by Glen Riddell, Chief Executive Officer Berkley Re Asia Pacific
Rising costs of groceries, construction costs and petrol have all been regular topics of discussion in the community. Inflation is one of the things that is difficult to forecast but you certainly feel it when it is happening.
The financial headlines have been a little confronting this year. But the culprit behind all of these things is shared: rising inflation.
But what exactly is causing the rise in costs and are those causes likely to lessen or get worse in the next 12 months?
Inflation Unleashed
For several decades, the annual inflation level sat in the so-called ‘Goldilocks zone’. That meant it was not so ‘hot’ (high) that it eroded purchasing power and stunted economic growth, but at the same time not so ‘cold’ (low) that it didn’t encourage firms to innovate, grow and raise wages. The target inflation band that the Reserve Bank of Australia (RBA) seeks to achieve through its monetary policy is between 2% – 3%. A significant component of the RBA’s monetary policy involves setting the cash rate target.
- When inflation is below the target band, the cash rate falls in order to encourage spending and investment.
- When inflation is above the target band, the cash rate rises in order to reduce the level of money in the economy and rein in inflation – in effect, putting the brakes on the economy.
In October 2022, inflation was well and truly above the 2% – 3% target. The most recent reported number is 7.3%, which is the highest reading since 1990.
According to the Australian Bureau of Statistics, some of the major drivers of this increase were:
- 10.5% increase in housing costs (building costs) and rent
- 9.2% increase in transport costs
- 9.0% increase in food and drink prices
- 7.7% increase in furnishings, household equipment and services.
But what were the underlying trends that actually caused these numbers to be reported?
Trends: Supply and Demand
First, let’s look at demand.
The pandemic era is (thankfully) fading, but its effects continue to be felt. Lockdowns and stimulus measures to cushion against the health and economic impacts were necessary at the time. But they caused a huge slowdown in economic activity by artificially suppressing it. After several years of consumer ‘underspending’ on many things (holidays, renovations, live events), 2022 marked a ‘catch up’ period of spending where savings gathered during the pandemic were pumped into the economy as demand went above pre-pandemic levels. The queues and delays at airports were a good visual representation of that phenomenon.
Now the supply side. At the same time as demand for goods and services was rapidly rising, there was a supply shock in several key areas:
- Severe flooding in NSW and Queensland limited the production of dozens of categories of fresh produce.
- Skilled tradespeople and building materials both became tougher to source as a result of pent up demand and the massive repair operation in flood-affected areas. This caused building and construction costs to spike higher. This collided with higher material costs worldwide.
- The war in Ukraine pushed up fuel prices globally (Russia is a major supplier of oil and gas but those supplies are now subject to economic sanctions). Oil is priced as a global market, and is a major cost input for every business from mining to farming.
The good news? Some of those trends are hopefully less likely to repeat and others will lessen naturally over time.
The bad news? The price pressures will not fall overnight. Price pressures can rise quickly, but typically take longer to slowly recede. The timing of when prices normalise is the million-dollar question.
Effects of Inflation
The challenge with insurance and reinsurance is that we are putting a price on a product where we don’t know the ultimate claims cost until many years into the future. Volatile inflation has exacerbated this challenge.
In terms of property insurance, one of the key factors is that higher rebuilding costs are a prime driver of the claims cost. Predicting the future rebuilding costs is particularly difficult when considering supply chain challenges, labour shortages and wage inflation.
This is an area that the reinsurance industry is focussing on in the lead-up to the upcoming treaty renewals as increased building costs should result in higher sums insured. It is important that the sums insured reflect the true costs of rebuilding, so that the customer has full coverage, but also that premiums are collected that are commensurate with the risk. Inflation affects both smaller and larger claims.
When you think of the number of properties that can be involved in a catastrophe event, there is a multiplier effect. Reinsurers will often pay for the majority of this increased cost via property catastrophe reinsurance programmes, which are written on an excess of loss basis. This is where the insurer will hold a retention and the loss greater than the retention is borne by the reinsurance market.
Reinsurers will also factor in other potential inflationary factors such as post-event inflation which adds another level of inflation when there is peak demand for building services and materials after a natural catastrophe. Key points that reinsurers will ask their insurance partners are:
- How are they factoring in inflation into their sums insured?
- Are they requiring updated valuations for the clients?
For liability business, there are other considerations that come into play which make it even more challenging. Liability is considered long-tail where the ultimate claims are not paid until years in the future when injuries have stabilised and the claims have made their way through the court system.
All of the issues discussed earlier on property insurance still have a downstream effect on liability insurance such as the building that was damaged due to the negligence of a third party. The building still needs to be rebuilt at an increased cost, with the final claim potentially paid by the liability insurer of the third party who caused the loss.
Liability also is faced with the challenge of medical inflation which often runs higher than general inflation due to new medical technologies that can add to the cost of a claim and also the longevity of claims as people are living longer due to medical technology innovation.
However, for bodily injury claims, another driver is wage growth. In Australia wage growth as of September 2022 is about 3.1% over the year. However, there is an element of caution here, as wage growth will often lag behind inflation. Considering it may take 4 to 5 years for a claim to reach finalisation, the question here is what is wage inflation likely to be in the next few years and beyond. This adds another level of volatility to the class.
Reinsurers will be looking to understand how insurers are monitoring wage growth, inflationary pressures and factors they are using for wage growth in the future.
Key Takeaways
A combination of supply and demand factors is causing a broad rise in inflation across the economy.
- Insurance is no exception. It is important for sums insured on property insurance to be fully indexed each year with accurate inflation factors.
- Insured’s should consider getting up to date rebuilding valuations of their assets to incorporate into the sum insured calculation.
- Wage inflation although not yet in-line with CPI, may take time to flow through to higher levels hence increasing the severity of liability classes.
The flow-on effect from inflation will still be felt by the insurance and reinsurance industry for some time to come.
