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Thursday, January 13, 2011

How Inflation Impacts Insurers

Inflation is the economic phenomenon of increasing prices for goods and services. It impacts insurers’ claims and general expenses, the value of liabilities and, less directly, the value of assets. Growth in insurers' claims costs has historically exceeded inflation due to additional factors include the effects of increased litigation, changes in social norms, and rising expenses for medical treatment.

Inflation affects life and non-life insurers in different ways

For non-life insurers, unanticipated inflation leads to higher claims costs, thereby eroding profitability. For life insurers, both inflation and deflation are risks. Inflation is often accompanied by rising interest rates, which reduce the value of return guarantees. Rising inflation can have a negative effect on demand, and may lead to policyholders cancelling their policies as well as increasing costs for insurers. In the case of deflation, or if very low inflation persists, interest rates tend to fall. This makes it more difficult for life insurers with large portfolios of minimum interest rate guarantee savings products to earn the appropriate asset returns.

Insurers have several options for mitigating inflation risk

Insurers concerned about inflation risk can mitigate this risk in several ways. On the asset side, insurers can invest in commodities, real estate and inflation indexed bonds, which are most viable inflation hedges. These investments have performed well during periods of high inflation.

Insurers can also modify insurance contracts to shorten the tail and hence the development risk. Insurers can introduce claims made' policies or sunset clauses to address the issue of latent claims. They can also add index clauses linking premiums, limits and deductibles/retention to an inflation-related index.

Reinsurance can also offer insurers protection against inflation surprises. It is particularly helpful in emerging markets, where the risk of high inflation is greatest.

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