An Update to D’Arcy’s “A Strategy for Property-Liability Insurers in Inflationary Times”

In 1980, D’Arcy wrote a paper to provide insurers with a strategy to immunize against inflation. Over the past year (2008), it appeared that inflation was going to be a significant obstacle for the insurance industry on the basis of a sharp increase in the cost of commodities and increasing severity trends for property coverage as a result. These inflationary concerns were eclipsed by a massive credit crises spurred on by years of questionable lending practices and commodity prices dropped precipitously in response. At this moment, the U.S. government is planning on spending initiative to stave off a long recession. To finance this initiative, the government could both print and borrow money, which could possibly lead to the kinds of inflationary figures last seen in the late 70s. Given the threat inflation poses to insurance firms, the following is an update to this seminal paper.

Insurance company profits are the sum of underwriting profit (premium less incurred loss) and investment income on the premium prior to paying incurred loss amounts as well as the capital necessary to support the operation. Each of these components will be discussed separately.