#262 | Inflation & Life Insurance
The picture for this post is a meme that has apparently been floating around the Reddit forums that have been instigating the surges in trading and prices of stocks, digital currencies and other commodities. Usually it’s accompanied by the caption “haha money printer go brrr,” which makes me chuckle every time.
In writing The Life Product Review, I make a conscious effort to focus only on life insurance and to steer clear of topics that have an ancillary connection to our industry – politics, technology and macroeconomics. Of the three, the toughest one for me to avoid is macroeconomics. Looking back over the history of our industry, it’s impossible to not see the connection between product and macroeconomics. Vanishing premium Whole Life and Universal Life in the 1980s fed on ultra-high interest rates. Variable UL grew in popularity alongside the 1990s euphoria for stocks. Indexed UL thrived in a lab-perfect decade of high portfolio yields, low interest rates and ultra-low equity volatility. Life insurance is, always and forever, a financial product. Macroeconomics matter.
But I know enough of macroeconomics from my undergraduate degree, a few dozen books and regularly listening to EconTalk since 2007 to know that I’d prefer not to write about it. Macroeconomics makes fools of us all, but especially the people who seem to know it best. However, I’ll make an exception for one topic in macroeconomics that is worth discussing – inflation. As the legendary economist Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” It is one of the few examples in macroeconomics of where a relatively simple input (money supply) should have a straightforward result (inflation). We are currently in a position where that relationship is being tested. Take a look at the graph of the total dollar monetary base since the year 2000:
No matter what way you cut it, there are more US Dollars than there were 20 years ago. Given that we haven’t experienced anything other than mild inflation, where did all of the money go? If you read articles from the early 2010s, the argument for why the US hadn’t experienced mass inflation was that the money generally went to shore up the capital position of US banks and other financial institutions, which meant that it wasn’t actively circulating in the economy and therefore wasn’t producing inflation. The metric for money sitting at US households is M2, which includes currency and liquid savings deposits (including money market funds). I read several articles from 2012 that pointed out that M2 had stayed relatively stable in the wake of the Financial Crisis. That was certainly true in 2012, but it’s not true anymore. Take a look.
Since January of 2011, M2 has increased from $8.8 trillion to $19.5 trillion, with $4 trillion of that increase coming just in the last 12 months. But, again, why haven’t we seen traditional inflation? Over the same period of time, the CPI has increased from 225 to 262, a 16.5% increase against a 120% increase in M2. Perhaps, just perhaps, we’re not measuring the right things with the CPI. In 2007, the market capitalization of all US Public companies was $19.7 trillion. Today, it’s $51 trillion, a ratio of 2.4 to GDP, the highest it’s ever been by a very long shot. In the 1980s, we had so-called “stagflation,” which was inflation without economic growth. Now, we have what I’ll call “specuflation” – the long-prophesied inflationary bubbles in asset classes that are the direct result of too much money sloshing around. Enter Robinhood. Enter GameStop. Enter Bitcoin. Enter the entire US Equities market, which has dramatically outperformed emerging markets since 2007, as indicated by Vanguard’s Total US Stock Market Index Fund versus Vanguard’s Emerging Markets Stock Index Fund which is 44% invested in Chinese stocks:
I would make the argument that inflation is here, we just haven’t recognized it yet because we’re used to it showing up as a frowning man in a suit, somberly marking up prices at the grocery store. This time around, however, inflation is here to party. He’s ditched the suit and is sporting neon rave glasses and a tank top, dancing like a fool to techno and throwing dollars in fistfuls out of a seemingly-bottomless iridescent fanny pack (yes, those are back in). Everyone loves inflation. He’s the life of the party. What could go wrong?
If Milton Friedman is right, then a lot could go wrong. But what do I know? I said I don’t write about macroeconomics and I am straying dangerously close to writing about macroeconomics with this post, but I’m doing it to make a simple point – inflation is a real risk and the life insurance industry is woefully unprepared for it. Inflation might not actually happen. A bone-dry forest in California might not erupt in flames. But that doesn’t mean you shouldn’t be prepared if it does.
