Stagflation: the risk is back, but not 1970s style

Fifty years on from the 1970s, stagflation fears have returned. The mix of multi-decade-high-inflation and slowing economic growth after the initial strong rebound from the COVID-19 crisis was already challenging for major economies worldwide. We now expect the conflict in Ukraine to push global inflation even higher and put a further brake on growth momentum. 

The impact of the conflict is already showing through in sharply higher prices for key commodities. Many developing countries highly dependent on food imports are now even more vulnerable to food insecurity. To exacerbate the challenge, high inflation is forcing central banks to tighten monetary policy into an economic slowdown, which carries further risks of recession.

Our baseline outlook can be characterised as “stagflation-like”. However, we see this as temporary and driven by cyclical factors, rather than the structural stagflation seen in the 1970s. Today’s economic conditions are very different, and we believe the expected growth slowdown will ultimately bring inflation down.

We see this year as one of transition for the insurance industry globally as it seeks to manage the inflation surge and rising interest rates. Lower equity markets and widening credit spreads will likely lead to mark-to-market valuation losses on assets and capital. Property & Casualty (P&C) insurers are most exposed to the inflation shock, which will increase claims severity. In the near term, property and motor will likely be hit hardest, as price rises in construction and car parts outstrip those in the wider economy. We see headwinds to P&C profitability in 2022, but also tailwinds from further rate hardening in 2023.

For Life & Health (L&H) insurers, sustained high inflation has primarily indirect effects, as rising interest rates support profitability. Investment results benefit as bond portfolios roll over into higher yields, while the profitability of saving products with guarantees – a large legacy book of the life industry – improves. The nature of fixed-benefit products insulates them from claims inflation, though indemnity-based health insurance is exposed to claims pressure in the near-term. However, we expect higher inflation to erode consumers’ disposable incomes and the value proposition of (in-force) saving policy benefits, resulting in higher rates of lapse and surrender.

Given the many uncertainties today, significant downside risks to insurers’ profitability remain. For example, if our alternative global recession scenario were to play out, premium revenues would fall across all lines of business and in all regions. And the “1970s stagflation” scenario would curb demand in both P&C and L&H. In addition, credit spread widening and equity losses would create large mark-to-market losses on assets. Downside risks can be mitigated by strong capital and risk management, underwriting rigour, reinsurance, asset allocation and hedging.

If there is to be a silver lining to this crisis, it is that we see an acceleration to the exit from extreme monetary policy. A paradigm shift towards higher yields is a long-term positive for insurance companies.