Measuring Inflation Impact on Life Insurance Costs

Author(s): David F. Babbel

Source: The Journal of Risk and Insurance, Vol. 46, No. 3 (Sep., 1979), pp. 425-440
Published by: American Risk and Insurance Association
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Measuring Inflation Impact on Life Insurance
Costs
David F. Babbel

ABSTRACT
A numberof methodologiesgenerallyused in comparinglife insurancecosts are
examined,andone is identifiedas appropriatefor measuringinflation'simpacton the
expectedcost of life insurance.The modelis used to demonstratethatanticipationsof
inflationare associatedwith higher(rationallyperceived)realcosts of life insurance
protectionwhen regulationimpedesinsurersfrom incorporatinghigherinterestrates
into nonparticipatingpolicy contractterms.

Introduction
Inflationis a problemthat has plaguedeconomies worldwide. Recently a
growingnumberof countrieshave experienceddouble-digitratesof inflation
which have affected basic institutionssuch as life insurance.The effects of
inflation on life insurance contractsare especially pronounceddue to two
factors:these contractsusuallyare specified in fixed, nominalcurrencyunits,
and most of them are designed to cover long periods of time. Because life
insurancevalues are specified in fixed nominal currencyunits, they do not
adjustto compensatefor the value erosionproducedby inflation, andbecause
the contracts are generally long-term, the accumulatederosive effects of
inflationon the insurancevalues can be substantial.Thus, while life insurance
productsaredesignedto provideprotectionagainstthe perilsof longevity and
prematuredeath, inflation and a rising cost of living can underminesuch
protection.
In this papera methodologyappropriatefor measuringlife insurancecosts
in an environment of inflation is developed. The model is then used to
examinetheoreticallythe effect of inflationon life insurancecosts. A number
of authorshave devised methodologiesby which the costs of life insurance
may be computed.1Nearly invariably,the methodologies have been devel-
oped and designed for use in comparing the costs of policies offered by
differing insurers. What is needed is a method appropriatefor measuring

David F. Babbel is AssistantProfessorof Financeand InternationalBusiness, Universityof

Californiaat Berkeley. He holds the Ph.D. degree. Dr. Babbelwas a FullbrightFellow, Rio de
Janeiro,in 1976 and 1977. The authoris indebtedto David Nye, WalterNess, PedroCarvalho
de Mello, Steven Manaster,ArnoldMatthews,andespecially David Denslaw for theirhelpful
suggestionsandcomments. Financialsupportfor this studywas providedby a Fullbright-Hays
Fellowship, the Brazilian Capital MarketInstitute, and the University of Florida.
'Most of these are conveniently summarizedin the nontechnicalReportof the Joint Special
Committeeon Life InsuranceCosts [23]. See also Belth [5].

425

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426 The Journal of Risk and Insurance

the changing cost of a given policy when subjected to an inflationary

environment.
In designing a procedureappropriatefor measuringinflation's impacton
the cost of life insurancefromthe consumers'pointof view, a useful startis to
consider first a numberof proceduresthat might be used which are inappro-
priate.2Such an approachis instructivein that the componentsof life insur-
ance costing are introducedin simplerforms, graduatingin sophisticationas a
better understanding of the complexities of life insurance is gained.
Moreover,this approachserves as a convenientvehicle for demonstratingthe
essential propertiesof an insurancecosting procedurewhich adequatelytakes
into account the effects of inflation, while alerting the reader to the
shortcomings of (mis)applying some of the conventional costing methods
presently in use.
In evaluating the effect of inflation upon the cost of life insurance, the
consumermay be entrammeledby variousdegrees of money illusion.3 Con-
cerned consumers may estimate the (net) cost of life insurance in either
nominalor real(or alternatively,presentvalue) terms. Furthermore,they may
link these costs to the nominal or real (or present)values of life insurance
protectionin force. Combiningthese alternativesleads to four general clas-
sifications of approacheswhich the consumer may take that are designated
here as "money illusion," "partialmoney illusion," "policy illusion," and
"no illusion. " The degrees of consumerawarenessin appraisingthe cost of
life insuranceare presentedin matrix form in Table 1.

TABLE 1
ConsumerApproachesto Life InsuranceValuation

Consumer's Units of Nominal Units of Real

Primary Focus Protection Protection

Nominal (Net) Partial Money

Money Illusion
Costs Illusion

Real (Net) Costs Policy Illusion No Illusion

2Thepurposehereis not to disparagethe methodsthatalreadyhave been devised. Mostof the

methods are appropriatein the applicationsfor which they have been employed-comparing
and rankingthe costs of life insurancepolicies offered by differentcompanies. In fact, some
evidence (Kensicki [25]) suggests that all the principal costing methods proposed in the
literatureyield similar rankingsof policies. The only purposehere is to draw attentionto the
limitationsof some of the methodsif they are appliedin estimatingthe costs of life insurancein
an inflationaryenvironment.
3The meaning of 'money illusion" is that the consumer, to some degree, bases his or her
decisions on nominally-valuedeconomic data ratherthan on real-valuedeconomic data.

