with actuarial work within the GI sector, a fundamental feature of its key processes and assumptions – such as the estimation of prior loss ratios and expected claims development patterns – is that these future projections are based, primarily, on past experience (ie historic data). Any new or intensified claims trend therefore has the potential to reduce the efficacy of this historic data and the methods that rely upon it, increasing the risk that future outcomes are materially different from what prior experience would have suggested was likely to occur.

Social inflation

Social inflation has recently become something of a buzzword in the GI sector and is one of the market’s ‘hot topics’. It is a broad term[1] that covers the observation of higher overall claim costs arising from various social trends, due to higher individual claim amounts and / or increased claims frequency. Some of the main contributing factors include an increased propensity to claim resulting from an anti‐corporate environment, the perception of a more litigious environment, litigation funding, increased jury awards in the US, new types of claims and longer periods to claims settlement contributing to higher legal costs.

Social inflation is primarily associated with liability insurance[2] and has, to date, mainly been observed within the USA. The USA dominates the liability insurance market accounting for c.50% of global liability premiums, partly because of the size of its economy but also because of its high penetration of liability insurance, driven by its litigious ‘claim culture’. Data from the USA on claim amounts are readily available – this is not always the case in other countries – and show a clear increase in both the number and the value of large pay-outs:

Figure 1: Verdict and Settlement Count Index for USA, 2014-2018. Source: adapted from ‘An Update for Property and Casualty Reinsurance Renewals 2020’ IFoA CIGI Webinar, Xiaohan Fang and Amrita Pattni (Guy Carpenter) 27/4/2020 (Original sources: Guy Carpenter, AIG, Shaub, Ahmuty, Citrin & Spratt, Lexis Nexis Verdict & Settlement Analyzer).

The extent to which social inflation will continue, either within the USA or by becoming more evident outside the USA, is unclear. It is possible that the phenomenon will prove to be largely confined to the USA because of its litigation environment and the nature of its legal system. For example, civil courts in the USA have a jury that determine both the outcome of the case and (to some degree) the pay-out that is awarded, whereas cases in UK civil courts are only heard in front of a judge with no jury present. Anti-corporate sentiment and the tendency to side with ‘the man on the street’ mean that juries typically award higher damages than a judge would[3].

As well as driving higher jury awards, anti-corporate sentiment is also a key factor more broadly, making people more likely to pursue a claim in the first place and in turn creating a thriving side-industry of claims companies and litigation funders to enable them to do so. Litigation funding, by no means confined to the USA, enables a party to litigate without having to pay for it. A third-party professional funder pays for the costs / expenses associated with a dispute in return for a share of the proceeds of the dispute if it is successful. This is commonly referred to / marketed as a ‘no win no fee’ arrangement.

Evidence of social inflation emerging outside of the USA does exist but is slightly more nuanced. Continuing with the UK, for instance, the proliferation of car insurance ‘whiplash’ claims that started in the mid-2000s was an example of social inflation (Figure 2). Readily available claims data allowed insurers to respond swiftly with premium increases and the rise in whiplash claims ultimately prompted regulatory changes. Although implementation of the new regulations has been delayed until April 2021 there is expected to be a significant decrease in the value of whiplash pay-outs being made and this is already feeding through into lower premiums for drivers.

Figure 2: Number and average cost of motor insurance claims notified to the UK’s Compensation Recovery Unit, 2000-2011. Source: adapted from ‘The AXA Whiplash Report 2013’.[4]

Other, less direct, examples of social inflation in the UK include a rise in the amount of litigation funding taking place and, in particular, the April 2019 increase in the Financial Ombudsman Service award limit from £150,000 to £350,000[5]. This means that the Ombudsman can order insurance companies to pay up to £350,000 in compensation to consumers and businesses without any court involvement. Importantly, the rulings made by the Ombudsman are based on what it considers to be ‘fair and reasonable’ rather than precisely what is required by law.

With ongoing well-publicised lawsuits being brought against GI companies in relation to business interruption insurance for the Covid-19 pandemic[6] it will be interesting to see how involved the Ombudsman may become in settling such disputes. The surge in Covid-19 claims now facing the industry is clearly quite distinct from the drivers of social inflation, but the claims that arise from it certainly may be increased by these factors – for example a litigious culture making people more inclined to pursue cases against insurance companies.

