Tag: Inflation

Categories
Cryptocurrencies & NFTs

Intrinsic Value of DeFi & Inflation

The Takeaways:

  1. The intrinsic value of cryptocurrency comes from being a part of decentralized finance ecosystem, where we divert the power of central authorities of the Fed and the FDIC and to distribute it among more agencies and entities.
  2. Decentralization does not mean getting rid of central authorities, now and in the future sometimes only central authorities possess the power to make a drastic difference.
  3. Decentralization does mean strengthening rules and regulations that are to be applied to all players and closing legal and financial loopholes as early as possible.
  4. Quantitative Easing monetary policy can work magic but can also induce inflation. The key is to turn the extra QE money into productive or non-productive uses. The former works to create new assets/wealth while the latter merely changes the ownership of existing assets and pushes the price up along the way.
  5. Transforming QE money into productive uses is easier said than done as creating new assets requires time and selective fund allocation to the best players while QE money can be created almost overnight.
  6. The reason central banks should work through local commercial banks is to turn the latter into local reservoirs that can release the QE flood of money slowly and selectively to the best value adding players, instead of overflowing to the entire economy indiscriminately overnight, which will push up overall price level.
  7. During the Covid, the Fed established multiple programs of “going direct” or sending money directly to firms and consumers on the ground, failing to take advantage of local money reservoirs, or overflowing them.  
  8. The fiscal stimulus of directly distributing cash to households also exacerbate the inflationary risk, although out of necessity due to Covid.
  9. Institutional decentralization (through local banks) is one way to build fund reservoirs, the other is household savings (and /or purchasing life insurance policies) to avoid too much money hitting the market at the same time. Firms and entities can inject cash into R&D projects, buying CDs and investing in money market funds.

It has been a long pause since the Kingstons last gathered together at the dinner table to talk about financial issues that interest them. Greg (the father) has been traveling out of the country for a multinational research project, while Joy (the mother) has been promoted to be the managing director of her consulting firm. Lily (the first daughter) is about to graduate from college but already started working full time for a financial service company, while Kimberly (the second daughter) just started her freshmen year in a local college. The Kingstons have finally found a day to all sit down at the dinner table to chat.

Kimberly: Gosh it feels like years since the last time we all had dinner together!

Lily, Jason & Cleo: I know!

Joy: So should we vote for the biggest event or largest change we’ve seen since we last met?

Greg: It has to be the collapse of the Silicon Valley Bank in my view.

Jason: I think it’s ChatGPT and artificial intelligence chatbot.

Cleo: What about Russia’s invasion of Ukraine?

Kimberly: I’ll vote for Donald Trump’s indictment.

Lily: Dad, you mentioned the Silicon Valley bank, what about the Signature Bank, the one that had a heavy hand in cryptocurrency?

Jason: Yeah, speaking of crypto, it seems that we’ve wasted all our time talking about it before.

Joy: Why did you say that?

Jason: Well, just look at the news. It seems every day someone from the crypto world is getting arrested or suited. We had no idea there were so many bad guys out there.

Kimberly: But should we separate the idea of cryptocurrency from its promoters?

Greg: That’s exactly what I was gonna say. Crypto as a new idea still has its value even though we have seen enough of the bad players.

Lily: So what is the value of crypto anyway in your view?

Greg: Nobody can deny the value of decentralized finance. That is ultimately where the intrinsic value of cryptocurrencies and blockchain is. In other words, the most fundamental value of cryptocurrencies is not directly measurable in money. Instead, it is measured by the value added from decentralized finance and decentralized professional services.

Joy: I agree. To be sure, it is still possible even today for any single cryptocurrency to fail or to crash just like Terra’s UST did, and the crypto prices will go up and down, sometimes significantly. Theoretically speaking — even though unlikely in reality — Bitcoin itself could die one day, making many Bitcoin haters or scoffers happy, allowing them to claim, “I told you so!”

Greg: If you think of it, the intrinsic value of blockchain and crypto is just like ChatGPT or large language models: They empower individuals and entities to reduce their reliance on third party entity whenever possible and whenever necessary. This is a part of the bigger trend, anything working toward that should be embraced.

Lily: But we can also learn a regulatory lesson from Silicon Valley Bank and the crypto world: Encouraging and embracing changes but working diligently on the rules and regulations to close the potential legal and financial loopholes as early as possible.

Greg: Excellent point there. Decentralized finance is not unregulated finance. It actually calls for more and tighter rules and regulations to provide guidance and guardrails, so everyone follows the same path. What I am saying is that the concept of decentralized finance needs to be clarified: It doesn’t mean to delete central authorities but rather to diversify and to spread the power to more parties and entities.

Jason: Excuse me, I know we talked about it before but what is decentralized finance?

Joy: Instead of asking us, why don’t you ask ChatGPT?

Jason: Actually I’ve been using Perplexity.AI lately. It allows current website search with no time delay. Okay, here it comes: “Decentralized finance (DeFi) is … a financial ecosystem based on blockchain technology that offers services such as lending, borrowing, and trading without intermediaries. DeFi operates on decentralized platforms using smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code.”

