How rising prices are affecting the risk transfer and insurance programs of construction companies
As inflation rates soar in many countries, construction companies need to consider the impact of rising costs, persisting supply chain pressures, and raw material shortages on their insurance program and make any needed changes to remain resilient amidst a changing environment.
Project-specific coverages or programs are most likely to be affected by a high inflation environment. In most parts of the world, two main types of project-specific coverages are exposed to inflation:
- Property: Builders’ risk (BR), construction “all risks” (CAR), or erection “all risks” (EAR) policies
- Casualty: Third party liability (TPL) or wrap up liability (WUL) policies
Both of these coverages generally have an exposure basis that is linked to the insured project’s estimated contract value (ECV). Payroll may be an additional consideration for casualty policies. In an inflationary environment, increases in raw material, labor, and various essential inputs (such as fuel, utilities, and interest costs) are likely to have a direct impact on the ECV of a project.
What are the considerations for construction companies?
Project-specific coverages are usually structured around the ECV at the start of the project, and the estimated contract value will usually drive a few considerations around the coverages:
- Premium: Project-specific coverages are typically rated against an exposure base of ECV, and are adjusted at the end of the project, depending on the final contract value. As inflation increases a project’s contract value, construction companies are likely to see a correlating increase in the premium. High inflation may also impact the availability of supplies and result in delays to completion timelines due to difficulties sourcing materials, which could also lead to an indirect increase in premiums.
- Builders’ risk, construction “all risks”, or erection “all risks”: The sum insured through property-specific coverages is typically based on the ECV. High inflation that leads to sizable increases in a project’s overall cost could lead to the sum insured becoming insufficient. This could happen both in the event of a total loss or if average clauses exist in the policy wording (as this could reduce the amount of a claim payout). Note that there are certain policy extensions that might help mitigate this exposure. Some policies are placed on a limit of loss basis, where the sum insured is lower than the ECV, with coverage limits decided by the project stakeholders, typically based on an their own internal approach that studies accumulation of values over the project timeline. Significant inflation that causes the price of certain materials to increase at various stages of the project timeline, could skew the original calculation of an appropriate limit.
- Third party liability or wrap up liability: Casualty coverages typically include limits of liability that are procured according to risk tolerance and expected exposure from potential third party claims. In some parts of the world, these limits are also aggregated within a project term. Although inflation does not directly impact the risk profile of a project, judgments from lawsuits and third party claims, known as social inflation, could see a significant increase. In such an environment, a single claim could erode a liability limit much quicker than in a low inflationary environment.
How does inflation affect insurers?
Insurers have traditionally considered inflation and the potential for cost increases when it comes to construction projects. The current inflationary environment — with triple-digit increases for certain materials — has become difficult for insurers to navigate, especially when looking at projects that are still in progress. When projects have claims, calculating an adequate reserve for an adjuster could be a challenge in situations that are not total losses. In this environment, Insurers can be expected to seek answers to multiple questions, including:
- What is the lead-time for securing key equipment for the project?
- How is the overall project timeline affected by ongoing supply chain issues?
- How often do we need to adjust the ECV during a project timeline?
- Has inflation been factored into the initial contract price?
Collaboration and transparency are key in addressing inflation risks
All stakeholders, from construction companies to insurers, should take a collaborative and transparent approach in order to help mitigate the effects of high inflation. Among other actions, consider:
- Communicating around strategy for tenders/bids. Work with your construction insurance broker or advisor to help communicate mitigation strategies and risk management protocols around cost increases due to inflation to the insurers on each project.
- Review ECV on a frequent basis. Stay up-to-date on increases in contract values on a project as contracts are awarded. Inform your construction insurance broker or advisor about any increases so that they can advise on the potential need to update existing policies.
- Understand your approach to risk transfer. For project polices with a limit of loss, carefully review the methodology used to determine an appropriate limit and run it again against the new contract value. Engage with your construction insurance broker or advisor to consider the potential impact of any discrepancies.
- Review your policies’ protection clauses. In some regions insureds can secure extensions of cover (such as cost escalation and inflation protection) to help mitigate inflationary effects. Work with your construction insurance broker or advisor to determine the availability of protection clauses and understand how they might help you mitigate your risks.
Today’s inflationary challenges can have a significant effect on both construction projects and their insurance coverage, underscoring the importance of reviewing your policies to identify potential underinsurance issues and address them immediately.
In order to develop an insurance program that meets your needs, it is important to involve your broker or insurance advisor as early in the process as possible, so they can help you assess the potential impact of your contractual obligations on insurance program design and allow sufficient time for terms to be negotiated.