Reinsurance

Reinsurance Renewal Season 2022

Navigating New Forms of Volatility

Managing the impact of inflation in the market: the UK example

Charlie New

UK Catastrophe Analytics, Reinsurance Solutions

Oriol Gaspa Rebull

Head of UK Catastrophe Analytics, Reinsurance Solutions

As many parts of the world continues to experience rising inflation, at Aon we have worked with insurers to better understand how inflation is accounted for from their underwriting process through to their reinsurance submissions.

With differing factors affecting individual countries, in this article our subject matter experts take a deep dive into the UK market to see how insurers are navigating this challenge.

We explore the inflationary drivers that are distinctive to the UK, how insurers are doing a good job in reacting to it, the suitability of indices and the need for reinsurers to delve into the details of exposures as well as catastrophe model adequacy.

Inflation in the UK

Supply and demand side-shocks (e.g. COVID, Russian-Ukraine conflict) have combined to cause the General Buildings Cost index to increase 16% in June 2022.

Despite this, the UK insurance industry is well positioned to manage this challenge. Insurers have a good handle on their exposure data and underwriting processes, the underlying valuation process is robust (especially for household business), and there are a variety of reliable economic indices available with which to understand past and future construction costs.

Accurate valuation and the subsequent indexation are incredibly important inputs into the catastrophe models or standard formula calculations, with their outputs influencing insurer’s capital requirement and reinsurance cost.

UK insurers understand the importance of tracking valuations

In Aon’s recent study of UK insurers’ approach to the underlying valuation methodology and indexation, we confirm below index impact on recent claims costs.

Typically, underlying valuation of household policies are based on the Buildings Cost Information Service (BCIS) (BCIS | Construction Data) rebuild calculator. This provides costs to rebuild properties which can be differentiated by geography and physical characteristics. The BCIS data is used in conjunction with the basic property characteristics provided by the insured at inception to estimate a rebuild value.

On the commercial space, desktop valuations are available for some smaller commercial risks (these desktop valuations typically use valuation metrics like those provided by BCIS), however valuation surveys are the main source of information. Larger/niche risks may be re-surveyed as often as every two years.

Whilst most of the insurers estimate property valuations at the point of inception (or renewal) of the policy, they do look at forward looking inflation as part of their premium calculation.

The UK market has robust approaches to capture inflation

Insurers are generally using at least one of the following construction indices when calculating their replacement values (or updating renewing policies).

  • General Buildings Cost Index (GBCI)
  • House Rebuilding Cost Index (HRCI)

Both indices represent the cost to rebuild properties from scratch, with the former relating to a composite of all types of property risk and the latter tailored to residential only.

Understanding how these indices have been constructed, allow us a strong narrative around changing claims environment by peril.

  1. Construction indices relate to the cost to rebuild a new property, and thus are designed to meet all new building regulations. Some regulations will not be relevant for repairing properties which have suffered weather damage (e.g., from June 2022 the indices include the cost to have solar panels or a heat pump to residential risks).
  2. For fire claims, where there is likely damage across the whole property, an index based on a complete rebuild is a good proxy. However, for weather claims, the cost to reinstate the property will be focussed only on a few select materials and costs. Wind claims are predominately driven by tiles, brick and replacing windows in addition to labour costs. Furthermore, the smaller the claim severity, the more the labour costs are likely to make up of the total claims cost.
  3. The indices are a composite of a variety of risk types. For example, the GBCI is weighted to include a representative distribution across commercial, industrial, residential risks, and then further breaks that down by construction type. This might not be suitable for all insurers who focus on specific risk types.

There are a few other indices that are available beyond HRCI and GBCI and some, given their methodologies, may ultimately better reflect claims costs for weather perils.

Both the Office of National Statistics All Construction index and the Tender Price index (TPI) show lesser inflation over the last 12-18 months which can be partly explained by the inclusion of contractor’s profits in the index. This highlights contractors have been absorbing some of the increased costs rather than passing them on to the client.