Lily: Sounds like getting rid of the central authorities and middlemen.

Greg: I probably won’t get rid of central authorities and all middlemen altogether. Sometimes a central authority can do magic with unmatching power from decentralized agents. Decentralization simply means adding more active agents to the system without completely destroying central agents. It’s about dividing the power of authority among more people to allow more to use financial services anywhere, anytime.

Kimberly: The idea sounds good, but I can’t stop thinking that in reality, all we’ve seen is the power of central authorities like the Fed and FDIC as this time for the Silicon Valley Bank.

Lily: I agree. Sometimes only government intervention can get the job done. Look at the First Republic Bank: After the nation’s top 11 banks pledged $30 billion to its deposit, the bank’s share was still down by 33%.  

Greg: Like I just said, centralized and decentralized players each have strengths and weaknesses and it’s best to integrate the two. But the other thing we should not forget is that currently we only have a centralized system. So of course we can only see the Fed & FDIC acting to make magic differences.

Joy: I agree. The current system works because everything moves around central authorities like planets moving around the sun. People have little idea how decentralized systems work so they always turn to central authorities for solutions.

Lily: Are you saying in the future the decentralized system will become mature and people won’t panic and only ask the Fed or FDIC for solutions?

Greg: That’s the hope, and we have reasons to expect a brighter, decentralized future. For one thing, I’ve seen commentators pointing to the Fed as the source — not the solution — of the Silicon Valley Bank crisis this time.  

Joy: I’ve noticed that, too. There is one article by the pioneer of Quantitative Easing, Richard Werner, who basically says the central banks created the inflation crisis.

Greg: Are you talking about that article on Conversation.com, I believe it’s called “Why central banks are too powerful and have created our inflation crisis”?

Joy: That’s right. I still remember what he said about how central banks managed to get more powers with less oversight, despite repeated policy failures.

Lily: So this guy, Werner, created the idea of quantitative easing?

Kimberly: Wait, what’s quantitative easing?

Joy: Werner did come up with the QE idea when he worked in Japan, which later became a widely used monetary policy after financial crisis of 2007-2008. To answer your question, Kimberly, QE is a monetary policy used by central banks to stimulate the economy. Central banks can increase money supply in two ways: buying short term treasuries or buying long term, riskier assets like treasuries and mortgage backed securities, even stocks. QE mostly does the latter.

Greg: Historically the Fed has been controlling money supply by adjusting the federal funds rate, or the (very short) rates that banks charge each other for overnight loans. The problem there is that sometimes we are out of luck — when the fed funds rate was already cut to zero or near zero and the economy still needs an extra push. QE is then used as another tool to reduce interest rates and encourage lending.

Lily: Can we use Federal funds rate and QE together at the same time?

Greg: Yes. The two work differently in two ways. First of all, the federal funds rate works on short term interest, while QE on longer term interest. Secondly, reducing the federal funds rate does not increase money supply directly, only indirectly through reducing the cost of borrowing money. QE on the other hand increases money supply directly.

Jason: What does it mean to increase money supply? You mean the government printing more money and adding it to the market circulation?

Lily: Printing money is an old way of increasing money supply. Although it is still used today, it is not the most efficient and most used way because in the modern economy, physical money is only a small portion of total money. The Fed today has better ways of doing it mostly through electronics.

Joy: Yeah, remember a central bank is still a bank, so it does what banks do the best: working with other banks, except a central bank works only directly with large national banks, not smaller ones at street corners. These banks largely make up the money supply system, energizing the economy like the blood vessel does to a human body.

Lily: That’s right. The details can vary but basically increasing money supply means a central bank gives more money to commercial banks, which then lend the money to businesses and consumers. When more money becomes available, the price of money goes down just like anything else.

Kimberly: But what’s the price of money? I know money is used to measure the price of everything, but I never knew money has a price itself. Isn’t a dollar always a dollar regardless of how much money is out there in the market?

Lily: You are talking about nominal value of money, which always stays the same: $1 is always $1 like you said. But “price of money” is different, and it can mean two things. One is the nominal interest rate, or the price of borrowing money. If I lend you $1,000 at 5% interest today, it means one year later you’ll have to pay me back $1,050. The extra $50 is the price you pay to be able to borrow $1,000. This is what we mean by “price of money.”

Kimberly: I see. What’s the other meaning of “price of money?”

Lily: It can also mean purchasing power of money, meaning the amount of goods or services each unit of money can buy. Purchasing power has more to do with inflation. By definition inflation always means lower purchasing power of money, meaning the same amount of money buys fewer goods and services.

Greg: Here is a good example. I visited Venezuela a couple of years ago and I can tell you how crazy inflation was in that country. In 2018, the hyperinflation rate was 1,000,000%, meaning the prices of goods and services have been up by 10,000 times.

Joy: Anyway, going back to Werner’s article that says central banks are the source of the problem. His arguments are interesting by separating two kinds of QEs, “productive” versus “unproductive.” The first one spends the extra QE money on real economy, while the second spends on buying and selling existing financial assets like bonds, stock shares and futures. Those transactions only change the ownership of assets from one agent to another, pushing up asset prices without adding real value to national income. Werner believes this is where QE can go wrong and leads to inflation.

