The Effect of Inflation on Hull Repair Costs - Analysis and Implications

Understanding claim inflation in the context of hull repair costs is crucial for insurance professionals, as it impacts future claim settlements, reserves, and pricing strategies. The study delves into the concept of claims inflation, its significance, and implications for the insurance industry. It also provides an illustrative example showcasing the effects of inflation on a cargo vessel grounding incident. The analysis emphasizes the importance of accurately accounting for inflation when estimating future claims payments and ensuring financial stability within the insurance sector.

• Inflation
• Hull Repair Costs
• Claims Inflation
• Insurance Industry
• Risk Management

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1. The Effect of Inflation on Hull Repair Costs IUMI 2010 ZURICH, 12 15 September Giorgia Rama, Swiss Re, Zurich 12 TO 15 SEPTEMBER

2. CONTENTS Claim inflation Why it is important to study claim inflation? Fact & Figures analysis on claim inflation: F&F inflation study: Additive model F&F inflation study: Multiplicative model Conclusions 12 TO 15 SEPTEMBER 2

3. What is claim inflation? Claims inflation Change in cost of settling claims: the future cost level will be different from the cost in the past Series of yearly Ultimate payment per claim (Cefor Annual Report 2009, recalculated by settlement year):excl. total losses - ocean hull 12 TO 15 SEPTEMBER 3

4. Illustrative Example Grounding of a Cargo vessel in 2004: Items 2004 2009 5 years inflation Series used World steel price Steel plates 274'662 456'108 66.1% series South East Asia wage index Work 787'789 1'056'453 34.1% Other materials and fix costs Flat inflation, 2% 918'617 1'014'228 10.4% year World equity Yard Profit 410'732 338'076 -17.7% index Total Loss USD 2'391'800 2'864'865 19.8% 2 scenarios: What happens if the loss is estimated in 2004 but the vessel repaired in 2009 (i.e. claim paid in 2009)? What happens if the premium charged in 2009 is equal to the premium charged in 2004? 12 TO 15 SEPTEMBER 4

5. Why is important to study claim inflation? What area? Where inflation counts? How we use inflation assumptions? Risk of misestimating or ignoring inflation? Reserving Estimate of future claims payments for claims outstanding Is past inflation a good indicator of the current/future inflation? Invalid evaluation of claims liability in Balance sheet Pricing Estimate of next policy year expected loss Use inflation assumptions to express claims in the value terms of the next policy year The Premium is too low to cover the claims liability Capital Modelling Estimate of Premium and Claims Reserves uncertainty to calculate the level of capital required Inflation is a key driver of the level of volatility of Premium and Reserves Insufficient financial resources to fully meet the insurer's obligations 12 TO 15 SEPTEMBER 5

6. F&F analysis on claim inflation Focus :Hull Bluewater repair cost inflation The claims payments reimburse for loss of goods and services which are purchased on the open market. Therefore the loss costs are affected by external economic variables. F&F aims to describe historical repair cost inflation using a combination of economic indicators. We need to answer the following questions: 1. Which are the drivers of the claim inflation? 2. Which economic indicators best represents the drivers? 3. How much weight is associated with each driver? 12 TO 15 SEPTEMBER 6

7. Repair costs: cost drivers Tangible components Material components raw material: Steel spare parts: Crankshaft, Piston Labour cost: Wage of specialized workers/ crew overtime / superintendent Removal costs: oil price Intangible components Demand of repair services Shipyard space Premium price Geographical shift Currency exchange Profit targets of the yards Increase of standards Insurance-driven components Changes in deductible 12 TO 15 SEPTEMBER 7

8. Sticky Inflation For certain commodities, when price goes down it goes down slowly, as if it is sticking to the existing price level, but when they go up, they are free to touch new highs. (example- wages). This phenomena inflation. However for certain commodities (e.g. crude oil) the sticky nature is not observed. is called sticky Series of yearly Ultimate payment per claim (Cefor Annual Report 2009, recalculated by settlement year):excl. total losses - ocean hull 12 TO 15 SEPTEMBER 8

9. F&F inflation study: Additive model Example of Additive model: Inflation = 35%* Wage + 50% * Steel + 15% * Equity Wage index and Steel price as Material components Equity index as Intangible Component Year Additive model inflation 2.3% -1.6% -3.0% 9.2% 19.0% 15.6% 2.9% 7.3% 9.1% -2.9% Economic Indicators Weights 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Wage index mix 35% China 4% Japan 9% South Korea 17% Europe (27) 5% Steel Price 50% Equity index 15% 12 TO 15 SEPTEMBER 9

10. F&F inflation study: Additive model 180 173 168 160 148 159 144 140 124 120 100 98 95 104 100 80 60 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Data inflation index Additive Inflation Index Data inflation derived from the series of yearly Ultimate payment per claim (Cefor Annual Report 2009, recalculated by settlement year): excl. total losses - ocean hull 12 TO 15 SEPTEMBER 10

11. F&F inflation study: Multiplicative model Example of Multiplicative Model Inflation = A* Equity B* Steel C A, B and C have been estimated with statistical techniques 4.9% annual average inflation is modified by movements in Equity index and Steel price Year Multiplicative model inflation 180 168 160 160 165 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 7.3% -2.3% -3.5% 7.7% 18.4% 13.5% 8.5% 11.5% 2.0% -4.8% 148 140 137 120 120 100 98 94 102 100 80 60 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Data inflation index Data inflation from the series of yearly Ultimate payment per claim (Cefor Annual Report 2009, recalculated by settlement year): excl. total losses - ocean hull Multiplicative Inflation Index 12 TO 15 SEPTEMBER 11

12. Conclusions Claims inflation exists It is important to study claims inflation F&F has produced two alternative models that describe Hull bluewater repair costs through a combination of economic variables: The alternative models represent reality very well: the goodness of fit has been tested by comparing the model output with the claims inflation (series of yearly Ultimate payment per claim recalculated by settlement year, Cefor Annual Report 2009). The alternative models are two valid examples of how to construct inflation series More details on the models will be published on the IUMI website 12 TO 15 SEPTEMBER 12