Thanks to Kurt Huie, ASA, senior vice president of the BVA Group, for his help authoring this article.
This article provides an update on the valuation issues facing companies, risk managers, and insurance brokers who either oversee or insure complex properties. Specifically discussed are the drastic changes in replacement cost values as a result of recent events, including the disruption of global supply chains following the COVID-19 pandemic, labor shortages, inflation, and the Russian invasion of Ukraine.
How Did We Get Here?
A myriad of factors contributed to the current issues facing complex property insurance. While energy prices were rising in 2021 due to supply and demand imbalances, global political events in 2022 have deepened these market discrepancies. In late February 2022, Russia invaded Ukraine, initiating the first land war in Europe in over 75 years. The immediate effects of the invasion were drastically increased commodity prices as well as disproportionately elevated inflation for goods and services within the energy sector. The cost of unleaded gasoline increased dramatically in the 5-month period following the Russian invasion as illustrated by the following chart that tracks West Texas Intermediate crude oil pricing.1
The COVID-19 pandemic has had a significant impact on the global economy. Global supply chains have been slow to return to pre-COVID levels. This has resulted in longer-than-expected lead times on certain goods, specifically those that are designed and manufactured overseas. The trickle-down effect of these supply chain constraints has been decreased production, higher labor costs, rising raw material costs, and increased prices for consumers.
CPI and PPI Inconsistencies
Current rates of inflation, as measured by both the Consumer Price Index (CPI) and Producer Price Index (PPI), are at levels not seen for nearly 40 years in the United States. While core inflation is a reliable universal measurement, it fails to capture the true nature of inflation data on a more granular level.
Domestic industries most adversely impacted by inflation quantified by annual percentages include the following.2
Oil and gas extraction (15.0 percent)
Petroleum and coal products manufacturing (58.1 percent)
Primary metal manufacturing (35.5 percent)
Gasoline stations (33.5 percent)
Truck transportation (24.8 percent)
Wood product manufacturing (24.7 percent)
Mining (21.2 percent)
A possible misconception among property insurers and risk managers is core CPI and PPI averages are a proxy of inflation for a diversified asset mix. As of December 30, 2022, the Bureau of Labor Statistics reported core PPI annualized inflation at 6.2 percent3 and core CPI at 6.5 percent.4
As illustrated in the annualized PPI inflation percentages for the industries cited above, core numbers are not reflective of industry and asset-specific inflation. To apply the core inflation across a diversified asset mix would be a misuse of the data and potentially lead to inaccurate replacement cost values.
Instability in the global commodity pricing markets has also played a major role in the current inflationary environment. The war in Ukraine has increased demand among European nations for natural gas from sources outside of Russia, which has long been the region's primary supplier, resulting in higher prices. Bans on Russian energy imports as well as political and environmental pressure for nations to reduce their reliance on fossil fuels have crippled European natural gas and coal production. These factors have led to skyrocketing consumer demand in advance of winter. Graham Weale, a professor of energy economics at Ruhr University in Germany, stated, "We've never seen anything like this. Energy, which was a basic good, is now becoming a luxury good."5
The following chart compares US and European natural gas prices from January 2020 through July 2022. Only a milder-than-average winter, thus far, for much of the European continent has prevented a significant energy shortage in Europe this winter.6
Other commodities and precious metals have been subject to increased demand and supply limitations. Beginning in the summer of 2021, as the American and Chinese economies recovered from the COVID-19 lockdowns, consumer demand for new automobiles was markedly high. Vital commodities and precious metals—such as palladium for catalytic converters, steel, copper, nickel, and other components of the automobile manufacturing process—were in peak demand cycles.
