High and persistent inflation has become a key concern for UK insurers, not only because it affects day-to-day costs, but also because it impacts the amount of capital that firms must hold under Solvency II and Solvency UK. While the industry has previously managed inflationary pressures, particularly in claims and operating costs, the current environment brings additional scrutiny from regulators, boards and stakeholders. When inflation rises, so does the uncertainty around future claims, expenses, and investment returns. This uncertainty can increase solvency capital requirements (SCR), influence strategy and change how firms communicate with regulators.
For boards, understanding these dynamics is essential for informed decision-making and effective oversight. Here, we examine how inflation affects capital adequacy and outline what boards should expect from their actuarial, finance, and risk teams to maintain resilience and capital discipline.
How inflation affects solvency capital
Under both Solvency II and Solvency UK, insurers must demonstrate that they can withstand adverse conditions. Inflation affects these calculations in several ways:
Claims costs rise – general insurers are already seeing the impact of inflation in areas such as repairs, construction materials and legal services. As the number of expected claims rises, insurers need larger technical provisions which result in increased SCR.
Operating expenses increase – inflation also affects the basic cost of running a business, with increased salaries, outsourcing, technology and energy costs impacting future expense projections. Under the Solvency II/UK frameworks, insurers must stress-test expenses to ensure that they remain adequate under adverse conditions. If expense assumptions are kept too low for too long, firms may underestimate both their liabilities and their SCR
Inflation risk and modelling assumptions – inflation assumptions play a major role in internal model calculations and influence risk in the standard formula. Even a small change in long-term inflation expectations can alter SCR. Boards, therefore, require regular updates on how sensitive the firm’s capital position is to inflation movements.
Shifts in interest rates and assets – inflation often leads to changes in interest rates. Higher rates may reduce the value of some long-term liabilities but they can also create volatility in investment portfolios. Boards need to understand how these changes combine across the balance sheet.
The board’s role when inflation is rising
Regulators, such as the PRA, increasingly expect boards to have a clear understanding of the risks inflation poses as well as extensive oversight of the issue.
Key board responsibilities include:
Challenging assumptions – to make informed decisions, boards shouldn't simply accept base inflation assumptions, but rather determine how they’ve been set, how often they’re reviewed and if they reflect specific trends, such as labour shortages or supply chain issues, which can impact sector-specific inflation.
Understanding capital sensitivities – to understand their organisation's resilience, boards also need transparent reporting on how changes in inflation affect issues such as SCR, solvency coverage ratios and risk appetite thresholds. This should include exploring outcomes in which inflation remains high for an extended period of time, or when it interacts with slower economic growth or other market shocks.
Overseeing management actions – to review what plans are in place to address inflationary pressures on capital adequacy, boards must review the proposals they have in place. Actions could include pricing reviews, expense management, reinsurance optimisation, and adjustments to investment strategy.
Ensuring regulatory engagement – The PRA has recently increased its scrutiny of inflation risk. Boards are required to demonstrate that their firm has regular, transparent communication with the regulator, a sound understanding of its own exposure as well as clear mitigation plans.
How actuarial, finance and risk teams can support capital adequacy
Actuarial, finance and risk teams already provide much of the insight that boards need to understand the impact of inflation. They can further add value by:
Regularly updating assumptions – inflation forecasts can become outdated very quickly, due to global economic trends and fiscal policies as well as unforeseen black swan events. Regularly updating reserving assumptions, capital calculations and pricing models can help to ensure that the board has an accurate picture of current and emerging pressures
Clearly explaining the impact – actuarial, finance and risk professionals need to explain the impact of inflation concisely and practically. They should be able to demonstrate how inflation affects SCR, the potential volatility in coverage ratios and capital strain and where the organisation faces the greatest exposure
Integrating inflation into pricing and planning – finance, actuarial and risk teams support boards in understanding where inflation affects profitability and where they need to take action by using consistent inflation assumptions around capital modelling, pricing, budget planning and underwriting strategy
Supporting decisions around capital optimisation – when boards are assessing reinsurance options, investment strategies or changes to their product mix, actuarial, finance and risk teams can assist them by providing accurate modelling in order to manage the capital strain that’s linked to inflation.
Actuarial, finance and risk insight informing inflation decisions
Under Solvency II and Solvency UK, inflation has become a significant factor in insurers' capital adequacy. Boards must understand how it affects claims, expenses, investments and capital requirements. By offering clear insight, regular updates, and unambiguous explanations, actuarial, finance, and risk teams can support boards in maintaining effective oversight and sustaining a more stable and efficient capital position amid continuing uncertain economic conditions.
Next time: Reimagining reinsurance strategies in an inflationary environment
If you would like more information about how we can support you in dealing with inflation and capital adequacy, contact Brighter Consultancy.