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 Inflation Impact on Life Insurance 427

In the four sections thatfollow, each of these approachesis examined, and

methodologies which have been suggested in the literatureare reviewed as
they relateto these approaches.An appropriatemethod for costing is devel-
oped and applied to determine the impact of inflation on the cost of life
insurance.

Money Illusion
Consumers suffering from money illusion may realize that inflation is
occurring,but fail to recognize the impact of inflationon the real costs and
values of their life insurancepolicies.4 "'After all," they might remark,"the
size of my premium has not gone up in spite of inflation."
Moreover, if insurersare able to lower the premiumcharge due to higher
returnson investments from higher interestrates, consumerssufferingfrom
this degreeof money illusion mighteven believe thatthe cost of life insurance
is declining. Their focus is on the nominal costs and nominal levels of
protection,and unless inflation affects these nominal values, consumersdo
not recognize the impact of inflation on life insurance.
Such consumers might employ a numberof specific costing procedures
which may give rise to, or could serve to reinforce their illusion. One such
method,commonly called the "TraditionalMethod," which has long been in
use andwhich continues to be popularamongconsumersof life insurance,5is
used here for illustrative purposes. Its procedure is to add the insurance
premiumsfor a numberof years, usually 20, and to subtractthe sum of the
illustratedpolicy dividends for the period.6The cash value at the end of the
periodis subtractedfrom the resultingfigure, and the final amountis divided
by 20 (or by the length of the periodif otherthan20 years), andby the number
of thousands of the amount insured. The result, which may be positive or
negative, is the insurancecost per year per thousandcurrencyunits of life
insurance in force. The calculation procedure may be representedby the
following formula: k k
z P - E D -CV
NC = n=1 n=l (1)
k

4The features most often included in life insurancepolicies are premiums, death benefits,
cash values, dividends, and terminaldividends. The dividend featuresare available in "par-
ticipatingpolicies," but not in "nonparticipatingpolicies."
All life insurancepolicies contain one or more of the three basic kinds of insurance:term,
whole life, and endowment insurance.Term insurancefeaturespremiumsand deathbenefits,
with or without dividends. Whole life and endowment policies feature premiums, death
benefits, andguaranteedcash values, with or withoutdividends. Terminsurancepolicies offer
financial protectionagainst the peril of prematuredeath; whole life and endowment policies
offer protectionagainstthe peril of prematuredeath and also offer cash savings, which can be
used in providingprotectionagainst the peril of outliving one's earningcapacity. For further
details, see Pfeffer and Klock [33].
'In a survey by the Instituteof Life Insurance[22], consumers of insurancein the United
States identified the TraditionalMethod as being the most "preferred"method.
'The calculationsuse an illustrativedividendscale; the scale does not representan estimate
of the amountthat the insurerwill pay, but ratherthe currentscale paid on existing policies.

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428 The Journal of Risk and Insurance

where

NCk is the average net cost of insuranceper year, per thousandcurrency

unitsof life insurancein force for insuredswho surrendertheirpolicy at
the end of year k;
Pn is the insurance premium payable at the beginning of year n, per
thousandcurrencyunits of life insurancein force;
Dn is the insurancedividendreceivable at the end of year n, per thousand
currencyunits of life insurancein force;
CVk is the guaranteedsurrendercash value availableto the insuredin yeark,
per thousand currencyunits of life insurancein force; and
k is the year of policy surrender.
The TraditionalMethod could undergo refinements to reflect the prob-
abilitiesof mortalityand persistence,but the majordrawbackof the methodis
that it fails to give recognitionto the time when money is paid eitherby or to
the policyowner. The focus is entirely on costs and coverage measuredin
nominalcurrencyunits. In none of the termsof equation(1) are inflationand
interest included as factors bearingon insurancevalues.
For years in the United States and elsewhere, short-sightedapproachesto
life insurancecosting suchas theTraditionalMethodwere reinforcedby some
insuranceagents who emphasizednet cost calculationsper thousandunitsof
insurancein force to theirclients. In countrieswith unstablecurrencies,such
approachescan foster distortedviews of the truecost of life insurance,as the
cost and benefit flows, which occur over long periods of time, may exhibit
largerangesof differingrealvalues. To avoid this distortionsome statesin the
United States now require the use of an "Interest-AdjustedMethod" (now
called the surrendercost index) in calculatinglife insurancecosts. More will
be written on this subject in the section entitled "Policy Illusion."