Trend identification

Regardless of the future development of social inflation, the issue has already been flagged as an area of concern by the Prudential Regulation Authority (‘PRA’). In November 2019[7], James Orr (GI Chief Actuary at the PRA) listed ‘Inadequate claims inflation allowance’ as one of six key issues identified from its recent reserving reviews, highlighting that ‘social and cultural drivers of inflation can impact materially the ultimate cost of claims.’ The letter highlighted the ‘significant differences’ between the claims inflation being observed by claims teams and the claims inflation assumptions being used by other teams such as reserving, pricing and business planning. Alignment across business functions is clearly desirable if the impacts of social inflation are to be adequately addressed.

With the GI landscape evolving rapidly it is not surprising that a recent industry survey found that ‘Earlier identification of trends’ is now seen as the top priority within the sector[8]. It is crucial to have access to timely, relevant and accurate data to enable the early identification (and continued monitoring) of key trends such as social inflation. Companies that are slow to react to the latest data will be selling policies based on old, out-dated assumptions and stand to lose out as a result.

However the identification and, in particular, quantification of trends can be challenging, especially if limited to internal company data. Even if data quality or timeliness is not an issue, there can be inherent ‘noise’ in a claims dataset. Claims volatility caused by a relatively small number of large claims can make analysis challenging. Furthermore, it may be difficult to isolate the impact of other changes such as premium volumes, exposures and underwriting strategies from underlying social inflation trends when analysing data. Disentangling ‘normal’ claims inflation from ‘social’ claims inflation is also not straightforward.

Trend identification is further complicated by the fact that liability insurance classes are often long-tailed and that larger claims, which are more likely to involve litigation, typically take longer to settle. There can therefore be a time-lag of many years between when the business was written and when that underwriting year becomes fully developed, with any social inflation trends acting throughout this period. Translating real-time claims data into actionable insight on emerging trends for underwriters is a complex process and requires a coordinated response across the claims, actuarial and underwriting functions. One possible approach would be to introduce an overarching data science team to better enable the sharing and interrogation of all the available data.

Conclusions

Social inflation is one of several trends acting on the GI industry that has the potential to increase the risk of future claims occurring or increase the size of average claim amounts, or both. The clearest effects of social inflation have so far been seen in the USA, driven by its litigious environment and readily available claims data, but more subtle examples of social inflation are evident in other countries. Ultimately, social inflation is likely to lead to higher premiums and to a strengthening in reserves across GI companies.

Pricing, reserving and capital modelling teams should consider how appropriate their historic data is as a basis for model projections and assumptions, as it may lead to an underestimation of future claims. Having access to timely, relevant and accurate data to enable the early identification of key trends is now a top priority for general insurers. However, being able to identify trends in close to real time, rather than after the fact, is easier said than done and may require companies to make significant changes to their work and / or data processes. The importance of investing time and money to improve data quality and data processes should not be underestimated. Instead of ‘the past being the key to the future’, a more appropriate adage for GI companies is that ‘change is the only constant’.

Rob Givens

July 2020

Notes / References:

[1] Some companies are including emerging risks – such as climate change and cyber – within the broad umbrella of ‘social inflation’ but, more commonly, social inflation is defined as above and excludes the impact of these more specific emerging risks.

[2] Liability insurance (also known as third-party insurance) provides protection to companies and individuals against claims resulting from injuries / damage to people / property that the company or individual could be found liable for. Importantly, liability insurance covers not only the pay-outs for which the insured could be found liable but also the legal costs.

[3] ‘Global head of insurance on the rise of social inflation in the UK’, Mia Wallace; Insurance Business 7/4/2020 (https://www.insurancebusinessmag.com/uk/news/ breaking-news/global-head-of-insurance-on-the-rise-of-social-inflation-in-the-uk-219104.aspx)

[4] The AXA Whiplash Report 2013 (https://www.axa.co.uk/contentassets /4a476aed40ff44e0b3b449c9d03783c5/t27733_axa-whiplash-report-v15.pdf/)

[5] ‘FCA confirms increase in Financial Ombudsman Service award limit’; FCA Press Release 8/3/2019 (https://www.fca.org.uk/news/press-releases/fca-confirms-increase-financial-ombudsman-service-award-limit)

[6] ‘Coronavirus: Lawsuit looms for Hiscox over business interruption policies’, Terry Gangcuangco; Insurance Business 14/4/2020 (https://www.insurancebusinessmag.com/uk/news/ breaking-news/coronavirus-lawsuit-looms-for-hiscox-over-business-interruption-policies-219518.aspx)

[7] ‘Feedback from recent PRA reserving reviews’ (‘Dear Chief Actuary’ letter), James Orr 5/11/2019

[8] ‘Insurance market review 2020 – The future of reserving’, Lane Clark & Peacock LLP 4/12/2019 (https://www.lcp.uk.com/insurance/publications/)