What Is Demand Surge And Its Implications For Policyholders?

Demand surge is defined as the demand for products and services exceeding the regional capacity to efficiently supply them. This phenomenon is relevant for both Christchurch post earthquakes, and for the east coast of the USA post Hurricane Sandy. It is a common phenomenon around the world, post natural disaster. Demand surge is relevant to all affected policyholders in that the need for disaster relief and recovery supplies increases dramatically due to shortages and increased demand, forcing the cost of these goods upward as people rebuild. Post disaster insurance dollars pour into the affected region, but rebuilding is limited by materials and worker shortages. These in turn lead to rising wages and sometimes very substantial material price increases. Construction materials and costs (e.g. steel, timber, cement, building materials such as gib) are usually the most visibly effected by demand surge but energy prices for oil and gas may also rise.

Around the world demand surge post disaster can be seen whether the disaster is a result of flooding, windstorm, hurricane or earthquake. It is clear that the equilibrium of demand and supply becomes unbalanced. Examples of earthquake events that have seen demand surges were seen as early as the 1886 Charleston, South Carolina Earthquake (U.S.) which created a demand for labour that far exceeded the local supply. Wage rates for both skilled and unskilled labour increased dramatically above pre-earthquake levels. The heightened wages and labour shortage had a knock on effect and created a long waiting list for repairs which not only caused severe hardship for owners but increased the loss at the property (due to deterioration over time or further damage) which in turn led to shoddy and inadequate repairs. We are currently experiencing exactly this scenario in Christchurch. Without a strong mechanism for the control of construction quality, materials and labour pricing, residents face a frustrating time ahead.

In 1906 the San Francisco Earthquake and Fire (U.S.) presented other demand surge challenges. The construction costs increased immediately after the event and led to larger insured losses than expected. The capacity constraints for labour and material drive the price fluctuations and substantially increase reconstruction costs as the demand rises for building contractors to repair the damage. The increasing cost of repair work, because of the shortage of materials and labour, leads to higher claims. And the more widespread the damage the greater the price for the rebuilding resources. Consequently contractors raise their bid on reconstruction projects and this leads to incredible price increases, sometimes twice as high as they would have been in a competitive market.

During the 1994 Northridge earthquake (U.S.) there was a lack of claims adjustors in the local area so the insurers brought in people from other parts of the country and overseas. We too have experienced the same pattern. These adjustors typically were not suitably trained in the area of seismic damage and were not able to assess the quantum or seriousness of the damage adequately and therefore not able to price it adequately.

After the Newcastle earthquake in Australia rebuilding costs were said to increase by 35%. After Cyclone Tracey in Darwin, building costs increased by 75 %; the ACT bushfires in 2003, building costs increased by 50% between November 2002 and January 2003. Preliminary reports following Cyclone Larry in Queensland indicated that there was a significant increase in local building costs after the disaster; with insurers estimating building costs increasing by at least 50% immediately after the disaster.

Demand surge is a function of the size of the catastrophe: the larger the disaster and damage to property, the greater the magnitude of the demand surge. There is no doubt that demand surge is currently a factor here too. In addition a remote and isolated country like New Zealand, where supply and transportation prove difficult have been suggested as reasons for particularly large demand surge events. (See http://www.stuff.co.nz/business/4129260/Price-gouging-threat-to-recovery-economist).

The critical element here is how economically can reconstruction materials, labour, equipment and financing be brought to the affected area? These elements will physically effect the repair and rebuilding of Christchurch and all must be available locally when needed. If demand for labour exceeds supply then the labour force can and will command higher wages. (See http://www.stuff.co.nz/business/rebuilding-christchurch/7438808/Builders-wages-rise-faster-in-Canty). In addition the total amount of repair work in the region will also define the demand surge and the local building codes will determine the level of repairs required and the necessary skill of the labour force.

It is likely that insurers probably have not adequately accounted for changes in building code requirements (e.g. strengthened foundations) when determining the quantum for replacement of the property. In addition the reality of schedules and the ability to meet them will affect the amount of work required and the speed of the work to be performed – will also have a dramatic impact on the ultimate costs payable.

Delayed repairs will ultimately cost more because of the deterioration and additional damage to property as well as changes in the pricing of materials, labour rates and contractors overheads. Overseas experience shows that these surges can be as high as 70%. The efforts of local and national government will also affect the timing of reconstruction. In light of the fact that we have seen a very slow start to the recovery phase one might predict very large increases in demand surge as both residential and commercial reconstruction ‘ramp up’. Well done National!

So my message is – insurers have to battle with the uncertainty of demand surge on claim costs following disasters. They see themselves as having a legitimate interest to pay only the portion of the loss for which they have calculated and charged a premium. On the other hand policyholders have to ensure that these demand price surges are factored into their final claim settlement, otherwise they will be considerably out of pocket and find themselves potentially in a situation of being unable to afford to replace what they have lost.

The more reputable engineering firms and quantity surveyors have already begun to include pre and post tender escalation rates which reflect these surges. The figures are variable and will no doubt only continue to rise.

As an example – you lose your house in 2010 and a rebuild is not possible until 2015 and you have not factored in a demand surge % – then you will sustain a substantial loss and your total replacement policy will not deliver on its promises.

So the message is – do not fail to make a provision for the demand surge in your final settlement.

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