Partial Money Illusion

While a consumer beset with money illusion would tend to believe that
inflation has no effect or, if inflation leads insurersto lower the premium
chargesand/orincreasethe dividendsand cash values, only a reducingeffect
on the cost of life insurance,a consumerhaving partialmoney illusion would
tend to think that inflation causes the cost of life insurance to increase.
Consumerswho reach this stage are somewhat less naive in their thinking.
They realize that indemnificationor cash surrendervalue, when actually
received, will exhibit a value thathas been erodedby the inflationprevailing
in the period interveningthe date when the policy is purchasedand the date
when it ends at death, surrender,or maturity.
This phenomenonoften has led to criticismof life insuranceproductson the
grounds that while premiums are paid in "good" money, benefits are re-
ceived in "bad" money, i.e., money whose value has been eroded by
inflation. The life insurancecontractsin existence in Brazil before indexing

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 Inflation Impact on Life Insurance 429

was applied7were among those subject to this criticism, as noted by the

following comment:
After the Second World War, galloping inflation created in the public a lack of
interestfor insurancein general and especially for life insurance.While premiums
were effectively paid in strong currency, indemnification,in the case of death, or
cash savings, at the end of the policy period, which were fixed in nominaltermsat the
beginning of the contract, had a purchasingpower infinitely less than the same
quantitiesrepresentedwhen the policy first came into force. Life insurancewas thus
abandoned,and savings were channeledinto real estate, stocks and treasurybills.8

A precise analysis, however, reveals thatas life insurancegenerallyis paid

for annually over a long period, the value of the premiums paid by the
policyowneralso declines over time with inflation. Thusnot all premiumsare
paid in "good'" currency. In addition, some life insurancebenefits (such as
dividends, where available, and death protection) are received during the
policy period ratherthan as a single lump sum settlement at the end of the
period. Consequently all benefits are not received in "bad" money.
A consumer who fails to recognize this relationshipbetween the timing of
premiumsand the timing of benefits may be led to a distortedappraisalof the
effect of inflation on the cost of life insurance. Although no models were
found in the published literaturethat reinforce this brandof (partial)money
illusion, the notion that premiumsare paid in "good" money while benefits
are received in "bad' money appearsto be common [17].

Policy Illusion
A more subtle erroris made when consumersare myopic in theirperspec-
tive of life insuranceupon consideringthe net cost (in real or present value
terms)of a policy offeringa given numberof unitsof insurancein force. Their
focus is incorrectlyon the vehicle (i.e., the policy contract)ratherthanon the
design (i.e., the protection offered) of the life insurance purchase. This
misdirectedfocus is denoted "Policy Illusion" in this discussion, and is a
subset of money illusion.
In discussing this type of money illusion, attentionis given to an elabora-
tion of a capitalbudgetingprocedurefound useful in measuringthe impactof
inflationon the costs and benefits associated with life insurance.The model
developedalso is used in the subsequentsection of this paperafterundergoing
a slight modificationto remove the final element of money illusion from the
valuationprocedure.
A Capital Budgeting Approach
Several authorshave advocateda capital budgetingapproachto the prob-
lem of consumer valuation of life insurance.9While such an approachin
7The applicationof indices to insurancecontractswas first authorizedin Brazil by Decree-
Law No. 73 of November 21, 1966.
8The English translationof this quote from Chacel et al. 19, p. 255] is that of the author.
9Thefirst study known to the authorto treatthe purchaseof life insuranceas a purecapital
budgeting decision was one by Kensicki [24]. Readers unfamiliarwith capital budgeting
techniques should find Brigham [8, chs. 11, 12] helpful.

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430 The Journal of Risk and Insurance

isolation theoreticallycannotbe used to justify the purchaseof life insurance

(Friedmanand Savage [ 18]), it is useful in analyzingthe costs and benefits in
monetary terms, and is well adapted to cost comparisons. The principal
advantagein using a capitalbudgetingapproachis its ability to accountforthe
opportunitycosts of money over time. As a life insurancecontracttypically
involves streams of payments and benefits over a long period, a capital
budgeting approach is especially suited for measuringthe values of these
flows.
Of the capitalbudgetingapproachesavailable, the net presentvalue (NPV)
method is employed here because of its theoreticalsuperiority(Hirshleifer
[20]) and its mathematicalefficiency in providingannual cost comparisons
(Kensicki [24]). The expected net present value of an insurancepolicy, per
thousandunits (e.g., dollars) of insurancein force, can be estimated by the
following formula:10
1 n=1 n
(1-DR (1-DR
k Pn (-DR a+t-) k n
E[NPVk = - a-i t=0 +: t=-
k n=~~~1 n n= n
n=l (1+i0) 11 (1+it_1) n=l 11 (1+it)
t=1 t=1

k
+ a+n-1 ($1,'0) + k DRa+n-1 (TD) (2)
n=1 /+1(1i ) n=1/i77 "
n_______-1
n 11 (1+i t- )
(1+i0) t=1 (1+i0) t=1

