There is no question that the world has changed since the onset of the COVID-19 pandemic. The majority would argue that there is no returning from the altered course in the fabric of our global society, at least not substantially. The pandemic has reshaped our evolution, bringing devastating social and economic consequences. Unfortunately, since the start of the pandemic in 2020, domestic and global crises have stacked and are starting to give the sense of acceleration in frequency and significance. This adds to the stress on both individuals and businesses. To name a few we have experienced since the start of the pandemic: political unrest, large scale civil unrest, labor shortages, supply chain disruptions, overwhelming natural catastrophes, and now the Russian invasion of Ukraine.
The COVID-19 pandemic and the associated stay-at-home orders have caused a systemic shift in behavior: specifically with regards to how people work, consume, socialize, and utilize technology. From an economic standpoint, the pandemic led to a short-lived stock market crash that evolved into global-wide shutdowns and failures of businesses, most notably small businesses. The median global GDP dropped by 3.9% from 2019 to 2020, making it the worst economic downturn since the Great Depression. In April 2020, the unemployment rate reached the highest rate observed since applicable data collection began in 1948, with the leisure and hospitality (including restaurants) sector being hit the hardest. In response, the U.S. Federal Government inserted trillions of dollars into the economy under various COVID-19 relief programs and cut interest rates to near zero.
There is no doubt that the pent-up demand and the supply chain issues have further impacted businesses around the world and led to increased input costs, which in turn have been passed on to consumers where possible. Some have argued that COVID-19 relief packages may have contributed to the labor shortage. Employers in the U.S. have had to lure workers back into the labor pool with increased pay and other incentives.
Looking in a rearview mirror, with all that has happened since the onset of COVID-19, it was inevitable that the U.S. economy and the global economy would face a new challenge: inflation. Businesses are staring down yet another challenge for survival, as high inflationary periods lead to economic instability. So, what is inflation and how does it affect insurance claims?
Inflation and How It Is Measured
The U.S. Federal Reserve defines inflation as the increase in the prices of goods and services over time. One of the main ways that inflation is measured is through a tool called the Consumer Price Index (CPI). The CPI is a measure of the average change over time in prices paid by consumers for a basket of goods and services. As of February 2022, the increase in the CPI for the last 12 months is 7.9% overall the highest since January of 1982.
One of the major categories driving this increase is energy, specifically the increases in fuel oil and gasoline. Fuel oil prices have increased 43.6% over the past 12 months and gasoline prices have increased by 38.0%. Another category leading to the surge is the increase in meat prices, which are up 13.0% over the past 12 months. However, these are not the only categories that are leading to an increase in the overall CPI. The CPI excluding energy and food costs (also known as the Core CPI) has increased by 6.4% over the past 12 months. Last year was the first year since 1995 that the Core CPI increased by greater than 3.0%.
Beyond the traditional measurements, there is another aspect of inflation that can greatly affect insurance claims: social inflation. Social inflation is a trend that leads to rising insurance claims costs (and larger premiums in response) due to more litigation, broader policy interpretations, negative public sentiment in regards to large companies, and larger jury awards. Collectively, traditional inflation and social inflation combine to create highly complex issues in the insurance industry, and specifically, in business interruption loss measurements.
Examples of Inflation and Their Impacts on Loss of Income Measurements
As forensic accountants, we are often tasked with providing our insurance and litigation clients with business interruption loss or economic damages measurements. Our objective is to determine the loss or damages amount by developing an accurate projection of the business’s operations, but for the loss or damages event. Accordingly, consideration must be made for non-loss related external factors that would have impacted the business during the period of evaluation. In the current economic environment, the likely impacts of inflation are one of those external factors. However, often there are multiple external forces which may impact an industry or a business at one time and combine to significantly impact the operations of a business.
