Heightened inflation returned in the 1970s, ranging from 6% in 1973 to 14% in 1982. Driven in large part by multiple surges in crude oil prices, the inflation fever finally broke when the Federal Reserve raised interest rates from 10% to 20%.7 However, with the breaking fever came two crippling recessions that lasted until November 1982.8 Ultimately interest rates peaked in 1981 and went down persistently for the next 40 years. Given that inflation has been with us for more than a year and interest rates are starting to rise, it appears that the generational trend has reversed itself once more. While there is no way of knowing what will happen next, looking to the past may be instructive. Many people are confronting major inflation and interest rates going up for the first time in their lifetime.
As policymakers sift through potential solutions to the current inflationary cycle, one commentator suggests looking back to the aforementioned post-WWII period, given the similarities of supply shortages, forced savings, and renewed demand for consumer goods.9 Recall, this was also followed by a period of rising interest rates. Others suggest that we’re entering a new era marked by geopolitical tensions, protectionist policies, and natural disasters, all of which will continue to stress global supply networks and in turn fuel inflationary headwinds for years to come.10
Insurance Industry Under Inflationary Pressure
History confirms that the inflation of the 1970s and early 1980s had dramatic adverse effects on the insurance industry, leading to weakened underwriting quality and performance, reduced reserve levels, and increased rates for policyholders and consumers. Property/Casualty insurers will be challenged to stem the tide of an extended period of inflation and rising interest rates; however, strong balance sheets and capital positions have Property/Casualty insurers in a stronger position today than during the period of the late 1970s and 1980s.
In extended inflationary periods, insurers will be challenged to keep pricing and reserve levels up to pace with inflation. The Federal Reserve will likely continue to raise interest rates to try to head off inflation, challenging insurer portfolios heavily invested in fixed-income instruments (U.S. treasuries, municipal bonds, etc.).11 Historically, Property/Casualty insurers have invested between 10‑20% of their surplus in common stock to keep pace with inflation to pay claims (auto repairs, construction costs, healthcare expenses, and labor) that are growing with inflation.12
Higher expenses for insurance operations and inflated unanticipated loss cost increases result in higher incurred loss ratios, particularly as inflation impacts key cost factors such as construction costs, skilled labor, auto repairs/total vehicle replacement costs, and litigation costs. The insurance area continues to feel its greatest pain in sectors associated with these key cost drivers. Simply put, if costs to repair vehicles and homes increase, and/or if there are more claims or litigation activity associated with those claims, insurance premiums are likely to go up as well.
Total reconstruction costs, including materials and labor, shot up 13.5% from April 2021 to April 2022, almost doubling the increase between January 2021 and January 2022. Powering the surge were price hikes in lumber and fuel prices, as well as increases in the costs to produce and transport goods.13 Spikes in construction labor and material costs and/or shortages in labor mean higher repair costs and delays as contractors have difficulty finding skilled craft positions and as backlogs in work mount. A recent analysis by the Home Builders Institute estimates that the construction industry is facing a shortage of more than 200,000 skilled trade workers.14,15
Not surprisingly, reconstruction costs rose in all states, paced by Delaware (16.8%), New York (16.2%), and Connecticut (15.5%).16