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Five Insurance Considerations for Managing Cost Escalation

Understanding and Managing Cost Escalation_NA Construction

Part Three in a Series on Controlling Construction Risk

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The most common form of escalation familiar to Risk Managers is the rising cost of insurance. Project specific policies give the benefit, typically, of fixing rates through the duration of the project, however are often more expensive and can carry additional limitations, like a limited completed operations period. Most contractors and subcontractors will find their most favorable rates, terms and conditions in their main insurance programs.  Since many projects will span multiple policy periods, a renewal premium increase can result in cost escalation. This is primarily a concern on fixed price contracts.

General Contractors and Construction Managers are also susceptible to the increased cost necessary for a subcontractor to meet minimum insurance requirements. The most common example of this is requiring a subcontractor to carry a higher limit of liability than they currently purchase. Often a subcontractor will quote the cost for a company-wide excess policy, as excess policies are typically not adjustable. It is important to ensure that any subcontractor bids include the cost of complying with minimum insurance requirements of the contract. If yor insurance requirements are included in the bid documents, it may seem intuitive to require the subcontractor to incur the additional cost at their own expense, however when faced with the prospect of using a significantly more expensive bidder, it rarely works out this way.

  1. Builders Risk - Builders Risk policies are designed to cover damage to the construction project, and to a certain extent, the materials. The final premium on these policies is subject to audit and therefore may be impacted by material price escalation.
  2. Ocean Cargo - Ocean Cargo policies are purchased to provide certain coverage on materials while they are being transported across the ocean.  This is an important coverage to consider when purchasing foreign material. Suppliers will often carry their own policies, which may or may not be adequate, regardless of responsibility.  Reviewing any agreements to see at what point responsibility for transported goods is transferred is crucial. 
  3. General Liability / Workers Compensation - When considering General Liability and Workers Compensation premiums, it should be noted that additional wages and bonuses to attract skilled labor during shortage may be subject to rating at audit.  This risk is compounded for those whose General Liability policies are rated based on Contract Value (CV) instead of payroll.  In this case, it is not merely the additional labor costs that can impact the final premium but additional materials costs as well.
  4. Surety Bonds - Surety Bond premiums are adjustable at substantial completion.  This is of concern, not only on subcontractor bonds, but on a bond provided to a project owner by the General Contractor or Construction Manager.  The bond penalty amount is a concern as well. The bond penalty will not provide for unanticipated costs.  The Penalty is a fixed amount, usually 100% of the contract amount. Escalation costs may increase the potential loss in the event of a default, as well as the premium, however the penal sum does not increase. 
  5. Subcontractor Default Insurance - Cost Escalation should be considered during a subcontractor’s prequalification.  The “Single Project Limit” assigned to a subcontractor by an SDI insured may be exceeded by increasing costs. The assigned “Aggregate Limit” for all projects may be eroded.  It is important to consider if the construction firm has a method of communicating escalation to the team that manages these prequalification limits.

Conclusion

The changes, good and bad, in the domestic and global economies have had far-reaching ripple effects throughout the construction industry and one of the most concerning impacts is the risk of Cost Escalation.  These unanticipated changes in costs can occur at any point, pre-construction, course of construction and post-construction.  The costs of labor, materials and even overhead can all be affected.  The one area where no one wants to see a reduction is profit. Regardless of a construction firm’s risk management philosophy, awareness and pro-activity are the best weapons to ensure a profitable project and therefore a profitable company.


This is the final article in a series on rising construction costs. Read the first two articles:

Part 1: Seven Issues that Boost Contractors' Costs
Part 2: Seven Ways Contractors Can Manage Cost Escalation Risk

OR DOWNLOAD THE COMPLETE WHITEPAPER HERE


About the authors

Daniel Tolman is a Vice President at the Willis North America Construction Practice and one of the National Market Experts of their Default Insurance Group (DIG).

Cheri Hanes is a Construction Risk Engineer with XL Group’s North America Construction team. She holds both LEED AP and CRIS certifications.

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