The Effect of Deflation or High Inflation on the Insurance Industry

Despite the relatively benign behavior of the general inflation rate in many countries for the past two decades, developments since the financial crisis of 2008 have created the potential for decreased price stability. One the one hand, the risk of a recession induced period of deflation is real and the fear of this scenario has led the U. S. Federal Reserve, and the central banks of other countries, to use both traditional and innovative policy tools to prevent deflation from taking hold. Conversely, in large part due to the expansionary fiscal policies adopted in response to the financial crisis, the risk of a significant increase in the inflation rate has grown. These forces illustrate that using the recent past to project future developments is not adequate to cope with the financial uncertainty that exists currently. This paper consists of six sections. The first section provides some background on inflation, describes some problems in measuring inflation, and explains some of its effects on an economy. The second section reviews historical inflation rates. The third section examines the effect of inflation or deflation on the property-liability and life insurance industries. The fourth section proposes risk mitigation strategies for insurers to cope with either deflation or high inflation rates. The fifth section describes a publicly available model that can be used to develop inflation/deflation projections under a regime switching format that can readily be adjusted to reflect current financial uncertainty. The final section provides conclusions.