The Effect of Economic Conditions on Insurance Rates

In today’s environment, when material prices are unpredictable, inflation is rising, claims are increasing, and disputes take much longer to resolve, that prediction of the cost of future claims becomes more uncertain. Learn how construction-related professional service firms may face certain future exposures, and how insurers must anticipate and prepare for losses from those exposures.

How the current economic environment challenges professional liability exposure and insurance calculations

Insurance is a bottom-line business. It’s a simple concept: collect a premium now for what you can predict is the future need for coverage of the transferred risks. In practice, however, it is a complex and somewhat speculative wager on factors that are beyond the insurer’s control. In today’s environment, when material prices are unpredictable, inflation is rising, claims are increasing, and disputes take much longer to resolve, that prediction of the cost of future claims becomes more uncertain.

How insurance should work

The basis for insurance coverage is the “law of large numbers” developed by the Swiss mathematician Jacob Bernoulli in 1713. The idea is that if a sufficiently large population of insureds pay into a pool, it is likely that only some will experience losses, and that insurers could predict those losses. As the number of exposure units (policyholders) increases, the probability that the actual loss per exposure unit will equal the predicted loss per exposure unit increases. However, that general mathematical logic does not work if there are unpredictable and impactful shocks to the equation.

For example, if one property insurer provided coverage for every building in Florida, it would seem to have a sufficient base of policyholders to both spread the risk and collect premiums adequate for future paid claims. However, that is a form of adverse selection due to the changing climate’s effects on Florida, in that the likelihood of severe property damage in Florida is greater than in most places. Thus, the chance of an extreme scale of destruction is far greater than average, leaving the insurer with too few assets to cover the massive losses, especially if unfavorable macro-economic factors exacerbate the scale of the losses.

What we will examine

This article will examine how construction-related professional service firms may face certain future exposures, and how insurers must anticipate and prepare for losses from those exposures:

• Supply chain issues[1]: delays, substitutions, and design modifications often result in increased costs and decreased quality
• Inflation[2]: the increased cost of materials and labor raise the remedial price tag of solving a problem
• Interest rates: the cost of money affects initial design requirements and the costs of claims
• Unpredictable weather events: climate variability and volatility amplify demands on the built environment
• Insurance market capacity: challenges to the return on investment may force some insurers to curtail some coverages to limit their risk
• A skewed mix of project types: the scale of exposure to claims is dependent on the type of project and who is funding the project

A historical example about US professional liability claims

In a ten-year period from the time of the oil embargo in late 1973 until interest rates peaked during the US’ rapid economic growth during the Reagan Administration in 1983, the frequency of US professional liability claims against firms in the Victor (then Victor O. Schinnerer & Company, Inc.) and CNA program tripled[3]. The cost of those claims also soared because of the increased costs of energy, materials, and money.

During that time, interest rates peaked at 18.87%, meaning that commercial borrowers for the construction of capital assets demanded that professionals build projects quickly and cheaply—a recipe for construction defects and design claims. Then, claims happened.

Many insurers of design firms raised rates significantly, stopped insuring design firms, or went bankrupt because they had not anticipated the drastic increase in the number and cost of claims. Other insurers rushed into the market, collected high premiums for insuring design firms, and then non-renewed firms before claims happened.  This was not only chaotic for design firms, but also disrupted insurance markets[4] and the rating system.

A look at current external factors

Recently, the world’s largest real estate company, Coldwell Banker Richard Ellis (CBRE), predicted a 14.1% year-on-year increase in US construction costs by the close of 2022[5], citing financial pressures such as inflation, labor shortages, supply chain challenges, Covid-19, and the worldwide impact of Russia’s invasion of Ukraine. It is the largest jump since CBRE began making cost projections in 2007. While CBRE predicts that cost inflation will fall to 4.3% in 2023 and 2.9% in 2024 as supply chain problems recede, it calculates that delays in material deliveries, labor scarcity, and product shortages will endure. The construction industry prospers when there is predictability in project demand and costs, but it will face continuing challenges and volatility, making estimating and managing costs more difficult and cost recovery efforts through claims more likely.

Supply chain issues may not improve in the next three to five years[6]. Lack of improvement will mean unpredictable delays, disruptions in design and construction schedules because of the need for substitutions, and design modifications in response to shortages that result in increased costs and decreased quality in putting capital assets in place.

The impact of inflation may be somewhat reduced in the next few years, but how the free-market system self-corrects is unknown. While some experts predict prices will begin to drop in 2023[7] in the near future, the costs of materials and labor may continue to increase, which not only affect the initial cost of capital assets, but also raise the remedial price tag for solving any design and construction problems.

Interest rates may continue to increase to help reduce the effects of inflation[8]. Because the cost of money affects initial design requirements and the desire to build quickly, higher interest rates can have a major influence on the quality of project and eventually on the costs of claims.

Experts predict that severe weather events will increase[9], and the climate variability and volatility will amplify demands on the built environment. Support for designing for resiliency—anticipating changes that might happen and convincing project owners to make the investment in hardened and adaptable facilities—may not happen in a marketplace of rising capital costs, leading to future claims.

