Effects of High Inflation on Property

EFFECTS OF HIGH INFLATION ON PROPERTY-CASUALTY INSURANCE INDUSTRY 1

Effects of High Inflation on Property-Casualty

Insurance Industry

Taras Feshovets

Global Corporate Risk Management


Insurance contracts are long-term in nature; therefore insurance companies

pricing, reserving and investment strategies are very sensitive to inflation trends. In

recent history, insurers were able to adapt to varying levels of inflation, but it is the

sudden and unexpected volatility of inflation that creates problems for property and

casualty insurers. In some cases, rapid increases in inflation have wiped out entire

pension and life industries. Martin Sullivan, former CEO of AIG and current deputy

chairman of Willis Group Holdings termed inflation as a bigger risk to insurers than

earthquakes, tsunamis or Europe’s sovereign debt crisis (Crowley, 2011). The United

States has experienced relatively tame inflation over the recent years. US Bureau of

Labor Statistics reports that the current inflation rate, as recorded on January 2014, is

1.6% and is expected to remain low throughout the year. However, as the global

economy is recovering from the recent economic downturn of 2008, higher inflation rates

can be anticipated.

Inflation can have adverse effects on property and casualty insurer’s financial

performance and operations but an effective Enterprise Risk Management program can

successfully mitigate the risks associated with inflation. In addition to minimizing the

effects of inflation risk, a successful ERM program can create opportunities for an

insurance company otherwise not available.

This paper will analyze the effects of high inflation on the operations of property-

casualty insurance companies. Specifically, the paper will focus on the effects inflation

has on insurer’s claims costs, loss reserving and profitability. Lastly, the paper will prove

how an ERM program can be used to manage the inflation risk by introducing a silo


approach to the risk management process and promoting risk management within the

organization.

Causes of Inflation

Inflation refers to the change in the overall price levels within the economy. The

two main drivers of inflation are the forces of supply and demand in the economy and the

supply of money. In growing economies, unemployment rate is low; therefore more

consumers are earning wages. Increase in wages leads to an increase in consumer demand,

and as demand reaches above the available supply it pulls the prices higher. This

additional demand creates demand-pull inflation. Shocks to supply resulting from

external events can lead to cost-push inflation. Increases in prices for things such as raw

materials and commodities after a natural disaster will get passed on to consumers in

terms of higher prices for final products.

Foreign currency can also affect inflation rates. When domestic currency weakens,

foreign products become more expensive. During economic expansion, consumers may

buy more foreign products in order to satisfy their growing demand, which will lead to

demand-pull inflation. In addition, when foreign raw materials and commodities are used

in production, weaker domestic currency can lead to cost-push inflation.

Nobel Laureate Milton Friedman argued that is it the supply of money that leads

to inflation. Ever since the breakdown of the gold standard, the value of money is no

longer fixed to an asset. Therefore, if the government decides to increase the money

supply, it will result in a devalued currency because there will be no corresponding

increase in output. Thus, monetarists focus on the growth of money supply as the key link


to long-term price pressures and point to examples of hyperinflation as evidence of this

link (Ahlgrim & D’Arcy, 2012).

Insurer Costs

High inflation increases the cost of claims on current policies for property and

casualty insurers. Claims for policies such as workers compensation, liability, and

property can increase in cost as a result of high inflation. Workers compensation

indemnity is based on wages at the time of a loss. According to Ahlgrim and D’Arcy

(2012), wages tend to increase during inflationary period, but not directly in line with the

Consumer Price Index, which is used as a measure of inflation. Workers compensation

claims rise with inflation, which ultimately increases the cost for the insurer through

higher claims paid.

High inflation may also affect property insurance claims. Property values are

based on the cost to repair or replace the property at the time of the loss. As inflation

increases, so does the value of property, which in turn will raise the cost to repair or

replace it. Claims associated with auto insurance may also increase with high inflation.