I’ve really struggled with what, exactly, preparation for inflation looks like for the life insurance industry. For life insurers, it seems, inflation would be a mostly positive thing. In the case of both annuities and life insurance, life insurers receive today’s dollars and pay claims with tomorrow’s dollars. Inflation would devalue the future payouts. But things aren’t quite that simple. Life insurers hold reserves against future claims and those reserves have to be invested. The future dollars being used to pay claims are really just today’s dollars plus investment yields, which may or may not dramatically increase in an inflationary environment. If yields increase dramatically to maintain stable real interest rates, then life insurers will realize a windfall on their in-force block. If yields don’t increase and negative real interest rates occur, then the relative sizeof the in-force block will shrink, essentially, and the life insurer will have to scramble to attract new sales that are paying with devalued currency. I’m sure other folks see different angles to this problem, but it seems to me as though inflation, in and of itself, isn’t a direct risk to life insurers. It’s probably a financial benefit.
What may be a benefit to life insurers, however, is a real problem for consumers. A person buying a $1 million policy today is thinking in terms of $1 million, which is a tidy sum for most folks. But in an inflationary environment, that $1 million policy might be the equivalent of a couple of years of salary for an entry-level accountant. For life insurance, inflation means that people will basically need more coverage to meet the higher future dollar costs of their needs. That’s a real problem. Increasing a death benefit or buying a new policy requires underwriting. You can’t just go out and tack on another few million dollars of coverage if you’re not as healthy as you once were. It’s currently impossible (to my knowledge) to buy a life insurance policy with a guaranteed ability to increase the face amount without underwriting, except on juveniles. The last time a company did that was when ING allowed 5x face increases on some of their policies and the pricing was so compelling that agents, BGAs and actuaries at other companies were practically breaking down the doors to buy policies on themselves. Ah, the good ‘ol days.
So far, I’ve been talking about inflation from a very US-centric point of view. But there’s another menacing danger lurking with inflation – that the US dollar becomes devalued relative to other currencies, putting US savers at a significant disadvantage relative to their global peers. Other countries are well acquainted with this risk and have prepared for it by offering products denominated in other currencies, especially in markets such as Japan, South Korea, South Africa and Hong Kong, all of which boast life insurance industries that are superlative in terms of saturation (Japan and South Korea) and sophistication (South Africa and Hong Kong).
The play with these products is the recognition that consumers in a certain country tend to have a domestic focus, which exposes them to significant currency risk. Life insurance products paid in another currency offer a hedge to devaluation of the home currency. To American ears, the idea of the dollar falling out of favor is unimaginable. But to folks in South Africa, a regional powerhouse with a globally connected economy, it’s an everyday reality. The exchange rate between South African Rand and the US Dollar was 3-to-1 in 1992. Now, it’s 15-to-1. I was at a wedding a couple of years ago chatting with someone from South Africa and I asked him about the exchange rate. His response was telling – “That’s why I work for a European company and get paid in Euros.”
In the United States, it’s been a very long time since we’ve had to worry about inflation. And it’s been a very, very long time since we’ve had to really worry about a meaningful dollar devaluation. But the time is now to prepare. Our current solutions are blunt-force tools. We basically have two options today. The first is Variable UL which, if invested in the proper funds, could produce asset returns that keep pace or exceed inflation. The second is Whole Life, which (in the context of a mutual company), forces the life insurer to pay dividends that can be used to purchase paid-up insurance, thereby theoretically increasing the death benefit alongside inflation. These products aren’t perfect, but they’re what we have. And when it comes to planning, inflation has to be a part of the conversation and it may very well change the product recommendation to something that can at least provide the semblance of a hedge.
Foresight in product development is building products for what clients will want before they know they want it. What would clients want in an inflationary environment? They might want life insurance denominated in Euros, Swiss Francs, Pound sterling or (heaven help us) something crazy like Bitcoin. They’ll want some sort of guaranteed inflation protection in their death benefit amount, something that (to my knowledge) doesn’t exist in today’s life insurance products. They’ll want a guarantee, in some way, that rising interest rates will result in higher crediting rates within their products. These are things that we can do in today’s environment, life insurers just haven’t really gotten around to doing them because no one is asking for them. Yet. But the time may well come – and we’d better be ready.