How Inflation Affects Whole Life Insurance
With inflation discussions ramping up and the Fed appearing open to a new policy on inflation metrics, we wanted to address the topic of its impact on insurance. While there is no evidence today that exceptionally high inflation is headed our way, we might see moderately higher price level increases versus the past several decades for the next few years as government agencies seek to overcome the impact Covid-19 had on the U.S. Economy.
This potentially higher inflationary environment may or may not be a net positive for insurance products.
Inflation a Quick Review
Inflation is simply the rise in price levels across the economy. The term “price level” is important when discussing inflation. Singular goods within the broader economy do not, on their own, create more inflation. For example, a spike in oil prices with all goods remaining relatively level is not a sign of rising inflation. The key is that all goods must generally rise in price for inflation to be on the rise.
The economic forces that lead to inflation are complex and lacking complete agreement among economists. That said, there are several broad areas of agreement that set government policy with respect to control inflation.
The Federal Reserve is the government agency whose primary responsibility is controlling inflation in the United States. It does this by influencing the money supply of the U.S. Economy. The Fed tracks inflation primarily through the Consumer Price Index (CPI).
Demand-pull inflation is essentially a rise in price levels due to rising aggregate demand. Aggregate demand is an economic term that seeks to encompass the consuming behavior of all entities operating within an economy. So you, your neighbors, friends, family, businesses, and government that buy things all contribute to aggregate demand.
The upward shift in aggregate demand without a corresponding upward shift in aggregate supply results in higher price levels. It’s this economic force that presently appears to be the most likely to spark inflationary pressure on the current U.S. Economy.
Cost-push inflation is the practice of the supply side moving prices up to accommodate rising price levels associated with bringing products to market. If, for example, commodities prices increase, manufacturers who depend on those commodities to manufacture their products will likely increase the cost of the end product to maintain a targeted profit margin.
Home and Auto Insurance
Rising costs have a serious impact on the Home and Auto insurance industry, and the industry developed its own methods for dealing with price increases. This was necessary because inflation metrics do not immediately capture the impact “improvements” have on goods we commonly buy and sell.
Take for example an automobile you can buy brand new today versus one you could buy brand new 15 years ago. The technology commonly found on a brand new car today is vastly different from what we had available 15 years ago. Many features that over a decade ago were only a dream or potentially a luxury feature developed into minimum safety standards on today’s vehicles.
This improvement in automobiles makes them more expensive, but it’s not because price levels are rising. It’s because they are becoming more advanced and sophisticated and these improvements make them more expensive. From a government monetary policy perspective, this requires no action. But from an auto insurance perspective, this absolutely requires actions because those higher car prices will be part of what the insurer assumes as a risk transfer from the policyholder to the insurance company.
Home and Auto insurers benefit from the short-lived policy period the insurance products they issue operate under. When you buy a policy from an insurance company, it only lasts for 6-12 months. After that, it renews and at this point, the insurance company has an option to adjust the price.
The biggest threat facing this side of the insurance industry may actually hit homeowners the hardest. Policies that require “full insurance” for a homeowners policy could end up reducing the claim benefit payable if the homeowner/insured does not keep up on his/her home’s value.
Life insurers are not so much directly worried about inflation in terms of claims payout because death benefits issued on a policy are traditionally set at policy issue. If the death benefit amount is insufficient years later due to the erosion of buying power through inflation, that effect hits the beneficiary of the policy.
That said, if inflation is high, life insurers may see a reduction in life insurance new business activity as people attempt to capitalize on the value of their money today versus what it might be worth in the future–which they would view as being less.
But with inflation likely comes higher targeted interest rates from the Fed, and this could significantly benefit the life insurance industry. We know fundamentally that the life insurance industry potentially benefits from higher bond yields if interest rates rise. But the industry also benefits from rising interest rates because it lowers the net present value of the liabilities (i.e. death benefits) outstanding at the insurance company. This frees up capital and allows the insurer to make ever more investment decisions that will most likely create a net positive to business operations.
Whole Life Insurance and Inflation
Whole life insurance and universal life insurance likely benefit from the same aspects already mentioned in the last section of this blog post. But those benefits will not likely be immediate if we see rising inflation.
First, I would not anticipate an immediate rise in dividend interest rates or index interest features if the Fed raises rates to combat inflation. It will take life insurers some time to catch up with market trends. This is the case because insurers need time to actually buy the new bonds that will produce higher interest income. Insurers will not move in a direction because they think something will happen. They will need to produce the actual investment result first.
Second inflation could put a strain on insurers holding a lot of these policy types as policy owners may likely begin tapping the cash value if they worry that inflation will erode the value of these policies. This move on the behalf of the policyholder is commonly misguided, but will likely take place to varying degrees across all insurers for an array of reasons.
For people who buy these types of life insurance specifically for their cash value, it’s important to keep in mind that this is a longer-term play, and short-term movements in price levels likely have little impact on the ultimate goal of the policy’s cash value.