Social Inflation: Navigating the evolving claims environment

Social inflation has re-emerged as a disruptive issue for the market, and insurers must proactively pursue initiatives to counter that threat, according to The Geneva Association.

Social inflation is a term that is widely cited in insurance debates but it is often ill-defined or at best only loosely explained. On a broad definition, social inflation refers to all ways in which insurers’ claims costs rise over and above general economic inflation, including shifts in societal preferences over who is best placed to absorb risk. More narrowly defined, social inflation refers to legislative and litigation developments which impact insurers’ legal liabilities and claims costs.

It is not a new phenomenon. Social inflation tends to occur in bouts or waves and respond to changes in the liability landscape. Earlier episodes occurred most notably in the 1980s and 1990s/2000s, especially for product and professional liability as well as medical malpractice insurance.

Recently, social inflation has emerged again as a disruptive issue for companies and their insurers. The number of claims being pursued through the courts has risen noticeably over the past few years and the level of compensation awarded has increased sharply. Though largely a US issue, there are signs of social inflation elsewhere with potential for further international contagion, albeit not to the same degree as in the US. For instance, class action lawsuits, especially for securities litigation, are driving up directors’ and officers’ liability (D&O) insurance claims in Australia.

Under-pricing

The long-run implications for insurers depend on how far recent developments represent an enduring shift to a significantly higher trend in claims growth that far outstrips estimates assumed when policies were originally underwritten. Such persistent social inflation that goes unrecognised for years can lead to chronic under-reserving and under-pricing, especially since liability lines are often long-tail in nature and large claims may come to light only slowly.

An unexpected change of claims inflation has a leveraged effect on required reserves – a change of 2% could increase liabilities by around 16% on a portfolio which takes eight years to settle.

The scale and persistence of social inflation will depend on what is currently driving it as well as any policy and industry response. Among candidate explanatory factors, aggressive strategies of the plaintiffs’ bar throughout the litigation process from client acquisition, pre-trial discovery to the trial itself have been significant. Combined with deepening third-party litigation finance and hardening juror attitudes towards social inequalities and corporate responsibility, this is creating a challenging litigation environment for companies and insurers.

COVID uncertainty

Widespread shifts in liability doctrines and practices in favour of defendants do not seem to have been especially influential recently. However, COVID-19 creates additional uncertainty over future liabilities, particularly as the pandemic could accelerate/ amplify some of the recent underlying drivers of social inflation.

To the extent that insurers are not adequately compensated for the risks they assume, including social inflation, this impairs their ability to fulfil their societal function. While it may be tempting to rely on the recent upswing in the underwriting cycle to bolster insurers’ results, such an approach leaves insurers vulnerable to a sudden spike in required reserves should the long-term outlook for claims deteriorate. Instead, alongside engaging with public policy debates to promote tort reform, encourage increased transparency over litigation processes and curb excessive legal costs, insurers should prioritise three areas:

  • Enhanced defence case management to offer a more effective counter to the plaintiffs’ bar
  • Investment in forward-looking liability exposure management to pre-empt new emerging perils and assess the potential liability costs of shifts in future social inflation
  • Product innovation to ensure liability insurance remains fit for purpose, including promoting more radical solutions such as risk participation arrangements, parametric solutions and, possibly in time, transfer of certain liability risks to capital markets.

In his foreword to the report, Jad Ariss, managing director of The Geneva Association, suggested that insurers need to accurately model the risks they underwrite and price them accordingly, otherwise, unexpected claims payments can seriously damage insurers’ balance sheets and challenge their capacity to provide vital support to society:

“Social inflation linked to liability risks, gone unchecked, poses such a threat. Social inflation is no longer plaguing only the United States but starting to spread to other jurisdictions around the world. The number of liability claims pursued through litigation is increasing along with the compensation awarded to plaintiffs.

“Liability insurance is long-tail in nature, meaning that large claims may occur far in the future and ultimately prove underpriced,” he added. “That is why the recent rise in social inflation is cause for concern: insurance premiums may no longer adequately compensate insurers for the liability risks they assume, including the cost of capital needed to cover unexpected or underestimated losses.”

Against this backdrop, Ariss added, insurers should be proactive: strengthen their claims management processes, focus on better understanding and measuring liability exposures – as rigorously as they do in property – and develop new products and risk-absorbing mechanisms.

“COVID-19 may exacerbate the identified underlying drivers of social inflation, including social inequality,” he said. “As emphasised in a recent Geneva Association report, insurers have a role in addressing this, too. Although private insurance was not designed to mitigate social inequality per se, the financial protection it can provide to vulnerable segments of society is a means of tackling social inequality as well.

“By combining these approaches to stem the rise of social inflation, insurers can safeguard their role in protecting people and businesses against liability risk.”

This is an abridged version of a report produced by The Geneva Association. The full report can be accessed here.

Recently, social inflation has emerged again as a disruptive issue for companies and their insurers. The number of claims being pursued through the courts has risen noticeably over the past few years and the level of compensation awarded has increased sharply.

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