The impacts of inflation on construction projects

ADAM DENNO: Thank you, Mike. Glad to be part of this discussion today.

MIKE SCOTT: Looking forward to it. Gents, we're here to talk today about the impact of supply chain and inflation on contractors. It's certainly a trending topic and has been now since the beginning of the pandemic. Some of the elements that were impacting supply chain have somewhat lessened, right? We think about commodities and things like lumber and steel. And we've certainly seen prices modulate and we've seen supply modulate. But there is still a tremendous amount out there that's impacting supply chain both in terms of what is available, what items are still in short supply, the labor issues that are impacting both production and the delivery of these items. And not to mention, political and economic conditions that are impacting those.

And we're going to talk about those today. Perhaps, we can jump in and you can give me some of your thoughts on that.

JOHN MARSICANO: Sure, Mike. We'll start around the claims aspect regardless of the different types of coverages that you have, whether it's subcontractor default, surety builder's risk, professional, whatever it may be. We've been hit pretty hard last year. So with hurricanes in the South and since the pandemic, a lot of the MEP trades have had issues garnishing equipment from overseas. And those that are able to get it have had to pay additional fees in order to have it shipped or to get moved up on the line. What really affects the claims or where contractors today still have some issues is it affects the downstream long-term aspects of completing the project on time and building that in. And a lot of the clients and the owners don't really look to give any relief. You signed the contracts and you own the scope, you own all that. And there's impacts in delays.

And the financial impact to some of these subs, and they look to contractors that look to pass it down to the subcontractors could be significant. You could be looking at anywhere from six to 12 months or a year. It seemed to be getting a little better months ago around switchgear. We're kind of back up there, right? So switchgear, chillers, things of that nature, UPS is-- actually, now, I think we're going to look to start seeing some impacts with drywall, right?

Just something recently, right, a week ago. Five cars of drywall going to Florida, right? Derailed. So that's a significant amount of drywall for the projects that are down there. Construction is pretty high. The insurance companies are kind of holding contractors feet to the fire for justifying the costs.

As you know, they don't want to pay inflationary increases in costs that are significant higher than 7% or 9%. It has an impact. And clients, really, and contractors really aren't prepared or aren't looking or have not looked downstream, right, to the impacts that it will affect their schedules and projects. So I think that's something that we've been living with since 2020 from the start of the pandemic. And I see it going through probably the rest of '23 and '24.

MIKE SCOTT: John, do you think that the impact is greater on the smaller contractor? They're probably having an even harder time accessing these items that are in short supply?

JOHN MARSICANO: Absolutely. It always goes to the big dog, right? The guys who have the buying power gets first preference, right? And the other problem is a lot of these smaller contractors are depleting their cash reserves, their balance sheets. So they're not able to pay any kind of expediting fees and what have you. And then when they get hit with damages or delays, they can't afford it, right? So you start to see some struggle with the smallest shops. The biggest shops are able to afford it and jump ahead of the line. So I think it's something that's got to be looked at. But I think we're going to keep seeing this over the next year, year and a half.

MIKE SCOTT: And don't you start to worry when you think about in an inflationary environment and in a potential recession, where when cash reserves are low, smaller contractors are paying more for these items, where are they cutting costs in order to be able to fulfil these orders? It starts to go into where they can control costs. It could be around the type of insurance they're buying. Or heck, even paying their taxes, right?

JOHN MARSICANO: Well, it's a lot of that. It's actually maybe reducing the amount of staff that they have, reducing their labor on the jobs. And then you have additional impacts of quality of the work being done. You then go into a safety issue, right?

So I mean those cost cutting measures to save dollars on equipment and these inflationary costs, whether it's labor or what have you has the trickle down effect. And eventually, it will affect it. And a lot of clients and developers are starting to kind of back off on maybe some of these mega jobs that they had because available space and inventory. It's not worth the squeeze to kind of invest all that money. And banks are tightening up on the cash loans and the interest rates really are favorable right now to borrow a lot of cash.

MIKE SCOTT: Well, that might be a good opportunity to bring Adam in here right and to start to weave in the conversation about the commodities and material trends. Adam, you want to amplify that?

