Practical Considerations in Assessing the Impact of Inflation on Carried Reserves

As the U.S. economy recovers from its most recent financial crisis, concerns are rising that inflation could increase dramatically in the near term. This paper attempts to quantify the effects that accelerated inflation could have on a company’s balance sheet using the methodology proposed by Mr. William Richards in his 1981 paper titled, “Evaluating the Impact of Inflation on Loss Reserves.” Data were evaluated regarding the appropriate loss components to use for modeling (loss, salvage/subrogation recoveries, loss adjustment expense) and the identification of appropriate indices in conjunction with the timing of the inflationary impact. In addition to testing several of Richards’ key assumptions, the methodology is utilized in a slightly different fashion than originally proposed. Instead of using a single index to deflate historical losses, a selection of reasonable indices was implemented so that a range of expected outcomes could be evaluated for each level of assumed future inflation.

Keywords: Discounting of Reserves, Exploratory Data Analysis. Inflation, Reserving Methods, Reserve Variability.