U.S. inflation has soared to 40-year highs throughout the first half of 2022, with the All Items Consumer Price Index (CPI) rising 8.5% from July 2021 to July 2022.1 While we feel the impact of rising inflation as consumers every day, it may be less obvious how inflation will affect commercial insurance. Workers’ compensation is especially susceptible to the impact of inflation due to the long-tailed nature of the line of business.
Executive summary
Rising levels of inflation will impact both historical unpaid claim liability estimates on open policies, as well as loss projections and budgeting for prospective policies. With some simplifying assumptions, we can begin to estimate the impact that elevated levels of inflation will have on the workers’ compensation industry. Key findings are as follows:
- When inflation is high, more claims will be pushed into excess layers, forcing excess carriers to not only pay out more, but also to pay out sooner.
- If inflation remains high for just one year, unlimited liability estimates and budgeting forecasts may be impacted as little as 3%—and potentially by more than 20% if inflation remains high for five years.
- The impact of inflation varies by layer. When inflation is high, excess insurers will likely be impacted at least twice as much as primary insurers that retain lower limits losses.
Impact of inflation on a sample claim
Throughout this article, we’ll make the simplifying assumption that inflation is equal to the workers’ compensation severity trend.2 Like consumer goods, the components of a workers’ compensation claim—medical benefits, wage benefits, and legal/expense costs—are also generally susceptible to price inflation.3 A medical service that costs $1,000 to administer today might cost $1,250 in five years. The longer a claim remains open, the more uncertainty there is in its ultimate cost, due to the compounding nature of trend. Let’s first review a sample claim to demonstrate the impact of various inflation levels on cost outcomes.
Suppose we have a hypothetical medium-large lost time claim that pays out (in today’s dollars) $50,000 in year 1, and $5,000 per year in years 2 to 10, with all payments made at the end of each year. This type of payment pattern might occur in the case of an up-front surgery and lost time, followed by several years of maintenance medical services. We’ll assume that inflation is the only factor influencing this claim’s cost going forward and that inflation is constant throughout each scenario. The graph in Figure 1 represents this claim’s cumulative payments at varying levels of inflation while the table beneath it shows the incremental payments.
Figure 1: Hypothetical lost time claim – cumulative payments at varying levels of inflation (ground-up)
When all is said and done, the ground-up cost of this claim may be anywhere between $95,000 and $137,000, depending on inflation throughout the lifetime of the claim. The key driver of the uncertainty isn’t the large up-front cost—even at 10% inflation, this “surgery” cost only increases from $50,000 to $55,000. The real uncertainty comes from the compounding of inflation, which can cause the cost of the annual “maintenance medical services” to more than double by year 10 in the high-inflation scenarios. This can also be seen in the line graph in Figure 1—the further into the lifetime of the claim, the more the lines diverge, as inflation has continued to compound.
Next, we’ll look at this same claim, but from the perspective of an excess insurer rather than from a ground-up standpoint. Let’s suppose the employer is self-insured and retains the first $100,000 per occurrence, and the excess carrier covers costs above this amount.
Figure 2: Hypothetical lost time claim – cumulative payments at varying levels of inflation (excess insurer)
In the scenario with no inflation, this claim never even reaches the excess insurer’s layer. However, as inflation increases, the excess carrier not only pays out more but also pays out sooner. If a period of high inflation persists, more claims will be driven into excess layers, driving up excess claim counts and costs.
Meanwhile, the employer’s maximum expenditure on this claim remains capped at $100,000 in all scenarios regardless of inflation, giving them much more certainty in their potential costs. Of course, if more claims are forced into the excess layer than originally anticipated, then these costs will eventually be passed back to the employer somehow. When inflation is high, the excess carrier will increase rates and/or push insureds to take a higher retention.
Impact on a book of business: Unpaid claim liability
Next, we’ll look at the impact that increasing inflation might have on historical unpaid claim liability for the workers’ compensation industry. Rising inflation impacts not only newly issued policies, but also the ultimate value of prior open policy years as well. Let’s quickly demonstrate why, using a simplified sample loss triangle.
Figure 3: Simplified sample loss triangle
Loss development triangles anticipate that historical trend levels will persist when “filling out” the remainder of a triangle. However, if a calendar year of higher-than-expected inflation emerges, the outermost diagonal will develop higher than anticipated because the historical loss development factors implicitly assume that future inflation will be consistent with historical inflation. This means that as we enter a period of high inflation, unpaid claim liability estimates based on historical trend levels may be insufficient.
Because we can’t definitively say how long this period of high inflation will persist or where the inflation rate will ultimately settle, this example will require several simplifying assumptions. The long-term industry-wide severity trend has hovered near 3% for many years,4 so we’ll use this as our “historical” rate. We’ll then consider several scenarios—a period of increased inflation for one, three, or five years, at 6%, 8%, or 10%—before returning to the historical rate of 3%.
