The word "deflation" has crept into the popular press over the past three months, as slowing economic growth in the United States and the severe pressure on the Asian economies act to put downward pressure on prices, writes Jay Cohen.

The Merrill Lynch economics analysis group has believed for some time that a deflationary environment has emerged. Given this attention being paid to deflation, we have taken a look at how a deflationary economy will affect insurance companies and their stocks.

The balance sheet effect

The balance sheet impact is fairly easy to see. Given that about 70% of the insurance industry's assets are invested in bonds, deflation is clearly good for the asset side of the balance sheet, in that a deflationary environment would be positive for interest rates and, therefore, bond values.

The liability side of an insurer's balance sheet would also benefit from the lack of inflation. The largest liability on an insurer's balance sheet is nearly always its loss reserves. When an insurer establishes a loss reserve, it assumes some level of inflation since the claim will not be paid for some time. (It is highly unlikely that an insurer would assume deflation in claims costs.) Should deflation emerge, reserves set up to pay future claims would turn out to be redundant.

Where deflation actually exists in the economy will be a key determinant of the effect on loss reserves. The most important lines of business for the property/casualty insurance industry are automobile, homeowners' and workers' compensation insurance. For auto insurance, claims costs are driven by health care, auto repair costs and the size of jury awards. Workers' compensation claims are fuelled by health care costs and wage inflation. Homeowners' insurance claims costs are largely determined by construction and materials costs. Over the past three years, health care costs have remained well under control, helping the important auto and workers' compensation lines. The costs of auto repairs have actually been on the rise as cars become more complex. Jury awards have also remained in check, aiding most liability lines of insurance.

While deflation will make reserves appear stronger, the lower interest rates associated with a deflationary environment would increase the present value of the reserves. If one were to measure the real economic value of a company's book value, the assets would be all marked to market, while the loss reserves would have to be discounted to present value (after assuming a payout pattern for the claims).

Using a lower interest rate would mean a higher present value for this liability, resulting in a lower economic book value, all else being equal. Having pointed out this somewhat academic point, we believe that the potential redundancies in reserves would be much more important to the balance sheet.

The income statement effect

The effect on the income statement is less straightforward than the balance sheet effect. In general, however, the net effect on the income statement will be negative. A deflationary environment will have a negative impact on premiums written, as it would likely dampen demand for property/casualty insurance. Further, the strengthening of the balance sheet would mean increased supply of insurance, which would prolong the competitive market conditions.

However, deflation would also put downward pressure on claims costs, as well. Over the past two years, claims costs have fallen faster than premiums (helped by favourable loss frequency trends and effective workers' compensation reform). The downward pressure on premiums over the past 12 months suggests that the premium rate reductions have caught up with the slide in claims costs. Keep in mind that the inflation (or deflation) in claims costs does not take into account the frequency of loss. Also, regulatory changes affect business lines.

The more important effect would be on investment income where most companies earn the bulk of their money. The lower interest rates caused by deflation in the economy would result in lower investment yields for a company's new cash flow - securities that mature and those that are called.

What happens to the stocks?

When it comes to changing interest rates, the balance sheet effect has always outweighed the income statement effect. Note that a change in interest rates would have an immediate effect on the balance sheet. The value of an insurer's bond portfolio will react immediately to the change in rates. The effect on the income statement (mainly investment income) would take time to emerge.

Should a deflationary economy emerge and persist, insurance stocks should do quite well. The companies that are most sensitive to changes in interest rates would be those with the longest bond durations and those that have large bond portfolios relative to shareholders equity. Such stocks would include: Hartford Financial Services, Allmerica Financial, SAFECO and Allstate. The least sensitive balance sheets belong to short-tail companies such as Vesta and Bermuda's RenaissanceRe and IPC Holdings.

Jay Cohen is an insurance analyst with Merrill Lynch, New York. Tel: (1) 212 449 5206. Fax:(1) 212 449 0209.