TD k k
k H (1-DR a+t1) cvk 1 (1-DRa+t 1)
t=1 t=t-1 a+-
+ + ~ ~k + k
t (t+i= (1+i
t=l t=l

I?Theformulaappearsin Babbel[3] andreflectschanges madeto correctwhatappearsto this

authorto be theoretical and technical errorsencounteredin the Kensicki [24] version. The
model assumesthe policyowner will surrenderthe policy in a particularyear, given survivalup
to that point. While the model was designed for the valuation of a participatingwhole life
insurancepolicy featuringa death benefit, a cash surrendervalue, and dividends, the model
may be extended to include such options as renewable and convertible clauses in term
insurance, policy loan values, settlementoptions, reduced paid up insurance, and extended
term insurance. For a presentationof a capital budgeting analysis of these options, see
Longstreetand Power [28]. The model also may be reducedto fewer terms when it is used for
the valuationof nonparticipatingwhole life andterminsurancepolicies. Fora nonparticipating
whole life policy, the dividend and terminaldividend expressions are eliminated, and for a
nonparticipatingterm policy, the dividend, terminaldividend, and cash value expressions are
eliminated.

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 Inflation Impact on Life Insurance 431

where
E[NPVk] is the Expected Net PresentValue of the insurancepolicy, per
thousandunits of insurancein force, for the insuredwho plans
to surrenderthe policy in year k;
Pn is the premiumpayableat the beginningof yearn, per thousand
units of insurancein force;
CVk is the cash value at the end of year k, per thousandunits of
insurance in force;
k is the year of surrender;
DRa+n-I is the conditionalprobabilitythatan insuredwho survivesto age
a+n-l will die before reaching age a+n where the insured's
attainedage on the effective date of the policy is representedby
the letter a;
it (or in) representsthe opportunitycost for the time value of money in
year t (or year n) and serves as a basis for determiningthe
present value of any stream of future costs and benefits. In
operationalterms, it can be viewed as the after-taxinterestrate
selected by the individualrepresentinghis or herrisk-freerateof
returnin year t (or n);
Dn is the dividendpayableatthe end of yearn, perthousandunitsof
insurance in force; and
TDn is the terminal dividend payable at the end of year n, per
thousandunits of insurancein force.
Formula(2) shows the basic cash flows in a participatingwhole life policy:
premiums, death benefit, cash surrendervalue, and dividends. The first
expression representsthe expected present value of the premiumspayable.
This outflow is weighted at each step to reflect the possibility that the
premiumswill not be paiddue to the deathof the insured." Pnis discountedby
n
1
(1+i0)
n (1+i t1) because premiums are payable at the beginning of the

year.
The second expressionrepresentsthe presentvalue of the dividendsthatare
expected to be received by the insured,weighted accordingto the probability
thatthe insuredwill surviveto receive them. This expressionis discountedby
n
11 (1+id) as dividends are receivable at the end of each policy year.
t=1
The thirdexpression representsthe death benefit, which is the amountof
insurancein force (one thousandunits) multipliedby the probabilitythat it is
received (i.e., the probabilitythat the insuredwill die). The death benefit is

" A probabilisticapproachalso can be takenwith respectto the uncertaintimingof the policy

surrender.Aggregate lapse rates could be incorporatedinto the formulawhere k, the year of
surrender,no longer would be viewed as the only year of policy surrender.

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432 The Journal of Risk and Insurance

,,1+1 n
n
discountedby + H (1+i -l due to the availabilityof the deathbenefit
0 t=1

uniformly throughoutthe year.

