Increased Construction Costs How big a problem is it and what should we be doing about it?
The pandemic has wreaked havoc on the global supply chain for building materials. In addition, the labor market is in an unprecedented shift that economists are struggling to explain. These combined factors have led to increased construction costs with broad implications for the insurance industry. In this analysis we provide some statistics to help quantify the magnitude of the change in cost and then discuss the implications for general liability and homeowners coverages. The easiest data point to identify and then extrapolate to the overall cost of a house is framing lumber. According to the National Association of Homebuilders (NAHB), the cost of framing lumber peaked this spring at a level over 300% greater than a year ago, translating to a $36,000 increase in the cost to construct the average single-family home. The price has been dropping for about 3 weeks now as mills return to 100% capacity but is still well above the pre-pandemic level. Further, as storm season approaches, a heavy windstorm or firestorm could dramatically impact supply and rebound prices. The chart to the right shows the price of lumber using the Random Lengths Framing Lumber Composite, which is determined by using prices from the highest volume-producing regions of the U.S. and Canada. As you will note, these prices track consistently with lumber futures pricing.
Lumber Cost Over Time Source: NAHB
In addition to evaluating the increases in lumber prices, we also pulled data from the Producer Price Index (Bureau of Labor Statistics) for some of the other main inputs to a residential construction project.
Concrete Products (Including Brick & Block)*
Gypsum (Including Drywall)*
Asphalt (Including Roofing, Siding, & Asphalt Related Products)*
Nonferrous Wire & Cable (Inclduing Electric & Copper Wiring)*
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270 272 274 276 278 280 282 284 286 288 290
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255
340
280
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*Not seasonally adjusted | Source: U.S. Bureau of Labor Statistics
When we run these factors through a total project cost calculator, which includes overhead but does not account for the recent increase in labor costs, we come up with a total construction cost increase of 11% . If we use the rule of thumb that the cost of material makes up approximately 40% of the total cost then this figure is consistent with the recent NAHB survey of single family home builders which estimated a 26.1% increase in material costs in the past 12 months (26.1% * 40% = 10.4%). Based on a composite of coastal homeowner’s data, this translates to an average increase in (re)construction cost of approximately $44,000 for the average 2,500 square foot home within 30 miles of a coastline. This is based on the current cost of material and does not factor in any post-event demand surge. Further, the labor market is in a transitional phase and we expect the true overall change in cost to be greater.
Impact on General Liability A large segment of the General Liability line of business relates to contractor exposures. The exposure base for these policies is related to costs, sales, or receipts for the presented rating information and future premium adjustments. The rapid increase in building cost inputs is expected to significantly increase receipts, and to the extent that policies are adjustable, we will see larger than anticipated audit premium adjustment increases. Future estimates of costs, sales, and receipts will have to consider the forecast cost levels for these building inputs as minimum. Deposit premiums are also considered along with the increased prices, which may or may not hold at current levels as we move forward. This creates a disconnect in the difference between real exposure (loss costs) and the exposure base (costs, sales or receipts). For example: suppose a contractor had $10M of receipts last year and paid $100k for their GL policy and that same effort of work would move the receipts to $12M due to labor and cost increases. If the rate on exposure base ($10 per $1,000 of receipts) is held flat, the premium would calculate to $120k, but for the same amount of work we would not expect losses to increase 20% in the current environment. If losses were to increase by 4% year-over-year due to estimated inflation, a reasonable premium estimate might be $104,000, but that is a rate decrease ($8.67 rate vs. $10 rate) when comparing premiums to the exposure base. While this is technically a rate decrease on the exposure base, the rate on true loss cost exposure is really flat. This dynamic will create pressure on rates in the market because of this disconnect. Underwriters should be granted the authority to think outside the box and reinsurers should adjust assumptions on a case by case basis depending on how their clients have reacted.
Impact on Homeowners Insurance Most policies have a building limit based on the insurer/agent’s best effort to calculate replacement cost. If these figures have not been adjusted for factors like those discussed above then most likely the homeowner is underinsured. This is a no-win situation for insurers – imagine the public officials lined up with their soap boxes if… A. The insurance industry decides at the same time to increase their ITV based on (presumably) short term spikes in material and labor costs due to the pandemic. Or, B. A severe wildfire or hurricane causes total losses within a region and homeowners are underinsured due to the pandemic. The Coverage A limits should hold up in court but this would not be great press for the industry. One possible solution for most standard carriers is to offer increased Coverage A limit as an endorsement. Typically the additional limit is 25% and the premium is around 1/4 th of the ground up rate. For example: • $500,000 Coverage A limit @ 40c rate = $2,000 in premium • 25% increased limit endorsement = $125,000 additional limit for $125 additional premium To the extent this coverage is an option, it is a win for everyone. It does not influence the pricing or sublimits for other coverages that are geared off the Coverage A limit. Furthermore, you can drop the endorsement when prices normalize making this a great short-term solution to a problem that is hopefully short-term.
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