As inflation continues, review your property and business interruption policies

Across-the-board price surges are affecting the value of assets, while supply shortages and delays are prolonging rebuild times and increasing the potential cost of operational stoppages.

This new reality makes it critical for businesses to review their insured values and their policy wording to determine whether their insurance programmes remain adequate. While inflation impacts and drivers vary by industry, geography, and ultimately by company, a range of factors — including the ongoing effects of the COVID-19 pandemic, the Russia-Ukraine crisis, the sharp rise in oil and gas prices in Europe, and natural catastrophes — are affecting businesses and driving increases in asset valuation, and are contributing to:

• Supply chain disruptions.
• Commodity price increases.
• Labour costs and availability.
• Higher manufacturing costs.
• Rise in costs of finished goods.
• Exchange rate instability.

As the costs to rebuild and recover after a loss increases, insurers are requesting updated property values from their clients to adjust their catastrophe modelling. Some are also reviewing premiums to determine whether they remain adequate for the current risks. Amid heightened underwriter scrutiny, organisations need to develop and maintain reliable asset values using consistent and prudent methods.

Rising inflation rates and costs drive underinsurance concerns

Annual inflation in the European Union rose to 9.6% in June 2022 (see Figure 1), with a wide range among the countries. Core inflation increased to just under 4.6% in June, while rates in different countries ranged significantly.

Source: tradingeconomics.com

Construction prices and building costs have also increased significantly over the past several years, but most sharply in the last 18 months (see Figure 2).

Source:  Eurostat

Moreover, according to the European Central Bank, a large majority of euro area enterprises expect their prices to increase going forward. Expectations of overall higher selling prices are shared across firms of all sizes.

In this environment, it is more important than ever to be mindful of the risks of underinsurance that may impede business recovery, as claims payments could be capped below the actual present value of lost assets. Further, stipulations in policy terms could mean additional implications if underinsurance occurs.

What can lead to an organisation being underinsured?

Underinsurance typically occurs when the declared values of assets (such as property, buildings, and contents) and exposures fall below the actual values, with potentially significant consequences, including:

Policy loss limits

If the value of insured assets goes up, but the relevant loss limits are not appropriately increased, a business may not have full indemnity in the case of a major loss that exceeds the policy loss limit.

Property — application of average or underinsurance clauses

Legislation, insurance market practice, and policy wording vary across Europe, but in most countries average or underinsurance clauses will apply. Most policy wording will include at least one average provision. These clauses allow insurers to proportionally reduce a claim. In the event of underinsurance, the insurer will proportionately reduce the amount it is obliged to pay based on the difference between the insured value and the actual value of the lost asset.

Explanation of common average provisions and their implications

The insured declares values on a reinstatement basis on the first day of the policy period, but the insurer pays the cost of repair or reconstruction at the time of the loss. The accuracy of the values is assessed retrospectively in order to determine whether the value declared by the insured was accurate at the start of the period of insurance. If the values declared on day one of the policy period are found to be inadequate, then the insurer can proportionately reduce the claims payment. To avoid underinsurance deductions, make sure you provide accurate values to your  insurer at the inception of the policy.

A day one uplift can be included in some policies to protect against inflation. However, market practices differ across countries and can also vary depending on the specific policy wording. In our example below, the declared values are increased with more than the uplift protection provided in the in policy. If an uplift protection is not provided or is insufficient, Insured values and policy limits must be adjusted mid-term to secure sufficient insurance protection.

Business interruption: adequacy of indemnity period

Most business interruption policies include a maximum indemnity period. This is the maximumduration which in surers will pay business interruption losses following an insured event. These are usually set at 12, 18, 24, 30, or 36 months following the loss event.

Delays resulting from damaged property not being reinstated before the expiration of the business interruption indemnity period may lead to uninsured extra costs and loss of revenue or profit. A 12-month indemnity period may not be adequate in today’s environment, since it may run out before an insured can obtain supplies and start rebuilding.

Added to this, many businesses experienced suppressed trading during the earlier phase of the COVID-19 pandemic. They are now just returning to normal levels of activity, while needing to increase their own prices to contend with higher payroll costs.

This volatility can result in a significant shortfall in the amount a business would have expected to receive in the event of a claim. Since supply and labour shortages could lead to shipment delays and protracted construction timeframes, companies should consider reviewing traditional indemnity periods and, where necessary, request an extension.

Business interruption — declaration-linked

Some business interruption policies include a declaration-linked mechanism that allows for some growth, for example a 33.33% increase in the estimated gross profit over the indemnity period. While this provides some protection against inflation, it may still be inadequate for rapidly growing and changing businesses during a significant inflationary period.

You should contact your broker to start a discussion today. You may need to modify your declared values in the interim before your next renewal, as valuation projects often require a significant lead-time. Insurers are increasingly querying the accuracy of reported values. Insureds who cannot convince their insurers that reported values are accurate, or who cannot demonstrate a robust approach to valuing their assets, may encounter coverage restrictions or a rate increase at renewal.

It is also wise to review your property and business interruption programme limits so they cater for higher insurance values, adjust indemnity periods, and tailor inflation-related clauses. Implications of inflation vary by industry, geography, and even by individual business, making it critical to work with your broker or insurance advisor to pursue suitably broad coverage to minimise the risk of underinsurance, while mitigating against premium increases and unexpected expenses in these turbulent times.