Because during inflationary period the general prices for consumer goods and materials

are higher, the cost of replacement parts for automobiles after an accident will also be

higher. Ahlgrim and D’Arcy explain that during the last bout of high inflation,

automobile manufacturers tried to control the prices for new vehicles by increasing the

cost of replacement parts at a level well above the inflation rate. Therefore, the insurance

industry can expect collision damage repair costs to increase more rapidly than the

general inflation rate if inflation were to increase significantly (Ahlgrim & D’Arcy, 2012).


Another important component contributing to the increase of property-casualty

claims costs is the cost of medical services. Medical payments can be included in the

claim payment under workers compensation, automobile insurance, homeowners

insurance, or liability insurance policies. In general, medical cost inflation for property-

liability insurers tends to exceed the general inflation rate (Ahlgrim & D’Arcy, 2012).

Because the cost of healthcare services is on the rise, insurer’s expenses may increase in

the form of higher cost of future claims.

Third party liability arising out of damage to property, or injury to a person

caused by an insured, is another reason why property-casualty claims costs may rise for

insurers. Due to the long-tail nature of liability claims, an increase in inflation can create

a serious risk for insurers. Because liability claims take years to develop and settle, the

ultimate loss may be higher than expected during an inflationary period. In third party

liability cases, the injured party has little incentive to control costs because the plaintiff’s

insurer will pay the damages. The usual practice for this kind of liability cases is to

generate the largest possible settlements for non-economic losses such as pain and

suffering. As this trend continues, insurer’s cost of claims will continue to increase. The

frequency and severity of liability claims is also correlated with inflation. As noted by

Lowe and Warren (2010), the last time inflation spiked in the 1980s, a full-blown liability

insurance crisis erupted, with claims costs increasing well in excess of the general

inflation rate.


Loss Reserves

In addition to the impact of inflation on the cost of future claims on current

policies, property-casualty insurers may also experience adverse affects on loss reserves

during inflationary periods. Loss reserves are commonly set based on the inherent

assumption that the inflation rate will remain static until the claims for current policies

are closed (Ahlgrim & D’Arcy, 2012). This works when inflation is stable, but not when

it is volatile. The loss reserve dollar amount is reported as liability on insurer’s balance

sheet under Generally Accepted Accounting Principles. However, if inflation increases,

the cost to settle the claims for an insurer will be higher than expected from the time

when the premium was charged, and loss reserves created under the old inflation

assumption may be inadequate for future loss payments. In order to adjust for the new

level of losses, the insurer will be required to increase the liabilities for incurred losses.

An increase in liabilities will reduce the insurer policyholder’s surplus.

Policyholder’s surplus is the excess of assets over liabilities and is the top

measure of insurer’s performance. It is used to measure the insurer’s financial strength

and capacity to write new business. A high policyholder’s surplus gives an insurer higher

AM Best rating and the insurer will be able to receive more favorable credit terms and

charge higher premiums. However, with high inflation and the increased claim liabilities

that come with it, insurer’s policyholder’s surplus may be drained. Consequently, a drain

on surplus will reduce insurer’s capacity to write new business.


Insurer’s Profitability

Property-casualty insurer’s profitability may be adversely affected by an increase

in inflation rate. Insurance companies’ profitability depends on underwriting profit and

investment income. However, insurance companies often write business while taking an

underwriting loss in hopes that the investment income received from the invested

premiums will keep the company profitable. Inflation can have some detrimental effects

on investment and underwriting income.

Due to the long-term nature of investments, investment returns are negatively

correlated with inflation rate. In order to generate profits, insurance companies invest

collected premiums in fixed income securities like bonds, as well as equity such as

company stocks. The level of sensitivity of these assets to inflation depends on the

duration and the type of investments. During high inflation interest rates increase. An

increase in interest rates reduces the value of long-term fixed income holdings, which

make up a significant proportion of investments for property-casualty insurers (Ahlgrim

& D’Arcy, 2012). Although statutory accounting does not require insurers to value bonds

that are expected to be held to maturity at the reduced market value, Ahlgrim and D’Arcy

argue that their economic value does indeed decrease (2012). Therefore, insurers that

have significant exposure to fixed-income securities may see their investment profits

decrease when inflation spikes.

