Inflation, Devaluation and Underinsurance: Impact and Possible Solutions

Anyone doing business in, living in, or familiar with Latin America would be aware of how often these phenomena affect the region, with Argentina and Venezuela leading the charge. While currency devaluation and ever-increasing inflation have plagued the region for decades, most economies in the region have stabilized and begun to grow at a constant rate. However, this has not been the case for these two nations. As currencies lose value and prices climb at an alarming rate, underwriting risks becomes more difficult. In this post, we look at some ways in which these phenomena affect the underwriting of (re)insurance, and some suggestions to address the problem.

The effect inflation and devaluation have on insurance is best explained with an example. A building in Buenos Aires is insured in pesos with a local insurer for 100% of its value, AR$ 1,000,000 (the equivalent of U$D 62,000) on the day of policy inception (January 1, 2017). Premium is calculated on this basis. The direct policy is reinsured by international reinsurers, in dollars. In 2017, the Argentinian peso devaluated by around 18%, and construction costs in pesos increased by around 26.6% (or 8% in dollars). On December 31, 2017, the building is affected by a fire and becomes a total loss.

At the direct insurance level, the value of the building in dollars is $52,400 at the time of the loss. However, the cost to rebuild the same building is now AR$ 1,260,000. That means that if insurers paid policy limits (AR$ 1m), the insured would be unable to rebuild the same building. It also means that at the time of the loss, the declared value of the building was lower than its actual value. The insurer could apply a pro rata underinsurance penalty, further reducing the insured’s recovery. This could result in an insured being unable to return to business because it cannot rebuild what it has lost. 

At the reinsurance level, this could cause local and reinsurance policies to become desynchronized as to the deductible levels. For example, at policy inception, the deductible was AR$ 100,000 (U$D 6,261). This deductible was the same under the insurance and reinsurance policies, although the former was expressed in pesos and the latter in dollars. However, at the time of the loss, the deductible under the local policy would be worth U$D 5,240 compared to U$D 6,261 for the reinsurance. This creates a gap in reinsurance of around U$D 1,000 for the local cedant. While the difference may be modest in this example, it could add up rapidly in bigger losses.

There are a few ways (re)insurers can reduce the risks presented by inflation and devaluation. First, the parties could agree in the policy that no underinsurance would apply to the extent that the difference in values is attributable to inflation or raising costs.

Second, to reduce the impact of devaluation and inflation, the parties could agree that the insured will provide periodic updates on the values of the insured property. In this scenario, insureds may be required to pay additional premium to correspond to the increased coverage.

Lastly, if permitted by local law, the policies’ sum insured, deductible and premium could be in dollars. This could help both parties avoid the uncertainty created by a rapidly devaluated currency. Since most insurance premiums are paid at the onset of the policy, this solution would at least provide predictability and stability for the relevant policy period.

It will be interesting to see how adjusters, insureds and insurers deal with these issues and the solutions they create as these problems become part of conducting everyday business in jurisdictions like Argentina and Venezuela.