Inflation puts construction wordings to the test

Wordings developed by Zurich Insurance Company and Swiss Re, both in their respective areas of insurance and re-insurance provide an efficient and equitable way to address inflation risks for construction all-risk insurance coverages, Matia Cazzaniga and Jimmy Keime write.

Inflation in the construction industry skyrocketed in 2022, with a sharp increase in the cost of key building materials, as well as energy, transport and labour. Construction inflation in mature economies was around 14% ("US construction costs will increase by 14% by end of 2022 - Global Construction Review) last year, although this average hides some dramatic increases. At one point, timber prices jumped 500% ("Inflation: The impact on the construction sector | Marsh) in 2022.

Large construction projects are extremely sensitive to unexpected spikes in inflation, which can result in significant increases in costs. This is a particular problem for construction all-risk insurance, where terms and conditions, extensions’ sub-limits and sums insured are established at the outset, and where a single policy runs for the lifespan of a project.

Even at the best of times, predicting inflation for the duration of a long-running construction project is close to impossible, let alone in an inflationary environment and with the current complex global geopolitical situation. Yet, despite the volatility of the past year, most construction all-risk insurance policies continue to lack an effective mechanism to address inflation risk.

Risks for policyholders and insurers

Periods of high inflation create a risk of under-insurance for construction policyholders, where sums insured and sub-limits are eroded by the compounding effect of price increases.

For insurers, inflation poses a significant risk of underpricing, as claims inflation can outpace the ability of insurers to adjust terms and rating, especially where valuations are not updated regularly. In addition, inflation can squeeze contractors’ margins, which can threaten the quality of construction work and lead to a higher risk of claims for insurers, especially at a time when skilled labour is in short supply.

Wordings put to the test

The construction all-risk wordings currently used in the market were not, however, designed for a high inflationary environment. As a result, wordings do not sufficiently protect insureds from under-insurance, neither do they provide contract certainty, an undesirable situation for both insurers and policyholders bound in close partnerships and multi-year contracts.

The historical use of under-insurance clauses by insurers to limit their exposure to inflation is also not an ideal option for construction risks, as such wordings are often difficult to define. Yet, in the absence of adequate protection, insurers would need to reflect inflation risks in their pricing, unnecessarily raising the cost of insurance.

Standard escalation clauses developed in the 1980’s, or the amended versions included in manuscript wordings, also do not fully meet insureds’ needs as they do not address the effect of inflation on sub-limits. Furthermore, a fixed percentage escalation margin on the Total Contract Value provides only a small buffer that could be easily exhausted by a few years of high inflation with most escalation clauses seen in the market lacking clarity on possible consequences when the limit is exceeded and insurers are not timely informed.

Index solutions

The good news is that index-based wording solutions are available that share the risks of inflation between contractors and their insurers.

Zurich Insurance and reinsurer Swiss Re have worked together on new clauses that provide insureds with automatic protection against increased costs in case of a loss, providing a margin of flexibility for insured values, sub-limits, deductibles and Delay in Start-Up (DSU) coverage - within pre-agreed ranges. These voluntary clauses, which can be adopted and/or adapted by insurers and brokers if needed, may be a good starting point for discussions on how to address the impact of inflation on all-risk coverages.

Material damage indexation clause

Although not currently widely used in construction insurance, indexation clauses offer an efficient way to manage inflation risk for material damage coverages. Indexation clauses help to protect the insured by increasing policy limit and sub-limits according to a third-party construction inflation index. They also protect the insurer by indexing the deductible with the same index, and remove the need for an underwriter to charge for the full inflation risk.

Key to the effectiveness of these clauses is the use of a consistently updated index – from an independent and trusted third party – that is matched as closely as possible to the underlying risk, such as the construction cost index of a public national statistics body. It is also important to make the calculation based on the date of settlement of the loss, rather than the date of loss, to better align with the actual repair cost.

DSU solution volatility clause

The volatility clause drafted jointly by Zurich and Swiss Re includes a pre-agreed percentage margin on monthly maximum declared values for Delay in Start Up (DSU) coverage, which is particularly relevant for projects linked to volatile commodities or goods whose gross profit sale price or fixed costs are affected by high inflation.

Including granular information on DSU sum insured on a monthly basis, and granting an additional percentage margin, provides comfort to contractors that could face price volatility when DSU coverage parameters, such as the agreed time-excess and indemnity period, remain unchanged. The clause will also provide certainty for the actual loss sustained on a monthly basis and on delays which are shorter than the full insured period.

A problem shared

Construction project business insurance forms a unique bond between insurer and the insured, which is more akin to a partnership than to a vendor-customer relationship. As such, it is in the interest of all parties – including those in the wider construction value chain – to find an equitable solution to the risks of high inflation in the context of insured loss.

Originally published in Commercial Risk on 31.01.2023