James Norman discusses Inflation Modelling within an Economic Scenario Generator
Understanding Inflation: Insights from an Expert Interview
Inflation has been a newsworthy topic in recent years. The inflation levels of 2022 were outside the range of our recent experience, yet similar episodes have happened in the 1970’s and 80’s. James Norman, a founding partner at Proteus Consulting, provides an analysis of the current issues insurers face, including the limitations of existing models and the broader implications on economic scenario generation.
Current Issues with Inflation Models
“Prevailing consensus has been that inflationary shocks were a thing of the past thanks to central bank independence and inflation targeting yet the inflationary shock of 2022 has proved this assumption wrong. Often, inflation models did not account for the frequency, severity and persistence of such events and this has led to a need for a redesign of these models to allow for fatter tails in the distribution of outcomes they produce.”
This is a Global Phenomena
“The inflationary shock was not confined to a single economy but was experienced across many economies simultaneously and affected both sides of the balance sheet as liabilities increased in cost and bond values fell. Models of inflation need to capture these global event characteristics as well as the impact on interest rates and other financial markets. Regulators are increasingly focusing on this issue and how inflation shocks or a change in inflation persistence could affect the financial position of firms they oversee”.
Have Inflation Linked Bonds helped mitigate risk?
“The impact of inflation on real yields, and hence on inflation-linked bond values, has taken some by surprise. During the inflation crisis, real yields increased dramatically leading to a decline in the market value of these investments, particularly for longer duration bonds. However, with real yields now relatively high, inflation-linked bonds are arguably an attractive investment for those seeking to hedge inflation-linked liabilities. While we have not yet seen a significant increase in market-implied inflation expectations, a further inflation shock or policy misstep could increase long-term inflation expectations and hence widen the spread between nominal and real yields.”
Regime Shifts and Economic Shocks
When asked about the concept of “regime shift”, James explained that he prefers to think in terms of “sudden changes or shocks”, followed by a persistent “new normal”, rather than distinct regimes. He said “the economy can settle into a particular pattern for several years, only to be disrupted by an unexpected event. We’ve observed this multiple times over the past few decades, with events such as the financial crisis of 2008 and the coronavirus pandemic. To paraphrase Harold Wilson, a year is a long time in economics. Even when the outlook seems calm, our models must capture the potential for a sudden shift so as to highlight the level of capital needed to weather the storm. A focus on tail risk “and the distributional shape in the tails” is essential”.
Is Inflation “One Size Fits All”?
“General inflation is composed of various components that feed into the overall level of prices. There can be significant differences in inflation rates across these different categories, such as construction materials or medical claims. For insurers, it may be necessary to break down price inflation into finer categories to better understand their specific exposures and, in modelling terms, explore specific indices that are linked to the exposures held.”
Inflation will likely be higher than forecast … mathematically at least !!
“The distribution of inflation tends to be positively skewed, meaning that the chance of large inflation shocks is greater than the chance of large deflation shocks. This results in the mean or expected value of inflation being higher than the mode or “most likely” outcome. The forecasts produced by economists are often for the most-likely value, rather than the mean. Users of these forecasts need to be clear on precisely what they represent and adjust as necessary.
Also, while central bank inflation targets are currently generally around 2%, these targets are not set in stone and there has been some discussion about increasing these targets to say 3%. When coupling these “policy led” increases with the skewed nature of the distribution, it seems likely that we could see higher levels of inflation than currently forecast - on average - in the future.”
Implications for Reserves, Capital and Pricing
“Regarding inflation, while “best estimate” inflation is typically used in the reserving process, non-linear contract features such as excesses and limits can amplify the impact of inflation shocks on reserves because they create threshold effects. The tail of the inflation distributions can also significantly affect capital requirements and solvency. Firms may benefit from stochastic modelling to investigate alternative reinsurance arrangements and/or investment strategy to help mitigate this. The possibility of future inflation shocks should also be factored into pricing and contract design. For insurers generally, the urgency of this issue is very much dependent on the classes of business written, the assets held, and whether, consequently, the balance sheet is particularly sensitive to inflation. ”
Conclusion
We hope we have shown that inflation models are in need of a renewed focus. As the economic landscape continues to evolve, it is crucial to remain vigilant and adaptable to the potential for sudden changes and inflationary shocks whether driven by political or natural events. These insights underscore the importance of robust modelling techniques that can account for extreme events and interconnected risks, ensuring that firms are better prepared to navigate the challenges that lie ahead.
