Rising Inflation Magnifies Underinsurance Risk

Supply-side issues driving inflation in Australia and New Zealand

According to Ian Harper, Professor of Economics and Dean of the Melbourne Business School, the construction industry has been particularly affected by inflationary pressures, largely due to supply constraints flowing from the conflict in Ukraine and the policy response to COVID in China. “Inflation has burst back onto the scene in 2022,” he says. “This has been influenced by supply-side factors associated with the Russian invasion of Ukraine, which has limited supplies of gas, oil and wheat, driving up prices for all of these commodities.”  

“These supply constraints have been further exacerbated by the response of the Chinese Government to the COVID pandemic,” he adds. “By shutting factories and ports, supply lines have been disrupted further. Ships have been unable to operate, driving up freight costs, and the rising cost of oil has compounded this increase. Building materials shortages resulting from restricted shipping include a reduction in the supply of many construction essentials such as nails and plasterboard. As will always be the case when the market is trying to allocate goods in limited supply to people who want them, prices of these goods rise as a result.” 

Risk managers in every sector are dealing with inflationary pressures

Every business should have property insurance that covers buildings, plant, equipment and contents and provides adequate cover for business interruption. Skyrocketing prices in the construction sector have the potential to raise organisations’ infrastructure costs and asset values across all industries and sectors.  

The steep rises in prices seen in the building sector can be attributed to a broad range of factors, including a tight labour market, input cost increases and increased demand stimulated by pandemic-related government incentives. Cost increases have typically started in residential construction, but we are now seeing these factors influence all forms of construction. 

Growth in construction costs and pricing across selected categories

Source: /link-between-construction-sector-and-underinsurance/ 

A business also risks being underinsured because of the effect of inflation on currency valuations. International projects may include equipment from other countries, which could alter the replacement cost of buildings and add to delays, which can push out schedules and budgets. 

Rising inflation means many businesses may now be underinsured

Underinsurance is an ongoing issue that has been exacerbated by rising inflation. In fact, some valuation firms and insurers have said that, even if you had correct values in 2021, you’re probably 15% below an accurate valuation today.    

Outdated valuations may leave businesses underinsured if the cost of repairing or rebuilding their properties and replacing stock exceeds existing coverage limits. There is also the risk that the insurer may decide that the business deliberately understated the declared values and refuse to acknowledge the claim at all. This is a worst-case scenario, but it can happen.  

It’s clear that simply adding a nominal 5 or 10% to last year’s valuation could potentially expose businesses to significant financial risk. 

How much unidentified insurance risk is your organisation taking on?

An often-overlooked consequence of underinsurance is co-insurance risk. A co-insurance clause is standard for policies covering buildings, equipment, inventory, business contents and other property. The purpose of the clause is to attribute risk between the insurer and the insured in the event of underinsurance.  

Co-insurance can result in an organisation being penalised in the event of a partial loss. Let’s look at a simplified hypothetical. An organisation has a total sum insured of $4 million. There is a fire and the organisation suffers a $2 million loss. It can be easy to default to the total sum insured when attributing risk, i.e. we’re covered for $4 million, so this shouldn’t be a problem. 

However, a loss adjuster appointed by the insurer assesses the insured value and seeks to validate the quantum of loss. Without a valid valuation, the loss adjuster concludes that the organisation is underinsured by 50 percent. The result is that the organisation may only receive 50 percent of the loss, i.e. $1 million, to replace a $2 million loss. 

When you consider that typically businesses only have 50-75% of the correct value insured, the potential financial exposure is significant. When a proper valuation is provided, an underwriter will generally remove a co-insurance clause. 

The risks of relying on a valuation that is not fit-for-purpose

Some common reasons businesses end up with an insurance gap when a loss occurs include:

• Basing the increase on real estate market conditions
• Relying on a valuation from a bank, builder, architect, or real estate agent
• Relying on advice from an in-house accountant or engineer
• Referring to building guides
• Adopting book value
• Using financial valuation reports and deducting the land value
• Adopting the second-hand purchase price of an asset.

To avoid being caught out with an inadequate cover, organisations must take ownership of the valuation process and seek profession al advice to ensure that insured values and cost assessments reflect the current replacement value of the asset or property. If you are underinsured, you are effectively self-insuring any gaps in cover.

Not only does a valuation help you mitigate financial risk, it can also help you fast-track the claims process by avoiding disputes around the insured values. If there is no solid basis for the declared values, the resulting investigations may lead to protracted claims processes and delayed settlements lasting months or even years.

Maintaining the accuracy of valuations is key to effective risk management

A proper valuation process removes the potential risk to directors and ensures there will be no gap to cover in the event of a claim.

At Aon, we recommend a valuation program including an on-site inspection followed by an annual desk review for the next two years. This will account for asset changes in the previous twelve months, such as new buildings, capital expenditure, and disposal or acquisition of assets. It’s also essential to have an up-to-date asset register which will allow you to respond to a loss with the minimum impact on your business.

This process maintains the accuracy of insured values and the integrity of the valuation process. If market conditions change significantly mid-term, declared values (and indemnity periods) should be reassessed. For example, current levels of inflation and supply chain constraints have increased the cost and time to build. Any inflationary provision in a valuation should also be reassessed if forward inflation has changed from the initial assessment. For example, projected residential inflation two years ago was 2.5%, but it has now grown four-fold to 10%.

Rising prices are not the only factor affecting insurance adequacy

As well as rising prices, the construction industry has seen significant time delays to complete projects due to labour shortages and also a global supply shortage in many construction materials, such as timber, cabinetry, cement, some electrical components, steel and paints.

Most businesses need to get up and running again quickly following a loss. Business interruption insurance is a key consideration when assessing your insurance in the current environment, with many companies revisiting indemnity periods and making contingency plans to manage longer rebuild periods.

In today’s challenging market conditions, it is a good practice for organisations to discuss coverage renewals well in advance. This helps insurers understand the latest trends in inflation and potential policy changes, specifically around pricing, prior to renewal.

Risk managers who use proper processes to manage valuations and coverage limits ensure greater risk-resilience in these turbulent times.

For more insights on the potential impact of underinsurance on your business, watch our recent webinar recording The Implications of Underinsurance.

For more insights from Professor Ian Harper AO on the current inflationary environment, watch our Inflation Outlook session, part of Aon’s recent Reinsurance Analytics seminar.