Take a Proactive Approach to Risks

BY GLEN MACRAE AND PATRICK RUSSELL

Inflationary pressures have heavily impacted the construction industry, and it is increasingly challenging to complete projects on time and on budget. Now more than ever, it is critical for project owners and contractors to leverage risk management tools and strategies to successfully complete projects. Surety bonds and insurance are two effective tools for managing risk and should be a core part of a sound project risk management strategy.

One recent example provides a good illustration of how quickly project costs, both direct and indirect, can escalate. At the bid stage, a 40 foot shipping container from Asia to the West Coast of Canada was estimated to cost $2,400. By the time the contract had been finalized and the contractor was mobilizing on site and ordering materials, the cost of shipping containers had skyrocketed to more than $18,000 — a 750 per cent increase inside of six months. Additionally, rising interest rates significantly increased inventory carrying costs over the same period and the contractor was forced to absorb a significant portion of the cost increases, which had a devastating impact on their bottom line. While this case is a bit of an extreme example that was exacerbated by global supply chain challenges at the time, it does highlight the importance of taking a proactive approach to managing cost escalation risks.

Some practical strategies to mitigate upward cost pressure due to inflation include:

• Recalibrate your assumptions and allow for higher and unanticipated cost increases when building out project budgets.

• Use hedging strategies such as forward/futures contracts for commodity-linked inputs and taking advance deposits to secure pricing and availability of critical project equipment/components that is not manufactured domestically.

• Ask for evidence of bonding capacity or prequalification letters from subtrades and suppliers to ensure they are experienced and have a track record of delivering projects on time and on budget.

• Obtain bonds from as many subtrades and suppliers as possible. Bonds help mitigate both the financial and timeline impact of a subcontractor default.

Surety bonds, more commonly referred to as “bonds” or “bonding,” are strong tools for mitigating contract default risk due to inflationary pressure. Bonds are unique instruments issued by insurance companies (sureties) on behalf of contractors that act as financial guarantees in the event of a contract default. Bonding a contract creates a stronger commitment and obligation to complete a project as prescribed in the contract, both in terms of cost and timelines. Practically speaking, bonds transfer the risk of cost escalation to the contractor that supplies the bond, create greater accountability, and provide assurance that defaults will be remedied, either by the contractor or surety.

Inflation can also be an issue with insurance. Most construction contracts are bound by the insurance requirements in CCDC 41 — Insurance Requirements that stipulates that project property insurance must be covered for 110 per cent of the contract price. For a decade or more, this never posed a problem as the cost of builders risk or course of construction insurance, as it is known, was relatively inexpensive. But decades of those low rates and premium levels made project insurance unprofitable for most insurance companies. As investors sought better rates of return, money left the insurance marketplace looking for greener fields. Insurance companies needed to increase premiums and lower their risk by demanding higher policy deductibles. In recent years, some deductibles for residential high-rise buildings have skyrocketed and are now in the range of $250,000 or more. Additionally, some premiums have doubled and even tripled from a few years ago. These changes are due to inflationary pressures on the availability of money that backs insurers’ daily operations.

When inflation increases the costs of labour and materials for a project, the owner or general contractor needs to increase the policy limits. However, finding additional insurance at a reasonable price can be an arduous task due to the reluctance of the insurance industry to insure projects at all but the highest premium and rate levels. Insurance brokers are often challenged to find enough capacity to increase the policy limits, which is driven by an insurer’s internal financial management requirements which can only allot a certain amount of money to insure a project. If the owner needs more insurance, they may need additional insurance companies to subscribe to the insurance policy.

The banks that finance the project, often along with the involvement of quantity surveyors, will be closely monitoring the project budget and will not accept underinsurance. To mitigate these challenges, it is important to work closely with a good insurance broker to monitor the construction project, particularly in terms of time and budget. Construction delays can prolong the work and will drive up the final price, causing a cascade of additional challenges that can take weeks to work through. The closer the contractor or developer works with the broker, the better the cost management for the project will be. Overall, a proactive approach to risk management can help reduce the impact of inflation on the construction industry as a whole.

Glen MacRae is executive vice president, and Patrick Russell is vice president, surtey at Wilson M. Beck Insurance Services Inc.