Michel Léonard Discusses Effects of Inflation on Insurance Ecosystem
The Institutes Griffith Foundation's Executive Director, Frank Tomasello, had an enlightening discussion with Michel Léonard, the Chief Economist and Data Scientist at the Insurance Information Institute, about the effects of inflation on insurance and the implications for insureds and insurers alike. What follows is a transcript of that conversation, which took place in October 2024, edited for length and clarity.
FT: What is inflation and how is it measured by indicators like the Consumer Price Index (CPI)?
ML: Inflation refers to the increase in prices of goods and services over time. The most commonly used measure of inflation is the Consumer Price Index (CPI), which tracks the prices of a basket of goods and services typically consumed by households.
The CPI is a survey-based index that has been around for about 50 years. Economists at the Federal Reserve in various parts of the country, such as San Francisco, Texas, and Atlanta, collect data on the prices of goods like butter from specific stores. They compare these prices over time to determine the rate of inflation.
Similarly, the Producer Price Index (PPI) measures inflation from the perspective of companies and manufacturers. It tracks the prices of goods at the production level, such as the prices farmers receive for their produce.
Ultimately, inflation is determined by the relationship between supply and demand. When demand increases, prices tend to rise, leading to inflation. This is why interest rates play a crucial role in managing inflation. Lower interest rates make borrowing cheaper, encouraging consumption and potentially driving up prices, while higher interest rates have the opposite effect.
FT: What is your assessment of the current inflationary environment, and how does it compare to historical trends?
ML: Currently, we are experiencing a period of comparatively high inflation by historical standards. Over the last 50 years, inflation in the US has averaged around 3 to 4% annually. However, in the past 20 years, since the 1980s, we have had what is often referred to as "cheap money," characterized by significant growth but limited inflation and low interest rates.
During this period, inflation averaged about 2% per year, which was relatively stable and beneficial for retirees with pensions and fixed incomes. In the last few years, due to the pandemic, inflation peaked at 8% across all goods. We are now hopefully coming back down to the 2% target.
The question now is whether we will return to the 2% level or settle around 3%. Many economists, including those at the Federal Reserve, believe that the historical 2% may be lower than what we will experience going forward. For those planning for retirement, sending kids to school, or considering insurance and replacement costs, an annual inflation rate of 2.5% to 3.5% is likely to be the new norm.
FT: What impact is inflation having on insureds, and how is it affecting different lines of insurance?
ML: As insureds, whether we are homeowners or businesses, we are going to face more expensive insurance premiums. One of the main reasons for this is the increased cost of replacing goods and paying for the associated services to rebuild or repair those goods.
During the pandemic, inflation reached 8% at one point, and for some insurance lines, it was even higher. For example, the price of 2x4x8 wood, commonly used in home construction, increased from $2 before the pandemic to $11 per piece at its peak. Although prices have come down a bit, carriers need to ensure they can cover these costs to remain financially stable and continue paying claims.
The impact of inflation varies across different lines of insurance. Homeowners insurance is likely the most significantly affected due to the high costs involved. In the commercial sector, there are additional factors at play, such as geopolitical issues in Ukraine affecting concrete bonding agents.
As buyers, carriers, and reinsurers, we are facing higher costs that are expected to remain elevated. While inflation is not the only reason for rising insurance premiums, it is certainly one of the factors beyond everyone's control.
FT: What are the impacts of inflation on both the liability and asset sides of insurer balance sheets?
ML: Higher inflation typically leads to increased interest rates, aiming to balance supply and demand and ultimately reduce inflation. Low inflation is preferable for everyone.
Insurers, reinsurers, and other industry participants manage substantial funds, primarily invested in low-risk instruments such as government and municipal bonds. Traditionally, rising interest rates resulting from higher inflation help carriers generate more income, which is beneficial for all parties involved. It can also indirectly alleviate some pressure on insurance rates.
Conversely, when inflation and interest rates decrease, it can negatively impact carriers' profitability, as returns from investments like CDs and bonds diminish. However, the industry is well-equipped to handle this environment.
Carriers have adapted to operate in a low interest rate setting for the past two decades. The industry remains well-capitalized and positioned to fulfill all its obligations, regardless of whether interest rates are rising or falling.
FT: What are the key questions facing lawmakers and insurance regulators today, given the current dynamics?
ML: The primary question is how we can collaborate to tackle the issues of affordability and availability in the insurance market.
It's also crucial for policyholders to consider how they can take more control over their risk profile. Even in my area of New York State, about an hour and a half from New York City, we experience extreme weather events like flash floods. As a homeowner, I must take steps to mitigate my exposure to such risks.
Ultimately, the main challenge is how public policymakers, consumers, insureds, and insurers can work together to develop solutions that ensure insurance remains affordable and available.
Dr. Michel Léonard, CBE, leads the Triple-I’s Economics and Analytics Department. He is responsible for providing analysis and insight on industry economics and business performance, as well as other forward-looking, data driven insurance insights. Dr. Leonard brings more than twenty years of insurance experience to Triple-I, and currently serves as adjunct faculty at New York University’s Economics Department. He is a member of the Insurance Research Council Advisory Board.
Frank Paul Tomasello, J.D., is Executive Director of The Institutes Griffith Insurance Education Foundation (“The Institutes Griffith Foundation”) He oversees the work of this affiliate of The Institutes and is responsible for advancing strategic plans, serving as a liaison to the Board of Directors and Advisory Council, and interacting with both internal and external stakeholders to further The Institutes Griffith Foundation’s mission. Tomasello was educated at Duquesne University School of Law. He practiced law in his native Pittsburgh before transitioning to a career in the non-profit realm.