The United States government, with its massive spending and money printing programs intended to address the current recession, together with social reform programs sponsored by the Obama administration, now runs the risk of unleashing a level of inflation not seen since World War II or the Carter years.

To sop up the money being issued and to scale back over-blown entitlement programs, will take a level of political will not observable in Washington DC today. Furthermore, there is no Ronald Reagan on the horizon to clear up the coming mess. Therefore, it is prudent to consider what the economy might be like under prolonged inflation, such as is often seen in the Third World.

Inflation has many casualties, but one of the sectors most seriously harmed is the insurance business.

Why high, persistant inflation harms the insurance industry

Insurance is a contract in which money is paid today in expectation of return of a greater amount to cover a named risk at some uncertain future date.

That named risk has a value to the insured, generally related to the amount it will cost at a future date to heal the damage related to that named risk.

For example, fire insurance is paid when one’s house burns down. The idea is that the amount of the insurance payment should be reasonably related to the cost of resolving the damage at that future date.

However, in an environment of high inflation, say 20% or more a year, the amount that would be necessary to cover the future risk will be much higher than in a non-inflationary environment. Also, because inflation may vary considerably from year to year, the cost is highly uncertain.

With high inflation, the cost of the premium goes up, well before the salary and wages of the insured. The higher the expected rate of inflation, the greater portion of current income must go to cover the future risk and the less certain that the coverage will be sufficient.

At some point, people stop buying insurance and the insurance business dries up.

Longer term insurance is more vulnerable than short term insurance

The life insurance one buys at the airport to cover the risk of dying on today’s flight is hardly effected by the rate of inflation. However, life insurance with expected payment in thirty of forty years is no longer purchased.

Each class of insurance is effected to a different degree by inflation, but generally, inflation is bad news for the insurance business.

Collateral damage of a disappearing insurance industry

In the United States, the principle buyers of municipal bonds include property and casualty insurance companies. Inflation will adversely effect municipalities, not only by driving up the rates on bonds directly, but also indirectly by reducing demand through insurance companies.

Life insurance companies are major buyers of equities in the United States. High inflation is the kiss of death to the life insurance business. As life insurers fold their tents and slip away into the night, this source of equity will disappear. Prices of stocks will be depressed.

Defined benefit pension plans and annuities are another casualty of inflation. Not only will inflation reduce the value of such programs to the beneficiaries, wrecking havoc on those in retirement, but another source of capital to support employment will be removed.

The impact of inflation on health insurance may be somewhat different than on other lines, principally because of government involvement and political connotations. In Brazil, in the hyper inflation of the early 1990s, doctors were found driving taxi cabs, because the government health insurance program did not provide them with sufficient income to make a living.

The net result of inflation: a smaller capital market

Insurance companies are an important segment of developed capital markets. However, with inflation, their contribution as a source of capital is removed or greatly diminished. The direct results are on equity and long term bond markets.

The current scandal over the bonuses paid to executives of AIG is a gigantic misdirection of anger which should be directed to members of Congress who are directly responsible for the excessive spending that is likely to drive future inflation. This inflation, if not controlled by some future government with far more backbone than the current, by wiping out the life insurance business will do more harm to the American taxpayer than all the irrational behavior of a few misguided executives.

In inflation, investment market may tend to shift to very short term commercial paper and real estate. Life goes on, it’s just different.

Get ready.

The Wall Street Journal has noted that New York Attorney General Eliot Spitzer’s investigation into kickbacks and other improper incentives in the insurance industry is widening and moving toward the area of employee-benefits.

Since there are real problems with the proper exercise of fiduciary responsibility for 401(k) plans, there could be long-term implications for capital flows, especially in the equity market.

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Because issues of money market mutual fund shares for the quarter were only $0.2 billion, net, the major activity in this instrument was the shifting of ownership between sectors.

Prior to 2002, net annual issues of money market mutual fund shares were strongly positive, averaging over $300 billion (1999-2001). Since 2002, because of the Federal Reserve low interest rate policy, net redemptions of money market mutual fund shares ran at an average annual rate of about $309 billion.

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