ADAM DENNO: Absolutely, John. Hey, thanks for that insight. Obviously, we're seeing more notices of claims and subsequent claims come out in the market and it's directly related to a lot of the economic focus that the economy is going through at this point. When we look from a technical services standpoint for our clients, we try to understand where their pinch points are in their current business models, their forecasts, and layer over what we're seeing not just in a national economy, but we'll try and break it down to the local and regional economies that they're faced to deal with.

With that being said, we have to appreciate that we are in a very tied together global economy at this point. As we saw over the last, oh, 18 to 24 months, the impacts from a global recession and shutting down certain production sources really can have an impact on access to such things as lumber and steel and subsequent chips and subsequent products that are being used. So we try to understand what's going on from that global perspective.

As we sit here today at the first quarter of 2023, we understand that some of those really impacted commodities, such as lumber and steel, really experienced significant growth in '22. We're seeing those start to level off, which helps our clients and our subsequent subcontractors that work with our clients really navigate some of these treacherous times a little bit more. We've seen clients really start to understand that some of the mega projects that John was talking about and yourself as well, Mike, some of these are getting pushed off a little bit towards maybe second quarter, third quarter of 2023. That's having a direct impact on the production and subsequent consumption of some of these materials. However, every day we come into work we start to see that there are some larger projects getting let. Just today there was notification that a large multibillion dollar EV plant in Kansas was released. How does that impact from a local and regional standpoint others that might be from a national and international perspective? When you have these larger mega projects come in, they're going to consume some of those materials that we have on projects in our backyard.

The steel, the gypsum board, the lumber, you name it, are going to be consumed. So we start to see now how the impacts of these commodities and materials will have an impact on projects moving forward. We're seeing now that from a global perspective when Chinese economy starts to open back up, Chinese economy contributes about one-fifth of the global GDP. So when you think about 195 countries, one country contributes about one-fifth of that. The consumption that's going to ramp up in that market will have a direct impact on other markets as we continue to go through '23 and beyond.

We're seeing really certain sectors being impacted by these trends. If we look at the lumber and steel, we are starting to see those start to moderate and come back down. But we're also seeing some of our clients, especially North of the United States and Canada, that are being asked to look at renewable construction materials, CLT, and things along those lines. Those are being consumed more and more and more.

Transformers, switchgear, these are elements of a construction project that we've seen be impacted by this global commodity shortage in the production shortage in '22. And as John mentioned, we're seeing that from the technical services side as well. We're seeing the limited availability of those elements as well continue into '23. And we're anticipating that as construction is seasonally impacted typically first quarter, we see a growth in unemployment, in construction. And then we see it ramp back down because construction projects start to come on board in the second quarter.

We start to see that building starts to pick up, with that being the case here, and we're seeing that from our side as well. Second quarter we're going to start to see some projects come back online. We're going to see buildings start to come back online. As we stand those materials, such as the lumber and the steel aren't necessarily being consumed at this point. But we're anticipating with some of these large multibillion dollar projects starting to come back online, we're anticipating that the need for the continued production is going to really impact some of the construction projects that we have on our books. So as we stand today, we're absolutely navigating a point where the production of certain commodities and materials is starting to uptick. There has been less pressure on some of that consumption because of certain aspects, such as global economic downturns. We are seeing that some of the inflationary impacts here domestically in the United States has reduced some of the consumption of those materials. However, we are anticipating as certain things come back online the consumption to start picking up here in second quarter to third quarter.

So we have to understand and appreciate how that growth in the consumption is going to impact costs and how we pass that on through and have our clients potentially speak with their owners, speak with their subcontractors, and others in the market to ensure that they stay ahead of the impacts of the growth in commodities and materials.

MIKE SCOTT: And you know, Adam, it kind of makes me think of a couple of questions. Because that advocacy that you were just talking about at the end there, it differs based on who we're talking to, right? Whether you're a small or a middle market contractor or you're a large general contractor, talk a little bit about on some of these mega projects the pervasiveness of large owners or even large general contractors stepping in and ordering some of these materials themselves, and then how that impacts the smaller and the middle market-sized contractors and their ability to access those materials?

