How Inflation Impacts Surety Bonds
August 16, 2021
Inflation is on the rise, and many experts predict that it will continue to expand for the foreseeable future. In the past year alone the cost of living has increased 5.4%, marking the largest year to year jump since the 2008 financial crisis. Many Americans are beginning to feel the direct impacts of inflation, as the prices of goods are increasing at a rate higher than that of their salaries, resulting in an overall decrease in real wages of about 2%. So what does this mean for insurance agents? Well, aside from having to pay more for goods and services, insurance agents will also need to navigate shifting market appetites. In this week’s blog article, we provide context surrounding the rise in inflation, and provide insurance agents with everything they need to know about what this could mean for the surety industry.
What is Inflation?
Inflation is the decrease in purchasing power of a currency over a measured period of time, and is most often reflected in price increases. There are three different causes of inflation:
Occurs when the supply of money is suddenly increased and consumer demand surges, resulting in demand outpacing supply
The cost of production increases, resulting in price increases to maintain the same level of profits
People expect prices to rise at a certain rate, and therefore demand wage increases to make up for the increased cost of living, which leads to prices increases, which leads to more wage increases and the cycle continues in perpetuity
Not all inflation is bad, as healthy levels can lead to an increase in consumer spending which in turn boosts the economy. However, when inflation rises too quickly and wages don’t have time to catch up to the increases in prices, the opposite effect can occur, as consumers avoid spending in excess to be able to cover their essential costs.
Why is Inflation Increasing?
Inflation is increasing because the rapid reopening of the US economy has resulted in major shortages of both supplies and labor, causing many companies to raise prices to help cover costs. A large portion of the country was under lockdown orders for the majority of 2020, and as a result were spending less money on previously routine items such as gas, travel, and leisure activities. With lockdown orders currently lifted, businesses able to operate at full capacity, and a general feeling of safety as a result of the vaccines, Americans are beginning to start spending money on a range of goods and services again. Where the problem now lies is that demand is far exceeding supply, as supply chain shortages and a lack of workers has businesses scrambling to find ways to satisfy consumer demand, which is currently resulting in an increase in prices. Additionally, 22% of all dollars in circulation were printed in 2020 alone, and as we learned in the above section, massive and sudden increases in the supply of money results in rising inflation.
How Does Inflation Impact Surety Bonds?
Inflation may result in an increase in the bond amount and premium paid for some surety bonds. The limits on most surety bonds are codified in state statutes, and rate structures are subject to intense regulatory scrutiny, surety companies and obligees can’t easily alter premium structures or increase bond amounts to match inflation. However, state legislatures do have the authority to raise limits, and may do so to ensure the protections offered to consumers are not diminished.
Additionally, inflation does have soft impacts on the surety market that can lead to principals favoring certain business ventures (and therefore bond types) over others. To better understand the overall effects of inflation on the surety market, we’ve broken down the impacts of inflation by bond type.
Contract bonds are arguably the most impacted by inflation, as price fluctuations can severely strain the construction industry. The limit on contract bonds are most often determined based on an estimate of the total project cost. For example, if a construction project costs $1 million to complete, then the contractor who is awarded the job will need to purchase a $1 million performance bond. During times of rapid inflation the cost of materials will generally increase, resulting in the total project cost to be closer to $1.5 million, causing the contractor to miss out on potential profits. Contract surety bonds contain overrun and underrun provisions, which adjusts the surety bond limit based off of the final project cost. So in a situation such as this, the contractor ends up paying more premium for their bond and receiving less profits, which can severely impact their business overhead. Simply put, the volatility in the price of materials has many contractors reluctant to take on more risky jobs. No one wants to bid on a project when they don’t know what the prices of materials will be 12 months from now. Periods of high inflation are bad for the construction industry, but will actually result in an increase in demand for contract bonds, as the risk of defaulting is much higher.
So how can contractors protect themselves from losses during periods of high inflation? Well, contracts that contain what is known as an “escalation clause” provide added protection to contractors when prices are volatile. An escalation clause is a contract provision that guarantees a change in the agreed upon price of the materials specified within the contract if an external factor, such as inflation, causes material prices to increase. In addition to protecting the contractor, escalation clauses benefit the buyer as well because they prevent delayed delivery from performance claims and defaults.
The mortgage industry is currently booming with valuations of homes skyrocketing due to a low inventory and the lowest rates seen in 30+ years. With inflation on the rise, mortgage lenders must be cognisant of their interest rates to ensure profits aren’t being eroded by a reduction in purchasing power over time. While inflation itself may not implicate the risk on Mortgage Broker/Lender bonds, those in the mortgage industry should ensure they remain in compliance with the statutes dictating their license requirements.
The automobile industry is currently experiencing a massive spike in demand for used motor vehicles, causing prices to soar. Additionally, a worldwide semiconductor shortage has caused manufacturers to decrease their output of new motor vehicles, making used vehicles a more viable option for most consumers. So what does this mean for the used motor vehicle market? With a supply shortage for new vehicles and an increased supply for used vehicles, we anticipate heightened demand for auto dealer bonds as savvy entrepreneurs eager to capitalize on the increased profits enter the used motor vehicle dealer space.
The limit on an ERISA bond must be equal to at least 10% of the total assets of the employee benefits plan. Since plan trustees often invest portions of the plan’s assets into the stock market, the limit on your customers’ ERISA bonds may need to be altered if inflation ends up having a significant impact on the stock market. It is important to note that the main driver for increases (or decreases) to ERISA bonds are the volume of contributions to the benefits plan. Additionally, ERISA bond amounts only need to be adjusted when being renewed, which only happens once every three years. If inflation does end up having a lasting effect on the market (which some are predicting it might), your customers may need to adjust their ERISA bonds accordingly.
Navigating Inflation in the Surety Industry
As we previously discussed, inflation may result in increases to bond limits and higher premium rates. Additionally, it can draw people to and from certain industries and therefore alter the demand for particular bond types. Agents who frequently deal with surety bonds, or who want to, shouldn’t be too concerned about seeing their book of business decrease (at least in the short term) as most surety bonds serve as a prerequisite to conducting business, and are therefore frequently in high demand.
How Can an Insurance Agent Obtain a Surety Bond?
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