Inflation was running hot even before Russia’s invasion of Ukraine, driven by higher commodity prices, supply-chain interruptions, and high energy prices. The war in Ukraine caused further price shocks for a wide range of commodities, energy and food. Several specific inflationary trends are particularly alarming, including how price indices for energy, raw materials and construction costs are developing, because these have an immediate impact on businesses and on potential insurance claims.
For example, it is now much more expensive to repair or rebuild damaged property. The cost of construction is soaring in many countries due to higher prices for energy and raw materials. The costs of cement, timber and steel have risen dramatically. Steel, for example, is almost 50% more expensive than it was a year ago. On average, construction inflation is around 11% to 25% in the United States, United Kingdom and Germany.
In addition, materials are not only significantly more expensive but often simply unavailable due to logistics, shipping and supply-chain bottlenecks. In May 2022, some 20% of the world’s active container ships were currently sitting outside congested ports. Many were in China, including Shanghai, which has been under COVID lockdowns, resulting in much longer cargo handling times. The average time to offload containers has increased to seven days from two days in 2019.
The logistics situation is challenging on land as well as at sea. In many countries, offloaded containers cannot be efficiently shipped because of a shortage of truck drivers. The American Trucking Association estimates that the United States is short 80,000 drivers. In the United Kingdom, job vacancies outpaced unemployment in the first quarter of 2022 for the first time on record. Generally, tight labor markets are also driving price spikes and shortages, resulting in higher claims costs. Both skilled and unskilled workers are in short supply as many have changed career or taken early retirement, just as demand soared after the pandemic.
Understanding the Effect on Claims
Inflationary trends drive up the average claims’ severity, which means that claims will become more expensive. Property and construction insurance claims, in particular, are exposed to higher inflation. Even before the Ukraine war, property and construction claims in North America had already seen an inflation-driven claim cost increase in the upper single digits as of the end of 2021.
Rebuilds and repairs are linked to the cost of materials and labor, while shortages of materials and longer delivery times inflate business interruption values. Warehouse inventories were replenished after the shock of the first pandemic wave and are currently fuller. In some cases—such as for lumber, steel, petroleum-based building materials, certain gases and raw materials, or computer chips—these inventories are worth considerably more than they were a year ago. Some materials may even not be procurable at short notice. In a nutshell, replacement costs more and takes longer. Therefore, both the property damage and the business interruption loss are likely to be significantly higher.
Inflation is also a concern for liability claims, such as directors and officers, professional indemnity, and general liability, which are already experiencing rising defense costs and “social inflation” in the United States, driven by higher jury awards for personal injury claims and shifting societal attitudes. In addition, we are also seeing the beginning of cost increases in professional services such as legal fees. U.S. legal services inflation is at 4% in 2022. Higher salaries and hourly rates of lawyers could also further drive up defense costs.
Ultimately, inflation can bring pressure on claims severity from multiple angles. The consequences of such sharp increases in inflation will also be felt across most lines of the insurance industry in the short- to medium-term.
Determing Accurate Insured Values
Inflation has reached levels not seen for three or four decades in some countries and is not expected to ease significantly in the coming months. Determining and updating insured values is therefore a pressing concern for everyone, from insurers and brokers to the insureds. It is important that businesses regularly monitor and adjust the value of assets, as well as the implications for the costs of replacement or business interruption, in order to ensure they are fully reimbursed post-loss.
The insurance market has already seen a number of claims where there has been a significant gap between the insured’s declared value and the actual replacement value. For example, in a claim for a commercial property destroyed in the 2021 Colorado wildfires, the rebuild value was almost twice the declared value, due to a combination of inflation, demand surge and underinsurance.
Therefore, the accuracy and timeliness of valuations provided by companies when obtaining insurance—known as the declared value—is crucial. However, in a high inflation environment, and with the growing complexity of large losses, insurers risk underpricing exposures where they rely on declared values that do not truly reflect the reinstatement costs.
Many companies have established processes for working with specialist appraisal companies to calculate the value of their property assets and determine the specific insurance values. Construction price indices will be relevant across all sectors, but beyond that a company needs to pick the right indices—for example for energy, raw materials, producer prices, commodities or labor—that are relevant for a particular sector.
Companies also need to consider regional differences because inflation differs from country to country. Even within one country there will be differences as some industry sectors are hit harder than others by inflation. An engineering or chemical company that relies heavily on oil and gas will be impacted differently than a financial services provider. Companies also need to consider which raw materials they source and store, and calculate these values.
Insurers need to work intensively with clients and brokers at renewal stage to build awareness and preparedness for updating asset values. Underwriters need to gain a clear understanding of a client’s valuation methodology. Values are expected to increase because of inflation, but if there is a drop in values there will have to be plausible reasons, such as an exit of a market or a site closure.
There is also some discussion in the market as to whether specific clauses addressing the risk of under-evaluation should be brought back into wordings if asset values are not updated.
Insurers will also need to manage their own inflation exposures by factoring in rising claims costs into underwriting practices. Claims and actuarial teams must monitor the development of inflation across segments and regions and systematically track the impact on claims costs across all lines of business.
The return of inflation presents a double-edged sword for the insurance industry. On the one hand, rising claims costs are a burden and represent a major challenge for pricing. On the other hand, the associated rise in interest rates could bring relief on the investment side, although investing will remain challenging as the interest rate turnaround will shake up financial markets, the gap between current interest rates and inflation rates is wide and not all invested assets will benefit immediately from higher interest rates but only over several years.