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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

An insurer holds a portfolio of fixed-coupon government bonds and has written index-linked annuities whose payments rise with consumer prices. Inflation unexpectedly rises sharply and nominal interest rates rise only slightly. Which is the most likely outcome for the insurer?

The insurer's position worsens. Index-linked annuity payments rise with inflation, increasing liabilities, while fixed-coupon bonds lose real value and market price as yields edge up. This asset-liability mismatch to unexpected inflation produces a loss rather than a gain.

  1. AIts liabilities rise in value more than its bond assets, worsening its financial positionCorrect
  2. BIts bond assets rise in value while liabilities stay constant
  3. CBoth assets and liabilities are unaffected because real values are unchanged
  4. DIts liabilities fall in real terms because annuitants spend less
  5. Its position improves because fixed coupons keep pace with prices

Explanation

Index-linked annuity payments increase with prices, so liabilities rise. Fixed coupons lose real value, and higher nominal yields reduce bond prices, so assets weaken. Real interest rates having fallen would raise liability values further. The insurer therefore suffers a mismatch loss.

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