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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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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.

overview
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

why study inflation deflation now
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

what is inflation
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

inflation measures
Inflation Measures
  • Consumer Price Index
  • Potential biases
    • Substitution effects
    • Quality changes
    • New products
  • Cost-of-living index

EPP Lecture 8: Inflation

inflation and insurance costs
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

extreme inflation scenarios
Extreme Inflation Scenarios
  • Deflation
    • During Depression
    • Japan 1980s-90s
  • Hyperinflation
    • European countries 1920s
    • Mexico 1974-2000
    • Various Latin American countries

EPP Lecture 8: Inflation

managing inflation deflation risk investments
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

managing inflation deflation risk underwriting
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

historical inflation rates
Historical Inflation Rates
  • United States
  • Canada
  • Mexico
  • Japan
  • Other countries available at:

http://tradingeconomics.com/

EPP Lecture 8: Inflation

proposed regimes for inflation model based on us and canadian experience
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

inflation deflation discussion
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

inflation generator model
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

using the model 1
Using the Model - 1

EPP Lecture 8: Inflation

using the model 2
Using the Model - 2

EPP Lecture 8: Inflation

using the model 4
Using the Model - 4

EPP Lecture 8: Inflation

using the model 5
Using the Model - 5

EPP Lecture 8: Inflation

using the model 6
Using the Model - 6

EPP Lecture 8: Inflation

using the model 7
Using the Model - 7

EPP Lecture 8: Inflation

using the model 8
Using the Model - 8

EPP Lecture 8: Inflation

using the model 9
Using the Model - 9

EPP Lecture 8: Inflation

a model of inflation
A Model of Inflation

EPP Lecture 8: Inflation

discrete process in model
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

impact of discrete process
Impact of Discrete Process

EPP Lecture 8: Inflation

annualized inflation projections
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

from the model
From the Model…
  • Inflation “process” needs to be compounded to measure annualized rate of inflation

EPP Lecture 8: Inflation

regime switching
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

initial regime parameters
Initial Regime Parameters

EPP Lecture 8: Inflation

initial transition matrices
Initial Transition Matrices

EPP Lecture 8: Inflation

running a simulation
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

output
Output
  • Summary statistics for inflation output
  • Inflation values for all sample paths
    • Can export for further analysis

EPP Lecture 8: Inflation

applications of the inflation generator
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

references
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