Lily: Let me make sure I understand it. So Werner says “good” and “bad” QE totally depend on how the QE money is used. Using it wisely, we can stimulate the economy and avoid recession; using it unwisely, we will run into inflation.

Kimberly: But how to use the money wisely? Is the key on investing the QE money for tomorrow, not spending it today?

Joy: Not exactly. Bear in mind not all investments are equal, and the key is to create new assets or add new value to the economy. When people are competing for the ownership of existing assets, they are still investing for the future, not exactly spending for today. What Werner is saying is that we really need to invest money to create new assets, not redistributing the existing ones.

Lily: If value added is the key, does it mean to invest to revitalize the manufacturing sector for the US, like the US government is currently trying to do?

Joy: Interesting questions! I believe it takes years or even decades to bring all manufacturing jobs back to the country, even if we assume that’s a smart thing to do. At the end of the day, economic principles still rule the game: Production flows to where the cost and risk are low, even after we take national security risk into account, even after we take governmental subsidies into account.

Greg: Yeah. This is not a financial matter, but have you noticed that Washington is quietly copying the moves of Beijing? China boasts its strength in manufacturing, so the Biden administration is trying to bring manufactures back to this country.

Joy: Speaking of that, sometimes this country moves not by long term strategic thinking but by reacting to its enemies in the short term. When Putin expected the US will stop supporting Ukraine after a while, Biden claims we will support Kyiv for as long as it takes. When Beijing wants to retake Taiwan, Biden then says we’ll send US military to defend Taiwan.

Greg: Let’s go back to financial matters. To answer your question earlier, Lily: No, creating new assets does not necessarily mean investing in manufacturing, although that would help. The good news is that this country is still the best in the world when it comes to innovations. All we need is a little financial push to make it better. A perfect example for creating new wealth is ChatGPT or AI Chatbots. Look at how much time we are saving each time we are search for answers to the questions we have in mind.

Jason: That’s true. Now that we have ChatGPT or Perplexity.AI, we are not going back to Google search, which was such a waste of time. Every time you ask a question, Google gave you millions of websites but just not the straight answer you need the most. It’s really a lose-lose game: You lose your precious time, and Google loses in giving you too much information that you never really needed.

Joy: Another good example of new asset is the mRNA based Covid vaccine. We were able to create a brand new drug in such a short period of time that beats China’s vaccine hands down in efficacy.

Greg: But here is a problem: Financial resources and innovation do not always go hand in hand. There will be mismatches. For one thing, it takes much longer to achieve innovations and breakthroughs, while financial resources can flow in and out of the economy at a much faster pace. We need to think about how to best spend the QE money, which can come quickly, almost too quickly to allow the economy to be absorbed and turned into value added assets.

Lily: Yeah, I see your point. Perhaps it’s easier said than done to follow Werner’s advice. It’s almost impossible to let the flood of QE money flow into new assets quickly, but it’s easy to use the money on consumption for today, not worrying too much about tomorrow.

Kimberly: Yeah, people were not allowed to work during the pandemic lockdown, but still needed money to buy groceries if nothing else. We can’t tell them to stop normal spending. So here is a problem: as workers we were not creating new wealth, but as consumers we were giving money for spending. This is a problem created by nature though, beyond human control.

Greg: Werner believes there is another problem with central banks that has direct bearing in inflation. He devotes an entire section to the cause of the current inflation and says the Fed was following the proposal of a private entity to go direct, meaning to get central bank money directly to the hands of businesses and consumers. Going direct means bypassing retail banks, who are in the best position to create credit by making loans to those most capable of creating wealth.

Joy: So we had two direct channels of money flowing: from central banks to businesses — bypassing commercial banks — and from federal and state governments to consumers in those stimulus checks to households.

Lily: Is it true that the Fed really went direct like Werner claimed?

Greg: Some evidence says yes. There is an article by the Brookings Institute that did a good job summarizing all the monetary programs by the Fed during the pandemic. Turned out that the liquidity was added to corporation (through the Primary Market Corporate Credit Facility , Commercial Paper Funding Facility , Secondary Market Corporate Credit Facility, supporting loans to small- and mid-sized businesses, Supporting loans to non-profit institutions), households and consumers (through Term Asset-Backed Securities Loan Facility or TALF) and state and municipal borrowing (through Direct lending to state and municipal governments, Supporting municipal bond liquidity).

Kimberly: Guess what I was thinking? If QE money flows too fast, especially without going through local banks, there is a simple way to avoid or reduce the bad consequence: Having businesses and households save the money and then slowly release it for the best time to use it.

Lily: I don’t see your point. Could you explain it?

Kimberly: Think of the QE money like a huge reservoir. When we open the dam money flows out too fast and too much at a time. Werner suggests that we use local banks to distribute the money more efficiently for creating new value. In a way the local commercial banks are like smaller reservoirs all over the country. When money flows from the big reservoir to many smaller ones, it protects the economy from being flooded by too much money, right?