The GBCI and the TPI also provide a forecast which is used by the construction industry to guide prices for future and long duration projects. They combine economic forecasts and expert judgement to estimate future construction prices. Based on these projections, which were updated in October 2022, the average annual inflation through 2023 will be around 3%.

Whilst this feels modest, it is important to remember that inflation is a measure of change. To achieve higher levels of inflation than the GBCI and TPI suggest we would need the high prices for materials/energy that we have today, to continue rising at similar level throughout 2023.

Claims point to lower inflation than the indices suggest

From Aon’s perspective the best way to understand the impact of inflation is to look at the claim’s severity, and how that has tracked over time.

Wind events have seen an increase in average claims severity through 2021 and into 2022. However, it is important to understand that Storm Arwen (November 2021) and then Dudley, Eunice and Franklin (Feb 2022) brought the highest windspeeds seen across the UK since Storm Kyrill in 2007.

Looking more broadly at claims inflation across a property book, there has been a slight uptick, but this is not in line with the construction or economic inflation indices. This suggests that insurers are controlling the claims costs through contractor agreements and that some of the costs are being absorbed by the contractors. This highlights that using pure construction indices is likely to overstate the impact of inflation.

We should also consider the further inflationary pressure that a surge of claims would have as a result of a widespread weather event – a concept typically referred to as demand surge or post loss amplification and captured by catastrophe models using a combination of economic theory and observations from historical events.

Aon have recently worked with Loughborough University on a thesis (“Investigating the transient nature of demand surge in Europe”, B815660-21BSP418) that has shown that high levels of underlying economic inflation led to enhanced demand surge. The study has found a relatively strong correlation between economic inflation and demand surge indices during periods of high inflation.

Model evaluation carried by Aon has also observed that two of the largest windstorm losses to have impacted the UK in history have occurred during periods of high economic inflation (in the 1970’s and 1990’s). These storms would be an important dataset used by the models and suggest that demand surge in the UK is well represented by the vendor models without need of adjustment.

Summary

Whilst the UK is facing unique issues around inflation, UK insurers have a robust approach to incorporate this into their business model (including reinsurance submissions).

From our perspective, construction indices provide a more robust approach to indexation than the more common wider economic metrics (e.g. RPI, CPI), however it is important to understand the methodology of each index and how well it relates to the portfolio and peril, and how it aligns with claims inflation.

UK catastrophe models have been calibrated based off events that occurred during high inflation environments, so demand surge is adequately captured by the vendor models. So no additional loading is required.

Each client has a slightly different approach to the underlying valuation and the subsequent application of inflation. It is important for insurers to differentiate themselves during the reinsurance renewal process by providing robust and transparent guidance on these topics. And, where possible should provide information around claims to support their approach or assumptions.

About the authors

Charlie New

Charlie has oversight of all catastrophe analytics for Aon’s UK & Ireland clients. Helping clients develop a clear catastrophe view of risk used for underwriting, capital modelling and reinsurance placement. He has been with Aon for 15 years and has worked across analytics and broking on both UK and international property programmes. Charlie is also a key member of our inflation working group that is helping (re)insurers understand the impacts of this topic on their business models.

Oriol Gaspa Rebull

Oriol leads the UK Cat Analytics team in London, responsible for the supervision and development of the catastrophe management, actuarial and research teams to provide risk assessment to (re)insurance clients and their markets to enable appropriate risk transfer. Between 2015 and 2020 Oriol led the Japan Analytics team in Tokyo with previous roles at Aon involving model evaluation and development at Impact Forecasting. Prior to joining Aon, he worked at the International Seismological Centre as a seismologist and developer, specialising in seismic hazard, data processing and software development. Oriol holds an MSc. in Physics and a Msc. in Seismology from the University of Barcelona and has more than nine years' experience in the field of geophysics with three of them working as a field seismologist.