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Pain before gain: cost headwinds arrive ahead of investment boost

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After years of inflation in the doldrums and falling interest rates reducing insurer investment earnings on premium income, the environment is changing in a hurry.

A jump in the annual inflation rate to a two-decade high last week made headlines, after a slew of warning signals, fuelling expectations that interest rates could begin rising as early as tomorrow’s Reserve Bank of Australia (RBA) meeting.

Inflation has remained muted following the global financial crisis and the RBA has repeatedly cut rates to new record low levels. Recently it has kept its foot to the floor as the pandemic presented challenges to the economy.

Now, supply chain pressures fuelled by covid restrictions have increased prices, a string of natural catastrophes culminating in the Queensland and NSW flooding have boosted demand for construction materials and labour, and the war in Ukraine is generating additional global pressures.

The Australian Bureau of Statistics reported last week that the consumer price index rose 5.1% over the 12 months to the March quarter. Among the influences were fuel prices and high levels of building construction, combined with ongoing shortages of materials and labour.

The RBA will hold its next monthly meeting tomorrow and will consider whether to raise the official interest rate from its current 0.1%. If it does move, it will be the first increase since 2010, but even if rates are not changed, there are expectations upward moves will begin within months, and much earlier than previously suggested by the central bank.

A Swiss Re Institute Sigma report looking at the global economic environment says property and casualty (P&C) insurers face a difficult, transitional year as claims inflation kicks in while the earnings benefit of higher interest rates lies further ahead.

“We expect claims inflation to impact P&C insurers’ profitability in 2022, leading to further market hardening in 2023,” it says.

“In the near term, property and motor will likely be hit hardest, as price rises in construction and car parts outstrip those in the wider economy. In the medium term, lines of business with longer tails will be most exposed to sustained elevated inflation.”

Swiss Re says tailwinds from premium hardening and rising interest rates will emerge from next year but in the meantime the inflationary headwinds are a more immediate issue for the property and casualty sector.

Supply-side shocks from the war in Ukraine are now being felt in global commodity prices, adding to inflation impacts driven by policy stimulus and reopening after covid and post-lockdown supply chain shortages, the report says.

Swiss Re expects the Ukraine conflict, as well as renewed lockdowns in China, to cause further disruptions to the auto supply chains, prolonging bottlenecks for new cars and spare parts and creating upward pressure on car part prices in the short-to-medium term.

Separately, other reports note the impact on the Australian insurance industry from a string of natural disasters in the past two years. These have caused a backlog of claims and increasing costs even before record-breaking rain in February and March brought catastrophic flooding to Queensland and NSW.

Gallagher Head of Claims Adam Squire says in a first-half Business Insurance and Risk Market Update that, taking into account the magnitude of the recent events and pre-existing factors, it’s likely the industry will be dealing with claims from the east coast storms for a “very long time to come”.

Mr Squire says that prior to the latest floods, claims stemming from the October 31 2020 Halloween hailstorms in southeast Queensland were still being finalised.

“There has been much written about the delays and cost inflation currently experienced in the case of building materials. A similar scenario with motor vehicles is also going to compound the recovery and complexity of this catastrophe,” he says.

Price inflation on heavy and domestic motor vehicles due to shortages in Australia will mean that even after the settlement of a claim the funds received may not be sufficient to purchase a like-for-like replacement vehicle, and there will be blow-outs in the time it could take to secure a replacement, he says.

The Insurance Council of Australia has warned a critical shortage of builders and trades continues to pose challenges for insurers in repairing homes and businesses in flood-impacted regions, while Marsh notes in a report that the NSW/Queensland floods have curtailed price easing that had been predicted for the property class at the start of the year.

The current scenario creates issues for insurers in managing costs, logistics and reputation as well as for policyholders who may find they don’t have the level of cover expected and who will be dealing with premium price impacts, particularly if they are risk-exposed.

Looking at the global picture, Swiss Re Group Chief Economist Jerome Haegeli says despite the near-term issues, the changing economic environment at least has an investment silver lining for insurers.

“We are exiting the ‘low-for-longer’ and negative interest rate environment and this regime shift will benefit insurance companies over the medium and longer term,” he says. “Risk-free rates are finally not return-free anymore.”

Nevertheless, increases from historical lows are likely to be gradual and insurers will have plenty of underwriting issues to manage in the meantime.