Lily: Yeah, it makes sense. So instead of relying on local commercial banks, we can achieve the same result by asking households to save the money they receive from governments, not spending it right away.  

Kimberly: Yeah, we essentially turn households into tiny reservoirs. That way, even though the Fed may have gone direct, bypassing local banks, households are still protected from the instant flood of money by saving it for the future.

Lily: We can also ask business firms to do the same. They can deposit money in the money market, in CDs and more importantly, inject it to R&D projects.

Joy: These are all good points. We may not be able to achieve those as most Americans don’t have a strong taste for savings.

Lily: We could suggest people invest in future oriented purposes like buying life insurance policies.

Greg: Speaking of the future, with today’s technologies we must rely on local banks to find the best value adding players but who knows, maybe in the future we can rely on ChatGPT to get the job done without so many local bank branches.

Everyone: That’s true!

Categories
Did You Know?

Ways to Lower Insurance Premium During Inflation

The Takeaways:

  1. Inflation will always have an impact on insurance cost or premium because the labor and parts cost of repairment and replacement for damaged properties will be higher.
  2. Inflation increases the value of insured assets like homes, cars and personal property. As the value of these assets increases, the cost of insuring them also increases.
  3. Inflation also pushes up medical costs, which in turn increases health insurance as insurers must pay more to cover medical treatments, prescription drugs and other related costs.
  4. Inflation has another type: Social inflation that may directly push up insurance cost due to the legal fees and attorney activities encouraging lawsuits and compensation or indemnification of financial losses, leading to protracted litigation and higher claims costs.
  5. Homeowners and renters should review policies to avoid underinsured during inflation.
  6. Shopping around, bundling policies, increasing deductibles, reviewing your insurance policy periodically and maintaining good credit scores and keeping your mileages low, these can all help decrease insurance costs even during inflation.

Bad News on the Insurance Front

Are you feeling the pinch of rising insurance premiums? You’re not alone. Inflation has a significant impact on the cost of insurance, and unfortunately not everyone is well prepared when it comes to planning or budgeting their policies ahead of the time.

In this blog post, I’ll explore how inflation affects insurance, why it can make your coverage more expensive, and what you can do to mitigate its impact.

Let’s begin from auto insurance. This report tells us that a recent study by Bankrate found annual auto insurance premiums will go up by $101 in California, to an average of $2,291, roughly 2.81 percent of their income. Say an average Californian is making $3,500 a month, then since 2.81% of $3,500 is roughly $98 a month, an average Californian will pay $98 for auto insurance.

Insurance business is regulated by state; thus insurance rate also differs across states. However, we can always compare the spending of auto insurance as percentage of income. In this regard, California is ranked 32nd in the nation, where the lowest (rank 1st) is Maine and the highest (rank 50th) is New York.

Why Insurance Rate Is Higher During Inflation: Demand Side

Knowing insurance cost is higher does not tell us why it is so. The best way to know the reasons, like knowing most everything in the market, is to look at the demand side and the supply side, as together they jointly determine the price of auto insurance.

Normally the demand for auto insurance is measured by how many people will buy auto insurance. However, since auto insurance is required by the law, at least for the liability auto insurance, meaning when you hit someone and it’s your fault, you will have the money to pay for the medical bills for the victim, and money for fixing the car. In that sense, the number of auto insurance buyers stays the same as everyone is supposed to buy it — unless when we look at the number of people buying auto insurance above and beyond the basic liability insurance but also policies with collision and comprehensive coverage. We will talk about that in another time.  

There is another way to measure demand for auto insurance: How many people are filling insurance claim. Other things equal, more insurance claims mean more traffic accidents. In case you don’t know, an insurance claim is a formal request from the policyholder (i.e., anyone bought an auto insurance policy) to their insurance company asking for payment after a covered incident.

Turns out that this is a more interesting measure for demand, which varies from time to time rather than being fixed. If more drivers do not follow traffic rules, there will be more accidents, which in turn lead to more claims.

One important factor driving up insurance cost is the riskier driver behaviors after the pandemic. Auto premium rates are affected by frequency and severity of claims. After decades of decline, traffic deaths have increased in the past several years due to riskier driving behaviors — more speeding, driving under the influence, not wearing seat belts, distracted driving — during the pandemic.

It’s like we have waited long enough at home during the lockdown period that when we finally get a chance to hit the road, we all trying to release ourselves by driving faster.

Let’s look at the numbers from the highways: In 2021, U.S. traffic fatalities reached a 16-year high, with nearly 43,000 deaths. In the first quarter of 2022, the National Highway Traffic Safety Administration (NHTSA) estimates, 9,560 people died in motor vehicle crashes, up 7 percent from the same period in 2021, making it the deadliest first quarter since 2002.

It is a safe bet that reckless driving leads to more accidents, followed by more insurance claims, which drive up insurance cost. After all, insurers do not have the magic power to keep the insurance premium the same regardless of how many claims they received. Remember several insurers became insolvent after Hurricane Ian in Florida? The truth is that when many insured file claims at the same time, insurers will have insufficient amount of fund to cover all the claims. They can do two things: raising premium and going to reinsurance for coverage.