Figure 4: Impact to unlimited unpaid claim liability using industry payment pattern
The table in Figure 4 displays the impact to unlimited unpaid claim liability estimates under several possible high-inflation scenarios, using an industry payment pattern.5 Liability estimates may be impacted as little as 3% in the lowest inflation scenario, or as much as 27% in the highest inflation scenario. However, as shown in the sample lost time claim above, the impact of inflation varies by layer. Figure 4 is likely overstated (as a percentage of liability) for primary layers and understated for excess layers.
Impact on a book of business: Loss projections and budgeting
In addition to impacting historical unpaid claim liabilities, an elevated inflation rate will also impact new policy years. Without adjustment for higher inflation, the impact on loss ratios or budgeting forecasts could be significant.
The graphs in Figure 5 quantify the impact of an elevated inflation rate on ultimate losses for a prospective accident year, as compared to a projection that relies solely on the historical 3% rate. We’ll rely on the same scenarios and assumptions from the prior example—a period of one, three, or five years of inflation at 6%, 8%, or 10%, before returning to the historical rate of 3%. Additionally, the graphs in Figure 5 display the impact to expected losses at various common retentions.6
Figure 5: Percentage increase in ground-up loss projection at common retentions
On an unlimited basis, expected loss estimates may be impacted as little as 3% in the lowest inflation scenario, or up to 21% in the highest scenario. However, with a $100,000 retention in the highest inflation scenario, the impact is only 9%. Once again, a lower retention results in more claims being capped, meaning less variation in cost for primary insurers. As the retention increases, so does the impact that an elevated inflation rate will have on losses.
Finally, we’ll look at the same graphs as in Figure 5, but from the perspective of an excess insurer. Each bar represents a percentage change in expected losses above the attachment point.
Figure 6: Percentage increase in excess loss projection at common attachment points
Notably, the percentage impact to excess losses is much greater than the percentage impact to retained losses under the same scenario. A retention provides certainty in potential cost to the primary insurer, while the inflationary risk is instead passed to the excess insurer responsible for the higher layers of loss.
Conclusion
Workers’ compensation is particularly susceptible to inflationary risk—policies are written and priced on an occurrence basis, but it takes many years for all losses to emerge and fully pay out. If the high inflation experienced throughout 2022 persists for several years, insurers and self-insureds could experience a significant increase in claim costs and material changes to what has been a relatively stable workers’ compensation market over recent years.
About Nodal®
Typically, large claims stay open the longest and thus are most impacted by inflation, which makes it critical to identify and resolve these claims quickly. Milliman’s Nodal is a predictive model for early claim intervention and cost reduction. Nodal uses advanced artificial intelligence (AI) technologies to identify high-cost and low-cost claims soon after reporting, allowing for efficient triage of claims and allocation of resources that maximize the use of staffing and cost containment strategies. Milliman’s team of actuaries, claims professionals, and data engineers has developed an end-to-end solution that is fully supported through implementation, deployment, and assessment.
Appendix
The graph in Figure 7 shows the cumulative change from 2006 through 2021 in All Items CPI, lost time indemnity severity, and lost time medical severity.7 These trends are directionally consistent, and lost time claim trends track well with CPI over a long period of time. The assumption used throughout this article that prospective inflation will equal the workers’ compensation severity trend is likely simplistic, but is reasonable for the purpose of this analysis.
Figure 7: Cumulative trends
1 U.S. Bureau of Labor Statistics. Consumer Price Index. Retrieved August 10, 2022, from https://www.bls.gov/cpi/.
2 See Appendix below for more discussion on relation between inflation and severity trend.
3 While wage benefits available to an injured worker are typically tied to wages earned at the time of injury, approximately half of states make a cost-of-living adjustment (COLA) to reflect inflation. This analysis assumes that all claim costs are sensitive to inflation, including wage benefits.
4 Based on unlimited industry payment pattern from Milliman’s workers’ compensation database. Note that payment patterns may shift as inflation changes. True impact to liability will vary by organization.
5 Based on unlimited industry payment pattern from Milliman’s workers’ compensation database. Note that payment patterns may shift as inflation changes. True impact to liability will vary by organization.
6 Based on industry payment patterns at various limits from Milliman’s workers’ compensation database. Note that payment patterns may shift as inflation changes. True impact to loss projections will vary by organization.
7 CPI data from https://www.bls.gov/cpi/. Workers’ compensation severity data, on an accident year basis, from National Council on Compensation Insurance (NCCI) State of the Line Guide 2022.