In addition to the value of fixed-income securities, high inflation reduces the

value of stocks. Stock returns were significantly negatively correlated with inflation


during the period 1933-1981 (D’Arcy, 1982). Because of this, it is reasonable to expect

that a return to a high level of inflation could reduce the value of stocks held by insurers.

Underwriting profit margins are also negatively correlated with high inflation.

Underwriting profit, also known as underwriting gain, is the profit that an insurance

company generates after paying claims and expenses. In today’s economy, underwriting

profit is rare, as insurers are willing to issue new policies at a loss in order to gain

investment income from premium dollars. However, underwriting profit remains an

important part of insurer’s performance. An analysis of historical relationship between

inflation in the United States and insurance industry’s underwriting profit shows that

during a moderate inflation environment, underwriting profit and inflation are negatively

correlated (Ahlgrim & D’Arcy, 2012).

If inflation rates were to unexpectedly increase, the impact on property-casualty

insurance companies would be substantial. Underwriting and investment earnings will

fall and policyholder’s surplus would decrease as a result of reduced asset values and

increase in liabilities. In order to avoid the risk of insolvency insurers must prepare for

such a scenario.

Inflation Risk Mitigation

To successfully manage inflation risk, property-casualty insurer can institute an

Enterprise Risk Management Program that takes into account actuarial, operational and

investment strategies. According to Ahlgrim and D’Arcy (2012), the moderate inflation

levels from 1983 to 2010 in the United States and Canada have produced an entire

generation of employees who have never experienced a high inflation environment.


Because of low inflation levels, contingency planning for hyperinflation has been

unnecessary. Ahlgrim and D’Arcy also state that similar to a long period without a

natural disaster, the lack of extreme inflation scenarios may lead to complacency about

managing risks. Therefore, Ahlgrim and D’Arcy (2012) argue that the first risk

management technique for insurer is to prepare staff to be ready to deal with high

inflation. Contingency planning that recognizes the impact of high inflation on insurance

company is the first step to effective risk management. Knowledgeable staff will allow

insurance company to respond quickly when inflation environment changes. Examples of

this include, training the underwriters to write insurance contracts with shorter policy

periods during high inflation, and training the investment staff to avoid investing in long-

term bonds when inflation rises.

Property-casualty insurance companies may have to rethink their actuarial

operations strategy to deal with spikes in inflation. One way to achieve this is to

frequently adjust rates in order to keep up with the inflation (Ahlgrim & D’Arcy, 2012).

Trend factor, which is used in the loss forecasting process to adjust for changing

economic conditions, may have to be adjusted frequently to stay in line with inflation.

This process may require significantly more staff than usually required for pricing

functions. Following this strategy would substantially increase insurer’s overhead costs

due to the increase in the number of pricing staff. The company should perform a cost-

benefit analysis to determine if the savings realized from inflation adjusted rates

outweigh the increased overhead costs.

In addition to frequent rate adjustments, insurers can reduce the policy terms in

order to decrease the effects of high inflation on claims costs and loss reserves. A shorter


policy term would reduce the negative effects of high inflation because the losses would

be paid out in a shorter period, and the insurer would be able to increase the premiums

more quickly at each renewal. Since insurance companies invest in fixed-income assets

with maturities that match the duration of the companies’ liabilities, shorter policy

periods would require the insurers’ to adjust their investment strategy accordingly.

A modified investment strategy that takes into account high inflation is an

effective hedge against inflation risk. One way insurers can mitigate inflation risk is to

invest in short-term bonds. As inflation increases, so do interest rates, which significantly

reduce the value of long-term fixed income bonds. Short-term bonds mature more

quickly, thus allowing the insurance company to reinvest proceeds faster and at the same

time reduce the impact of inflation on its earnings. Another effective investment strategy

against inflation is to invest in commodities such as gold. Northwestern Mutual invested

$400 million in gold bullion in May 2009. And however inflation did not increase

significantly since then, concerns over inflation and economic stability pushed the price

of gold up almost 60 percent (Ahlgrim & D’Arcy, 2012). Although Northwestern Mutual

deals with life insurance, property-casualty insurers can take advantage of gold’s inflation

hedging capabilities as well.

