The impact of rising inflation and insolvency on the construction insurance market

The challenges faced by the construction industry are continuing to grow and insiders wonder when the storm is going to hit. For some, like Probuild, it already has. Rising inflation and the increasing cost of debt, labour shortages, supply chain delays and escalating cost of freight and materials are putting the industry under enormous pressure.

Simultaneously Governments have invested heavily in building and construction to maintain growth in the economy. In 2020 during the pandemic the Federal Government introduced the HomeBuilder scheme which resulted in an influx of work for larger scale domestic builders. In Victoria, the Government has committed significant funds to its ‘big build’ infrastructure program committing billions of dollars to new projects in this year’s state budget.

What happens when contractors enter into fixed price contracts in circumstances where the costs of building are increasing rapidly and there is a significant shortage of labour? There are heightened risks of delay and breaches of contracts because contractors do not have control over the supply of materials or labour. There is significant potential for cost blowouts, projects to be run at a loss and insolvency.     

In this article we look at how these challenges might impact insurers in the construction space.  

What is the impact of these challenges on the construction industry?

In 2019 the average construction time for completing a single detached home was 8.3 months, today, it is more than 12 months[1] The escalating cost of materials has made fixed priced contracts an increasingly risky proposition. A typical domestic builder will aim for a profit margin of between 15 – 25%. Margins are tighter for commercial builders. In 2022 Lendlease’s target EBITDA margin for its construction division is 2 – 3%[2]  With the blowout in construction costs and labour shortages, profit margins will continue to be squeezed.

In researching for this article, we spoke to a Melbourne domestic builder who shared correspondence he had recently received from suppliers. A glass supplier explained their pricing had increased 30% before Christmas and was to be increased again at the end of April 2022 by a further 20%. A specialist window supplier advised of the increased cost of materials it used in the manufacture of its products which included an increase of 50 – 59% in the price of Aluminium over 12 – 18 months, an increase in 38 – 46% on hardware in 12 – 18 months and an increase of 62 – 69% in the cost of glass over the same period. In the same vein, a timber supplier explained that their pricing would increase from 1 July 2022 to absorb supply cost increases of between 10 and 40%. This increase was explained as being the result of a number of contributing factors including tariff, changes to freight and country of origin.

In addition to the increased costs of supply, contractors are facing ongoing supply chain delays. Supply chain issues are typically multifaced and unlikely to be easily resolved. Take copper and timber as examples. Copper is used extensively in construction for uses such as hydraulic pipework systems, electrical cabling and heating and cooling systems. Analysts forecast that by 2030, global demand for copper will outstrip supply by more than six million tonnes[3] Copper is also used extensively in the renewable energy sector including in the production of electric vehicles, wind turbines and solar panels. Demand in this sector will only continue to grow. The likelihood is that the price of copper will continue to rise and the shortage in supply will last for years. Similarly, a shortage in timber has created a huge headache for the building industry. The cost of framing timber started at $3.20 per metre in January 2021 and went up 150% in 8 months, selling at $8 per metre by November 2021[4] Again the reason for the shortage and increased cost is multi-faceted. There has been a shortage in supply due to fire destroying pine plantations across Australia, the US and South America[5] In addition, NSW and Queensland have suffered timber losses due to floods.

Both the Ukraine and Russia are global suppliers of key materials used in construction including copper and timber, as well as bitumen, aluminium and iron ore[6] The ongoing war, together with the sanctions imposed on Russia are also contributing to the shortfall in supplies.

Labour shortages are also having a significant impact on the construction industry. Trades are in demand and demand is outstripping supply. The floods in NSW and Queensland have meant that there has been a significant jump in demand for trades in those states. In the current environment there is an increased risk that contractors will fall behind in their programme not only due to their own labour shortages but because their sub-contractors are also stretched and cannot keep up with the demand for their services.

On the plus side, there continues to be significant investment by governments in construction, which should equate to growth in both the commercial and domestic construction markets. Despite the challenges facing the industry, competition remains strong. The competitive pricing of tenders for building contracts and professional services is likely to continue to be a challenge for the foreseeable future. In the current climate there is a very fine line between hitting that sweet spot of a competitive price and being the successful tenderer whilst ensuring a sufficient buffer to withstand price escalation and remain profitable.

