The cost of renovating and repairing buildings has increased substantially. In light of this, Sherrie Morton, AXA XL’s Senior Claims Specialist for Property & Construction, advocates for cost-plus contracts instead of the traditional fixed-cost model.
Over the past 6-12 months, consumers worldwide have experienced steep price rises on virtually all goods and services.
This entrenched, ongoing inflation wasn’t anticipated. In 2020 and 2021, price increases were prevalent, driven by pandemic-related shutdowns, supply chain disruptions, and, to a lesser extent, government stimulus programmes in some countries. However, these pressures were expected to ease in 2022. In fact, at the beginning of the year, the Organization for Economic Cooperation and Development (OECD) predicted that inflation above six percent would be extremely rare in any of its 38 member countries, including Australia. Fast forward to June, when the OECD issued a revised update: average inflation among its member nations is expected to be close to nine percent this year, double the previous forecast.
What is driving this new development? The lingering effects of the pandemic, especially the continued shutdowns in China and, more significantly, Russia’s invasion of Ukraine. Russia is one of the world’s top energy and grain producers, and the sanctions against it have supercharged food, fuel and fertiliser prices. The conflict has also cut off Ukraine’s grain exports—about ten percent of the world’s supply—adding even more upward pressure on food prices, whilst raising the spectre of famine in poorer food-importing nations.
Although the war is having less of an impact on Australia compared to many Western European countries, our current economic conditions are still quite severe, especially considering our recent history. According to the OECD, “Consumer prices rose by 5.1 percent year-on-year in the first quarter of 2022, with underlying inflation reaching 3.7 percent. This is the highest level since before the Global Financial Crisis”. The OECD also notes, “While the direct impact of the war in Ukraine on the Australian economy has been limited, both the war and the recent stringent lockdowns in China have exacerbated the country’s supply-chain issues”.
Constructing, renovating or repairing a building: Expect to pay more
Although food and energy supply and pricing get the lion’s share of the media coverage, costs have risen even more sharply for products and services used in constructing, renovating and repairing buildings; starting with the skyrocketing costs of common building materials. Here is a partial list from the Australian Master Builders Association, showing how much building material prices have shot up in the past year:
• Reinforcing steel: 43%
• Steel beams: 41%
• Structural timber: 39%
• Plywood: 29%
• Electrical cable: 27%
Two factors are behind these increases. The first is pandemic-related logistical hurdles and bottlenecks which curtailed production. The second is dramatically higher shipping costs stemming from scheduling disruptions and port congestion that, in turn, have led to surcharges and increases in demurrage and detention fees.
However, the story doesn’t end there. Two other factors are adding even more stress to building projects: labour shortages and increased demand.
Labour shortages aren’t a new trend; this is something which the construction industry has struggled with for years, as older workers retire and fewer young Australians opt for careers in the building trades. The pandemic made an already difficult situation even worse, as some tradespeople decided not to return to work after the lockdowns ended. Australia’s closed borders has also prevented overseas workers from entering the country for an extended period.
At the same time, consumer demand has never been higher. In Australia—as in other countries—many people spent much of the past two years at home, and since they weren’t socialising or going on holidays, many took advantage of their newfound time and greater disposable income to make home improvements.
Basic economics tells us that prices rise when labour and supplies are constrained in the face of increased demand. Which is why, as we are seeing currently, constructing, renovating or repairing a building is now significantly more expensive.
Fixed-price versus cost-plus contracts
The current environment is especially challenging for one corner of the building industry: contractors working on behalf of property insurers such as AXA XL.
The market standard in Australia, and many other countries, has been to use fixed-price contracts when hiring contractors to repair or rebuild buildings damaged or destroyed by fire, floods, windstorms, etc. The insurer and contractor agree on a price upfront. This allows the contractor to set an exact budget in advance and the insurer to have certainty about the project’s total cost.
The downside to this model is that certainty may come with a price. The contractor assumes the risks associated with a fixed-price, and the price often includes a buffer for unexpected costs arising during the project. Fixed-price contracts also tend to be less flexible for managing changes, since new requirements can lead to price re-negotiations or modifications to the project schedule. Finally, an excessive focus on maintaining a fixed-price may come at the expense of quality, creativity and timeliness. The value of the work can become less important than the price itself.
Notwithstanding its advantages and disadvantages, the fixed-price model has worked well in Australia and other countries and has been, as noted, the market standard for decades.
Nonetheless, I believe the fixed-price model is becoming increasingly untenable; this is based on my experiences over the past year resolving dozens of property damage claims and working with a wide array of building contractors and tradespeople. In my view, fixed-price contracts are less suited to today’s volatile economic environment since adjustments can’t readily be made when material and/or labour costs rise (or fall) significantly during a project. This volatility is further exacerbated by supply chain or contractor availability issues pushing out the project’s timeline.
The solution: cost-plus pricing. With a cost-plus contract, the contractor gets paid for all the project’s expenses plus either an agreed-upon profit, usually defined as a percentage of the contract’s total costs, or a fixed fee.
For contractors, the primary benefit of this model is that it insulates them against rapid and significant cost increases, as we’re currently experiencing. For insurers, the ease of calculation is a primary benefit. Although there are various calculation methods, the standard practice includes the product costs and a profit amount. While the insurer doesn’t require detailed cost estimates to use this model, it will often ask the contractor to set a cap on the maximum possible cost of the project.
Cost-plus pricing ensures that the contractor has the flexibility to adjust its fees, at the insurer’s expense, to cover cost increases. In other words, the insurer, as opposed to the contractor, assumes the risk if costs rise significantly after the work begins.
Now, why would an insurer be advocating for cost-plus contracts? Ultimately, it is because the cost-plus model is in the best interests of our clients. A contractor working under a fixed-cost contract that suddenly sees its expected profits disappear or that the project will generate a loss will naturally start cutting corners or simply walk away. However the contractor responds, the client now must contend with lesser quality work, a longer timeline or both.
Project delays can be especially onerous for some clients. For example, 九色视频insures many aged-care facilities. When any of these buildings are damaged or destroyed, speed is of the essence to lessen not just the financial impacts but also the physical and emotional toll on displaced residents.
Another reason for advocating cost-plus contracts is that if prices go down, insurers reap that benefit (and contractors still receive their share of the profit or a fixed fee). If prices suddenly drop by 20-30 percent on a fixed-price contract, you’re already locked into a price. While I hesitate to predict the course of the global or national economy over the coming years, it is possible that the current inflationary pressures may ease at least somewhat.
Finally, while our experiences with cost-plus contracts are limited, the evidence shows that when prices are changing rapidly and delays are common, they can deliver a better outcome for all parties: building owners benefit from higher quality work accomplished with fewer delays, contractors are guaranteed a reasonable profit, and, in most cases, the insurer ultimately pays less to resolve the claim.
In closing, although fixed-price contracts deliver value in times of relative economic stability, the current environment is anything but stable, which is why, in my view, cost-plus agreements are better suited to today’s global conditions. That said, claims consultants always strive to resolve covered losses fairly and promptly and they are empowered to structure contract agreements and manage service providers to achieve the best possible result for their insureds.
About the author: Sherrie Morton is a Senior Claims Specialist, Property & Construction. Sherrie has over 20 years of experience working on complex and technical property and construction claims. She is based in Sydney and can be reached at sherrie.morton@axaxl.com