Similar considerations come into play for homeowners insurance. Global economic losses from tornadoes, hurricanes, severe storms, wildfires, floods, and other natural disasters reached $270 billion in 2021, according to Swiss Re. Of those losses $111 billion were insured, Swiss Re says.

Much of this loss trend is due to people moving into risk-prone areas. More people, homes, businesses, and infrastructure means more costly damage when extreme events occur. More damage to insured properties means more and larger claims. An Aon analysis of U.S. Census Bureau data shows the number of housing units in the United States has increased most dramatically since 1940 in areas that are most vulnerable to weather and climate-related damage.

Why Insurance Rate Is Higher During Inflation: Supply Side

Now we must consider the supply side factors that also drive up insurance cost: the people and businesses whose jobs are to fix cars involved in accidents, care for drivers injured, and repair and recover properties lost or damaged.

Unless your car is “totaled” or deemed worthless for repairment, insurers will pay for your vehicle to be fixed. From the following Triple-I issue briefing on inflation and higher insurance premium:

As material and labor costs rise, the cost to repair and replace damaged homes and vehicles increases. If the original premium rates are too low to cover these increased costs, insurers would quickly exhaust the funds they set aside for the rainy days to ensure they can keep their promises to pay all claims. If their losses and expenses exceed their revenues by too much for too long, they risk insolvency — unless they have reinsurance or insurance for insurers.

Social Inflation: Definition and Cost

The other side of story is social inflation, which is the amount of insurance claims that above economic inflation. One narrow definition is “legislative and litigation developments which impact insurers’ legal liabilities and claims costs.”

ChatGPT offers a more detailed definition: “Social inflation is a term used to describe a phenomenon where the cost of insurance claims rises due to societal factors such as changing attitudes towards personal responsibility, increasing jury awards, and the growing willingness of juries to award large sums of money to plaintiffs. In other words, social inflation refers to the trend of increasing costs of insurance claims due to broader social, cultural, and economic factors rather than traditional factors such as inflation, interest rates, or market fluctuations. This trend has been observed in a variety of industries, including personal injury, product liability, and medical malpractice claims. Social inflation can have significant impacts on insurance companies and their policyholders, leading to higher premiums and reduced coverage options.”

Two things to be remembered about social inflation. First, it is social rather than economic, which means the cause of it is not economical but social, especially the legal part of society. Two, its impact is not to be underestimated.

In a recent report by Triple-I, it is found that “U.S. commercial auto insurance liability claim payouts increased $30 billion more than would otherwise have been expected between 2012 and 2021 due in part to social inflation.”

Inflation and Underinsured Homeowners

Inflation means lower purchasing power of the same amount of money. For example, $1 before inflation could buy you 4 eggs but only 3 after inflation. But the same logic can apply to buying insurance. The best example is from homeowner insurance. Before inflation your $1,500 premium homeowner policy could be enough to cover the cost needed for repairing a partly damaged house. However, after inflation everything (parts, labor) has a higher price, meaning your insurer will have a hard time to cover the cost of repairing the house to the original state.  

According to a report by policygenius.com in 2022, construction costs have risen sharply because of inflation, which means you may not have enough home insurance to rebuild your house after a disaster, which in turn means many homeowners could be left underinsured. 

During periods of rapid inflation, the cost to rebuild may suddenly spike to account for higher lumber prices or a shortage of contractors. If homeowners don’t update their policy to reflect these fluctuations, they may not have enough insurance to fully rebuild their home after a disaster.

The price of materials used in home construction has increased 36% since the start of the pandemic. As we settle into what forecasters predict will be another active hurricane and wildfire season, it’s more important than ever for homeowners to review their policy and make sure they have enough coverage should disaster strike.

From a recent survey of insured homeowners by policygenius.com:

  • More than half of homeowners (56%) did not review their home insurance policy in the last year to see how much coverage they had. 
  • Homeowners who reviewed their policy’s coverage limits in the last year (44%) were more likely than those who didn’t to:
    • Increase their home’s coverage limits.
    • Take action to lower their insurance premiums.
    • Have at least one coverage feature in their policy that accounts for high rebuild costs.
    • Be “very sure” their house is fully insured.
  • Just 9% of homeowners have increased their home’s coverage limit in the last year to account for rising construction costs and inflation.
  • Only 33% of homeowners are “very sure” their home’s coverage limit is high enough to cover their home’s entire rebuild cost.  
  • 83% of homeowners either don’t have or aren’t sure if they have inflation guard coverage, which is a crucial coverage feature that automatically increases your home’s coverage limit each year to keep pace with inflation. Notice this is an endorsement so it will cost you money to keep it. For example, say your home is insured for $100,000 and your inflation guard coverage is set at 8%. Now say you suffer a total loss of your home 90 days into your year-long policy term. Your dwelling coverage limit will be upped to reflect an 8% daily inflation rate, so your coverage limit would now be around $101,973, instead of $100,000. 
  • More than two in three homeowners (68%) may not have guaranteed replacement cost coverage, and 80% of homeowners may be without extended replacement cost coverage — two important coverage add-ons that buffer the impacts of demand surge and higher rebuild costs after a disaster. Note replacement cost is a basic type of insurance policy that pays for the cost of replacing or repairing a damaged property up to its current market value of materials and labor. This type of coverage does not take into account any increase in the cost of materials or labor that may occur in the future. Guaranteed replacement cost provides coverage for the full cost of replacing or repairing a damaged property, regardless of the current market value. This means that even if the cost of materials or labor increases in the future, the insurance company will still pay for the full cost of repairing or replacing the property.

