Inflation is defined as a general increase in the level of prices of goods as well as services in an economy within an identified period of time. Differently said, when the price level increases, a unit of currency in only able to buy fewer goods and services than when the inflation rate was smaller. Accordingly, inflation also reveals diminution in the money's purchasing power. In other words, there is a loss of the actual value money (Alfred 356-357). Apart from affecting life insurance companies, inflation affects life insurance clients. For instance, a few years after a client takes adequate and sufficient insurance cover, the cover may not meet his or her family's needs. Evidently, life insurance and inflation have a relationship that could be described as very delicate. Some life insurance companies as well as most clients fail to acknowledge the fact that eventually, life insurance policy may be gravely affected by inflation. Therefore, life insurance companies need to bear in mind the futurity value of money. This paper digs into how inflation affects life insurance companies.
Inflation and Life Insurance
Amongst the most notorious and most affected casualties of inflation is the life insurance industry. Persistent high rate of inflation seriously scathes the insurance sector since insurance is a convention in which money is given out in anticipation of return of much more money to cover a particular risk at some indeterminate time ahead. That particular risk has an economic value to the covered, usually related to the amount of money it will be worth at someday ahead, to bring around the harm allied to that risk (Alfred 358). For instance, fire insurance is compensated when fire consumes a client's house. The main point here is that the value of the insurance defrayment ought to be realistically related to the amount of money of settling the damage at that date ahead.
Generally, average prices are measured in accordance with the Consumer Price Index (CPI), which is a weighted measure of the price of various goods and services that the average US household buys (Journal of American insurance 14-15). Most insurance companies, including life insurance companies, tie their premiums' cost to the Consumer Price Index. In other words, as the Consumer Price Index goes up, life insurance companies increase their premiums' cost to correspond with inflation. It is for two reasons that insurance companies increase the cost of their premiums; one, there are several insurance policies that cover the replacement of damaged or lost products. While the substitution of these products goes up, insurance companies have to increase their premiums to correspond with this price inflation. The situation is the same in life insurance companies-inflation affects the cost of items necessary for insurance cover. Two, just as for any profit-intended enterprises, insurance companies do their best to post steadily strong gross. When the country is experiencing growing inflation, life insurance companies have to record higher gross annual profits to give similar ROI (return on investment) to their stakeholders.
Value of Annuities and Inflation
Incase of annuities or stipends-policies which involve policyholders issuing specific amounts of money for a specified duration-inflation directly affects the value of the annuity policy. Except when the size of disbursals is tied to inflation, the value of the disbursals will lessen over time as inflation goes up, contrary to what life insurance companies could desire. There, when computing an annuity's price, life insurance companies try to forecast the futurity inflation rate, to ensure they do not lose (Franklin 269-272). Interestingly, in the insurance sector's link with inflation is that insurance policies are typically issued for a specific duration.
All the same, because of inflation, the value of policies may vary between the beginning and at the end of the set term. Accordingly, life insurance companies normally price premiums depending on a forecast increase in inflation. While some life insurance companies tie price variations to the CPI, other companies apply industry specific measures. For instance, companies that provide life insurance use indices that evaluate the cost of health benefits. In other words, the more particular an index is to a specific policy, the more exact the life insurance company can modify costs.
Value and Inflation
In a situation where the inflation rate is as high 20% per year, the amount of money that would be enough to cover the risk sometimes ahead will be remarkably higher when compared to a situation where there is none of low rate of inflation. Besides, since inflation may vary significantly from one year to another, the cost is extremely indeterminate. By high inflation rate, the prices of premiums increase, irrespective of the income of the insured. The higher the forecast inflation rate, the higher the percentage of the insured salary must be spent cover the future risk, and the low guarantee that the cover will be adequate (Hall 179).
On the part of life insurance companies, people may stop purchasing life insurance service leading to the drying up of the insurance business. Remarkably, longer term life insurance is less protected when compared to short term life insurance. For instance, the life insurance a passenger purchases at the airport to cover the risk of death on a flight within a day is barely affected by the inflation rate. All the same, life insurance with awaited requital in 30 of 40 years is not bought any more. Generally, every class of insurance is affected individually to a different level by inflation, but as a rule, inflation is unwelcome issue to the life insurance enterprise (Hall 179-180).
In the US, among the top purchasers of municipal bonds are property and life insurance companies. Increase in inflation rate will undesirably affect municipalities, not just by directly increasing the rates on bonds, but also circuitously by shrinking the need through insurance companies. Since life insurance companies are chief purchasers of equities in the US, high inflation rates affect life insurance business (Fung 35). This basis of equity demand will vanish while life insurers leave the scene. Consequently, the cost of stocks will be suppressed.
Inflation will not only dilute the value of annuities and pension plans to the insured, it will also cause devastation on the retired. On the other hand, life insurance companies will lose workers because the companies are unable to compensate their personnel. Because of the underlying factors such as the government's involvement and political intentions, the effect of inflation on life insurance sector may fairly vary from other sectors of insurance. For instance, in Brazil, in the major early 1990s inflation, most doctors turned to taxi cabs drivers on account that the government health insurance program could not provide the doctors with adequate income to pay their bills. Relatively, inflation will drive the personnel in life insurance companies to looking for a living elsewhere on their spare time, leading to further reduced efficiency (Fung 35-38).
Life insurance companies are actually a crucial section of advanced capital markets, but with inflation, the companies' share as a source of income is unfortunately gotten rid of or greatly belittled. The effect is directly detected on equity and long awaited bond markets. Therefore, if the government does not appropriately control inflation, life insurance companies will have to close their doors leading to severe losses of taxpayers' money, jobs, market, and national revenue.