The Effect of Inflation on Losses and Premiums for Property-Liability Insurers

The paper develops a model clearly differentiating between losses whose ultimate settlement value is determined primarily at settlement or at occurrence. Along with an assumption that rates of inflation and interest rates move in tandem, the author suggests that insurance operating results are not as sensitive to fluctuating price levels as one may assume. Abstract: The purpose of this paper is to determine how inflation affects the important element of losses, and consequently how premiums are influenced. We start with a simple model of an individual policy, which is the basic unit comprising the property-liability insurer. The key element of the single-policy model is its stream of future claim payments. By applying inflationary adjustments to these anticipated amounts, the dynamic effects of inflation-rate changes through time are determined. These results allow us to calculate the effects of inflation upon incurred losses and loss reserves. This analysis shows that, when claim costs are related to prices at the time of settlement, incurred losses may rise faster than the inflation rate at the time policies are sold. By introducing investment income directly into the pricing calculation, we further show how inflation in claim costs is related to interest rates and how the combination of these two elements influences the competitive price to charge for the policy. This development illustrates why insurers are, to a large extent, insulated against unanticipated changes in rates of inflation. Finally, the theoretical results, which are somewhat at odds with traditional concepts, are summarized into specific areas of practical application. Keywords: Rate of Return, Risk, Inflation