What is claims inflation and how does it affect your insurance premium?

21 September 2022

Policyholders will notice some insurance premium increases upon renewal, particularly on policies that include buildings or contents cover.

It’s estimated that rebuild and replacement costs have risen 24% this year, and with many other costs increasing, organisations will want to make sure their insurance is cost-effective and covers them adequately for their most important risks. If you would like to review your insurance, then get in touch with one of our brokers. 

Many costs are being impacted directly or indirectly by inflationary increases. This article explains why you’ll be paying more to transfer buildings and contents risks through insurance on renewal as well as explain terms you might hear such as claims inflation and index linking/indexation.

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Why are insurers increasing premiums?

Insurers are increasing premiums based on an index they apply to the declared value of items each year to keep in line with claims inflation, so the sum insured reflects the true cost of reinstatement and so avoids you as the policyholder being put in a position of underinsurance.

What is claims inflation?

Claims inflation is the increase in the amount it would cost to settle a claim.

Due to increased costs in materials and labour and other inflationary costs, reinstatement costs are higher, so the cost of settling claims following damage to buildings/contents will also increase.

What is index linking/indexation?

Index linking is an essential tool insurers use to protect clients’ interests. The indexation applied to policies, is designed to allow for the annual effects of claims inflation, so the sum insured reflects the true value of reinstatement. One index such as the rebuild cost or the materials index, shown below, allows for the increases in costs of rebuilding a property following damage which would influence the cost of settling a claim following damage to the property. These increases ensure that you are not left in a position where you are underinsured against the actual cost of rebuilding the property.

With buildings insurance, the declared value is the rebuild cost of the property from day one (known as Day One Reinstatement) which should be accurately valued at the outset to avoid underinsurance. The sum insured, is the declared value (rebuild cost) plus the inflationary increase to allow for the period of time it would take to reinstate the building. Insurers apply the indexation to your policy to adjust this sum insured at renewal (providing this was accurate at the start of your policy) to allow for the annual claims inflation. This will be a larger increase than usual due to the large increase in claims inflation.

So, what is driving rebuild costs up?

Rebuilding costs will be impacted by the rise in costs of construction materials as well as labour expenses due to labour shortages. These will increase the rebuild cost i.e. the amount it will cost to replace the exact same property including demolition, decontamination and clearance of the site, local authority restrictions on materials or construction, external works and infrastructure, and professional fees. BIBA describe the rebuild cost as “the anticipated sum, net of VAT, of a fixed price competitive tender cost that would be submitted by a competent contractor to completely
rebuild the property on the day of valuation”.  These increases in rebuild costs have been slowly increasing but now jumped by 24% overall this year (BCIS).

Effects from Brexit and the Covid-19 pandemic have been largely responsible for these increases. Here are some of the specific factors influencing high materials and labour costs:

• Brexit induced inflation and complexity in international trade and supply chain such as tariff changes
• Migrant workforce shortages and changes caused by new immigration rules
• A decline in the value of the pound and added bureaucracy further complicate workforce issues
• Covid lockdowns and closures reducing manufacturing capacity around the world
• Furloughing of construction workers putting delays and driving up labour costs
• Surge in DIY projects, creating strain on the supply chain and further increasing the cost of materials
• Material stockpiling and over-ordering cause further strain on the supply chain
• Low unemployment and increased salaries, increasing the cost of labour
• Inflation of fuel and energy costs driven by supply chain issues
• Long lead times in manufacturing
• Environmental factors like war driving up energy prices as well as extreme weather events that have damaged timber production

As the graph above shows, these factors aren’t going to ease quickly, but the forecast currently expects inflation in material costs to die down in 2023 and beyond.

What about contents?

Again, due to the issues of demand outweighing supply, the cost of reinstating contents has risen which in turn inflates the cost of settling claims following damage to contents. Policyholders should ensure accurate valuations of specified items to avoid being disappointed when the maximum settlement is below what you would expect because of underinsuring the items at the outset. Insurers will apply an indexation on contents to ensure the sum insured is adjusted to meet the rise in claims inflation.

When insuring computer equipment, plants or machinery, again the same should apply, make sure the declared value is an accurate cost. Most will be insured on the amount it would cost to replace the items of the same value. You must also consider, particularly with specialist machinery that if you bought it second-hand, and it can no longer be found on the second-hand market, the replacement cost would include that of a brand new machine.

What does this mean for business interruption policies?

After an event such as fire or flooding, your buildings and contents cover will put you back in the position you were before for the physical building and items. However, when you take out business interruption insurance, you will be covering the losses as a result of the interruption to operations during the time the building/contents are being reinstated. Policyholders should consider that when estimating the indemnity period, and delays in manufacturing and supplies, the rebuild/reinstatement period could be longer. BIBA also recommend calculating gross profit carefully to avoid underinsuring as well as taking into account predicted growth.

What is the danger of underinsurance?

Insurers use index linking, applying the indexation to the sums insured, to increase the premium to protect your interests. The danger is that not increasing the sums insured will cause you to be underinsured and therefore will be subject to the average clause which means any claims settlement would be reduced by a percentage based on the underinsured amount which may not be enough to pay the true cost of rebuild/repair/reinstatement. See our guide on the average clause and underinsurance which goes into more detail.

What can I do?

• Ensure the amount you put as the declared value (rebuild cost) at the start of your policy reflects the true value it will cost to rebuild it.
• Ensure other declared values on specified contents, computer equipment, plants and machinery are as accurate as they can be.
• Check the indemnity period for business interruption cover to account for supply chain issues and delays.
• Consider using a valuations expert for specified items and a rebuild cost assessment which Access clients can obtain through us at a preferential rate (from £156) using our partner RebuildCostAssessment.

If you don’t have an independent broker like Access looking after your insurance, then now may be a good time to review your insurance with one of our experts. We can help you make your insurance cost-effective, so you only pay for the cover you need.