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Casualty Actuarial Society Experienced Practitioner Pathway Seminar Lecture 8 – Inflation Stephen P. D’Arcy, FCAS, MAAA, Ph.D. Robitaille Chair of Risk and Insurance California State University – Fullerton D’Arcy Risk Consulting, Inc. . Overview. General discussion of inflation/deflation

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  1. Casualty Actuarial SocietyExperienced Practitioner Pathway SeminarLecture 8 – Inflation Stephen P. D’Arcy, FCAS, MAAA, Ph.D.Robitaille Chair of Risk and InsuranceCalifornia State University – FullertonD’Arcy Risk Consulting, Inc.

  2. Overview • General discussion of inflation/deflation • Why inflation/deflation matters to insurers • Historical inflation/deflation rates • Modeling future inflation/deflation • Applications of inflation/deflation model EPP Lecture 8: Inflation

  3. Why Study Inflation/Deflation Now? • Recent inflation rates have been low • Potential for dramatic change • Recession could lead to deflation • Financial crisis of 2008 • Euro crisis • Expansionary policies could lead to high inflation • Quantitative easing in developed countries • Rapid growth in some developing countries • Increased uncertainty exists for inflation forecasts EPP Lecture 8: Inflation

  4. What is Inflation? • For consumers • Change in prices • Change in cost-of-living • For investors • Impacts purchasing power of investments • Real vs. nominal interest rates • For insurers • One of the most significant risks facing insurers • Affects cost of doing business, underwriting results and investment performance EPP Lecture 8: Inflation

  5. Inflation Measures • Consumer Price Index • Potential biases • Substitution effects • Quality changes • New products • Cost-of-living index EPP Lecture 8: Inflation

  6. Inflation and Insurance Costs • Expense component for all insurers • Wages • Cost of goods used in operations • Property-liability insurance losses • Replacement cost coverage for property • Medical cost inflation for injuries • Social inflation for jury awards • Life insurance and annuities benefits • Indexed policy benefits EPP Lecture 8: Inflation

  7. Extreme Inflation Scenarios • Deflation • During Depression • Japan 1980s-90s • Hyperinflation • European countries 1920s • Mexico 1974-2000 • Various Latin American countries EPP Lecture 8: Inflation

  8. Managing Inflation/Deflation Risk: Investments • Fixed income investments • Default rates rise during deflationary periods • Market values decline when inflation increases • Inflation indexed bonds • Limited availability • Current low real returns • Equities • Short term impact negative • Long term impact mixed EPP Lecture 8: Inflation

  9. Managing Inflation/Deflation Risk: Underwriting • Property-liability insurers • Loss reserves need to account for inflation • Policy terms • Adjust length based on economic conditions • Index deductibles and retentions • Adjust frequency of rate changes • Life insurers • Lapse rates increase with inflation • Index face value and premiums • Cap inflation indices for annuities EPP Lecture 8: Inflation

  10. Historical Inflation Rates • United States • Canada • Mexico • Japan • Other countries available at: http://tradingeconomics.com/ EPP Lecture 8: Inflation

  11. United States Annual Inflation Rate1914-2010 EPP Lecture 8: Inflation

  12. Canadian Annual Inflation Rate 1916-2010 EPP Lecture 8: Inflation

  13. Japanese Annual Inflation Rate1971-2010 EPP Lecture 8: Inflation

  14. Mexican Annual Inflation Rate 1974-2010 EPP Lecture 8: Inflation

  15. Proposed Regimes for Inflation Model Based on US and Canadian Experience • Deflation • Inflation rate is negative • Moderate inflation • Inflation rate from 0 to 6% • High inflation • Inflation rate over 6% EPP Lecture 8: Inflation

  16. Inflation/Deflation Discussion • How likely do you think it is that the U. S. will be in a deflationary regime within five years? • How likely do you think it is that the U. S. will be in a high inflation regime within five years? EPP Lecture 8: Inflation

  17. Historical Inflation/Deflation Experience EPP Lecture 8: Inflation

  18. Inflation Generator Model • Model documentation • http://www.soa.org/research/research-projects/finance-investment/research-effect-deflation.aspx • Provides details about using the model EPP Lecture 8: Inflation

  19. Using the Model - 1 EPP Lecture 8: Inflation

  20. Using the Model - 2 EPP Lecture 8: Inflation

  21. Using the Model - 4 EPP Lecture 8: Inflation

  22. Using the Model - 5 EPP Lecture 8: Inflation

  23. Using the Model - 6 EPP Lecture 8: Inflation

  24. Using the Model - 7 EPP Lecture 8: Inflation

  25. Using the Model - 8 EPP Lecture 8: Inflation

  26. Using the Model - 9 EPP Lecture 8: Inflation

  27. A Model of Inflation EPP Lecture 8: Inflation

  28. Discrete Process in Model • Model projects inflation process in monthly time steps • Future inflation process is weighted average of past inflation and mean reversion level EPP Lecture 8: Inflation

  29. Impact of Discrete Process EPP Lecture 8: Inflation

  30. Annualized Inflation Projections • Model projects a sample path for the monthly inflation process over next 50 years • User can enter number of sample paths • However, the “inflation rate” is based on the cumulative (compounded) monthly process EPP Lecture 8: Inflation

  31. From the Model… • Inflation “process” needs to be compounded to measure annualized rate of inflation EPP Lecture 8: Inflation

  32. Regime Switching • At any point in time, parameters of process drive future inflation • However, model can switch between three separate inflation regimes • “Normal” inflation • High inflation • Low inflation (deflation) • Switching between regimes is based on a probability matrix EPP Lecture 8: Inflation

  33. Initial Regime Parameters EPP Lecture 8: Inflation

  34. Initial Transition Matrices EPP Lecture 8: Inflation

  35. Transition Probabilitiesand Regime Duration EPP Lecture 8: Inflation

  36. Running a Simulation • User enters “ModelInput” parameters • Parameters of process for each regime • Transition probabilities across regimes • Initial inflation value • “DefineOutput” • Choose the inflation rates of interest • Start projections EPP Lecture 8: Inflation

  37. Output • Summary statistics for inflation output • Inflation values for all sample paths • Can export for further analysis EPP Lecture 8: Inflation

  38. Applications of the Inflation Generator • Model can be used as engine for other applications • Inflation component of an economic capital model • Medical claim inflation may be modeled from general inflation rate • Salary increases for pension projections • Interest rates may be correlated with some target inflation EPP Lecture 8: Inflation

  39. References • Inflation/Deflation Report available at: http://www.soa.org/files/pdf/research-2012-02-effect-deflation-report.pdf • User Guide available at: http://www.soa.org/files/pdf/research-2012-02-effect-deflation-user-guide.pdf EPP Lecture 8: Inflation

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