Chris O’Kane looks at why the industry urgently needs to wake up to the real possibility of “commodity surge”.

The largely unanticipated losses from the 2005 “demand surge” following Hurricanes Katrina, Rita and Wilma could be repeated if insurers ignore sharp rises in the cost of raw materials.

Headline inflation rates are running at just over 4% in the US and 3% in the UK. Yet, these broad indices only take partial account of the true underlying inflationary factors that are in turn spurring rapid growth in claims inflation. On the casualty side, medical and legal expenses continue to run well ahead of the consumer price index. The soaring cost of oil, metals and other raw materials could have an even bigger impact on many lines of property insurance.

Overall, commodity prices have increased by more than 30% in the past year, leading some commentators to warn that the property bubble is giving way to a commodity bubble. Iron ore has risen by more than 60% in 2008, leading to increases of more than 30% in the cost of key building materials such as steel and concrete. Some of this inflation stems from the decline in the dollar and mounting demand in China, India and other emerging economies. Others suggest that speculation is also heightening the volatility in commodity markets and exacerbating the uncertainty in insurers’ pricing, reinsurance, reserving and capital management strategies.

“The inflation in the price of key commodities and resulting claims exposures could escalate into hyperinflation

Following a large catastrophe or series of mid-level events, the inflation in the price of key commodities and resulting claims exposures could escalate into hyperinflation. We have already seen shortages of building materials leading to lengthy reconstruction delays and hence increased business interruption claims. However, while many insurers and reinsurers adjusted their model assumptions to take account of the demand surge for repair and reconstruction services following the windstorm losses of 2005, the industry has yet to take account of the comparable threat of commodity surge.

At Aspen, we are exploring the potential impact on our portfolios and will model parameters accordingly. Ultimately, dealing with the acceleration in inflation demands sound and proactive underwriting judgement.

Chris O’Kane is CEO of Aspen Insurance