We probably thought that there wouldn’t be a bigger impact on the UK economy than the pandemic, which has helped inflation in the UK to reach its highest rate in 30 years. This is expected to continue, at least in the short term and is exacerbated by rising energy costs and increasing wage costs.
Now we are reeling from the Ukraine crisis which has already had a major impact on energy costs (wholesale gas prices have increased by 80%) but we have yet to understand or see what else might happen.
The Bank of England is saying that interest rate rises will reduce inflation from an anticipated high of around 7% in the Spring to nearer the 2% target.
However, the construction industry is bracing itself for something different. This is due to the different way’s inflation is measured in the UK as a whole and in construction. While both use the ‘basket of goods’ measure, a basket of bread and milk don’t compare to the cost of cement and timber. As a result, the two measures, while moving in the same general direction, can diverge significantly.
One of the biggest issues the construction industry faces is the persistent skills shortage due to an ageing workforce, lack of investment in training and limited access to migrant labour. This is placing increasing pressure on wage costs, which combined with higher material costs, puts pressure on construction company cashflow. We discussed the potential for building businesses to fail in a previous paper and interest rate increases will only add to these pressures (as overdrafts start to cost more and credit becomes more expensive). So, the Bank of England’s action may not help construction companies, at least not in the short term.
The increasing cost of materials has been felt in construction more than many other businesses and the general opinion is that this will remain so for a longer period than initially thought.
Construction companies remain at risk and must work out ways to manage these inflationary costs and increase their resilience as businesses. One thing they can do, is identify any weaknesses in their current suppliers, look at their options and put some alternatives in place.
They also need to control their debt and that may include reviewing their payment terms in some instances.
Construction customers may find that builders start only accepting work where payment terms and payment history is good.
Longer term, the construction industry must address the skills shortage and cannot rely on Government support, apprenticeships are a huge commitment for companies, especially if they are under increased financial pressures as discussed above.
Comparing the pre-pandemic workforce levels to now, most regions in the UK have not got back to the levels they were at in Q4 2019. London has seen a 17% decrease following Brexit and the Covid pandemic. Other regions, such as Wales have proportionately larger workforces, but this is partially due to the low base level.
Businesses need to plan ahead to build skill capacity in the right areas and this requires a diverse skills pipeline, starting from school. For businesses to do this, they need early sight of potential work, so they are confident to invest. Whether this will happen is still subject of much debate.
Many observers are now asking: what if there is a recession?
While we all hope that over the next couple of years, energy prices will reduce, hostilities in Ukraine will end, new people will enter construction leading to steadying or lower labour rates and that the current inflationary surge will not be sustained, there is much nervousness in the construction sector.
Some more optimistic experts think it likely that as interest rates increase, disposable income will fall, leading to lower demand for new work and greater competition, which will help stem the cost increases further.
The truth is that hope may not be enough and as the effects of Covid continue, exacerbated by the war in Ukraine that shows no sign of abating or stopping in the short term, the pressures on costs will be maintained for some months yet and potentially, well into 2023.
The effect on adjusting
Adjusting operates in a sector where there are already capacity and cost pressures whenever there is a weather-related surge in claim volumes. The storms in the first months of 2022 have seen localised cost increases due to a lack of building repair and scaffolding capacity.
The obvious point here is trying to ensure that reserves for building repairs are accurate when there are all these inflationary pressures, but we should also consider the Value at Risk (VAR). Is the cost of rebuilding , still accurately reflected in the Sum Insured or Declared Value?
In a Major Loss situation, the higher repair costs could overwhelm the Sum Insured very quickly.
Where there is a Declared Value, the wording regarding Index Linking can be vague. One insurer states: “Whenever a Sum Insured is declared to be subject to Index Linking it is adjusted at monthly intervals in line with 'suitable' indices of costs.”
So, what is ‘suitable’?
Others fix the inflation to a percentage, usually between 25% and 35%. Will this be enough to align with current rates of building cost inflation?
Adjusters must be prepared to accurately calculate the current rebuilding cost of the property (including fees, site clearance, external features such as outbuildings, etc.), compare this to the Sum Insured and Declared Value and report to their clients accordingly. Assuming the VAR is adequate could result in disastrous consequences for the policyholder and the adjuster with repair costs subject to such large increases.
As previously mentioned, the forecast for 2022 and into 2023, is for costs to continue to rise, due to fuel and power increases adding to the Covid and Brexit influences and the industry skills shortage. There is currently no sign that fuel prices will reduce in the immediate term, any more than the skills shortage and while we start to return to ‘post Covid normality’, there will be ongoing issues with the supply of manufactured/processed materials due to the UKs reliance on Europe for materials and production cost increases.
We will continue to monitor developments and provide regular updates to this changing landscape.
For more information, contact Nick Turner on 07736 892148 or n.turner@woodgate-clark.co.uk
