Section II INTRODUCTION Inflation is said to exist when there is a rise in the general level of the prices of goods and services. Extremely high rates of inflation are generally referred to as "hyper-inflation" or "run-away" inflation, and low rates of inflation are referred to as "creeping" inflation. There are no precise definitions of these terms. An historical example of the effect of hyper-inflation on the social fabric of a country could be seen in the German experience in the 1920's (see Appendix II). Table 1 of Appendix I gives a comparison of the index of inflation for 16 selected industrial countries for the period 1961-71 and for years 1971 to 1974 with estimated 1 rates for 1975, and Table A summarizes the information. IMPACT OF INFLATION ON LIFE INSURANCE POLICYHOLDERS The major problem faced by the life insurance policyholder in an inflationary economy is the declining "real" value of a fixed benefit. The real return on premiums paid may be extremely low or even negative. As discussed in Appendix II the extreme example is Germany where a fixed amount of 25,000 marks in 1918 could have purchased a house, but by 1923 the same number of marks could not have purchased even a postage 1Table 2 of Appendix I compares the average annual inflation rates of the periods 1966-70 and 1970-74 for countries around the world. Report of Commission on Inflation and Insurance Page 12 stamp. The policyholder can attempt to increase his insurance in real terms, as inflation erodes the face amount of his contract. As his age increases, the premium rate will also increase and he has to face the possibility that he may be uninsurable. Group life insurance offers some relief if it is wage related, but some insurance needs may continue beyond the period of employment when group life coverage may have ceased. While inflation decreases the real value of life insurance death benefits considerably, its effect may be catastrophic to policyholders receiving fixed annuity or pension benefits. Retirees with fixed pensions are particularly vulnerable since they have little or no opportunity to increase current income. Insureds receiving fixed disability incomes are in a similar position. IMPACT OF INFLATION ON POLICYHOLDERS IN NON-LIFE INSURANCE In non-life insurance the problems created by inflation for the insured differ from life insurance problems because benefits are on an indemnity basis rather than on a fixed-amount basis. Premiums inevitably increase and may become so high that the policyholders whose incomes have not kept pace with the increases either relinquish their policies or continue them on a reduced basis in real terms. In fire and homeowners insurance, the insured who fails to increase his policy face amounts according to the increase in the values of his property faces a large risk that the insurance will be inadequate if a total loss occurs. In the case of a partial loss, he may be Report of Commission on Inflation and Insurance Page 13 penalized financially by the operation of a coinsurance or proportional clause. The potential increase in building costs from the time of the loss to the time of replacement of the property is an additional risk. For those who are injured in automobile accidents and who look for compensation under the liability insurance system, inflation has two effects. First, those who are in the process of settlement may settle early for inadequate amounts because of immediate financial problems caused by the rise in the cost of living. Secondly, those who have received a settlement in the past find it inadequate as time passes and the cost of living continues to rise. IMPACT OF INFLATION ON COOPERATIVE INSURANCE COMPANIES The fortunes of cooperative insurance companies are closely linked to those of their policyholders, but the problems an insurer faces in an inflationary economy are not identical to those of its insureds. Most of the problems are related to the nature of the insurance business. As a "service" the insurance product depends more on wage levels than on price levels, both in administration expenses and, in non-life insurance, the loss or claim component. Thus, the "cost-of-living index" may not be a particularly adequate measure of inflation problems from the perspective of the insurer. In addition, inflationary problems differ somewhat for life and non-life insurance. Report of the Commission on Inflation and Insurance Page 14 Inflation Problems of Life Insurers One major problem faced by life insurance companies is the escalation of expenses caused by inflation in servicing individual fixed-premium long-term policies. Expense loadings which are fixed at the time of issuance can become seriously inadequate. When the inflation rate is volatile, it becomes extremely difficult to forecast inflation and include an adequate allowance for expenses in the premium structure. Increased sales of new policies in an inflationary period, leading to increased expense allowance per policy, may not be sufficient to cover the increase in expenses. And even if growth of insurance volume is sufficient to cover such expenses, the result is that newer policyholders carry too high a proportion of the costs and subsidize policyholders who hold older contracts. A second major problem that life insurers face under conditions of inflation is the investment of reserve and surplus funds. Because individual life insurance contracts are long-term commitments, life companies invest in long-term, secure investments. If inflation is moderate, the earnings on investments are usually sufficient to produce positive real returns, at least equal to the nominal rate of interest assumed in reserves; and, other things being equal, the valuation of assets and liabilities will not disclose a deficiency. However, if investment earnings produce negative real returns, as is the case in a highly inflationary period, the impact may be financially disastrous because the real value of the benefits have eroded |