While current levels of inflation are at a 40-year high and one of the hottest economic topics, there is cause for optimism that price increases will soon moderate. Below, we discuss the micro and macroeconomic factors driving these US inflation levels and the strategies reinsurers can use to mitigate inflation’s impact on books of business and renewal rates as they struggle to predict the level of inflation over the next few years.
The onset of the COVID-19 pandemic in March of 2020 was the impetus for the supply and demand changes that resulted in today’s elevated inflation levels. As the world went into lockdown, broad patterns of demand changed dramatically and instantaneously: services like restaurant meals and travel evaporated, while products like laptops, cars and building materials skyrocketed.
Even now, in early 2022, demand for goods continues to far outpace demand for services. The stimulus bills and injection of trillions of dollars into the economy only added to the overall demandJohn Jacobi, Managing Director in Aon Analytics
Supply changes more slowly than demand, as it takes time to retool factories, build inventories, source parts and train workers. Lockdowns and COVID-19 precautions further limited production capacities. Supply chain bottlenecks have become common, with lockdowns in key Asian ports, a shortage of truck drivers and lack of production capacity for items suddenly in high demand.
Personal Consumption Expenditures for Goods, Services and in Total Indexed
Impact on reinsurers
Inflation can present a challenging environment for reinsurers, which need to calculate how and if they should build elevated costs into their pricing models and negotiating at policy renewals.
Claims handling, especially, is more difficult, caused by shortages of goods and labor, and volatile prices. However, insurers with appropriate inflation guard mechanisms in their policies likely reflect current inflation in their limit profiles.
If insured values are being properly captured, premium will naturally rise with inflation as compensation for the increased insured value. Further protection is provided if percentage deductibles are in place since they will float with inflation. It’s important to consider which inflation metric is being used when adjusting insured values though, as some of the broader metrics like CPI could undercount the true rise in costs such as that seen with building materials and CPI over the past year. There are numerous sources of this type of cost indexing that could be consulted.
Care should be taken to avoid double counting losses when inflation is already built into limits profiles. Actuaries applying trends to historical losses should also strongly consider using a two-step trending method which has been long established in the Casualty Actuarial Society exam syllabus. The inflation we’ve seen has been mainly driven by the COVID-19 pandemic and its disruption to normal patterns of spend and work. These patterns were not present before 2020 and are unlikely to persist beyond the pandemic. It’s important to carefully consider prospective trends given the unique circumstances behind recent inflation.
On the modeling and pricing front, demand surge is already built into the catastrophe models. Demand surge loads of 30%+ are in the models for very large events. Smaller events have smaller demand surge loads, but they are typically still more than 10% for events more than $10 billion.
In summary, the elevated rates of inflation over the past year have largely been caused by disruptions to supply and demand due to the COVID-19 pandemic and measures implemented in response. While current levels of inflation are high compared to the past 20-30 years, there is cause for optimism that price increases will soon moderate as the Federal Reserve jumps into action, supply catches up with demand and bottlenecks in the supply chain begin to ease. For insurers, it is critical that attention continues to be paid to properly accounting for inflation when adjusting limits. Care should be taken to avoid double-counting losses or applying excessive trends.
Tips for reinsurers to ride out the inflation wave
- Understand which inflation metric is being used when adjusting insured values, as there are numerous cost indexing sources
- Steer clear of applying excessive inflationary trends when insurers might already have appropriate inflation guard mechanisms in their policies
- Avoid double-counting losses when inflation is already built into limits profiles
Picture of Inflation
The increased demand for goods, lack of supply and supply chain issues have led to record inflation levels. Through March 2022, the Consumer Price Index (CPI) grew 8.5% year-over-year. The core CPI, which excludes volatile food and energy prices, was up 6.6% YoY.
The CPI is a broad index, so it can hide important details relevant to the (re)insurance industry.
For example, the prices for new and used motor vehicles were up over 20% YoY and energy prices rose nearly 30%, while prices for medical services are up less than 3%.
When looking at inflation metrics, it’s helpful to review the goods and services of interest in addition to the broader measures.
The category of goods most relevant to the property insurance industry is building materials. Prices for building materials have outpaced inflation over the past year and a half, with lumber and steel prices up between 100% and 300% compared to pre-pandemic levels. Broader measures of building materials costs have not seen the dramatic increases of lumber and steel specifically, but prices are still up around 15-20% YoY.
The Aon Property Cost Index combines the costs of goods and labor (a major component of construction costs). Combining the two provides a more holistic view of construction costs than looking at goods or labor alone. The index shows an inflation rate of just over 15% YoY.
Property Cost Index
A weighted average of goods (60%) as measured by the Producer Price Index for net inputs to specific construction sectors and labor (40%) as measured by the average hourly construction earnings Values shown are the change in price in that month compared to the same month in the year prior.
There are several metrics that can be used to anticipate what might happen with inflation in 2022 and beyond. Consumer inflation expectations are predictive since it can become a self-fulfilling prophecy. When people expect prices to go up, they buy now to get ahead of the price increases. But buying now increases demand which pushes prices up and the cycle continues. Consumers are currently expecting inflation of just over 5% over the next year and a historically consistent level of around 3% over the next five years.
Consumer Expectations of Inflation
The Federal Reserve initiated a series of rate hikes over the course of 2022 with a quarter point increase in the Federal Funds rate at the Fed’s March meeting. The Fed itself and futures markets both anticipate at least six more rate hikes by the end of the year.
The interest rate hikes reduce overall demand by making savings more attractive and should help to lower inflation.
The Fed, various Wall Street banks and other economists all predict an easing of inflation over the next year from its current highs. Wall Street and the bond markets are predicting a return to inflation levels of 2-3% over the next five to 10 years, while the Fed predicts inflation levels of ~4-5% in 2022 and 2% in the longer term. Of course, the ongoing COVID-19 pandemic and war in Ukraine are both capable of upending the current picture.
Berkshire Hathaway Letter to Shareholders 1977 (Excerpt)
In 1977 the winds in insurance underwriting were squarely behind us. Very large rate increases were effected throughout the industry in 1976 to offset the disastrous underwriting results of 1974 and 1975. But, because insurance policies typically are written for one-year periods, with pricing mistakes capable of correction only upon renewal, it was 1877 before the full impact was felt upon earnings of those earlier rate increases.
The pendulum is now beginning to swing the other way. We estimate that costs involved in the insurance areas in which we operate rise at close to 1% per month. This is due to continuous monetary inflation affecting the cost of repairing humans and property, as well as “social inflation”, a broadening definition by society and juries of what is covered by insurance policies.
Unless rates rise at a comparable 1% per month, underwriting profits must shrink. Recently the pace of rate increase has slowed dramatically, and it is our expectation that underwriting margins generally will be declining by the second half of the year.
by Yana Keller