Things to Do for Lowering Insurance Cost During Inflation

There are things you can do to lower or control your cost of insurance even with inflation being high.

The first thing is to shop around for the best value. Note the need to avoid the trap of comparing apples to oranges: You don’t want to just look at the premium and decide on the policy or insurer that offers the lowest premium. You must take the insurance coverage payout into consideration and also ensure that you have the right coverage for you and your family. Many low premium policies come with coverage limits. One easy example is that your house is valued at $1.2 million but the policy only covers $1 million replacement cost. That defeats the purpose of buying insurance in the first place, as you will not have peace of mind when something bad happened to your house.

The second thing is to keep a decent amount of deductible, which is the amount you will have to pay — out of your own pocket — before your insurance coverage kicks in. It is always the case that a higher deductible means lower insurance premium because insurer knows they don’t have to cover all the cost in a claim, you will pay a part of it by yourself. This applies to those with enough savings to pay the deductible. The other reason insurer prefers high deductible is that people willing to pay a higher deductible tend to be more careful in avoiding risks.

The third thing, perhaps the most important and least risky, is to bundle your policies together. See my other post on details.

The fourth thing is to maintain a good credit scores, which insurers use to determine the premium rate.

The fifth thing is to ask for discounts from your insurer. There are numerous discounts, and many insurance agents will actively search for you in order to attract you and to get your business.

Note the flip side of seeking discounts is to avoid “premium boosting” factors. The best example is having a teenager driver on your auto insurance policy. For example, this report by Bankrate tells us that for a married couple the national average premium without a teen driver is $1,898, but after adding a teen driver it jumps to $4,392! The final thing is to always review your insurance policy to ensure that you have enough insurance coverage even during inflation. See above discussion on homeowner insurance for details.

Categories
Life insurance

Is Annuity a Good Idea with Inflation?

The Takeaways:

  1. Investing in a time of inflation is essentially buying the best physical and financial products to preserve the value or the purchasing power of your money. The goal is to invest so that your rate of return on investment will beat the inflation rate.
  2. An annuity is mostly a retirement product offered by insurance companies to provide protected, reliable income for life after retirement. It can help bridge the income gap between the savings you’ve accumulated over time, traditional sources of retirement income, like Social Security and the goal of living a comfortable retirement life.
  3. The chain of reactions: Inflation entices fed to raise interest rates, which in turn push bond yield high, and potentially lead to higher annuity income. Bond yield is the rate of return earned by an investor who buys a bond and holds it until maturity (i.e., Annual Interest Payment / Face Value x 100.).
  4. The higher the interest rate, the more money you earn on your annuity. When you’re ready to retire, you’ll have more wealth in your account as a result of earning higher interest, also with regular payment that is inflation adjusted to keep the same purchasing power for your retirement money.

A Common Question People Ask

I’m not sure about you but in my experience one of the most common questions people have asked is what the best investment is today. We can be curious for different reasons — sometimes just for the sake of striking a conversation, other times deadly serious about investing and making money.

Of course, you do not need me to tell you that one of the biggest concerns for today is inflation. Thus, the above question becomes what investment tool we should choose that can beat inflation.

Let’s find out first what ChatGPT has to say. Below is the heavily edited answer, as the original version was too “plain vanilla” for lacking a better word. My hope is to make the explanation easier and livelier.

Inflation means price hikes for goods (e.g., gas, eggs, meat) and/or services (e.g., ridesharing price), which lowers down how much goods you can buy with the same amount of money (e.g., $10).

Sometimes people ignored the fact that inflation must be sustainable for a period of time rather than a short-term phenomenon. You may also hear people saying inflation is “general” price hike, although inflation can be “sectorized,” meaning different sectors of an economy can receive different impacts rather than all sectors move together.

In a farming economy, food price can be a major driver of inflation, but in an energy or natural resource centered economy like Russia, oil price change plays a big role.

A simple, hypothetic example is $1 buys 3 eggs now, compared with 4 eggs before inflation. The value of your $1 decreased and it took one egg away from you (or 25% of its original value was “eaten” by inflation.)

Formally, we say the value of your money decreases, even though a $10 bill will always be $10 on the face value, no matter how long it sits in your wallet. Another way to say the same thing is consumer’s “purchasing power” goes down when inflation goes up. Note value of money comes from its purchasing power, in addition to other factors like its intrinsic value (e.g., gold or silver), acceptance, scarcity, stability, government backing.

