Due to a combination of current political and economic factors, the global prices of goods and services are steadily increasing with no signs of slowing down. The US CPI rate reached a 40 year high on June 10 at 8.6%1.
It is not since the late 1970s that global businesses have had to grapple with high inflation, ensuring where possible that increasing costs of supplying goods and services are passed on down the value chain, thus maintaining margin.
One such cost of supplying goods is of course insurance. The cost of which is derived from exposure to the underlying risk, hence the cost isn’t just impacted by insurer’s needs to pass on their own cost base increase but also the policy holder’s inflated costs/turnover/fixed asset price. Inflation therefore has a very material impact on property insurance, although not only because of the increase in expense each year. A more worrisome impact is the potential for underinsurance during inflationary periods.
Property coverages are commonly insured based on a declared value at risk (Sum Insured) rather than a loss limit. If said value is understated at the time of the incident, underinsurance can apply, no matter the size of the claim. This is true for buildings, machinery, fixtures and fittings, stocks and business interruption.
In addition for property, most coverages are on a replacement value, rather than depreciated book value. Therefore, the cost of replacement depends on the current market price, both for the machines/parts, raw materials but also for the labour associated with reinstatement.
Inflation is causing the cost of replacement to increase significantly. If this is not factored into the declared values then underinsurance may apply, where, subject to leeway clauses in individual policy wordings, any claim will be proportionally reduced by how much the sum insured declared falls short of the actual value at risk at the time of the loss.
The resulting rate of insurance could be far less than 100% and any claim proportionally reduced, as summarised in Figure 1 below:
| Sum insured/ Valued at Risk | Damaged Property | |||||
|---|---|---|---|---|---|---|
| Replacement cost | Inflation rate | Claim for partial loss | Rate of insurance (“Average”) | Recovery | Difference | |
| (Sum insured) Sep 2019 |
50,000,000 | |||||
| Dec 2020 | 51,250,000 | 2.5% | ||||
| Dec 2021 | 53,812,500 | 5.0% | ||||
| Dec 2022 | 59,193,750 | 10.0% | 5,000,000 | 84.5% | 4,223,419 | (776,581) |
| Rate of insurance | 84.5% | |||||
We therefore strongly advise all clients to have a plan for revaluation of assets and ensure that the declared values are conservative, thus avoiding the risk of policies not responding in the manner intended.
The same is true for stocks of raw materials and finished goods, as well as business Interruption. For the latter, up to date forecasts will need to be considered and any changes in the ratio of variable costs to revenue when estimating gross profit taken into account. Please discuss with your local contact at WTW for further information.
1 https://www.theguardian.com/business/2022/jun/10/us-inflation-rate-may-2022-four-decade-high
2 Subject to policy wording and whether the sum insured was broken down by location in the policy.