ADAM DENNO: Absolutely, Mike. In '22, what we saw is we saw a rush to acquire materials because there was this understanding in the market that materials were becoming more limited. And that really increased the price of lumber and steel. We've seen that correct lately.

But as these large mega projects come on, there may be that mentality. And we're starting to see a need to acquire and control costs. So if there's a large steel package on these mega projects, we may see that mentality of, hey, let's start really price matching the steel that we have so that we can lock it in and have that through the duration of the project.

What that does when you have these multibillion dollar projects, we still have a lot of clients that are building schools and health care projects and doing additions and tenant improvement fit-ups. So those smaller regional contractors that we work with as well are seeing that access to commodities and materials really be stressed. So they now have to participate. They have to play in that same game of we need steel, we need lumber, we need ships. And they have to really appreciate the fact that it's going to have an impact.

These large mega projects, projects that were pushed from '22 into '23 because of potential inflationary impacts, developers, owners may look at rates and say it doesn't necessarily pencil out at a higher rate, at the end of '22. But maybe it does now. And they're locking in these projects.

All of this we anticipate end of Q2, into Q3, maybe into Q4, we're going to see that real demand of the commodities materials that are really important-- the plywood, the gypsum like John talked about. Gypsum is something that is continuing to feel an increase in prices. And gypsum, drywall, is a large component on a lot of these projects.

We're looking at architectural coatings and paint. That's also feeling a significant increase. So absolutely, Mike, when these large projects come on, we also focus on it and help navigate these times for the smaller and middle market. Really, the clients that look to us to help them understand, what are the trends in the marketplace and how can we be better prepared to move forward with those trends?

MIKE SCOTT: Yeah, it's a great point, right? Because it's almost impossible to forecast an end to this because it's really a multidimensional problem, right? There's a supply chain issue that's connected to the availability of materials, the availability of raw materials. But there's also a labor element connected to it as well and the ability for some of these producers to staff back up in terms of finding the people who are working in these facilities prior to the pandemic now. So there's not one easy solution as to how we can forecast the end of this challenge, you agree?

ADAM DENNO: Absolutely. Here, we're talking about more of the materials and commodities. And we see those trends really impacting our clients. But labor is, and has been for a number of years, one of the more critical aspects to focus in on. We'll try and consume some more database information, Bureau of Labor Statistics. We'll look at Federal Reserve, OECD data.

But it's typically at about 30 days in arrears. As of January, the construction space, the Bureau of Labor Statistics stated that we were at an unemployment rate of about 6.9%, which is well within line of the seasonality we've seen over previous years. What we're not seeing, what I think a lot of people don't appreciate is the amount of job openings as well. And at that same period we were at, we're near a historical high in just about over 413,000 job openings in construction.

When we look at that gap between unemployment and openings, we see that there is a significant space in the labor that's available in the market. We're also helping our clients understand trends within their subcontractor base. One of the things that we're seeing as of the end of '22 into '23 is a lot of subcontractors are experiencing that move or that push of the projects into '23 that they originally had in they're schedule in '22.

But they're not getting the revenue yet. Overhead is a very, very costly point in their income statement because they don't want to lose their overhead. Jobs are coming, but they're not on the books yet. So we're in this real inflection point for our subcontractor partners as well.

And in the market, companies are maintaining the overhead because they understand there's a significant gap in the space. But with these projects being moved and pushed into '22, it's a time that John really touched on earlier in his discussion. Cash is paramount at this point. Reliance on their lines of credit, reliance on maybe a shareholder to cover their overhead.

All of this being said, the impacts of commodity prices the impacts of labor. We're in first quarter of '23 where there's been more uncertainty in this space than I've seen in some time. However, it's not just all doom and gloom. We are starting to see some real expansion in some of these projects coming back online.

Again, what are these projects coming back online really mean to that commodity and materials aspect? We're going to see additional consumption as we move through the year. But that labor as well is going to be a significant component to ensure that our clients navigate these times.

