Pinning down inflation effects

Many of us have not experienced inflation in our working lifetimes. The challenges associated with the rising cost of living are expected to be with us until at least 2024. From a risk management perspective, inflation touches all areas of the business - from the economic to the human.

Eurozone inflation reached a new record high of 9.1% in August, with UK levels hitting 9.9% in the same month. Key drivers include the war in Ukraine, rapidly increasing energy prices, the fallout from the coronavirus pandemic and the impacts of Brexit. Such high inflation creates several major headaches for risk managers.

Hoe-Yeong Loke, head of research at Airmic, says: “First and foremost, risk professionals need to really understand their organisation’s balance sheet, and their business model, in the current economic climate. Then they need to understand how that balance is being impacted by what is happening around the world today.

“In this volatile global landscape shaped by increasingly interconnected risks, geopolitical risk is fuelling a multitude of other risks such as financial and supply chain risks, and this further creates a feedback loop. The imperative is for risk professionals is to be alert not only to ancillary risks, but also to emerging and systemic risk.”

Here are the top seven inflation-linked threats that risk managers must manage, mitigate or transfer:

1) Underinsurance

European businesses are at serious risk of underinsurance unless they carefully review and update their declared values. However, experts warn that monitoring and updating these is much harder than it has been in the past due to varying rates of inflation globally.

Those risk managers who have not kept up to date may see significant hikes in premiums as values are rebased. There is an added concern that insurers will take longer to adjust and settle claims, particularly when there is a suspicion that a facility was underinsured.

Andrew Slevin, director at Charterfields said: “Underinsurance is, of course, not a new phenomenon. But the rapid growth in inflation over the past years means that the potential costs to companies is greater than ever before.”

He suggests five steps risk managers can take to reduce the risk of underinsurance:

• Ensure that information on locations is accurate, detailed and consistent with the declared values for those locations.
• Carry out a review of declared values to understand the basis and calculations behind [them] and what may need to be updated. Use credible independent third parties to assist, if helpful.
• Review deductibles and any first loss limits – many of these have not changed in years
• Discuss with internal engineering/project teams, or third parties, the assumptions on reinstatement periods, to ensure they match the current situation.
• Review any documentation on values to ensure that these are consistent with the policy terms, include all insurable assets, and include all the necessary information for insurers to help speed up a claim settlement.

2) Rising claim costs and higher premiums

During periods of high inflation, insurance companies face rising costs for claims pay-outs and increased operating costs. In addition, inflation can also reduce the value of investments held by insurance companies, impacting solvency. This can all lead to higher premiums.

Li Xing, head of insurance market analysis at Swiss Re Institute said: “During high inflation periods, insurers may find the uncertainty too volatile, and they may scale back services, thereby reducing the capacity/competition in the market, and therefore the market drives premiums upward.”

Xing suggests several steps that risk managers can take to counter these risks. Firstly, conducting a review on the appropriateness and efficiency of insurance policies, including deductibles and policy limits. Secondly, talking to insurers and brokers to determine whether there is appropriate protection that is fit for purpose. Finally, continuing to invest in and improve the analytics, data and insights required to manage at pace.

3) Supply chain risk

Heightened supply chain exposure is another potential consequence of high inflation that risk managers must have on their radar.

Steve Bishop, Research & Information Director at ORX, says: “Concerns around the financial health of suppliers could lead to business disruption and (third party) resilience concerns. This is particularly material where third parties support the delivery of one or more critical operations/important business services.”

He says risk managers must reprioritise operational resilience testing programmes to focus on scenarios relating to third party resilience. This helps ensure the business has taken actions to remediate vulnerabilities (e.g. third party concentration risk) and are prepared to manage eventualities.