To highlight the impact of multiple external market forces on a business or industry, consider the restaurant industry. Below, is a very brief timeline of events related to the COVID-19 pandemic which have significantly impacted the industry:
- Spring 2020 – Onset of the pandemic and subsequent government mandated restrictions
- CARES Act – March 27, 2020
- Summer 2020 – Temporary governmental closure orders lifted
- Fall 2020 – Delta variant
- Spring 2021 – Vaccine rollout
- Winter 2021 – Omicron variant
At the onset of the pandemic, many jurisdictions imposed significant capacity restrictions or outright bans of in-person dining. Due to varying operating restrictions and mask and social distancing requirements, many restaurants temporarily closed for periods of time throughout the United States. Some restaurants were able to adapt to take-out/delivery only models during this time, which allowed them to maintain a portion of their operations, but impacted their profit margins, among other things.
Beyond the direct initial impacts of COVID-19, many restaurants found a changing landscape for operations in 2021. For example, following the initial onset of the pandemic, many hospitality workers left the industry, resulting in significant shortages of available labor. According to the U.S. Bureau of Labor Statistics, there were 12,360,600 individuals employed by Food Services and Drinking Places in February 2020. In April 2020, that number fell to a low of 6,364,600 and improved throughout the remainder of 2020. As of February 2022, the count had improved to 11,536,600. Nonetheless, two years after the onset of the pandemic, employment levels are still 824,000 positions below pre-pandemic levels. While this impact varies by region, according to the National Restaurant Association, 43 states still have employment levels below pre-pandemic levels, as of January 2022.
Due to the shortage of labor and other inflationary forces, the hospitality industry experienced significant average wage growth. The U.S. Bureau of Labor Statistics reported that the average hourly earnings for Leisure and Hospitality sectors was $16.89 in February 2020. As of February 2022, wages had increased by nearly 15% to an hourly average of $19.35.
How does inflationary wage growth impact a damages evaluation for a restaurant? Following a loss event, a restaurant may reduce the number of workers and thereby cut the number of labor hours incurred. If the evaluation of payroll is only contemplated on a high-level basis of prior year versus current year total labor spend, no reduction in labor may be identified. This is due to the fact that during inflationary times with rising wages, the total payroll expense may remain relativity consistent with prior years as wage growth offsets the reduction in headcount and hours. A more accurate method would be to evaluate the change in labor hours and apply actual loss period wage rates.
Beyond the impacts of increasing labor costs, the restaurant industry has also had to cope with significant increases in food costs. As of February 2022, the National Restaurant Association reports that wholesale food costs increased by 15.1% from February 2021. This represents the largest 12 month increase in wholesale food prices since the early 1970’s. The table below outlines year-over-year price increases for a number of food segment categories based on the Producer Price Index (PPI).
With significant increases in the costs of labor and food, many restaurants have been forced to raise prices. The National Restaurant Association reports that the average price for limited-service restaurants increased by 8% in February 2022 when compared to February 2021. In addition, full-service restaurants increased menu prices by an average of 7.5% over the same period. As previously referenced, with labor rate increases of 15% and wholesale food cost increases of 15.1%, the average menu price increase would still result in a reduction in profit margins for many restaurants.
When evaluating a loss involving a restaurant experiencing rising costs, it is important to evaluate the business’s ability to maintain profit margins. In a partial loss scenario, an evaluation can be performed on the actual profit margin achieved during the loss evaluation period. In addition, it would be important to understand how and when the restaurant determines their menu prices. As the evaluator of a loss, if you’re able to establish the known cost increase of supplies and the business’s likely pricing model during that period, you can accurately forecast profitability during the loss period.
Customer Purchasing Power
Further, while increasing menu prices may allow some restaurants to maintain profit margins, the impact of weakening buying power for consumers during inflationary times, combined with elevated prices could result in a decline in overall customer traffic. For example, according to a January 2022 survey fielded by the National Restaurant Association, “A majority of restaurants did not experience a complete sales recovery to pre-pandemic levels in 2021. Sixty-three percent of operators said their sales volume in 2021 was lower than it was in 2019”.
While it’s common practice to rely upon historical financial records to quantify losses of income, solely utilizing this historical data approach may result in inaccurate quantification of damages during inflationary times. In the current environment, to accurately evaluate a loss of income, it is critical to contemplate the likely impact to profitability caused by inflation, supply chain constraints, and other changes in the economic landscape. Further consideration must also be provided for the mitigating steps that businesses may take to deal with these financial pressures.
This blog was co-written by Eric Rapp.