Inflationary pressures to drive up claims costs and create underinsurance risk

Post-pandemic supply chain bottlenecks, higher energy and transportation costs, and shortages of labor were already contributing to higher inflation at the start of 2022. Now the war in Ukraine has further fueled global inflationary and supply chain pressures, causing price shocks for a wide range of commodities, including energy, food and construction materials. In June 2022, inflation in the euro area hit its highest annual level since the creation of the euro currency in 1999, jumping to a record 8.6% [1]. In the US, consumer price inflation reached 9.1% – a 40-year high, [2] while in the UK in May it was also at 9.1%, again a 40-year high [3].

The consequences of such sharp increases in inflation will also be felt across most lines of the insurance industry in the short- to mediumterm. Property and construction insurance claims, in particular, are exposed to higher inflation, as rebuilds and repairs are linked to the cost of materials and labor (claims in North America had already seen an inflation-driven claim cost increase in the upper single digits as of end 2021, prior to the Ukraine war), while shortages of materials and longer delivery times inflate business interruption values. Other lines of insurance, such as directors and officers, professional indemnity and general liability, are also susceptible to inflationary pressures through rising legal defense costs and higher settlements. Ultimately, inflation can bring pressure on claims severity from multiple angles.

Supply chain disruption and rising prices are driving up replacement and rebuilding costs for property and construction claims. The cost of construction materials, including cement, timber and steel, have risen dramatically. Steel, for example, is almost 50% more expensive than it was a year ago, according to valuation company John Foord. [4] Construction inflation is around 11% to 25% in the US, UK and Germany.

“Inflation has accelerated in 2022 and is now at levels not seen in a generation. We have to keep a watchful eye on this issue, as a high inflationary environment leads to higher claims costs for property and construction in particular and brings additional challenges when adjusting claims,” says Scott Inglis, Head of Global Practice Group for Property and Business Interruption Claims at AGCS.

Inflationary and supply chain pressures are particularly acute during post catastrophe ‘demand surges’, where national or local resources are insufficient to meet demand for repairs and building materials following major storms and wildfires. For example, property damage claims from the December 2021 Colorado wildfires were inflated by a local surge in demand for building materials, already in short supply due to a post-pandemic rise in building works. Timber prices were almost triple their pre-pandemic prices. [5]

Global supply chain disruption, shipping delays and labor shortages are also impacting business interruption claims, with longer waiting periods for parts and materials.

Ongoing Covid-shutdowns in China, port congestion and shortages of truck drivers have increased delivery and repair times. Shipping cargo turnaround by major carriers has risen up to 60 days from the normal 50 days [6], which means 20% more containers were ‘in shipment’ than was the case in 2019, while 20% of the world’s 9,000 active container ships are currently sitting in traffic jams outside congested ports. In addition, the average time that containers offloaded from ships sit on docks has risen to over seven days compared to the pre-pandemic two-day average.

The global energy crisis, made worse by the Ukraine conflict, is also driving up costs and disrupting supply chains, with power outages in China and temporary production stoppages for energy- intensive products like fertilizer, paper and aluminum. The price of gas in Europe, for example, is five times a year ago, while the price of jet fuel is 120% higher. [7] The cost of shipping a container on the world’s transoceanic trade routes increased seven-fold in the 18 months following March 2020, while the cost of shipping bulk commodities spiked even more, according to the International Monetary Fund ( IMF). [8]

Tight labor markets are also driving increased claims severity for large claims. In what has been described as the ‘Great Resignation’, skilled and unskilled workers are in short supply as many have changed career or taken early retirement, just as demand soared after the pandemic. The American Trucking Association ( ATA) [9] estimates that the US is short of 80,000 truck drivers. In the UK, job vacancies outpaced unemployment in the first quarter of 2022 for the first time on record.

Increased competition for workers and higher wages drives up repair costs, as well as the cost of defending legal claims. US legal services inflation is at 4% in 2022. [10]

Inflation is also a concern for liability claims, which are already experiencing rising defense costs and ‘social inflation’ in the US. Rising legal defense costs continue to inflate liability claims, including those for directors and officers, professional indemnity and products liability.

“US inflation has hit a 40-year high. We have yet to see this filter through, but it is likely to influence future D&O claims through larger settlements and higher pre-judgement interest rates. It could also further drive up defense costs, with higher salaries and hourly rates,” says Angela Sivilli, Co-Head of Global Practice Group for Commercial D&O and Financial Institutions Claims at AGCS.

Increased litigation costs, fueled by for-profit litigation funders, higher jury awards for personal injury claims and shifting societal attitudes, already continue to drive ‘social inflation’ in the US, contributing to higher severity general liability and workers compensation claims. The average size of large awards in the US rose by 26% for general liability cases between 2010 and 2019, according to Swiss Re. [11]

Therefore, the accuracy and timeliness of valuations provided by companies when obtaining insurance – known as the declared value – is crucial. In a high inflation environment, and with the growing complexity of large losses, insurers also risk underpricing exposures where they rely on declared values that do not truly reflect the reinstatement costs.

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 replacement value paid by insurers. 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. Meanwhile, for a marine insurance claim, the actual vessel value was 50% higher than the declared value.

“Insurers have to make sure that we capture increased values at the point of pricing. During the prolonged soft market, clauses that historically were in place to deter under-declared values were taken out of the policy, shifting the risk of underinsurance to the insurer. There is now discussion in the market as to whether this should be brought back into wordings if asset values are not updated,” says Cremer.

“AGCS will be working together with clients and brokers in the run up to renewals to update asset values and ensure clients have appropriate cover that is fit for purpose, understood and appropriately priced and financially monitored in our portfolio. Nobody wants a dispute about underinsurance after the loss. It’s much better for all parties to get the right value and charge the right premium in the first place,” says Cremer.