The fourthand fifth expressionsrepresentthe expected presentvalue of the
terminal dividend. The terminal dividend appears twice because this cash
flow is payableto the insuredwhen the policy maturesby deathor surrender.
The discount factors in the expressions are based on the assumptionthatthe
policy will terminatedue to deathor surrenderat the end of a policy year.12
The final expression represents the expected present value of the cash
surrendervalue for year k, the year of surrender.The probabilitythat death
will terminatethe policy before the projectedyear of surrenderis includedin
the numerator,and the denominatoris the discountfactorassociatedwith cash
flows occurring in the year of surrender.
The focus in this study is on nonparticipatinglife insurancepolicies. Thus
some of the expressions of equation(2) (along with theirproblemsof estima-
tion) can be eliminated, in particularthe dividend and terminal dividend
expressions. The currencyunitfor measuringinsurancein force for a policy is
the dollar ($). It is convenient (but not necessary) to simplify equation (2)
furtherby assuming that it = i for all values of t. Then, by multiplyingeach
term by a negative one, the equation for a level premiumnonparticipating
whole life policy reduces to:
P n-I

E a-1) (I a
E[NPCk]
E[NPC = (I-DR_a t- n-i a+t-1) k DR n-1
. ($1000)
n=I (i+i) n=I (l+i)

(3)

k
CVk HI (I -DR +t-1

(i+i)k

where E[NPCk]is the expected net presentcost'3 of the insurancepolicy, per

thousand dollars of life insurance in force, for the insured who plans to
surrenderthe policy in year k.

'2Althoughthe terminaldividendis not necessarilyreceived at the end of the policy year in

the event of death, the discount factor for the "mortuarydividend" is calibratedas if the
dividend is paid at the end of the policy year. The model assumes thatif the mortuarydividend
(whose value, unlike the deathbenefit, is not fixed in the contract)is paidduringa policy year,
its nominal value will be reduced so that its present value will remain the same.
'3As noted, anticipated inflation, as opposed to realized inflation, is the economically
relevantfactor to consider in consumer valuationof life insurance.For an explanationof this
point, see Neumann [32].

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 InflationImpact on Life Insurance 433

Inflation and the Cost of Life Insurance Policies

To be able to utilize equation (3) in examining the effect of anticipated
inflation on the NPC of whole life insurance,therelationshipbetween the
nominalrequiredrateof return,i, used by the individualin his or her discount
factor,and the expected rateof inflationmust be specified. Along the lines of
IrvingFisher's [ 16] work on inflationand interestrates, their relationshipis
specified as the following:
(i+i) = (i+r) (i+j) , (4)

wherer is the real rateof returnrequiredon a risklessinvestment14 andj is the

annualrateof inflationexpected to prevailduringthe periodof concernto the
insured.In the analysis that follows, the assumptionis that the real required
rate of return is expected to vary independentlyof the expected inflation
rate.15Substitutingequation (4) into (3) yields the following formulation:
I n-I
k P (I-DR a ) (I-DRa+t-1) k DR ($1000)
a-i t=O
E[NPCk v +n-?nn?
n=1 (i+r) (l+j) n=I (1+r) (1+ j)n

k (5)
cvk TI (1-DR at-)
t=1
k k
(1+r) G(+j)
To determinethe likely impactof a change in the expected rateof inflation
on the cost of life insurance, the method of differential calculus may be
employed such that
dE [NPCk]
dE [NPCk] - dj dj.

'4Lifeinsuranceis consideredto exhibit characteristicssimilarto a riskless investmentwhen

risk is defined in terms of the probabilityof payment default.
'5Whilethis assumptionoften is employed in models of a world of certainty, it has been the
subjectof considerabledebate. The hypothesisthat real discountratesare unrelatedto the rate
of inflation goes back to Fisher [16]. Mundell [30] has argued that nominal interest-elastic
demandor supply of money can lead to a reductionin the real rateof interestdue to inflation
expectations. However, Mussa [3 11and Enders [11] separatelyhave contended that a more
appropriatemacro-economic model specification leads to conditions that do not necessarily
resultin a real interestratedecline with increasedinflationexpectations.Mundell'sresultor its
inversedepends on whethercash balancesand capital are complementaryor substituteassets.
The response of interest rates to inflation expectations has been examined by numerous
economists. The researchis based almostentirelyon the responsein one nationaleconomy, that
of the UnitedStates. Hess and Bicksler[ 19] have shown thatthe realrateof interesthas notbeen
stable, whereas Fama [ 12, 13] and Feldsteinand Eckstein [14] have found thatthe real rateof
interest has been stable.
The propositionsderivedin this paperassume an independentrelationship,butalso hold true
even if inflationexpectationsarepositively or negativelyrelatedto the realrateof discount.The
only condition that must be met is that if anticipatedinflationrises, the nominaldiscountrate
also must increase.

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434 The Journal of Risk and Insurance

Returning to the level premium whole life policy (equation 15]) and differ-
entiating16
1 k 1-n -n n-i
dE[NPCk] [P (1-DR 1) (l+r) (1-n) (l+j) n (1-DR )
a-i n=Itt1

($1000) z DRa+n (l+r) (2-n) (l+j) i (6)

n=I ?