General Principle of Investment During Inflation

Regarding what investment is the best for inflation, the idea is this: During inflation most if not all goods are getting more expensive or priced higher. This is the time to ask yourself what specific goods you should buy so that not only your initial investment will not be washed away or severely reduced by inflation, but you make money beyond the invested money — despite inflation.

Let me use an example to illustrate the point. If you believe the price of pork will be significantly higher one year from today, it will be a good idea for you to buy piglets and raise them so that one year later you can not only get your investment money back but with a large profit margin.

The pig example involves physical property. Another example of physical property is real estate. For those not know yet, real estate is known for its value in fighting inflation because housing price and rental income both tend to go up during inflation.

They are like boats: When the water level is up, boats go up with that.

As you can see from the above example, the key to fight inflation is to compare two rates. The first is inflation rate, typically measured by Consumer Price Index (CPI). The CPI is a measure of the average change in the prices paid by urban consumers for a basket of goods and services over time.

The second is your rate of return on investment. Say one year later the inflation rate hits 5%, but selling pigs gets you 10% of return, you win because your return is twice the inflation rate. On the other hand, with the same 5% inflation rate but your pig sales only offered you 4% of return, you know your real return is actually 4% – 5% = -1% or negative 1%, because real return must be adjusted against inflation.  

Note sometimes you hear people mixing up “rate of return on investment” and “profit margin.” They are related but not the same. Briefly, profit margin focuses on measuring the efficiency of a company’s operations, while the rate of return on investment is on evaluating the performance of a particular investment, although both are percentage figures.

Investing in Financial Products

Investing in physical properties (pigs, real estate) sometimes is not the most convenient thing to do to earn a high return. To raise pigs you will need the piglets, the feed, the pig farm, the labor and the veterinary, to name just a few. To invest in rental income you must do a good job in maintaining the properties and also in dealing with dishonest renters.

Is there anything else that allows profit but is easy and fast to operate?

You bet. They have a special name “financial products” to differentiate from physical property. The former possess ideal features and should be among your first consideration for investing.

Speaking of investable financial products, in the old days gold came first but not anymore, as there are financial products that do better nowadays. I won’t get into the list of all the investment portfolio options for inflation purpose here. Let’s just consider one financial product that will benefit from inflation: annuity.

A Sideline Story of Eggs

Before proceeding, let me tell you a side story to lighten up the reading a little bit.

Assuming my previous hypothetic example of egg price in inflation is real, does it mean we should all stop buying eggs because their prices are so high and $1 now only gets you 3 eggs instead of 4?

I actually asked ChatGPT this egg question just for fun. Interestingly, although the database of ChatGPT does not cover the latest news, WebChatGPT, a free Google Chrome extension, does that. Every time you ask a question, the app will search three pieces of latest news related to the inquiry and then ask ChatGPT to present a conversational answer drawing from these reference.

Perhaps you already know the answer but formally, no, we don’t want to stop buying eggs if they are important to us. WebChatGPT also correctly points out that “the increase in egg prices is not directly caused by inflation, but rather as a result of various market factors.”

We need to separate consumption from investment, as well as separating segments of consumers. For some people eating eggs is a daily necessity and eggs are their staple food that nothing else can substitute. Others however will be happy to explore alternative sources of protein that are more affordable, such as beans, lentils, and canned fish.

Now let’s switch to the topic of “Annuity and Inflation.”

Nature of Annuity

Let’s begin from ChatGPT again. The following is an edited version of the answer.

An annuity is a financial product that provides regular payments to the owner over a certain period, often for the rest of their life. This means you won’t be too far off if you link annuities to retirement, as they are frequently retirement related investments products.

I say “not far off” because some annuity like immediate annuity provides regular income payments right away for a set period of time or for life, and you don’t have to wait until retirement. Instead, you can begin receiving payments immediately after purchasing the annuity with deposited fund.

Similarly with deferred annuity you may or may not have to wait until retirement — as long as you wait long enough to enter annuity’s “annuitization” phase (i.e., time to receive annuity payment).

You may hear some people calling annuity “annuity insurance” but that is not exactly right — even though annuity is a type of insurance contracts between insurance company and the person receiving annuity payment, or “annuitant” as they are called.

For one thing, insurance, especially life insurance, is designed to benefit one’s loved ones (i.e., spouse or children or any designated party), while annuities are mostly for oneself.

Secondly, annuities usually do not need a particular “trigger event” to start the payout, as long as enough money has been accumulated to pay. Life insurance however always requires that (most likely death but also terminal or chronical illness) to start the payout. In other words, you can’t start receiving insurance payment just because you feel like it. You must convince the insurance company that it’s time for them to pay you according to terms of the insurance policy. Annuity does not need you to do anything in particular, as everything is in the contract and is predetermined.

Finally, most annuity features regular payouts over a fixed interval, while life insurance can have a lump-sum payment to the beneficiaries.

