Claims, inflation and the replacement challenge

The contract entered into between an insured and a non-life insurer centres around the insurer’s promise to indemnify the insured from losses suffered due to certain named perils or risk events. To borrow from the third edition of my book, ‘Everything you need to know about non-life insurance in South Africa’, the contract sets out how the insurer will compensate the insured for the loss, with it being common for insurers to either pay for repairs to the insured item, replace the item, or pay out an equivalent cash settlement to the insured. Unfortunately, as detailed in this FAnews exclusive interview with AGCS Chief Claims Officer, Thomas Sepp, replacement can be a tough ask in a high-inflation environment. 

The inflation monster is on the loose

FAnews turned to Sepp to answer some pressing questions on how inflation is impacting claims values, and why the undervaluation of assets is a key concern for both insurers and policyholders midway through 2022. It is a timely discussion given the July interest rate hike announced by South Africa’s central bank, pushing the country’s Repo rate up 75 basis points to 5.5%. And it nicely reinforces our recent newsletter exploring aspects of non-life insurer claims inflation, titled ‘This inflation spike is going to hurt’, so do visit that link for more local flavour. Without further ado, let us dive into our interview with Thomas Sepp. 

FAnews: Consumer price inflation rates in the Euro zone, US and the UK have increased to record highs of between 8% and 9% in June 2022. Which inflationary trends are you most concerned about from an insurance perspective? 

Thomas Sepp: 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. As a corporate insurer, we find several specific inflationary trends particularly alarming, and we are closely monitoring how price indices for energy, raw materials and construction costs are developing, because these have an immediate impact on businesses and on potential 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 US, UK and Germany. In addition, materials are not only significantly more expensive but often simply unavailable due to logistics, shipping and supply-chain bottlenecks. 

FAnews: We have heard a lot about these constraints, can you tell us more? 

Thomas Sepp: In May 2022, some 20% of the world’s active container ships were 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. And 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 (ATA) estimates that the US is short of 80 000 drivers. In the UK, job vacancies outpaced unemployment in the first quarter of 2022 for the first time on record. Generally, tight labour markets are also driving price spikes and shortages, resulting in higher claims costs. Both skilled and unskilled workers are in short supply. 

FAnews: How does inflation impact claims across some of the different lines of insurance business? 

Thomas Sepp: Inflationary trends drive up the average claim’s 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 end 2021. 

Rebuilds and repairs are linked to the cost of materials and labour, while shortages of materials and longer delivery times inflate business interruption (BI) values. Just imagine a fire at a warehouse: inventories were replenished after the shock of the first pandemic wave and are currently fuller and, on top of that, some inventories are worth considerably more than they were a year ago, for example lumber, steel, petroleum-based building materials, certain gases and raw materials, and computer chips. Some materials may even not be procured at short notice. In a nutshell, replacement costs more, replacement takes longer. Therefore, both property damage and BI losses 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 defence costs and ‘social inflation’ in the US, 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. US legal services inflation is at 4% in 2022. Higher salaries and hourly rates of lawyers could also further inflate defence 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. 

FAnews: Do you agree that underinsurance is a real concern? 

Thomas Sepp: 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: insurers, brokers and 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 BI, 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 under-pricing exposures where they rely on declared values that do not truly reflect the reinstatement costs. 

FAnews: What should companies consider when assessing and updating their valuations? 

Thomas Sepp: Many of our clients have established processes working together 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 labour, whichever 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. 

FAnews: What steps is AGCS taking in response to inflation? 

Thomas Sepp: We need to work intensively with clients and brokers at renewal stage to build awareness and preparedness for updating asset values. Our underwriters are ready to support clients and will seek 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-valuation should be brought back into wordings if asset values are not updated. 

Clearly, we also need to manage our own inflation exposures in underwriting. Essentially, this means factoring-in rising claims costs in our underwriting practice. In our claims and actuarial teams, we have dedicated specialists to monitor the development of inflation across segments and regions. We also systematically track the impact on claims costs across all lines of business. And finally, 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. 

Writer’s thoughts:
We enjoyed the ‘impact of inflation’ insights shared by AGCS Chief Claims Officer, Thomas Sepp, which are clearly offered from a commercial non-life insurer perspective… We would love to hear more about your daily struggles with inflation as you advise clients, large and small, on their financial and risk needs. Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.