Deflation and Its Effect on the P-C Industry

Insurance Information Institute October 2010

Steven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief Economist Insurance Information Institute ♦ 110 William Street ♦ New York, NY 10038 Office: 212.346.5540 ♦ Cell: (917) 494-5945 ♦ [email protected] ♦ www.iii.org Deflation Basics

2 Definition

„Deflation is ŠA falling general price level ŠNtNote: thiithis is differen tft from ŠA fall in the rate of increase of the general price level; Š This is called disinflation ŠA fall in the prices of some items or category of items ŠFor a prolonged period ŠThat is expected to continue indefinitely

Sources: http://www-personal.umich.edu/~alandear/glossary/d.html; http://en.wikipedia.org/wiki/Deflation; I.I.I. 3 Primary Causes and Major Bouts of Deflation „Deflation results from some or all of ŠA surge in productivity, generally from technological itiinnovation ŠA steep and prolonged drop in the money supply ŠA steepppg and prolonged recession ŠNote: this is different from a fall in the rate of increase of the price level

„Major US Bouts of Deflation Š1920-22 Š1930-33

Sources: http://www-personal.umich.edu/~alandear/glossary/d.html; http://en.wikipedia.org/wiki/Deflation; I.I.I. 4 Broad Impact of Deflation

„Deflation causes… ŠConsumers to delay buying things ŠThey expect tt to b uy th ose thi ngs l at er at tl lower pri ces ŠA drop in the level of aggregate demand, from the delay in consumption ŠA transfer of wealth ŠFrom borrowers and holders of illiquid assets ŠTo savers/lenders and holders of liquid assets and currency ŠA drop in the level of business investment ŠFollowing the drop in aggregate demand ŠSlack in capacity if the economy is in recession ŠIncreased likelihood of lower profits or losses as selling prices drop below costs

Sources: http://en.wikipedia.org/wiki/Deflation; I.I.I. 5 What History Teaches Us About Deflation and the P-C Industry

6 1920-1950: Inflation, Deflation and the P-C Industry’s Combined Ratio*

Combined Ratio Combined Ratio Price Index Price Index

110 26

Declining CR Almost 24 Completely a Result of Sharply 105 Lower Loss/LAE Ratio 22

100 20

18 95

16

90 From 1930 to 1933 the Price Level 14 Dropped 24% 85 12 1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 From Year-end 1929 Through 1932, the Industry’s Combined Ratio Rose from 96.3 to 104.9 as the CPI Droppe d. Bu t from 1933 i nt o th e 1950s, th e C ombi ned R ati o Remained Below 100 Even as Prices Slowly Rose, Then Shot Up after WWII.

*From 1920-1934, stock companies only Sources: Best’s Aggregates & Averages; http://www.rateinflation.com/consumer-price-index/usa-historical-cpi.php?form=usacpi 7 1920-1950: Inflation, Deflation and P-C Industryyy Profitability*

Return on Average Surplus ROAS Price Index Price Index

15% 26 From 1930-32 ROAS was below From 1930 to 1933 1. 2%, but was 5. 1% in 1933 an d the Price Level 10% or higher in 1935-36 Dropped 24% 24

10% 22

20 5% 18

16 0%

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 1947 1948 1949 1950 14

‐5% 12 The Significant Deflation from 1930-32 Punished the Industry’s ROAS, But an Improving Economy (and Slight Inflation) Helped Achieve ROAS in Double Digits in 1935-36. *stock companies only Sources: Best’s Aggregates & Averages; I.I.I.; ; http://www.rateinflation.com/consumer-price-index/usa-historical- cpi.php?form=usacpi 8 Deflation’s Effects on the P-C Insurance Industry „Lower Claim Severities ŠParticularly for property claims, severity drops for many items that insurers pay for „Rate contingency margins increase ŠAt least until rate construction reflects persistently declining claims sev erity, margins w ill be higher than otherw ise du e to high trend assumptions arising from use of historical data „Reserve Releases? ŠReserves may develop beneficially to become “redundant” „Lower Claim Frequency as Fewer Claims Reach Deductible, Retent io n Le ve ls „Less Use of Reinsurance ŠLower costs Î risks burn through their retentions less quickly, reaching policy limits less quickly

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