INFLATION

Many insurance policies pay benefits based on the amount of loss at existing price levels. When there is price inflation, the claim payments increase accordingly. However, many deductibles and benefit limits are expressed in fixed amounts that do not increase automatically as inflation increases claim payments. Thus, the impact of inflation is altered when deductibles and other limits are not adjusted.

Looking at the increases from one year to the next, the expected losses increase by 10% each year but the expected claim payments increase by more than 10% annually. For example, expected losses grow from 750 in year 1 to 1098 in year 5, an increase of 46%. However, expected claim payments grow from 650 in year 1 to 998 in year 5, an increase of 54%. Similarly, the standard deviation of claim payments also increases by more than 10% annually. Both phenomena are caused by a deductible that does not increase with inflation.

A fixed deductible with no maximum limit exaggerates the effect of inflation. Adding a fixed maximum on claim payments limits the effect of inflation. Expected claim payments grow from 610 in year 1 to 819 in year 5, an increase of 34%, which is less than the 46% increase in expected losses. Similarly, the standard deviation of claim payments increases by less than the 10% annual increase in the standard deviation of losses. Both phenomena occur because the benefit limit does not increase with inflation.