Insurance market capacity will have an impact on what coverages some insurers can offer, how quickly they can grow, and whether they can continue in a market at all. Challenges to the return on investment may force some insurers to curtail some coverages to limit their risks. To ensure that a carrier stays solvent, it cannot sell policies that could potentially result in more losses than the carrier can absorb. This creates a limit on the amount that an insurance company can cover in its total policies because underwriting capacity represents an insurer’s ability to retain risk. The more risk that an insurance company assumes by underwriting new insurance policies, the more premiums it can collect and later invest. When an insurer accepts additional hazards through the issuance of policies, it also increases the possibility of insolvency. Striking the right balance is essential to maintaining and improving the financial health of the insurer.

A skewed mix of project types can lead to more claims that challenge an insurer’s viability. With a huge increase in federal government-sponsored project, the increase in the size of infrastructure projects is likely to result in an increase in the remedial amount demanded in a claim. The larger the price tag for a project, the larger the remediation costs can be if something goes wrong. With federally funded projects incorporating new energy, environmental, and societal requirements, the increased complexity may lead to increased disputes and professional liability claims.

In addition, government projects are increasingly a source of claims[10] as the government attempts to protect taxpayers from cost overruns and deficient project performance. Because the scale of exposure to claims is dependent on the type of project and who is funding the project, design firms and their insurers have to take special care to assess appropriately the risks intrinsic in government funding.

The bottom-line business of insurance

Just as policyholders want a stable and responsive insurance program, so do insurance companies. However, recent conditions show that past historical norms can no longer guide insurance loss predictions. Claims are taking longer to resolve, leading to higher demands by plaintiffs and increased defense costs.

In the professional liability insurance environment for those working in design/construction, claims cost more today than they did two years ago due to inflation, increases in costs of materials, labor, and supply chain challenges, and insurers anticipate that trend will continue. For example, the average indemnity payment in the Victor and CNA A&E program was $208,437 in 2019 and $271,337 in 2021[11]. Current claims differ from past claims as bodily injury claims (those with harm to construction workers, bystanders, and project users) are increasing significantly. As projects grow in scope, bodily injury claims become more likely and, because of “social inflation,” can result in excessive jury verdicts or cause expensive settlements.

Most professional liability claims, however, are a result of market conditions. As market conditions become increasingly difficult to anticipate, the cost of insurance has to include a calculation to accommodate the uncertainty that the design and construction industry and its insurers must acknowledge.

Managing exposure in a time of change

Architects and other design professionals should be especially prudent in their pursuit of projects—the client, the project type, the project location, and the delivery system are now of even greater concern. The possibility of poorly timed value engineering, the need to perform additional services because of substitution requests, and (unless taken into account in the contract for construction) the likelihood of contractor demand for a change in the contract price or contract time all could ensnare the design team in prolonged litigation. Demands to design above code to meet climate volatility and to meet government requirements for energy efficiency, environmental protection, and social goals add a new level of business and professional risk.

Design firms must recognize their risks. Through their contracts and their internal procedures, they need to serve their clients and the public while remaining sustainable as a professional practice. Firms are encouraged to talk with their insurance brokers about insuring options available to them to help navigate these disruptive times.

Victor and CNA work with the AIA Trust to offer AIA members quality risk management coverage through the AIA Trust Professional Liability Insurance Program, Business Owners Program, and Cyber Liability Insurance program to address the challenges that architects face today and in the future. 

[1] Source: Associated General Contractors (AGC) of America “2022 Construction Inflation Alert,” April 2022 https://www.agc.org/sites/default/files/users/user21902/Construction%20Inflation%20Alert%20Cover_Apr2022_0.pdf

[2] Source: U.S. Bureau of Labor and Statistics https://www.bls.gov/news.release/cpi.nr0.htm

[3] Source: From Risk to Profit: Benchmarking and Claims Studies, Victor Insurance Managers LLC https://www.victorinsuranceus.com/School-of-risk-management/from-risk-to-profit/

[4] Source: TIG Advisors, https://tigadvisors.com/impact-of-inflation-on-the-commercial-insurance-market/

[5] Source: CBRE, https://www.cbre.com/press-releases/construction-costs-expected-to-post-largest-increase-in-years

[6] Source: CBRE, IBID

[7] Source: CNBC, cnbc.com/select/inflation-when-will-prices-go-down/

[8] Source: Kiplinger, https://www.kiplinger.com/economic-forecasts/inflation

[9] Source: National Oceanic and Atmospheric Administration, https://www.noaa.gov/news-release/noaa-predicts-above-normal-2022-atlantic-hurricane-season

[10] Source: Public entities claims study, Victor Insurance Managers LLC https://www.victorinsuranceus.com/WorkArea/DownloadAsset.aspx?id=10737419122

[11] Source: From Risk to Profit: Benchmarking and Claims Studies, Victor Insurance Managers LLC https://www.victorinsuranceus.com/School-of-risk-management/from-risk-to-profit/