-k -k-i k
CVk(1+r) (-k) (+j) - l (1-DR ) ]dj

Here it is seen that for k= 1,2,3,... the first term will be a nonpositive
expression while the second and third terms (including their preceding signs)
will be positive. The sum of these three expressions, whether positive or
negative, specifies the direction of the impact of a change in the expected rate
of inflation on the expected net present cost of a given amount of life insurance
coverage. If the sum is positive (negative), an increase in the expected rate of
inflation will produce a rise (decline) in the expected net present cost of the
policy. It can be shown that for the insured who plans to surrender at the end of
the first policy year, an increase in the expected rate of inflation unambigu-
ously will lead to an increase in the expected net present cost of a term policy.
It also can be shown that if insurance is priced fairly (where present values of
expected costs and benefits are equal), the same pattern will hold true for an
insured who plans to surrender at the end of the second policy year.17 In
general, however, determining the impact of expected inflation on the cost of
life insurance will require more information with regard to the levels of costs
in relation to benefits, the time horizon, and the mortality rates. When such
information is provided, it was found in several cases [4] that the expected net
present cost of life insurance increases with anticipated inflation for surrender
in year one, but decreases with anticipated inflation for surrender thereafter.
At first blush these cost patterns may seem counter-intuitive, but can be
explained readily through examining the interaction of two opposing forces
deriving from the timing of cost and benefit flows, and the magnitudes of
these flows. The timing of cost and benefit flows leads to an increase in the
expected net present cost of a life insurance policy, when inflation is intro-

'6In addition to assuming independence between the real requiredrate of returnand the
expected inflationrate, the model implicitlyassumes that(1) mortalityratesare independentof
the inflation rate, and (2) policy terms are independentof the inflation rate. While the first
assumptionmay be a close approximationto reality (except, perhaps, in the case of the fixed
income recipient, whose anxiety level increases with inflation, therebycontributingto earlier
death), the second assumption may not hold if markets are free to adjust policy terms in
accordancewith the ratesof inflation. Inthe countriesstudiedby the author,policy termseither
were slow to incorporateor did not adjustto the higherinterestratesaccompanyinginflation.
'7The proof of these assertions is available to the reader upon request to this author.

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 Inflation Impact on Life Insurance 435

duced into the model. It will be noted that the benefit flows are always
discountedat higher rates than the premiumflow, because they occur later
within each time period leading to a higher expected net present cost of the
policy.
If costs exceed benefits (the usualcase), the relativemagnitudesof the cost
andbenefit flows tend to reducethe expected net presentcost of an insurance
policy when inflation is introducedinto the model. An example illustratesthis
point. If two unequalquantitiesare discountedequally in percentageterms,
the largerof the two quantitieswill decline more in absolute terms. Thus, as
costs are of larger magnitudethanbenefits, their discounted values will fall
more rapidly in absolute terms with inflation, thereby decreasing the net
present cost.
The problem encounteredin comparingexpected (net) present costs of a
life insurancepolicy underdifferinginflationrate assumptions,as performed
in the analysis of this section, is that not only do the costs change, but the
productalso changes. Therefore,any comparisonyields aboutas muchuseful
informationas comparingthe cost of apples underone inflationrateassump-
tion with the cost of peanutsunderanotherinflationrateassumption,hoping
therebyto infer the effect of inflationon the cost of apples. Under inflation,
the realprotectionachievedthrougha life insurancepolicy purchasedeclines,
while indemnificationvaries in real terms accordingto the date of death. As
the nominalterms of the policy remainthe same, it is temptingto comparethe
effects of inflation on the cost of the policies ratherthan on the life insurance
protection. However, the policy is merely the vehicle through which the
objective (i.e., protection)is sought. Thus attentionmoreproperlyis centered
upon the effects of inflation on the cost of protection.
To demonstrate more concisely the problem associated with using the
ExpectedNet PresentCost model in determiningthe effect of inflationon the
cost of life insurance,the formulais given in simplified notationas follows:
F [PV(C)] -
E[NPCI/per 1000 units /per 1000 units E[PV(B)]/per 1000 units (7)
ins. in force ins. in force ins. in force
In the foregoing formula, C and B representthe cost and benefits associated
with each one thousandcurrencyunitsof insurancein force. The E and PV are
expectations and present value operators, respectively. Unfortunately,the
numeraireto which the benefits and costs are attachedis a poor choice. The
one thousandnominal units of insurancein force representdifferentlevels of
protectionunderdiffering inflationrateassumptions.Hence, such a model is
inappropriatefor use by a consumerfree from policy illusion in determining
the cost of life insurance.
Many of the life insurance cost computation methods presently in use
incorporateelements thattend to inducepolicy illusion on the partof the user.
For example, the "Interest-AdjustedMethod," which was developed to
overcomedefects in the "TraditionalMethod" andwhich was recommended
by the JointSpecial Committeeon Life InsuranceCosts [23] and requiredby
law in some states of the United States, makes explicit use of a nominally
valued numeraire(one thousandunits of insurancein force). Accordingly,

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436 The Journal of Risk and Insurance

when the discountfactorsare adjustedto reflectinflationaryexpectations,the

change in the cost index that results will indicate only the influence of
inflationon the real cost of life insurancepolicies, and not on the real cost of
protectionavailable throughthe policies; hence the term "policy illusion."

