This article was writtenBy Hendre Garbers, Senior Economist, Swiss Re Institute & Ayush Uchil, Insurance Economist & Data Scientist, Swiss Re Institute

Published on:03 Oct 2023

Economic uncertainty is high, with recession and inflation risks still elevated. In this environment, a "severe global recession" and "1970s style stagflation" are two key alternative scenarios that insurers should think about. Each pose distinct challenges, the former around balance sheet strength and solvency concerns, and the latter around underwriting performance. Valid to both scenarios is that mitigation responses can involve long lead times.

Key takeaways

· Ongoing economic uncertainty highlights the value of scenario planning for insurers.

· As one of two alternatives, a "severe global recession" scenario would hit both sides of the balance sheet and raise solvency concerns.

· The impact of "1970s style stagflation, meanwhile, would stress underwriting performance most.

· Key developments to monitor for a shift to either scenario are inflation momentum, monetary policy mistakes, renewed energy/ commodity price pressures, and financial market stress.

· Even with strong balance sheets, insurers should remember that mitigation actions can come with long lead times.

As our baseline, we expect the world economy to continue to slow gradually, growing only 2.2% in real terms next year, down from 2.5% in 2023, and 3% in 2022. At the same time, we expect inflation to remain above central bank targets through 2024. The tenuous growth outlook is rooted in advanced economies, where we forecast the lowest real GDP growth since the 1980s (outside of the global financial and COVID-19 crises), due to the cumulative impact of the unprecedented 2021-2023 global monetary policy hiking cycle.1 Amidst these challenging conditions, we expect the insurance industry to demonstrate resilience over the next two years.2 Nevertheless, slow growth, elevated inflation and the resulting uncertainty around the economic outlook will present challenges for insurers, and risks are to the downside.

In this context, we regard two distinct and more adverse scenarios as key to think through for balance sheet resilience, capital planning and risk appetite: a "severe global recession" and "1970s style stagflation". A global recession would generate unfavourable macro and financial conditions, with sharp slowdowns in economic growth, falling interest rates and significant financial market losses. A scenario of 1970s style stagflation would bring severe inflation amid stagnating growth. As of now and based on our monitoring of scenario signposts, the risks of either scenario playing out appear contained. Still, developments that could portend a shift to one of the alternatives include unanticipated inflation persistence or reacceleration, renewed energy price pressures, monetary policy mistakes, and/or financial market distress.

A severe global recession would hit both sides of insurers' balance sheets and raise solvency concerns. Contracting demand would lead to falling nominal premium growth in both non-life and life insurance

(see Figure 1). At the same time, lower interest rates, widening credit spreads and asset price declines would generate negative investment returns. In addition, for life insurers falling incomes and rising unemployment would likely see premium volumes contract with savings products most affected due to the added impact of low interest rates. In non-life, however, lower inflation and economic activity would reduce claims relative to our baseline.

Figure 1: Swiss re's alternative scenario narratives, key US forecasts and insurance industry impacts relative to the baseline

Our scenarios are parametrized to capture 5-10% likelihoods. Select parameters for only the US are shown, though we monitor the broader scenarios and across major economies. Green/red arrows indicate an overall rather positive/negative impact on the industry relative to the baseline, whereas purple indicates neutral or mixed impacts, reflecting variation across different lines and/or between new and in-force business. Non-life impacts comprise property, liability, and motor, excluding trade credit. Underwriting profitability for non-life: claims; for life: operating margins. Source: Swiss Re Institute

A 1970s-style stagflation scenario, meanwhile, would stress underwriting performance most. Demand for both life and non-life insurance would be curbed, and non-life insurers would be most exposed to the inflation shock through increased claims severity and weakened profitability. As rates rise to meet claims costs, nominal premium growth would be strong, but high inflation would result in lower real premium growth than in our baseline scenario. The adverse impact on investment income would depend on the degree of ALM matching (ie, the extent to which higher reserves are immediately matched with additional assets, which lose value with higher yields). Reinvestments in higher-yielding bonds, however, could support longer-term investment income.

The good news is that the insurance sector entered 2023 with solid capital buffers, and solvency and liquidity positions well above 100% and only slightly below pre-COVID levels.3 Monetary tightening has brought the end of financial repression, and new business can be written on more profitable terms.4 Reserve adequacy, however, is more of a concern.5

But mitigating potential downside scenarios is not about capital and risk management alone. It is also about recognising that strategic actions can come with long lead times. For example, when facing inflation pressures, mitigation options include repricing risks and steering new business to lower-risk products, both of which take time. And, while asset allocation and other hedging tools enable more agile management of investments risk, repositioning still has to consider capital requirements and liquidity needs.

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