Will Inflation Bite Insurers?

The twin features of the years following the economic crisis have been confusion and contention. Indeed, the normally staid arena of monetary policy has become politicized with decisions like the Federal Reserve’s quantitative easing policy drawing particular scrutiny.  

“After the crisis monetary policy increased apprehension of both inflation and deflation,” said Kurt Karl, chief economist, Swiss Re Americas, speaking in Toronto this week at the International Insurance Society’s Annual Seminar. “In the past five years, we’ve been through hysteria over inflation, hysteria over deflation and back to hysteria over inflation.”

In his presentation, Martin Hegarty, co-head of global inflation-linked portfolios at Blackrock USA, said there are ample data points for people on either side of the argument to latch onto. Those fearing rapid inflation can point to the persistence of easy monetary policy, large budgets deficits, a weak dollar and rising commodity prices. Those concerned about deflation can point to high unemployment, stagnant wages, a reeling housing market and ongoing household de-leveraging.

Hegarty said the markets have largely discounted the threat of deflation since QE2 and the Fed seems to be shifting its stance as well, noting recent remarks by Federal Reserve Chairman Ben Bernanke. “For the first time in a while, the Fed is not entirely happy with the progression of inflation,” Hegarty said. “The Fed is moving the inflation-fighting part of their mandate front and center. Given the change in inflation dynamics, the hurdle for a QE3 is much, much higher.”

Given the Fed’s vigilance, Hegarty discounts both the prospect of rapid inflation and grinding deflation. Rather he foresees a modest 2% rise in the Consumer Price Index over the next year.

Swiss Re’s Karl was also laudatory of the Fed’s efforts, but did express concern over calls by some in Congress to grant legislators more oversight over the Fed. “As long as the Fed is independent we have great confidence in it. The greatest risk to inflation is [Texas congressman and grassroots presidential hopeful] Ron Paul.” 

So with inflation and deflation seemingly in check, should insurers afford the issue much concern? Karl thinks so. “I am sanguine about inflation, but it is certainly an area we watch very carefully.”

Inflation affects all insurers on the investment side. For P&C insurers the primary threat from inflation comes from claims costs. “If you target 2-3% and actual inflation is 4-5%, your book of business could be under water in just a few years,” Karl said.

To mitigate against inflation risk, Karl said insurers have three primary options. One option is improved contract design, with insurers trying to shorten the duration of the liabilities by including sunset and index clauses in contracts. Another mitigating strategy is purchasing reinsurance. Lastly insurers can hedge by investing in inflation-resistant assets, purchasing derivatives or diversifying into low-inflation geographies.

For life insurers, the inflation is a more mixed bag. Generally, the longer the tail of a line of business, the higher the inflation risk. Todd Solash, SVP and head of retirement services product lifecycle management at AXA Equitable, said life insurers’ assets are certainly at risk due to inflation, but said inflation is not nearly as destructive as deflation to the liability side of the balance sheet. Indeed, the higher rates expected to combat inflation would be very helpful for virtually all long-dated guarantees, such as variable annuities with living benefits.

Moreover, Solash said, insurers regard the prospect of an inflationary period as an opportunity, as it should ignite demand for new products to protect against inflation risk. “I certainly think there is a potential for new consumer products,” he said.

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