MIKE SCOTT: So kind of opening this up to both of you now, we really need to start to think about-- and we know there's a lot of interest in this-- what are some of the solutions here? WTW just released a survey of 800 senior decision-makers as it relates to supply chain risk. And 89% of the respondents think that insurance for supply chain risk is mission critical. We know we're not there right now.

So what are some of the short-term solutions? And then what are some of the longer term opportunities here to take care of this?

JOHN MARSICANO: So Mike, I think what you're going to start seeing is owners taking more ownership working with the contractors on the upfront design and procurement of critical equipment and materials for their buildings. One example is the contractors that do cookie cutter facilities that are the brands-- an Amazon, a Costco, a Walmart-type thing. The same contractors over and over again seem to do the same type of building. They're buying the same equipment in bulk, right?

A lot of owners are now sitting with clients up front. And maybe it's a matter of changing the type of equipment that's going into the building based on where the trends are from the shortage of materials, right? Pre-planning, actually working with the contractors and the subcontractors. We're spending a lot of time training them what to do in the event of the impacts, how to address the labor shortages, how to start tracking more accurate, contemporaneously documenting the cost, updating their schedules, which is critical as to how you move forward with any delays, right? And how those schedules impact the success of the project, right?

And again, Adam's point, during pre-qualifying these contractors, there's a lot of focus now more so on cash and labor, right? Are you getting an accurate account? Are you asking for a dedicated labor crew? It doesn't mean anything. What is the bench strength, right?

Are you sometimes better off marrying two companies to fulfil the contractual obligations on labor because of the shortage of labor pool, right? And again, we've seen it in the past where labor migrates, right? West Coast is busy. They leave from the East Coast and Midwest. They go to the West Coast and vice versa, right?

So I think it's all hand-in-glove. But I think you're starting to see contractors and owners work a lot closer on the solutions required to fulfil all obligations on the project, and collectively working with finance, and making sure that the assets are there. And there's more due diligence being done on the subcontract community to make sure that the subs, too, the first tier subs, the second and third tier subs, they are in line with what's going on. And if they're beholden for the equipment and the solutions, these now first line subs are taking more responsibility and there's a lot more taking ownership upfront than it was in the past.

MIKE SCOTT: And when you think about the number of contractors that you, and Adam, and others here are interfacing with, probably an opportunity to synergize around best practices as we continue to aggregate them across the entirety of the contractors we interface with.

ADAM DENNO: Absolutely. And Mike, as John mentioned, it's critical right now to ensure that you review your contract language, not just with your subcontractors, but with your owners. What are the terms in place to protect you against some of these inflationary impacts? Some of this risks that we're starting to see and seen for a while in construction, one of the things that we try to help with is to do a review and see what elements of your agreement might possess additional risk that should be covered. We've had discussions with market participants as well looking at how to improve, as you mentioned, certain coverages to ensure that as these periods and these times continue to grow in risk, they have ample coverage. Looking at your general liability policy, looking at your professional liability policy. Pollution even comes into play. These are things that we really want to ensure that our clients have in place because the worst time to find out that your policy isn't exactly what you thought it might have been is when you need it.

We're also working with our clients to develop such things as cargo insurance and read insurance that are critical at this point. We have seen shipping and cargo transport, the costs come down. But there is still significant risk. When we're looking at going to alternative locations where we can't find a certain piece of material or a certain commodity domestically or locally, we may have to start to look outside of the borders of the US.

When that occurs, a whole other group of risks come into play. And that's really where we step in and say, well, if you're having these materials shipped from Europe, shipped from China, here are some considerations that you may want to look at to ensure that you have the protection against that risk.

Unfortunately, we've seen in times past where there's dependent on a unique material or commodity being shipped overseas. And one thing or another happens-- rough seas, storms like John had mentioned.

These are things that can potentially impact the delivery and the quality of those materials. And when that comes to your job site and it's not what you expected or it's in a deteriorated form, you cannot use that. So what do you have in place to protect against those potential risks? So Mike, we are working with our clients to look at some of the additional coverages that are available in the market space today.

