Despite a strong construction market, contractors today are almost universally experiencing five sources of pain. We describe some of those sources and give our suggestions for how to alleviate that pain.
1. Use contract terms to address Inflation and supply chain
Inflation and supply chain challenges are inflicting pain that contractors haven't seen since the 1970s. Existing contract terms simply don't address these issues, and we recommend that you structure bids and contracts to address these issues proactively with owners — especially on projects with extended durations. Some possible approaches include:
- Use allowance prices for specific commodities or items.
- Negotiate early payment terms for shipping and storage costs, so that costs can be locked in at the time of contracting. Owners may balk because earlier payment comes at the expense of larger financing costs. Without such clauses, however, owners will still pay, because contractors will need to build material escalation premiums into their bids.
Early payment is also a particularly effective way to address supply chain issues. Even if the material comes in late, it may not affect the progress of the work, because you ordered it earlier than needed.
In a variation of the above, identify specific long-lead items and agree to an early purchase of those items when possible, both to avoid inflation and to address supply chain issues. - Index all or part of the cost of the work. There are several popular indexes, such as the ENR Construction Cost and Building Cost Indices, and any contract clause allowing for price indexing should specify the index used.
Argentina has suffered significant inflation over the last 20 years, and it's common for contracts there to contain provisions adjusting the contract price over the course of the project for actual inflation.* - Negotiate risk-sharing terms on inflation. These terms could specify that the owner agree to price increase for inflation-related costs either up to a threshold or beyond a threshold.
In contacts priced on the cost of work (COW), the COW sections will need be rewritten to incorporate the new reality contractors are facing.
For example, most such provisions allow payment for lump-sum subcontracts as part of the COW. When price escalation was predictable, subcontractors could incorporate relatively small risk premiums into their lump-sum pricing to account for expected inflation and normal market variations. In the current market, however, the risk premiums need to be much higher to account for both overall inflation and unpredictable price surges.
Rather than pay a risk premium for price surges that may not occur, the COW provisions should be rewritten to allow for price adjustments in subcontracts based on actual price increases. This provision is similar to a differing site conditions clause, which allows for price adjustments based on differences in actual site conditions instead of making a contractor build a risk premium into the contract for the possibility of a differing site condition.
As with lump-sum pricing, guaranteed maximum price GMP amendments will need to incorporate flexibility for overall inflation and price surges in critical commodities.
Another issue to consider is over-reliance on certain suppliers who cannot deliver because of war, COVID-19 shutdowns, prime material shortages, etc.
In short, contractors need to be forward looking when it comes to securing proper supply channels and need to consider having several sources for any given material. At the same time, owners need to consider contributing to the solution by sharing some of the risk of both supply chain issues and price escalation.
2. Manage the labor shortage
Construction is a services business, and contractors are facing multiple issues. First, many skilled workers are retiring, and younger workers are not replacing them. This trend results in labor shortfalls and leads to significant wage and benefit pressures.
In the absence of societal changes that will bring more people into the workforce, contractors need to look increasingly to management and technology to increase productivity. One example is the use of trackers on the job site to see where people are actually working. We recently heard of one contractor who used trackers to plot out the actual movement of its workers on the job site. Based on this study, the findings saved more than $100,000 just by moving the porta-potties daily to be closer to where the workers were working.
On the management side, an increasingly competitive job market coupled with candidates with no real project knowledge impacts overall productivity. For example, many new scheduling professionals don't understand how construction projects work, but are great at data entry. Because these scheduling professionals don't understand project pressures or construction sequences, our clients are finding schedules that have incorrect durations and sequencing, which leads to trade stacking, bad workflow, etc., all of which cause poor productivity.
The only way to address this issue is to spend more time on training and making sure your managers get the experience they need. For example, instead of having a team of schedulers sitting in a computer room at the home office scheduling multiple projects, make each scheduler spend a week each month on the job site to learn how the process works.
These issues are compounded with the twin problems of overexpansion — taking on too much work — and overreaching into areas of construction in which firms have little experience. Whenever a contractor enters a new market — whether geographical or type of work such as solar or government work — the contractor is more likely to be on the bleeding edge than the leading edge.
3. Get the right construction coverage
Coverage is obviously Gallagher's area of expertise, but getting the right coverage really does require a conversation regarding your business and the individual projects we're working with you to insure.
The best example involves procurement of proper Builders Risk insurance to fit potential failures. Builders Risk policies come with many endorsements to cover potential risks and sublimits. Getting the right policy for each project requires an understanding of the project and the project needs.
For example, if the project has a fixed deadline — such as a school that must be ready for the first day of class — then you will need greater limits on expediting expense. We also recommend adding time to the construction schedule, so there will be no need to extend the builders risk coverage.
Some key coverages to consider:
- Extra expense
- Soft costs
- Delay in completion
- Debris removal
- Professional services
- Claim preparation
- Exclusions for mold, faulty workmanship, water intrusion and earth movement
4. Adjust terms and conditions for the new reality
Older contract terms don't necessarily address the risks found in today's market. For example, many force majeure clauses drafted before March 2020 don't include a pandemic as a source of excusable delay. Of course, the impacts were not so much caused by the disease as by the changes in law that occurred because of the disease — such as government lockdowns and new safety protocols. Contract terms need to be adjusted for the new reality.
The other major impact of COVID-19 was to accelerate and exacerbate earlier trends involving labor and supply issues. Contract terms need to be updated to share the risk of those items more fairly, and some key issues to review are:
- Limitations of liability
- Liquidated damages and appropriate caps on those damages
- Waivers of consequential damages
- Change order rights to reflect time and cost impacts of inflation and material shortages
- Notice and claim provisions
- Relief for changes in law
Outside of the direct contract, contractors must have a better understanding of some ancillary agreements, such as those relating to site access. Of particular importance are consent agreements from lenders. Many contracts require contractors to modify their agreements based on lender requirements, and those terms must be carefully worded to allow the contactor to avoid terms that will increase the contractor's risk, as we are finding the lenders are trying to impose more onerous and aggressive terms.
5. Encourage a healthy subcontractor market
All good prime contractors should admit they are only as good as their subcontractors. While the temptation is to push all the risk onto the subs, we need healthy subcontractors who not only can do the work, but can also finance it through payment cycles. We are seeing cases in the New York market where contractors and subcontractors are refusing to bid work unless owners — including public owners — improve payment terms to bolster subcontractor capacity.
During the 2008 financial crisis, we saw many smaller subs go out of business. This loss was not only a tragedy for those firms and their people, but it became a problem a few years later when work rebounded and no one was available to do the work.
Due to the unprecedented challenges we now face, all parties must work together to mitigate the impact of price and labor shortages with an eye on the long-term benefits of keeping a healthy subcontractor market.
At Gallagher, we can help by educating and providing real-time operational suggestions to our clients. We have the knowledge in-house to help guide our clients through this challenging time.
Because of the highly nuanced nature of this market, it's imperative that you work with an insurance broker who specializes in your particular industry or line of coverage. Due to the variability that we're seeing in this market and specific account characteristics, your individual situation may vary from others. Gallagher has a vast network of construction insurance experts who understand the construction industry and business, along with the best solutions available in the marketplace for your specific challenges.
