The Right Measure of Inflation for the (Re)insurance Industry
Since the first days of the COVID-19 pandemic, price movements have captured headlines around the world. Early lockdowns stalled manufacturing and shipping operations, pinching supply chains and initiating global price increases. More recently, the Russian invasion of Ukraine has constrained global supplies of food and fuel, with inflationary effects cascading through nearly all regions and sectors.
The growth in the US Consumer Price Index (CPI) has been steady over the last decade, around one to three percent per year, until 2020. Even as the pandemic pushed this rate higher, overall growth was still steady, even while prices of individual goods within the basket swung dramatically. But looking deeper, many of the largest movers within the CPI, for example, airline fares and men’s suits, are not relevant to the insurance industry. How then, should insurers measure inflation?
For property insurers, rising construction costs increase potential liabilities, and measuring changes in construction costs requires a more specific index. In the US, one such example is the Producer Price Index (PPI) of residential construction costs. Since 2020, this index has risen more quickly than the consumer-focused CPI, but the volatility – considerably greater than the CPI – is also important to understand. Are the recent increases permanent, or are they likely to reverse?
Past fluctuations in this PPI are instructive. Sawn lumber, one of the goods in this PPI’s sector-specific basket, experienced steep price hikes in late summer 2018 after trade issues with Canadian suppliers strained US supplies. But as winter approached, seasonal reductions in demand and an upswing in US sawmill capacity led lumber prices, and overall home construction costs, to tumble back to previous levels.
What conclusions can we draw from this? First, when quantifying inflation, it is important to use a price index that is specific to the underlying exposures. Equally important is that a sector-specific index relies on a smaller basket of goods, and the internal price correlation will result in higher volatility in the index. Therefore, while today’s consumer inflation appears to be on an unrelenting upward trend, measures more relevant to property insurers show that trends can slow or reverse, and that much of this inflation story remains to be written.