Rising construction costs pose major insurance challenges—especially in catastrophe season

Property damage losses and construction liability costs can deliver a potential blow to insureds and the construction industry as the 2021 catastrophe season develops.



By Ryan Matcham, CPCU, AU, Director, Global Property Claims and Matthew O. Kovacs, Esq., Manager, Construction Claims

While COVID-19’s financial impact on property insurance underwriters appears to have been quite limited, it still has the potential to deliver a major blow to insureds and the industry as the 2021 catastrophe (cat) season develops, impacting the cost of first-party property damage losses as well as third-party construction liability costs. This article discusses certain general precautions that carriers and insureds can take now to help protect themselves.

The construction cost overhang of COVID-19

Let’s start by rewinding to the spring of 2020. As COVID-19 began to impact the global economy, virtually all industries felt the effects. Construction in particular was heavily hit. Many planned government, commercial, and residential projects were either postponed or cancelled.

"While COVID-19’s financial impact on property insurance underwriters appears to have been quite limited, it still has the potential to deliver a major blow to insureds and the industry."

 

According to Dodge Data & Analytics, new projects plunged to a level 22 percent below the first half of 2019. Commercial and multifamily construction projects in the top 20 US metropolitan areas posted a similar drop of 22 percent through the first six months of 2020.

The impacts were still being felt in June 2021 as higher material prices and supply chain issues, combined with the lack of skilled labor and continued COVID-related safety measures, had a direct and notable influence on residential and commercial construction activity. While the situation is expected to improve, the impacts will almost certainly be felt into 2022—and possibly even beyond.1

"This era of pricing uncertainty spotlights the importance of building strong relationships in the construction-related insurance ecosystem."

 

Due to the 2020 shutdown of many raw material supply plants who are now still playing catch-up, contractors are reporting an inability to secure materials on time, leading to bottlenecks, significant delays on projects, reduction in labor productivity rates, and material price escalations.

Impacts on claims costs are already significant

Over the past 12 months, prices for construction materials have experienced heavy inflationary pressures due to increases in demand (including increased do-it-yourself demand) along with constraints on the supply chain. While lumber prices have declined since May 2021 when they reached 400 percent of those a year before,2 that does not mean we are out of the woods. New proprietary data from Engle Martin & Associates show that lumber and many other commodities remain higher than 12 months prior; and if there are significant price drops, we could see lead times become even more of an issue. Contractors may want to plan the rest of their purchasing year, meaning significant orders may be placed, potentially leading to resources being further stretched.

Moreover, the impending hurricane season raises new concerns that may compound this problem. The 2021 hurricane season is predicted to be busier than average, with forecasts of 13 to 20 named storms, including six to ten hurricanes and three to five major hurricanes. These figures are above the 30-year average of 14 named storms, seven hurricanes, and three major hurricanes, and we have yet to factor in for other unknown events.3

If we were to go by the damage from Winter Storm Uri in February 2021, which is currently calculated at $10 billion to $20 billion,4 we can assume that the increased cost of building materials will continue to lead to drastically higher construction and reconstruction costs for the rest of 2021 and quite possibly into 2022.

We are also in the midst of an expanding workforce crisis. According to second quarter data from the US Chamber of Commerce Commercial Construction Index, finding skilled labor continues to be a challenge for most contractors, with the majority reporting difficulty engaging the experienced and skilled labor force that is required to do the jobs right.5

The supply and demand disruptions already discussed will also pose a heightened risk of additional business interruption claims due to the extra costs associated with time delays.

It remains to be seen how this combination of factors will affect pricing accuracy for property and liability insurers.

Increasing complexity of claims resolution—including liability costs

Increasing costs may also add another layer of complexity to claim resolution. Stakeholders at every level of the claim—claimant, insured, and carrier—may be speculating about the right cost to resolve a claim, since they have less confidence in pricing accuracy. This speculation may effectively ensure that the premium originally bargained for is likely to be incommensurate with the risk ultimately being taken on by insurers.