No Illusion
If consumersare befuddledwith money illusion, partialmoney illusion, or
policy illusion, they are likely to view the influence of inflationas producing
life insurancecosts that are unchanged, higher, or lower, respectively.
To arriveat a costing methodology in which money illusion, in any of its
forms, is absent, a good startingpoint is formula(7), reproducedbelow for
convenience.
E[NPC] E
E[PV (C)] E
E[PV(B)]I
/per 1000 units /per 1000 units /per 1000 units
ins. in force ins. in force ins. in force
The nominalnumeraire,which gives rise to policy illusion, can be eliminated
in alternativeways. For the Expected Net PresentCost method, considered
earlierin the chapter,a simple andeffective approachis to divide each termin
the foregoing formulaby the last termthatappearson the right-handside. The
resulting equation is
/per 1000 units E[PV(C) /per 1000 units E[PV(B) /per 1000 unit
ins. in force ins. in force ins. in force (8)
E[P(B) /per 1000 units [P(B)]/per 1000 units [P(B) /per 1000 units
ins. in force ins. in force ins. in force

which simplies tQ
E[NPV] = E[PV(C)] 1. (9)
E[PV(B)] E[PV(B)]

Note that in the foregoing expression, the numeraireof one thousand

nominal units of insurancein force has been cancelled out of all the terms.
What remains is the expected net cost (in present value terms) per unit of
expected benefits (also in present value terms). Note that the foregoing
expression differs from the expected cost-benefit ratioby an amountequal to
unity. In economic terms, the price of insurancehas been "deflated" by the
actuariallyfair price of insurance.This deflation is appropriatebecause a fair
price is "costless" to the individual in the sense that his or her expected
expenditureis equal to his or her expected benefits [1O].
Threeproblemsimmediatelyarise in operationalizingthe generalformula-
tion given by (9). First is the matterof what should be considered a cost and
what should be considered a benefit of life insurance.This problemwas not
encountered in the horizontal outlay of the Expected Net Present Cost
method, but the vertical natureof the cost-benefit ratio raises questions of
whatproperlyconstitutethe componentsof the ratio. Subtractinga particular
item from the cost component rather than adding the item to the benefit
component will affect the ratio. Although insurance premiums and death
benefits are unquestionablycosts and benefits, respectively, of a life insur-
ance policy, other items such as cash surrendervalues and dividends (where

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 Inflation Impact on Life Insurance 437

available) can be viewed either as reductions in the cost or as additional

benefits [7]. Still another approachis to remove such elements altogether
frominsurancecost calculationsandto determineseparatelythe costs of these
8
benefits.1
A second problem arises if uncertaintyis extended to include the inflation
rate, as well as the intraperiodmoment of death. Up to this point the
assumptionhas been that if death occurs in a given period, it occurs, on the
average, about midway throughthe period. Anotherimplicit assumptionwas
no uncertainty regarding rates of inflation that will prevail in the future.
Relaxing either of these assumptions will result in an additional source of
randomnessin the values of cost and benefit flows. Relaxing both assump-
tions will serve to reinforce the possible deviations in realized flows from
expected flows.
Forany insuredconcernedwith morethanjust the first momentsof the cost
and benefit distributions, the existence of uncertaintywill affect the con-
sumer's perceptionof the cost of insuranceprotection. For example, if the
insuredis riskaversewith respectto the value of his or herbequestin the event
of death, the fact that the expected present value of his or her bequest is
adequatemay not quell his or her concern. For such an insured, the unit of
account-expected presentvalue unitsof benefits-no longer will serve as an
adequatenumeraire.Expectingto leave "on the average" a given real valued
bequestin the event of deathis not the same as leaving with certaintythe same
real valued bequest in the event of death. As death is a once in a lifetime
occurrence to the (typical) insured, the law of large numbers is of little
consolation to the risk averse individualor to the heirs for whom he or she is
seeking to ensure financial security.
A third problemexists in using the model. Different expected cash flows
may elicit differingdiscount rates, even in a model such as the one presented
here where uncertaintyis limited only to survival[2 1]. If the model is used in
isolation as a decision criterionto buy or not to buy insurance, it should be
recognized that the death benefit has negative covariance with the returnon
the humancapitalportionof the policyowner's portfolio and thus may elicit a
lower or even negative discount rate.19This observationholds even though
the expected cash flows associatedwith insurancemay not exhibit covariance
with other financial assets in the policyowner's investment portfolio.
Three potential problems in using formula (9) for the valuation of life
insurancehave been identified. In this paper, the first problemis resolved by