Experts argue that real estate provides and effective hedge against inflation. Fama

and Schwert (1977) propose that investment in private residential real estate is a complete

hedge against both expected and unexpected inflation, and on average, the nominal real

estate returns move in one-to-one correspondence with both expected and unexpected

components of the inflation rate. And Case and Wachter concluded that returns realized


by investing in publicly held stocks of real estate investment trusts (REITs) can

effectively offset the effects of high inflation.

Inflation- indexed bonds may also help insurers to hedge against inflation.

Inflation- indexed bonds are tied to the Consumer Price Index; therefore they increase in

value when inflation increases. Inflation- indexed bonds have the advantage of providing

income like nominal bonds and have low-risk based capital charges (Hobbs, LeGraw &

Veit, 2010).

The investment, operational and actuarial approaches to managing inflation risk

cannot be addressed with a silo mentality. In order to successfully manage inflatio n risk,

they have to be integrated into an insurance company’s ERM program. Insurance

companies have to establish clear communication lines between the companies’ actuarial,

operational and investment functions. The first step of an ERM process is risk

identification. Therefore, the first step for insurance companies is to identify that inflation

is a legitimate risk with significant consequences if not managed properly, and train its

employees to recognize inflation as a risk.

The objective of an ERM program is to enable an insurance company to take risks

more intelligently; done correctly, an ERM program aligns a company’s risk appetite

with its risk-taking initiatives (O’Donnell, 2012). Unlike traditional risk management,

ERM manages all risks of the organization in a holistic approach. For an insurance

company those risks include: operational, strategic, hazard, investment, insurance and

financial risks. Based on the concepts of harmonization, standardization, integration and

centralization, an ERM program for a property-casualty insurer will be able to coordinate


and streamline the different business groups of the insurer. Process controls and

management oversight under ERM will improve risk identification and monitoring.

Quantitative standards established under ERM will improve the company’s risk

assessment and measurement. Lastly, with the help of ERM framework, property-

casualty insurers will be able to integrate their risk mitigating techniques into the

company’s other business processes for increased efficiency and better strategic decision-

making. Insurers that engage in ERM will be able to better understand the inherent risk in

different activities of the company. This provides them with a more objective basis for

resource allocation, thus improving capital efficiency and return on equity (Hoyt, Moore

& Liebenberg, 2008).

Unexpected spikes in inflation can have adverse effects on property-casualty

insurance company’s operations and profitability. However, an ERM program that

integrates actuarial as well as operational and investment functions and encourages

communication among different functions throughout the company, will allow the

company to successfully manage inflation risk, and if used effectively can even provide

opportunities for profit.


References

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Lowe & Watson. (2010), “Post-Recession Inflation: An Emerging Risk for P&C

Insurers,” Emphasis 3, 24-29.

Fama, U.F. & Schwert, G.W. (1977). “Asset Returns And Inflation.” Journal of Financial

Economics 5. Crowley, Kevin. (2011), “Inflation may be ‘Monster’ Looming for Insurers, Sullivan

Says”, Businessweek, September 8, 2011. (http://www.businessweek.com/news/2011-09-08/inflation-may-be-monster-

looming-for- insurers-sullivan-says.html) D'Arcy, S. P., (1982), “A Strategy for Property-Liability Insurers in Inflationary Times,”

Proceedings of the Casualty Actuarial Society 69, 163-186.

Case, B. & Wachter S.M. “Inflation and Real Estate Investments.” Samuel Zell and Robert Lurie Real Estate Center, The Wharton School, University of Pennsylvania. http://realestate.wharton.upenn.edu/research/papers/full/716.pdf

Hoyt, R.B., Moore, D.L., Liebenberg, A.P. (2008), “The Value of Enterprise Risk

Management: Evidence From the US Insurance Industry.” Society of Actuaries. O’Donnell, A. (2012), “10 Pillars of an Effective Insurance ERM Framework”,

Insurance & Technology. 23 April, 2014. http://www.insurancetech.com/security/10-pillars-of-an-effective- insurance-erm/240144481?pgno=1

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http://www.insurancetech.com/security/10-pillars-of-an-effective-insurance-erm/240144481?pgno=1

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Effects of High Inflation on Property