What Insurance Companies' Response To Hurricane Florence Can Teach Us About The Business Cycle

by: Mises Institute

By Brian Balfour

Hurricane Florence has left a huge swath of devastated communities in its wake. Some estimates predict more than 750,000 homes in North Carolina, South Carolina, and Virginia will sustain flood and wind damage, with reconstruction costs of up to $170 billion possible.

For most, dealing with their insurance company to reimburse part of their damage repair costs will be a vital part of the process.

So how are insurance companies responding to this sudden, temporary surge in claims?

"The Travelers Cos. Inc. and The Hartford Financial Services Group Inc. have sent hundreds of adjusters and other staff to the region, reserving hotel rooms and establishing a presence to work with customers and others immediately after the storm passes," reported the Hartford Courant.

In short, insurance companies are mobilizing their current available resources to handle the massive influx of business.

Their responses include: sending claims adjusters from other parts of the country to the Carolinas, manning customer service lines for extended hours, longer shifts and shorter breaks, and perhaps some temporary workers as well.

Imagine, however, if the insurance companies mistook this temporary surge in business as a permanent phenomenon, and instead decided to invest in more long-term expansions of their capacity.

What if they instead hired and trained hundreds of additional permanent staff? And say they borrowed millions to build new office buildings to house these new staffers?

When the Hurricane Florence claims are completed, these long-term investments will be revealed to be a major miscalculation.

Hundreds of staffers will sit idle because the work load has returned to pre-Florence levels. These unnecessary workers will be fired. The new office buildings housing them will likewise become an unnecessary and unaffordable financial burden and need to be put up for sale. Reality revealed that the long-term demand for the insurance company's services is much lower than during the temporary upswing following the Hurricane.

Such a situation is reminiscent of an analogy made by investment advisor Peter Schiff and cited by Tom Woods in his book "Meltdown," in which a circus comes to town for a couple of weeks.

When the circus arrives, its performers and the crowds it attracts patronize local restaurants and businesses. Now suppose a restaurant owner mistakenly concludes that this boom in his business will endure permanently. He may response by building an addition, or perhaps even opening a second location. But as soon as the circus leaves town, our businessman finds he has tragically miscalculated.

What can this teach us about the business cycle?

Much like the hypothetical insurance company that responded to a temporary signal with a long-term investment to expand capacity, many businesses during a period of easy, low-interest credit will mistakenly invest in more durable capital goods to increase their production with an eye toward the future.

In reality, however, insurance companies obviously recognize the surge in claims to be temporary due to the one-off event of a major hurricane. They would understand this to be a situation that will pass in the near term, and not a signal to expand operations for the long term.

In the case of artificially low interest rates courtesy of Federal Reserve policy, however, many entrepreneurs read this as a signal to invest in a permanent production expansion.

Low interest rates tell entrepreneurs that it is a good time to invest in longer-term capital goods not only because it makes it cheaper to borrow the funds, but low interest rates indicate that consumers are tending to save more of their money now, raising the likelihood of increased consumption in the future.

Long-term investments are especially interest-rate-sensitive because even a small decrease in the interest rate over, say, a 20-year loan can make a significant difference in the total amount of interest required to be paid back over the life of the loan. New factories, office buildings, and durable capital goods are typically financed with long-term loans due to the lengthy period of time they are expected to provide productive services.

Durable consumer goods - housing in particular - also fall into the interest-rate-sensitive category because they are so commonly purchased using long-term financing methods, like mortgages.

But if the low interest rates are a product of Fed money creation, entrepreneurs are receiving a false signal. Underlying time preferences and market conditions are not conducive for future-oriented, long-term expansions of production capacity. Investments in durable capital goods, and the resulting expansion in the industries that produce durable capital goods, will turn out to be malinvestments.

As Woods wrote:

The central bank's lowering of the interest rate therefore creates a mismatch of market forces. The coordination of production across time is disrupted. Long-term investments that will bear fruit only in the distant future are encouraged at a time when the public has shown no letup in its desire to consume in the present.

For those long-term investments that do begin to churn out finished products in the future, Woods wrote, "with the public's saving relatively low there is reason to believe the purchasing power won't be around later, when businesses hope to cash in on their long-term investments."

For other companies that embarked on long-term investments, they will find themselves in a resource crunch. The complementary factors of production needed to go along with the durable capital goods, such as labor, replacement parts, and other inputs, will be in high demand yet no more plentiful supply. Entrepreneurs will find these complimentary goods to be more expensive than anticipated.

The investments will reveal themselves to be unprofitable, a mistake enabled by artificially cheap credit, and need to be abandoned.

Massive layoffs in those impacted industries will occur. The capital goods will need to find new owners who can put them to use, a reshuffling process that takes time. The economy finds itself in recession.

Economic actors respond to signals. In the case of a spike in insurance claims after a hurricane, the response will be a temporary rearrangement of available resources to accommodate the influx.

In the case of low interest rates, however, the signal is a green light for entrepreneurs to invest in long-term commitments like factories and durable capital goods to expand production capacity to meet anticipated future demand. When the interest rate is manipulated by Fed policy instead of market preferences, the low rates are a false signal and result in a "cluster of errors" that sow the seeds of the next bust.

Disclosure: No positions.