May 20, 2021
COVID-19’s Impact on Replacement Costs
To make sure there are no surprises, asset owners across sectors need to ensure that their valuations are up to date.
In April of last year, as COVID-19 cases were rising around the world, I made a number of observations on the pandemic’s potential impact on reinstatement costs for asset owners, insurers and reinsurers, financiers and brokers.
One year on, the time feels right to look back to that moment when the world entered the first wave of lockdowns and travel restrictions — and consider what appears to have happened in a turbulent year.
The key case I would make from all of this is the need more than ever for asset owners across sectors to ensure their valuations are up to date.
The volatility over the last 12 months and the future uncertainties on global supply chains is likely to increase the chance of disagreements with insurers in the event of a claim, where current reinstatement costs are higher than those stated in insurance policies (under-insurance).
But a careful review will also help asset owners avoid overpaying insurance premiums (over-insurance) in the situations where costs have fallen since COVID-19 struck.
Oil, construction, stocks, travel
On oil prices: They stayed low, at around $40 a barrel, throughout 2020, only rising to around $60 a barrel in early 2021.
The low cost of oil benefitted a number of sectors, but in reality this does not appear to have translated into significantly lower costs of raw materials or equipment.
On construction, activity slowed drastically across many markets as movement of people and goods was constrained.
This has translated into different cost changes around the world, with some countries experiencing significant falls in tender prices while others have seen material increases over the same period.
Most material and equipment suppliers were affected equally by COVID, and as a consequence there was not the imbalance that could have driven down expected margins.
I wrote at the time that “companies may have stockpiled in advance of the major impact on supply chains and could flood the market with products once business picks up.”
In practice, the opposite appears to have happened — with governments early on in Q2 2020 ordering the shutdown of non-essential businesses, stocks have been at record lows across many industries.
With many industries experiencing low stock levels, firms have not been under pressure to drop prices.
With travel restrictions and huge variations between countries, it appears that, as at early 2021, most firms continue to be cautious on travel generally.
Government support, materials, rates
In terms of governments stepping in with support, it appears that most governments prioritized job protection in their policies, and there was no sign of the financial support for businesses causing widespread lowering of prices.
While the cost of materials and equipment appears to have held up during 2020, there was downward pressure on the cost of services, as firms and suppliers in these sectors tried to maintain activity.
The latest commentary from central banks around the world indicates that they foresee continued challenges to economies throughout 2021, and accordingly they see continued low inflation for the remainder of the year.
This supports the idea that prices should be under downward pressure, but in practice the cut in capacity/production from suppliers has ensured that costs have remained stable.
Supply chains, commodities, manufacturing
A year ago today, I suggested the possibility that “increased costs in the supply chain due to delays, reduced capacity and increased border checks could drive up costs.”
This certainly seems to have occurred, with shipping costs alone appearing to have rocketed in the last six to nine months.
Firms in Europe have been talking about the cost of shipping from Asia going up by tenfold since early 2020.
In terms of goods and commodities, while oil prices remained low, steel and other commodity prices have shot up through 2020.
This has been driven by increased activity in places such as China matched to the reductions in capacity due to shutdowns, and historically low inventory levels.
Steel mills for example were quick to idle blast furnaces but were slow to bring this idle capacity back online in many locations.
For manufacturing, there are few indications that manufacturers have materially shifted more production to domestic (more expensive) markets to maintain consistency in supply chains.
While this is mainly because of the widespread impact of COVID-19, it still remains a possible outcome of the disruption that has occurred.
As mentioned, some commodity prices have increased significantly in recent months, and there is no questions this will have a knock-on effect on construction and “factory gate” prices for goods if this supply imbalance continues.
Inflation, furloughs, tariffs
So far, inflation remains low, and with capacity coming back online perhaps the recent surge in prices will be short-lived.
On furloughs, many countries are seeing unemployment levels rise, keeping downward pressure on wages generally. This could be exacerbated once current staff retention schemes are withdrawn.
However, COVID-19 has created a new focus on digitization and analytics for many firms, and people with those skills are likely to be well sought after.
One consequence of the widespread application of government support across many industries is that many firms have been able to manage the impact of COVID-19.
However, as with any recession, the real impact usually hits as the economy starts to recover, and we could still see insolvencies become a factor toward the end of 2021 and into 2022.
During the last year, there was no obvious sign of increased application of tariffs and barriers.
The change in the U.S. administration at the start of 2021 may herald a new approach to international trade, reducing the prospect of further protectionism and tariffs.
With continuing travel restrictions and huge variations between countries, it appears that, as at early 2021, most firms continue to be cautious.
So, what has stood out when considering what I thought might happen back in April 2020?
I suppose the speed and depth of the impact of COVID-19, both on local industries as well as on global supply chains, took most people by surprise.
The stop-start approach to lockdowns and restrictions continues to make it hard to decipher the systemic changes in industries and markets.
The uneven rollout of vaccines (and “passports”) is unlikely to make that issue easier, either.
Certainly, the rapid price increases over the past year in the cost of transportation and commodities have caught many out.
With U.S. steel (hot-rolled band) costs up 90%, aluminum up 10%, copper up 2% and U.S. concrete prices up over 400% from a low in March 2020, the potential impact on reinstatement costs for major facilities should not be underestimated.
Insurers, asset owners, brokers and financiers would do well to keep these issues top of mind as the rest of 2021 plays out.