Parties in the Annuity Contract

The typical parties listed on an annuity contract are:

  1. Annuity owner: The person who buy the annuity either in a lump sum payment or more typically through a series of regular contributions in order to receive regular payments either immediately or wait for a period of accumulation.
  2. Annuity issuer: The company or institution that issues the annuity and is responsible for making the payments to the annuity owner. This is generally an insurance carrier but can also include other financial service firms.
  3. Annuitant: The person whose life expectancy is used to calculate the annuity payments. The annuitant can be the same person as the annuity owner or a different person. This is why I say annuity is mostly designed to protect oneself.
  4. Beneficiary: The person or persons who will receive any remaining funds in the annuity upon the death of the annuity owner or annuitant. However, unlike a life insurance policy there is no guarantee for annuity beneficiary to receive money. It all depends on whether there is fund left in the annuity account when the annuitant died.

Let’s use a hypothetic example to show how annuity works on the high end. I made the human characters up, but the rest of story is reasonably realistic.

Owning a Luxurious Shipboard Condo

Beth is in her 50s and has never married with no child. As a company executive, her personal assets are in the millions. One day she received a phone call from her friend Gloria who is also in her 50s and a female executive in another firm. Gloria suggested Beth to check out the sales materials she received and invited Beth to own one of the “private residential yacht” apartment rooms next to her, in the world’s largest residential ship called MS The World with 12 decks, 165 luxurious shipboard condos built 13 years ago and equipped with every possible modern convenience in each apartment, costing from $825,000 to $7.3 million. Beth and Gloria each must prove a net worth of at least $5 million, then add another 10 to 15 percent for annual maintenance and other fees based on your apartment size.  

Beth and Gloria have no problem with provable net worth, the concern is with the regular annual payment for maintenance and other fees. They both want to set up a way to take care of the money. Beth has a Farmers insurance agent friend named Tiffany who heard the issue and offered to help. Tiffany told Beth, and through her to Gloria, that since they both will own the shipboard condos after retirement, annuity would make sense for them.

How Annuity Works

The steps are listed below:

  • You make either a lump sum payment or a series of payments into an annuity account. For Beth and Gloria, a one-time only, lump-sum investment makes sense.
  • The annuity provider (or issuers, in this case, Farmers insurance) invests money from Beth and Gloria in a portfolio of assets such as stocks, bonds, and other securities.
  • The investments generate interest, dividends, or capital gains, which accumulate in the annuity account and are tax-deferred until you withdraw them. Here “tax deferred” means taxpayers owe IRS taxes on investments, revenues, or profits but they don’t have to pay now and can be “delayed” or “postponed” to the future. (If you know the concept of “time value of money,” you know $1 today carries more value than $1 next year, so delayed tax payment is a good thing.)  
  • Depending on the type of annuity, you may receive payments immediately — if you made a lump sum investment into the annuity like Gloria and Beth will do, or at a future date, either for a fixed period or for the rest of your life. Most people will choose not to receive a lump sum payment. The whole reason they invest in annuity is to get a stream of regular payments month to month, quarter to quarter and year to year. In that case, the annuity issuer (i.e., Farmers in Beth and Gloria case) will write you a check on a regular basis and it’s worry free.  
  • The amount of the payments depends on several factors, such as the size of the initial payment, the duration of the annuity, and the interest rate or returns generated by the investments.

An important thing to know is that sometimes an annuity can pay you (the annuitant, like Beth and Gloria) more money than you initially invested because the earnings from stock and/or interest rate from bonds are higher than expected.

Beth and Gloria each will invest $500,000, but Beth picks a “Single Premium Immediate Annuity (SPIA)” that provides a guaranteed income stream for life (or a specified period). This annuity is ideal for those who want to convert a lump sum into a guaranteed income stream. It is possible that Beth’s $500,000 may turn out to be $550,000 in the end, due to good marketing performance of the investment by the annuity issuer.

Gloria on the other hand decides to invest in a variable annuity, which is for annuitant with a higher risk tolerance and wants to invest in a range of mutual funds or other investment options within the annuity. Variable annuities can offer potentially higher returns but come with more risk and fees.

Why Is Annuity More Attractive During Inflation?

When price increases during inflation, annuities become a more attractive investment option because it provides a fixed income stream that is immune to inflation. For others without owning annuity, inflation lowers their purchasing power of money. An annuity, however, can provide a guaranteed income stream that is typically linked to inflation, meaning that the income increases along with inflation. This can help protect annuity owners from the negative effects of inflation on their purchasing power.

For example, say an investor (not Beth nor Gloria) purchases an annuity that promises to pay her $1,000 per month and inflation is 3%, the annuity may increase the payout to $1,030 per month to keep up with inflation. This has a special name for it: cost-of-living adjustments (COLAs), which helps her payments keep pace with inflation and keep her purchasing power over time, even if the general cost of living goes up.

Of course, money does not fall from the sky. The reason annuities can afford to pay COLA is because the insurer (or annuity issuer) will invest the annuity premiums in assets that will provide a higher return to offset the impact of inflation. According to this report, “In general, insurance companies earn more in bond yields when the Federal Reserve raises interest rates. As a result, they can offer their customers higher rates.”

Remember the “boat” metaphor I used earlier for real estate? When price level goes up, rental income and housing price goes up as well. This applies to annuity which is guaranteed income to annuitant.