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The impact of inflation on commercial property insurance

October 4, 2022

Under the current economic conditions, one of the biggest questions for a commercial property owner to consider – from an insurance perspective – is if they have adequate coverage.

This question looms large because the largest spike in construction material costs since 19701, pandemic-related supply chain issues, historic weather severity and continuing inflation increases2 are driving costs related to maintaining and repairing property.

This article offers insight into the factors driving inflation and its impact on commercial property coverage. In addition, there are steps policyholders can take to keep pace with the changing conditions and reduce their risk of a loss.

Factors driving inflation and construction costs

There has been a confluence of factors driving inflation and construction costs. All of which impact property values, as well as construction cost and repair costs.

  • Skilled worker shortages. Across the board, labor shortages have been the norm for employers this year. With a near all-time high of 11.2 million job openings, the U.S. is still down about 4 million workers compared with pre-pandemic levels3. Specific to construction, the industry needs to attract nearly 650,000 additional workers on top of the normal pace of hiring in 2022 to meet the demand for labor.4 Over the past decade, more than 40 percent of construction workforce growth consisted of low-skilled construction laborers, who represent just 19 percent of the workforce.5 This trend is leaving many skilled jobs unfulfilled, making retaining and hiring qualified workers one of construction’s biggest challenges. With many construction jobs remaining open in many places across the U.S., the shortfall is causing project delays and forcing increases in employee pay, driving up costs. That, in turn, can affect rising cost in the construction industry.
  • Worker wage growth. Wage growth has fueled a 6.8 percent rise in the cost of goods and services, the largest increase in 40 years. Specific to construction, wages have increased for all major labor trades, most notably 6 percent for carpenters and 23 percent for siding installers, driving inflation on the cost of goods and services.7
  • Supply chain disruptions. Inflation readings have spiked this year due to both COVID-related supply disruptions and consumer demand outpacing inventory for many goods. Supply chain issues related to various essential building materials have caused the price of these items to skyrocket. In particular, the National Association of Home Builders reports that the costs of lumber and steel have more than doubled during the pandemic. Such inflation is further evidenced by the latest BLS data, which shows a substantial Consumer Price Index (CPI) increase over the past year for some structural elements, including floor coverings, window coverings, major appliances and overall construction materials. On a positive note, both economists and the federal government anticipate overall supply chain conditions to improve in the latter half of 2022, lowering the risk of disruptions and helping ease inflation concerns.6
  • Raw material costs. Material costs are skyrocketing, having seen their biggest spike in 50 years and experiencing a 22 percent increase this year alone. Most notably, steel-mill products are up nearly 113 percent from February 2020, plywood is up nearly 85 percent from February 2020, and lumber materials are up nearly 29 percent from 2021.7 Beyond raw material cost increases, the Producer Price Index (PPI) for inputs to nonresidential construction (the prices charged by goods producers and service providers such as distributors and transportation firms), remained 14.6 percent above its July 2021 level. Notably, costs to ship a container from Asia have risen tenfold since 2020.8 Putting additional pressure on the material costs outlook, the index for new nonresidential building construction, a measure of what contractors calculate they would charge to erect five types of nonresidential buildings, continued to climb, increasing 23.9 percent over 12 months.9
  • Increased frequency and severity of weather events. Over the past 5 years, there has been a 37 percent jump in billion-dollar disasters compared to 2000 to 2009, with 86 high-cost disasters in the past 5 years versus 63 occurring from 2000-2009. The total cost of billion-dollar disasters from 2017 to 2021 is $742.1 billion, or an average of $142.4 billion a year, triple the inflation-adjusted annual average for the previous 42-year period.9 With catastrophic weather events occurring at a record pace, it’s putting underwriting pressure on insurers and pushing insurance premiums higher across the board.
  • Supply shock. Supply shock is created when an unexpected event changes the total supply of goods and services in a market, up or down. Typically, supply shock is felt regionally. For example, a wildfire in California typically would put a strain on the area affected, with minimal impact to supply and demand surges elsewhere. Given the global impact of an uncertain economic environment, supply chain strain challenges and global unrest, supply shock is putting added strain on inflation.

Impact of inflation on commercial property insurance

Inflation has many direct impacts on commercial property insurance include, but not limited to:

  • Policyholder premiums. Elevated property loss costs may lead to situations where premiums are increased and coverage restrictions are introduced. While most property policies have a provision that accounts for a small percentage of inflation, with heightened repair and rebuilding costs increasing overall claim severity, policyholders may encounter potential underinsurance concerns following larger property losses.
  • Real property. Given the historic rise in the cost of construction materials and labor, if it cost $1 million dollars to replace a business’s real property last year, it might cost $1.2 million this year. And with supply chain issues, repairs are also more time consuming. As a result, losses are more expensive, too. Also factoring in the rapid increase in labor costs means that the estimated replacement cost for real property may not be enough to cover a rebuild if there is a claim. To avoid underinsured situations, it’s important to confirm that replacement cost coverage is part of the policy and that the replacement cost estimate is accurate.
  • Business income. A typical commercial property policy not only covers the cost to repair or replace buildings or equipment, but also loss of income. This coverage is essential to protect revenue during a disruption to business operations. In light of current inflation rates — which can affect sales, wages and the amount of time to repair property —  business income limits should be adequate to keep income flowing and avoid co-insurance penalties. Supply chain delays can also delay a business from returning to normal operations, which increases the severity of lost income. So while it’s critical to evaluate limits for real property, it’s also very important to evaluate adequate business income coverage limits and business continuity plans to help shorten any impact of loss.

Risk mitigation tips

Preventing a loss before it happens, or proactively reducing the risk of loss, is the best way to avoid coverage issues. Even with normal levels of inflation, risk-management planning can lead to better business outcomes. The following steps can help manage risk and avoid out-of-pocket losses.

  • Review policy details and coverage limits. Considering rising construction and repair costs for commercial property, it’s a good idea to review policy terms and conditions. It’s also a good time to address issues that could impact coverage, such as how labor and supply shortages may affect estimated replacement costs.
  • Reassess property valuations. During inflationary periods, it’s especially important to review property valuations annually to ensure coverage is keeping pace with catastrophe, labor and supply-cost risks. Detailed information on the covered property’s construction can impact the valuation. This review should include real property (buildings, pavement, land, plumbing, electrical, etc.), business personal property (such as furniture, machinery, supplies, tools, etc.) and business-income limits (loss of income or profits due to covered peril). Related to business income, it’s important to note that determining the amount of coverage to be paid under future lost income can be difficult to predict, so keeping accurate records of the prior year’s income and profit is important.
  • Implement risk management and loss control programs. In addition to inflation, commercial businesses face many risks, such as fire, natural disaster, theft or vandalism. At a minimum, it’s important for a Business Continuity Plan to be developed and maintained. This includes an action plan for catastrophic disasters and/or the likelihood of the business being shut down, with procedures for what to do before, during and after a loss. Nationwide’s My Loss Control Services can be accessed for assistance in developing a Business Continuity Plan along with other loss control resources to help manage risk. Loss Control Services consultants can help tailor solutions to meet specific risks faced by businesses.