JOHN MARSICANO: One thing just to add on that is contractors need to look at this, and the contractor community in general needs to look at this is a team sport, right? Up until the last couple of years, insurance was always referred to as the necessary evil you needed in order to move forward. But the resources that the insurance companies are able to bring to help mitigate these exposures and these risks are becoming more and more critical as you mentioned before, right, where the insurance companies are your friends.

So we look at this as a team sport. And what we try to tell everybody is early intervention is the best thing. Get everybody involved up front on the planning. Understand the different coverages that are out there so that your best protected moving forward. So we're seeing more of a trend that way where owners and contractors are getting more involved with their insurance brokers, and even the carriers up front, to make sure that everything is moving in the same direction and all parties are in lockstep.

MIKE SCOTT: You know, John, I think that's a great point, right? It's bringing all of the stakeholders together. Everybody engaged in a project-- the owner, the general contractor, the subcontractors, your broker, your risk advisor, your carriers. The multidimensional elements of risk means bringing multiple carriers to the conversation as well.

Something that I think about that was a challenge before the pandemic and before supply chain became a topic of conversation was the topic of delay and project extension. And now we have an element here that absolutely contributes to delay and contract extensions. And we know the complications there. You want to address some of that?

JOHN MARSICANO: Sure. A lot of clients don't realize when you get to DSU coverage and you talk about DSU coverage and moving forward, the owner gets DSU coverage, it covers their portion of the work. A contractor gets DSU-- it's like Adam is talking about-- there are other instruments to protect you, especially when you're dealing with the commodities, when you're dealing with equipment and transport from foreign seas, whether it's by train, whether it's by water, or what have you, right? So I think the delay in startup is not everything.

Contractors have this myth that everything outside the four corners is considered force majeure. It's not necessarily the case, right? It's not the dumping ground, right? Builders risk is no longer the dumping ground.

People are more focused as to the intent-- what's driving impacts? What's driving delays? What's driving losses, right? People have to think out-of-the-box. And like I said earlier, intervention early, planning early. And when there's a delay or there's going to be those impacts, bring the owner in earlier, right? Because sometimes the owner will give you a solution that you may not think of, right? Or they may be willing to go the extra yard to keep their building on track and stuff.

There's no longer hiding in the corner, that it's bad to go to an owner and says, hey, we've got a problem securing some equipment, or we can't do this, or we can't get that. So I think the mindset of this industry has changed in the relationships between owners, contractors, subcontractors. I think it's a more hand-inglove, everybody pulling together, because they realize it's the only way we're going to get to the end game.

MIKE SCOTT: Your thoughts on that, Adam?

ADAM DENNO: Yeah, I absolutely agree with John. One of the things that is critical as we continue to move through the beginning of 2023 here is to look at your organization's approach to move through these times that are impacted by inflationary constraints. And as we've talked about, some of the commodities and materials are really impacting that bottom line. They're the components of the project. Our clients build buildings.

Each of those lines is impacted in some degree by these inflationary impacts. Whether those commodities are locally sourced or they're internationally sourced, we have to understand throughout that entire process where are the potential areas of risk are present. And in doing so, we can help our clients understand how to move forward through Q2, Q3 as projects come in line, as demand starts to come really coming back. If history is any indication, the construction is going to fare very well.

We are going to continue to see projects come back online. And as we move through '23 into '24, there's a consensus in the marketplace that strength will continue to see itself come into our market. With that being said, we have to also appreciate along with strength comes opportunity for risk. And how do we help our clients and help others in the market ensure that each line that you have in place is directly related and plays well with each other.

As John mentions the hand-in-glove, we want to make sure that if a default or an issue arises on that contract, your owner's appreciative of that. But you have yourself protected from the contract language and the coverages that are in place. We've experienced claims in the past where you don't even appreciate or there may not be an appreciation of how a pollution line might come into play, how a cybersecurity line might come into play, how a marine line might come into play.

But when you're looking at the overall scope and breadth of that construction project, there is a lot of different coverages that come into play. And unfortunately, as John has worked through claims over the years and I've seen, when an issue does arise, again, that's not the time to find out that you don't have what you necessarily thought you might have had. There is growing knowledge in the space of risk that continues to impact the construction market. We continue to monitor it on a daily basis. We work with our clients to look at their book of business, as well as how these global trends, these national and local trends can impact potential successes on project.