"8Examplesof this approachcan be found in [5, 6, 15, 26, 27, 34, 35].
'9Whetheror not differing discount rates may be properly applied to separate cash flow
streams that are part of a "package" is debatable. Arditti [1] has demonstratedthat the
procedureof using a differentdiscountfactorfor cash flows exhibitingcomplete certaintyfrom
that applied to uncertain flows is appropriate.Other cash flows, he contends, should be
discounted by a similar risk-adjustedrate, because they are not separable. Whether these
conclusions areapplicableto the life insuranceproductis debatable.The policy can be arranged
to include any desirable cash flow provisions, and is cancellable by the policyowner at any
moment.

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438 The Journal of Risk and Insurance

treatingthe surrendercash value as a benefit, ratherthanas a reductionin cost;

hence, it is included in the denominatorsof each term in formula (9). The
second and third problems evoke individual utility considerations in their
resolution;these problemsare handledin the analyticalframeworkof Time-
State Preferenceby Babbel [2]. In defense of the methodology employed in
this paper, there appearsto be merit in devising a cost index that is indepen-
dent of specific utility functions because then the index becomes universalin
applicationand provides an unbiasedmeasureof insurancecosts in expected
monetary(present) values. This informationthen can be evaluated in con-
junction with other factors (e.g., other moments of the cost and benefit
distributions)which may receive varyinglevels of importance,in accordance
with the individual who is appraisingthe insuranceproduct.20
To determine the impact of anticipated inflation upon the cost of life
insurance(as measuredby the expected net presentcost per unit of expected
benefit in present value) the differential of equation (9) may be taken as
follows:
d E [PV (C)]
d E [NPC] E [PV(B)] dj
E[PV(B)] dj

If the derivative of the cost-benefit ratio is positive, a rise in anticipated

inflation will cause an increase in the expected net presentcost, per (present-
valued) unit of expected benefit. It can be demonstratedmathematicallythat
as long as an increase in anticipatedinflationis associated with an increasein
the discountrate, the sign of the derivativeof the cost-benefitratiois positive;
hence, an increase in expected inflationwill be associated with an increasein
the cost of life insurance.21
Although the precise magnitudesof cost increases are dependentupon the
conditions of the particularpolicy analyzed, including the surrenderand
mortalityrate assumptionsutilized, the upwardtrend is not subject to these
qualifications. Increasingratesof inflationalways lead to higher costs of life
insurance protection available through nonparticipatingcontracts. The one
exception to this rule occurs only if the nominal terms of the insurance
contract (specified premiums and benefits) adjust to compensate the con-
sumer fully for changes in inflationrates. Unfortunately,this type of adjust-
ment seldom is the case. The life insuranceindustryoften is constrainedby
governmentalregulators, and generally is slow to adjust to inflation.22
Summary
The purposeof this paperwas two-fold: (1) to develop a model capableof
measuringthe cost of life insurance,and (2) to utilize the model in determin-
ing the effects of inflation on the cost of life insurance.
20TheExpectedMonetaryValue methodis discussed at length in Mao [29], and is evaluated
in conjunction with the variance associated with the resulting value.
2'The proof of this assertion is available to the reader upon request to the author.
22See explanation in footnote 16.

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 Inflation Impact on Life Insurance 439

En routeto accomplishingthese objectives, a numberof byproductswhich

the authorfinds interestingemerged. Among the more importantwere (1) a
classificationscheme for identifyingvariousdegrees of money illusion on the
part of the consumer; and (2) the observation that some of the insurance
costing proceduresserve to reinforceconsumer money illusion in one of its
formswhen used in an inflationarycontext. Finally, a methodappropriatefor
determining the cost of life insurance was introduced. The method was
capable of measuring changes in the cost of life insurance incurredunder
inflation. The model then was applied in determininghow the cost of (non-
participatingwhole life) insurance would change under different rates of
anticipatedinflation. It can be demonstratedmathematicallythatwhen insur-
ance terms are slow to adjust to the realitites of inflation (perhaps due to
regulatoryconstraint), the net cost of insurancerises in real terms.23
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23The magnitude of the increased net real cost of life insurance under inflation can be
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