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 and it is beginning to spread beyond the US to other countries, says The Geneva Association’s Mr Darren Pain.
A recent Geneva Association report identifies three underlying drivers of social inflation and suggests how insurers can take a proactive approach to mitigating the impact of social inflation on the liability claims landscape and their ability to provide meaningful support to society.
What is social inflation?
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.
Insurance actuaries typically label such growth in claims costs ‘superimposed inflation’, and also separately include increases in claims handling costs and medical expenses to which insurers are often especially exposed. More narrowly defined, social inflation refers to legislative and litigation developments that impact insurers’ legal liabilities and claims costs.
Social inflation is not a new phenomenon. It tends to occur in waves and respond to changes in the liability landscape. Earlier episodes occurred most notably in the 1980s and 1990s/2000s. Moves towards no-fault liability, pursuit of claims against defendants with deep pockets, under the doctrine of joint and several liability, and the emergence of environmental hazards such as asbestos, greatly expanded liability of companies and their insurers.
To the extent that insurers set premiums to cover expected increases in claims costs and hold capital to absorb unexpected losses, temporary bouts of social inflation that quickly subside, though unwelcome, should be manageable.
Much more problematic is when outsized claims represent an enduring shift to a sharply higher trend in claims growth that far outstrips estimates assumed when policies were originated. 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.
Recent escalation in litigation and claims
There are signs that social inflation has emerged again as a disruptive issue. The number of claims pursued through the US courts has risen sharply over the past few years, especially class actions. According to one study, between 2017 and 2019, securities class actions across US federal and state courts were more than double the average number in the previous five years shown in the figure below.
The level of compensation awarded has also increased. As a result, US insurers’ claims across a number of key liability lines accelerated rapidly over the past five years, growing at a rate well in excess of consumer price inflation.
Evidence of social inflation is present in some other countries too, at least for selected types of cases. Litigation in a number of European countries has expanded the categories of compensation – so-called ‘heads of damages’ – available to a victim of tort. Beyond personal injury cases, securities class actions have surged in Australia, with ever-larger sums awarded to plaintiffs leading to significant directors’ and officers’ liability insurance claims.
What are the underlying drivers?
Social inflation reflects a complex set of interacting socioeconomic, institutional and behavioural factors that change over time. Many factors are most pronounced in the US, where adversarial legal procedures often combine with a litigious culture to promote lawsuits and high jury awards/settlements, including large punitive damages. But some resonate more widely, suggesting potential international sources of social inflation, at least for certain types of cases.
There are signs in some jurisdictions of a recent judicial backlash against ongoing tort reform, e.g. of the 32 US states that have reformed punitive damages, four had reforms struck down as unconstitutional and have not enacted additional reforms. Compared with earlier episodes, however, it is not obvious that changes in judicial protocols and reinterpretations of legal doctrines can explain the recent pick up in compensation awards, at least so far.
More generally, the perceptions of companies’ senior attorneys and executives of the litigation environment have improved over recent years despite the pick-up in jury verdicts. Outside of the US, legislative changes have also worked to curb frivolous or abusive litigation and limit damages, at least for personal injury cases. Instead, the key recent drivers for social inflation reflect:
- Aggressive strategies of plaintiffs’ attorneys who have strengthened their activities throughout the litigation process from client acquisition, pre-trial discovery and evidence gathering right through to tactics at the trial itself.
- The development of third-party litigation funding and collective redress mechanisms in a number of jurisdictions, which are changing the economics of litigation and the appetite and ability of claimants to file lawsuits.
- Shifts in judge/public attitudes, on the back of growing recognition of social and income inequalities, about who should bear risk and the appropriate duty of care that firms and institutions should extend to individuals.
Many of these developments pre-date the COVID-19 pandemic situation. But the pandemic could ultimately work to accelerate and/or amplify the underlying drivers to make the claims landscape even more challenging for insurers. This includes possibly expanding the scope of liability standards as well as further hardening anti-corporate public sentiment.
How can (re)insurers respond?
Insurers need to continue to engage actively in the public policy debate to promote changes in the legislative framework that further level the playing field between plaintiff and defendant in order to ensure fairness and financial practicality in settlement awards. In particular, increased transparency and the exchange of information relevant to the calculation of damages, as well as initiatives to curb exorbitant legal fees or at least ensure they are proportionate, would be welcome.
However, on its own, further tort reform it is unlikely to be enough. Likewise, relying on a continued upswing in the underwriting pricing cycle to boost insurers’ results still leaves them vulnerable to a further deterioration in the social inflation outlook, which for long-tail lines can have a leveraged effect on required reserves.
The following three areas of focus for insurers are proposed:
- Enhanced defence case management.
- Better exposure modelling.
- Product innovation. A
Mr Darren Pain is director evolving liability with The Geneva Association.