There are areas that are out there that are being more and more risky than they have in the past. So as we continue to move this, your question, I apologize, was what are the solutions for it? It's to take a real critical look at the projects you have on hand and work with your critical partners, your broker, your carrier, your bank to ensure that we have this collective mindset of where the potential risk may be coming from, and ensure that you have those insulated, protective elements to move forward.

MIKE SCOTT: So I think what we've talked about here is not only have we covered the spectrum of the supply chain disruption is ongoing and where we continue to see the challenges. We don't see an end in sight because it is multidimensional. It's not just around materials. It's also around the labor shortages and economic conditions and political conditions. We talked about the importance of insurance budgeting for contractors and for owners during a construction project and the very significant importance of how your contracts are structured.

The one thing I think we should touch on also is how have we seen the insurance carriers response to the evolution of this challenge? We know that there's not necessarily an insurance answer that covers it all.

But in general, they've also had to be nimble. And how have we seen that happen?

JOHN MARSICANO: Mike, I think it depends on the policy for which you're looking to get the coverage, right? Builders risk, you know, they cover it. It depends. Inflationary depends on the uptake and costs, right? If you talk about the SDI coverage, there's coverage. But it's triggered by a default.

So a lot of contractors are now being forced to default. They could be the best subcontractor in the world, but their supplier, their second tier sub is falling down. General contractors are being forced to default their A-rated subcontractors in order to get coverage under the policy to protect them on their indirect costs, on their schedule impacts, and what have you. So there's a ripple effect.

ADAM DENNO: One of the things that we continue to strive for here at WTW is understanding where the risks in the market lie and how to protect against those. Carriers are critical components to our client success and also helping us understand where potential risks may lie. We're seeing different lines address these risks in different ways. Whether it's general liability, whether it's builder's risk, whether it's surety or SDI, we work directly with each of those divisions within WTW to gather a more comprehensive understanding of what others are dealing with.

As an SDI line, we are appreciative of what's occurring in surety. We're appreciative of what's occurring in builder's risk in general liability because each of these risks, we're finding, are related. So if there is a concern on one line, we have to be appreciative of it here. And in doing so, we help lead our carriers and our carrier partners to understand how to evolve their policies.

With our WTW default insurance group, we have an active engagement with each of the carriers that underwrite default insurance in the marketplace. We help them understand and craft different endorsements. We help them understand and craft different policy terms. The sheer fact of the matter is from an SDI standpoint, from a surety standpoint, from these lines that are critical in construction there is a need to increase capacity to offer and extend these coverages more so than ever.

And in doing so, carriers are very appreciative. And we're able to help understand where our clients risks are, where the market risks are, and help develop policies that are comprehensive enough to insure that each specific and unique client that we have has their unique and specific policy in each of those lines, because each deal with risk differently, each have different risk appetites. So we want to ensure that we have these conversations. That we provide this insight into not only our intellectual capital, but what we've developed with our carrier partners, with agencies in different elements in the marketplace to ensure that we have the best information possible to help make the most informed decision possible.

So from your question of do we see carriers appreciating this, absolutely. But we take an active approach with our carriers to appreciate where the risks are coming and how to protect against those moving forward.

MIKE SCOTT: Well said. Thank you. Gentlemen, thank you for your time today and for your thoughts.

Any closing comments you'd like to make? John, I'll start with you.

JOHN MARSICANO: Thanks, Mike. No, I think we've kind of covered it all. I appreciate the opportunity to have this discussion around supply chain and inflationary topics as it continues to grow and we help work with our contractor partner, owner partners to get through these challenging times over the next few years and foreseeable future. So again, I appreciate the opportunity to share my thoughts on these important topics.

ADAM DENNO: I'll echo those same sentiments that John said. I appreciate everybody's time today to just understand a little bit more about what we're seeing in this space as well.

MIKE SCOTT: Fantastic. Thank you gentlemen. Thank you to everybody who listened. And thank you for joining the WTW "Construction Blueprints" podcast. We'll talk to you again.

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