1. 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.

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 2EPP 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 3EPP 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 4EPP Lecture 8: Inflation

5. Inflation Measures Consumer Price Index Potential biases –Substitution effects –Quality changes –New products Cost-of-living index 5EPP 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 6EPP Lecture 8: Inflation

7. Extreme Inflation Scenarios Deflation –During Depression –Japan 1980s-90s Hyperinflation –European countries 1920s –Mexico 1974-2000 –Various Latin American countries 7EPP 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 8EPP 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 9EPP Lecture 8: Inflation

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

11. United States Annual Inflation Rate 1914-2010 11EPP Lecture 8: Inflation

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

13. Japanese Annual Inflation Rate 1971-2010 13EPP Lecture 8: Inflation

14. Mexican Annual Inflation Rate 1974- 2010 14EPP 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% 15EPP 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? 16EPP Lecture 8: Inflation

17. US 1914-2010 (97 years) Canada 1916-2010 (95 years) FrequencyMeanFrequencyMean All Years 3.4% 3.3% Negative13.4%-4.0%9.5%-5.5% 0 to 6%66.0%2.6%70.5%2.3% >6%20.6%10.5%20.0%10.7% Historical Inflation/Deflation Experience 17EPP Lecture 8: Inflation

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

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

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

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

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

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

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

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

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

27. A Model of Inflation 27EPP 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 28EPP Lecture 8: Inflation

29. Month Initial1.00% 11.17% 21.32% 31.46% 41.59% 51.71% 61.81% 71.91% 82.00% 92.09% 102.16% 112.23% 122.30% Impact of Discrete Process 29EPP 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 30EPP Lecture 8: Inflation

31. From the Model… Inflation “process” needs to be compounded to measure annualized rate of inflation 31EPP 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 32EPP Lecture 8: Inflation

33. Initial Regime Parameters 33EPP Lecture 8: Inflation

34. Initial Transition Matrices 34EPP Lecture 8: Inflation

35. Transition Probabilities and Regime Duration Monthly Likelihood of Remaining Annual Equivalent Switching Mean (In years) Median (In years) 99.9%1.2%83.3357.73 99.8%2.4%41.6728.85 99.7%3.5%27.7819.23 99.6%4.7%20.8314.41 99.5%5.8%16.6711.52 99.4%7.0%13.899.60 99.3%8.1%11.908.22 99.2%9.2%10.427.19 99.1%10.3%9.266.39 99.0%11.4%8.335.75 98.5%16.6%5.563.82 98.0%21.5%4.172.86 35EPP 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 36EPP Lecture 8: Inflation

37. Output Summary statistics for inflation output Inflation values for all sample paths –Can export for further analysis 37EPP 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 38EPP 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 39EPP Lecture 8: Inflation