"Supply and demand disruptions will pose a heightened risk of additional business interruption claims due to the extra costs associated with time delays."

 

This lack of confidence may also create accelerated timetables for claim response, driven by both consumers and carriers. To protect their reputations and avoid undue inflation in the value of a claim, carriers may be inclined to push for speedy resolution versus completing a thorough review that might ultimately entail investigations of liability defenses and/or risk transfer options.

Sophisticated contractors—both large commercial and large custom residential—may guard against some of the inflationary risk by including contractual price escalation terms or schedules. However, a large percentage of claims typically come in without contracts between the parties; and the absence of a contractually agreed-on parachute can often lead to tension between contractors as they attempt to account for increases in cost.

In addition, increasing material costs put pressure on contractors to try to save money elsewhere, potentially through prime or general contractors’ increased use of unskilled labor. This may create downstream risks and increase the likelihood of future claims—whether due to worksite injury, ongoing operations, or defect.

Broader implications for both carriers and insureds

As project coordinators attempt to save money on the margins of projects, there is a real risk that the growth of capacity within both property and liability insurance will point to premium reduction as an opportunity for savings. However, such short-term savings could come with catastrophic impacts as claims are presented. Because of the increased cost of construction, we’re already seeing projects with insufficient coverage, highlighting how imperative it is that underwriters are accurately modeling and pricing the risk.

There is also potentially a trickle-down effect as carriers become increasingly protective of loss runs. Even in the early stages of the emerging situation, we’re seeing examples of first-party carriers entirely skipping out on their obligations while pointing the finger straight at potentially implicated third-party liability carriers. This starts off the claim resolution process on the wrong foot, as it builds delay into the early stages of the claim and skews the expectations of every stakeholder. Perhaps most troubling is that we’re seeing some agents encourage this behavior because of the perceived difficulty of remarketing an account with an open or paid claim.

"Because of the increased cost of construction, we’re already seeing projects with insufficient coverage, highlighting how imperative it is that underwriters are accurately modeling and pricing the risk."

 

Risk transfer between carriers has also become more complicated as carriers put up barriers to participation in the claims process. The demand for a quick resolution in the face of increasing costs pressurizes the claims handling process—especially for liability carriers.

There are a number of precautions carriers and insureds should be taking to protect themselves against these potential consequences. Good contracts are perhaps the most important protective measure on the contractor side. But in particular, this era of pricing uncertainty also spotlights the importance of building strong relationships in the construction-related insurance ecosystem. As increasingly complex claims emerge in the wake of COVID-19 and its aftereffects, trust is essential in order to facilitate a world-class claims handling experience. And ultimately, to permit honest evaluation, proper placement, and pricing of risks, there must be trust between stakeholders at every level.

1 “Total Construction Falls in May as Housing Stumbles,” Dodge Data and Analytics, June 16, 2021, construction.com/news/Total-Construction-Falls-in-May-as-Housing-Stumbles.
2 Isabelle Lee. “Lumber prices are cooling after rallying over 400% in 12 months,” Business Insider, June 30, 2021, msn.com/en-us/money/markets/ lumber-prices-are-cooling-after-rallying-over-400-in-12-months-here-is-where-4-experts-say-the-red-hot-commodity-goes-from-here/ar-AALeMa6.
3 Weather.com meteorlogists, “Hurricane Season Expected to Be Busier Than Average,” June 1, 2021, weather.com/storms/hurricane/ news/2021-05-20-atlantic-hurricane-season-2021-outlook-noaa-twc-may.
4 “Winter Storm Uri Losses in Texas Expected in $10B-$20B Range,” Insurance Journal, March 1, 2021, insurancejournal.com/news/ southcentral/2021/03/01/603269.htm.
5 US Chamber of Commerce, US Chamber of Commerce Construction Index, Q2 2021, June 17, 2021, uschamber.com/report/us-chamber-of-commerce-commercial-construction-index-q2-2021.