The following chart highlights the dramatic increase in the PPI for metals and metal products from 2012 through 2022.7
The Breakdown of the Global Supply Chain
While inflation has certainly been at the forefront of the headwinds facing the insurable values landscape, supply chain and logistics channel breakdowns continue to present new challenges. Components that are essential to vehicle manufacturing as well as the oil and gas industry are experiencing extended lead times, specifically for equipment sourced from overseas. Under normal market conditions, the anticipated lead time for motor control centers, a vital component necessary for maintaining electrical integrity for complex properties, would be approximately 4 weeks. Based on discussions with industry experts and operations personnel, the current lead time for these assets can range between 6 and 18 months. Companies have resorted to paying exorbitant premiums to expedite imported goods. Specifically, large natural gas compressors and drivers have lead time increases from 6 months to 24 months due to supply chain bottlenecks.
The Great Resignation
As of December 2022, over 50 million Americans have left the workforce in the past year. The labor market has been slow to return to pre-COVID levels across a multitude of industries. The rate at which Americans are leaving the workforce has reached levels that have not been recorded since the Job Openings and Labor Turnover Survey was initiated by the Bureau of Labor Statistics in December 2000.8 These jobs consist of skilled laborers, technicians, welders, pipe fitters, mechanics, and transportation personnel.
In certain areas of the country with relatively sparse populations and a highly concentrated number of complex properties, the demand for skilled labor has reached critical levels. The Williston Basin of Montana and North Dakota is a region flush with oil and natural gas production with a relatively small population center to attract laborers. While there has been an uptick in the commodity trading prices for crude oil and natural gas, production in the basin has been slow to return to prepandemic levels as a result of a reduced labor workforce.
North Dakota's Department of Mineral Resources Director Lynn Helms stated, "Operators have increased wages by as much as $10 an hour and it hasn't flipped the switch."9 To plug the labor shortage gap, many operators have shifted to hiring "supercommuters" who live outside the region and work for 2-week stretches and then return home. To attract these supercommuters, companies are forced to pay significant premiums.
The ramifications for increased labor costs for insurers are clear. Higher inputs into new construction models that do not reflect current labor costs are likely significantly underestimating the costs necessary for developing accurate replacement cost values.
Liability Risk and Exposure
It is not uncommon for companies and risk managers to apply core inflationary data to the entirety of the statement of values (SOV). Depending on the industry and diversity of assets, the potential liability facing these companies is a significant risk that the core inflation is not reflective of true asset-specific inflation and is, therefore, underinsured. The graphic below illustrates the juxtaposition between core PPI inflation and the current inflation-impacting entities in the industries cited previously in this article.
Current Valuation Trends
In the years preceding the COVID-19 pandemic, it was common practice for risk professionals to apply 2 or 3 percent annualized inflation to the SOV. While there are fundamental issues with applying blanket inflation to complex properties, there was very little resistance to this approach from the broader insurance market.
When considering current CPI and PPI data, a range of 6 to 8 percent is suggested since the practice of implementing 3 percent inflation to an SOV is falling well short of capturing basic core inflation. This has led to increased resistance from insurers who are well aware of the inflationary and supply chain issues and the economic impact they present. In many instances, the use of a blended inflationary trend that captures both core and asset-specific data is an effective means of developing reliable replacement cost values.
Outlook for 2023
The consensus among the majority of analysts and industry experts is a continuation of the headwinds facing the complex property insurance community. While there is still a robust debate with respect to an economic recession in 2023, there is an almost universal agreement that growth will be stagnant or potentially negative in the coming year. Workforce shortages are also anticipated to plague various industries leading to higher labor costs and reduced productivity. Further, the war in Ukraine is likely to continue well into the coming year, which will have worldwide implications for the supply and demand of natural gas and other goods coming from Eastern Europe. While COVID-19 has reasonably been contained, the disease will continue to persist for years to come.
It is imperative for risk managers, brokers, and underwriters to be aware of the issues facing property insurance and the implications of having outdated or inaccurate values. In the event of a natural disaster or other unforeseen loss, the incurred costs to replace any destroyed or damaged assets will reflect current replacement values. An appraisal that includes a thorough on-site inspection of the assets as well as detailed conversations with personnel in finance, operations, and accounting can be an effective means for securing reliable, accurate, and detailed insurable values.
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