The risk of insolvency on the PI insurance market

In February 2022 Probuild collapsed after its South African parent withdrew its financial support. Gold Coast builder Condev collapsed a month later. It is likely more will follow as inflation continues to rise and supply chain issues continue, unabated. Insolvency not only leaves developers, property owners and employees in the lurch but it leaves sub-contractors and suppliers out of pocket. Where defect claims are concerned, warranty insurers and professional indemnity insurers will be left to resolve matters and pay out, with the builder absent from any litigation and settlement discussions. Whilst proportionate liability provisions in some states may assist, in practical terms the attention will be on the insured defendants.

Contractor insolvency will lead principals and liquidators to look at ways to claw back funds. There will likely be a focus on accountants who have prepared and signed off on financial statements which builders are required to submit to obtain Builders Warranty Insurance. Did the accountant overlook signs of insolvency?

Similarly, there will be focus on contract administrators. Have contractor progress claims been approved prematurely or incorrectly? Were the works in fact progressed to the stage claimed by the Contractor prior to their insolvency? Is there sufficient capital left in the contract to complete the works? Have architects or project managers carrying out regular inspections of building works failed to detect any non-compliant works? Insolvency of contractors brings additional risk to those involved in these aspects of the building process.

Lawyers advising owners and developers will also face additional scrutiny and potentially claims. Did the lawyer carry out any or adequate due diligence on the builder/contractor before the building contract was entered into? Did they ensure as much as possible that the terms of the building contract were adequate to protect the owner/developer in the event of the builder/contractor becoming insolvent, mid project? What type of building contract was entered into? Was the owner/developer warned of the particular risks inherent with that type of building contract in the current market? Were the progress payments under the contract adequately aligned to the construction stages to avoid the owner paying too much to the builder, too early in the construction?

The effect of claims inflation

Whilst inflation and the cost of supplies continues to rise Insurers need to be mindful of claim reserves. Australia’s residential construction costs increased 9% over the 12 months to March, which is the highest annual growth rate since 2001[7] Rectification works carried out now compared with 12 months ago are likely to cost at least 10% more. Quotes for carrying out rectification works are likely to become outdated quickly so inflation needs to be factored into reserving. 

Rising inflation and construction costs may also impact policy limits. The lifespan of claims can vary so much. It is the long tail claims that drag on over years that pose the greatest risk to Insurers and Insureds in the current environment. Insurers need to monitor the quantum of claims and policy limits. Is the quantum of a claim approaching the policy limit? In this situation Insurers need to cognisant of the real potential for policy limits to be exceeded, as a claim drags on exposing an insured to uninsured loss which may have been avoided if the claim was resolved earlier in the life of the claim.  Questions of the insurer’s duty of utmost good faith in managing the claim may come under scrutiny.        

What can insurers do to try and limit their claims exposures?

In the current market, with higher risks of insolvency and the increasing cost of claims, where possible, and while it is trite to say, Insurers should try to settle claims as soon as they can. Oftentimes in negotiating a resolution of building and construction disputes, settling a claim early can carry a premium. In the current environment it is likely that premium is worth paying. Remember, settlements buy certainty and presently, there is value in certainty. 

When assessing claims, factor in the insolvency risk of other wrongdoers/defendants. Is there the potential for a party to become insolvent? Consider this risk when negotiating the settlement of claims and the joinder of parties to a proceeding.

The increased cost of construction means that it will cost more money to resolve building claims. Factor inflation and increasing construction costs into your claim reserves. Does the claim have the potential to be drawn out? If so, factor that into your reserving. Whereas 12 months ago you might have set a claim reserve of $x, now you might consider setting a serve of $x plus 20%.

Where excesses are cost inclusive, obtain payment of the excess promptly once claim costs are being incurred. Settlements can become more challenging where an insured has become insolvent and not paid their excess. Whilst the excess is an uninsured loss to the claimant that is unrecoverable, the practical reality of this situation is that insurers can be forced to agree to pay the excess amount to get a settlement over the line.