Inflation can be bad news for engineering

Inflation can be bad news for engineering insurance but there are smart ways to avoid the risk

In our assessment, inflationary pressure in the form of higher-than-usual price increases could have adverse impacts for insurers given the current set of underwriting practices. We need to take effective measures to mitigate such impacts. This article argues that the best mitigating action for industry to adopt would be in the form of index clauses that link limits and deductibles to an inflation-related price index.

Fueled by the pandemic recovery and policy actions, we now have some of the highest US inflation rates seen in 30 years. Currently, the Swiss Re Institute expects inflation to ease once economies have fully reopened. However, the tail risks of higher-than-anticipated inflation are significant and something we're watching very carefully, from an engineering underwriting angle especially.

Figure 1 – Evolution of consumer price inflation (%)

** UK inflation is the monthly EU harmonised series, Source: Refinitiv, Swiss Re Institute

Construction prices are driven by material and other input costs. And these have recently skyrocketed. For example, the price of softwood lumber has jumped by more than 150% compared to the previous year.  Non-residential construction input prices have increased by almost 24% in the space of one year. While these drivers are volatile in nature, wage inflation tends to persist. In advanced markets, wages contribute up to 50% of overall construction costs. This factor, coupled with the current shortage of labour, will likely result in sustained upward wage pressure going forward.

All of that said, it's not only central bank policy support and economic reopening dynamics that can drive up construction prices. Changes in societal behaviour are also significant factors in this connection. Demand for residential houses, changes in government investment policies in the field of infrastructure projects or the push for a net-zero economy can also increase production costs.

High inflation is harmful on multiple fronts

But how does all the above affect Engineering Insurance policies? First, a period of high inflation can seriously undermine portfolio quality and policy performance. Insurance rates and reserves may not be sufficient to cover the inflated claims. Especially in a scenario with considerable construction price increases, the impact on the bottom line could be significant and crucially affect all long-duration policies in a construction portfolio in the same way. Next to claims, deductibles, sums insured, and policy limits would also be affected. While sums insured are usually reviewed during the life of the construction policy to avoid under insurance, the leveraged inflation effect on deductibles will be of most concern. Claims will not only be higher, but they will also exceed the deductible threshold more often, thereby increasing severity and frequency at the same time. Figure 2 shows how inflation leverages the impact of having a fixed deductible. On top of this, the longer the tail, the more significant is this leverage effect and the higher the losses on such policies are.

Figure 2 – Illustration of the leveraged impact of inflation

Source: Swiss Re

Second, high inflation can translate into poorer construction quality. In most countries, the risk of inflation is borne by the contractors. To maintain their margins, higher than anticipated construction costs force contractors to cut all costs in the value chain, from construction materials all the way to labour costs. A job done with poorer quality materials, in less time or by less experienced workers can impair the quality of construction work and lead to increased claims on Construction All Risks and Inherent Defect Insurance policies.

An insurance policy should cover perils that are understood, costed, and do not lead to systemic accumulation. Therefore, we usually exclude Cyber and Pandemics from classical Engineering policies, for example. If not properly accounted in our models and rates, the same should apply for inflation. Luckily, there are mitigation strategies that protect all parties from unanticipated surprises.

Solutions

To avoid direct inflation impact, we should adopt index clauses that link limitsand deductibles to an inflation-related price index. These clauses are already part of very long-term inherent defects insurance policies but should also be considered for CAR/EAR policies above a certain duration. Together with clear escalation and underinsurance clauses, they provide an effective measure to avoid a disproportionate impact from high inflation.

With respect to deteriorating construction quality and the associated risks, we should learn from regions that have experienced long periods of very high inflation such as Turkey, or countries in Latin America. For example, in most construction projects in Latin America, inflation risks are shared between the owner and the contractors, rather than being fully supported by the contractor. Such an arrangement ultimately benefits the construction quality.

Inflation is a real concern and a challenging risk for our industry. Simply having contracts written in currencies which have seen low inflation in the past will not be enough should inflation become a more systemic issue. There is a need to focus more on contractors in our risk assessment, either looking at their financial robustness or into their project contract finance schemes.