Jane Warring | Zelle
With interest rates on the rise, sticky inflation, few signs of a cooling labor market, and continued instability in Russia, China and beyond affecting energy prices and exports, the builder’s risk insurance industry is in store for more complex claims in 2023.
Builder’s risk insurance may be purchased by owners and contractors to insure against physical loss or damage to a project during construction. This type of insurance can include coverage for hard costs, soft costs and time element loss — lost income or rent due to physical loss or damage.
Hard costs, or repair costs, may be relatively easy to calculate depending on the scope of damage. Soft costs, on the other hand, can be more complicated and often include a variety of expenses associated with project delay, such as additional taxes; architect, engineer or consultant fees; permitting costs; insurance premiums; and interest on construction loans.
The policy language drives whether and to what extent soft costs will be insured. Project administrative costs, extended general conditions or management fees paid to a related entity may or may not be insured. Soft costs, as well as lost income or lost rent calculations, require the parties to determine the appropriate delay period, which in turn can require expert analysis.
So what can we expect in 2023 given the current economic and trade environment?
First, loan costs will comprise an even larger portion of builder’s risk claims.
Construction delays frequently cause increased interest expense, but with rising interest rates, such costs are growing. We expect to see claims for further downstream impacts such as claims for higher interest rates on variable rate loans or higher rates on permanent financing. A four-month delay between July and November 2022 is the difference of over 2 percentage points at prime.
The new landscape may also complicate refinancing arrangements that further slow completion of construction or drive indirect effects on project capitalization.
This was the situation in Indianapolis Airport Authority v. Travelers Property Casualty Co. of America, where the court held that bond interest paid from a capitalized account instead of revenue constituted a “soft cost” because the unanticipated draw-down left the insured with less money to spend on other endeavors.[1] This was despite the fact that the total interest paid did not exceed the budget. Creative financial solutions to deal with rising rates may lead to creative arguments from policyholders.
Second, labor and materials volatility will continue complicating project scheduling in 2023.
All builder’s risk claims involve a large degree of forecasting. Indeed, most of the time, the repair period is not coextensive with the delay period. The repair period can be shorter than the delay period, such as when a subcontractor leaves a job during repairs to take other work and is not available when the repairs are complete. The repair period can be longer than the delay period, such as when the contractor is able to resequence the work to avoid some or all of the loss-related delay.
In calculating the appropriate delay period, the parties must examine whether the existing construction schedule was reasonable. Project schedules have required frequent adjustment recently due to supply chain issues and labor shortages. When thousands or millions of dollars of insurance delay damages are on the line, any subjectivity in forecasting the “but for” date of completion can lead to disputes.
Third, a variety of externalities will increase the risk to both insurers and insureds.
An externality is an event or condition that affects the project schedule or conditions of the project itself unrelated to the loss event. Determining whether the policyholder or the insurer bears the risk of an externality is a key issue in builder’s risk claims. Unforeseen costs beyond the insured’s control and directed at effectuating repairs are typically insured risks. However, additional costs to complete work on undamaged portions of the project are born by the insured.
Rising interest rates’ effect on pricing is sure to challenge project budgets prepared before the interest rate hikes started. Moreover, the threat of a looming recession, if it were to materialize, may degrade demand characteristics for a project. Heightened consideration of externalities is likely to persist in builder’s risk claims through 2023.
Fourth, in a period of volatility both from a construction scheduling perspective and loss exposure perspective, it may be more difficult for the parties to judge whether expediting costs will ultimately result in a reduction in the delay damages. Spending $1 million to expedite repairs to one portion of the project may have no effect on the final completion date if other portions of the project are delayed due to material shortages.
Policy language may affect this analysis. Pure extra expense provisions or expense to reduce loss provisions may limit insurance recovery to the amount by which income loss was actually reduced. Other provisions may reimburse for expediting costs or other extra expenses if they were directed at reducing the loss.
Finally, we may see more frequent or more contentious litigation over builder’s risk claims in the coming year. Indeed, gaps in coverage and the application of exclusions can lead to coverage disputes, particularly in challenging financial times.
Building industry reports indicate that the U.S. has a housing deficit at the same time major builders are scaling back new home construction in the face of falling prices due to higher interest rates. A long-term recession could cause the construction industry to shift to less expensive multifamily builds. Some suggest vacant office space is also ripe for residential conversion. More construction, longer construction periods and complicated conversions likely spell more builder’s risk claims.
Meanwhile, sources estimate the need for millions of new workers to meet construction demands in the coming years.[2] The industry is offering higher wages to fill positions.[3] This may mean the entry of newcomers and an increase in errors. While most builder’s risk policies exclude the cost of correcting faulty workmanship, many have exceptions for ensuing loss — when the excluded peril causes a separate ensuing loss that results in damage to other property.
Moreover, exclusions for loss caused by cessation of work or interruption of operations may become applicable as work is paused due to financial issue or increased lead times. The industry saw this during COVID-19 when job sites were abruptly shut down.
The expectation of continued inflation means contractors are pre-purchasing materials and storing them off-site for longer periods of time. Builder’s risk policies generally insure materials temporarily off site. This could be another area where we see more disputes due to a lack of appropriate coverage for this longer-term storage.
In summary, the builder’s risk industry will continue to encounter challenging and unique issues in measuring delay claims in 2023.
[1] Indianapolis Airport Auth. v. Travelers Prop. Cas. Co. of Am. , 849 F.3d 355 (7th Cir. 2017).
[2] CRC Group – https://www.crcgroup.com/Tools-Intel/post/carriers-shift-more-risk-onto-builders-for-multi-family-frame-projects; McKinsey – https://www.mckinsey.com/industries/public-and-social-sector/our-insights/will-a-labor-crunch-derail-plans-to-upgrade-us-infrastructure.
[3] https://www.wtwco.com/en-US/Insights/2022/12/insurance-marketplace-realities-2023-construction.
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