Loss Reserving and Ratemaking in an Inflationary Environment

Along with the rest of the economy, the insurance industry has felt the profound effects of the fluctuating inflation rates of the last several years. Insurance rates must be set to pay for future events; therefore, they have to consider future inflation in claim costs. Similarly, because losses often are paid considerably after the event causing the loss, inflation will affect the adequacy of loss reserves. This paper investigates the effects of an increase in the inflation rate on a company's loss reserving and ratemaking capabilities. We show that during a period of spiraling inflation, losses are underestimated, inevitably leading to rates that are too low and consequent underwriting losses. On the other hand, if the inflation rate drops, reserves become redundant and rates too high, resulting in larger than average profits. Although there may be no way to avoid completely the profit-and- loss cycles in today's economy, using reserving and ratemaking techniques that are more finely attuned to inflationary swings will significantly mitigate the effect of these cycles.