4) Fraud

Many commentators point to fraud as a rising risk in times of high inflation. Garry Slater, group director of investigations at the Claims Consortium Group commented: “As inflation starts to bite this autumn, and the cold winter weather begins to creep in, there is no doubt that risk managers will need to put in place measures to combat potential fraud from cash-strapped individuals and businesses”

He adds that the rise in automation for claims processing and validations may mean that the insurance market is seen as an easy target for both opportunistic and organised fraudsters. Another complication is a lack of data recording and sharing outside of the motor sector.

To combat this, risk managers must continue to focus on threat intelligence, customer and staff communication and education.

5) Medical insurance plans and benefits

The cost of health insurance continues to spiral with medical inflation rising as much as 90% in parts of Europe, such as Turkey. This leaves limited options for companies – either they absorb the cost or look to mitigate by reducing cover, increasing medical limits, or removing cover entirely.

David Dodds, partner, mid-market leader at Mercer Marsh Benefits said: “The complexity of soaring medical premium inflation is already starting to impact the bottom line for many organisations with many looking at ways to control costs. This combined with ever rising employee benefit costs means there is a real risk that Employee Value Propositions (EVPS’s) are being eroded if investment drops off. The result? Risk to the health and wellbeing of the workforce and risk to the health of the business - reduced business productivity and growth risk, increased cost of absence, business operational risk and ultimately reputational risk.”

He says risk managers must revisit plan designs to ensure the best coverage is available at a cost that is market relevant. They need to evaluate whether plans meet the needs of the workforce or if money is being spent on areas that do not drive return on investment.

The introduction of cost sharing through higher deductibles or the introduction of caps on medical policies will be more commonplace over the next 2-3 years. However, Dodds argues it is important for businesses to understand that the current economic won’t last forever and any changes made now must not come at the expense of long-term strategy.

6) Employee mental health

Mental health issues have grown increasingly commonplace as a result of the coronavirus pandemic, with more people suffering from stress, anxiety and depression than ever before.

ORX’s Bishop says: “From an operational risk perspective, in the short term, this could lead to staff shortages and reduced productivity, while in the longer term it could drive reduced staff retention and impact organisational and risk culture.”

Risk managers must review their employee health and wellbeing plans to ensure that mental health is a priority. Insurance needs to cover mental health issues, and firms must train managers to spot the signs of poor mental health among teams.

7) Business disruption

Business disruption has long been on the risk manager radar; however the risks are exacerbated in times of high inflation. For instance, longer lead times for equipment sourcing and longer rebuild periods mean that business interruption coverage timelines may no longer be sufficient.

Meanwhile, the potential for unrest is rising across Europe in anticipation of a long winter of energy disruption due to the war in Ukraine. Food insecurity trigged by high or volatile prices can also spark social tensions and conflicts. Risk managers must ensure that crisis management and business continuity plans are up to date and consider inflation-related exposures.

José Manuel Fonseca, chairman of Brokerslink says: “This ‘perfect storm’ will undoubtedly increase the possibilities of civil turmoil and fraud, among other ancillary risks. Risk managers have always taken care of this kind of risk, but now it will be indispensable to cross-check with the brokers and the insurers for risk transfer possibilities and with risk consultants alongside the internal teams of their companies for managing the eventual non-transferable risks.”

Boxout – stress testing for insurance

Danny Wong, founder of Goat Risk Management, shares how he helped a FTSE100 client stress test their viability as part of their external disclosure requirements.

1) Look at the business and identify all the tentacles related to inflation, consider: supply costs especially energy but everything might go up, customer and creditor bad debt, wage inflation and industrial action, market and competitor response, fraud, security and social unrest risks.

2) For each risk, work out the severe but plausible scenario and the corresponding cost impacts including any assumptions broken out over the next three years.

3) Model these impacts using quantitative methods, taking into account levels of correlation to identify the mean impact. For Monte Carlo fans, I applied an exponential curve to most of the risks meaning those subjective estimates aligned to very low probabilities.

4) Compare this impact against your financial model and tolerance liquidity to see if the company will be viable over the coming period. If not, consider what levers such as reducing capex spend, cost reduction and cutting dividends can be pulled.