A recent survey conducted by the Royal Institute of British Architects (RIBA) found that the vast majority of construction contracts are still awarded on a fixed-price basis, despite the risks posed by rampant inflation.

Of a total of 950 construction professionals (including consultants, advisers and contractors), 77% said that fixed-price contracts remained the most frequently used pricing mechanism for construction contracts. While inflation was at a steady 2%, this was a fairly low-risk strategy that allowed contractors to price their services competitively. With inflation hitting 11.1% year-on-year in October 2022, however, contractors face the real risk of seeing their profits entirely swallowed by inflation.

So, could the fixed-price contract be on its way out? Is there any way of protecting contracts against inflation? And what other pricing mechanisms are there?

Pricing for inflation

As we have explored most construction contracts are fixed-price or ‘lump-sum’ contracts, which sees the contractor bear the risk of price increases. Many standard contracts, such as the JCT Standard Building Contract, the JCT Design and Build Contract, and the NEC Engineering Construction Contract Option A, use this pricing structure. In order to decrease the risk of losing profits to inflation, some contractors are now using different types of pricing structures or including inflation clauses in their contracts. These include:

1) ‘Provisional sums’ clauses

These are estimates, or ‘best guesses’ of additional sums that cannot be accurately defined or calculated at the time of drafting the contract – i.e., the increased cost of materials as a result of inflation – or works that the employer may or may not decide to carry out.

2) ‘Fluctuation provisons’

These allow for price increases in line with the costs of materials or labour, thereby pushing the risk of inflation onto the client. While clients have traditionally been reluctant to include these in contracts, contractors are increasingly (and understandably) pushing back as inflation soars.

3) ‘Cost plus’ contracts

According to this type of contract, the contractor is paid for the actual costs expended on materials and labour, plus an additional fee for overheads and profit. This contract equally enables the contractor to pass on all price increases to the employer or client. Understandably, this type of contract is not popular with clients due to the difficulty of budgeting for an unknown final cost, in addition to concerns surrounding contractors’ ability to essentially charge what they like.

4) ‘Target cost’ contracts

Under this type of contract, the contractor must endeavour to stick to a pre-agreed target cost. If the project comes in under budget, the contractor and client will share the savings; if it is over budget, the contractor must make a contribution towards the overspend. This way, both the client and contractor share in the risk of price increases.

“Keeping business owners up at night”

Despite the growing threat of inflation, however, the RIBA survey showed that just 4% of construction professionals were using ‘cost plus’ pricing mechanisms, while a further 6% were using ‘target cost’ contracts. This leaves the vast majority bearing the full brunt of inflation.

It is a situation that is continuing to “keep business owners up at night”, according to Rob Driscoll, Director of Legal and Business at the Electrical Contractors’ Association. According to a study of 500 builders and tradespeople by ElectricalDirect, it is the top concern of nearly half of respondents going into 2023.

Using insurance to mitigate the impact of inflation

It is vital during this period of high inflation that contractors ensure they are sufficiently insured for the project at hand, both now and into the future. Contractors taking out insurance now must consider whether their sum insured is sufficient to cover them for damage or liability five or 10 years down the line.

Some insurance policies may include what is called a ‘Day One Uplift’ – i.e., a clause that protects against a shortfall in a claim payment caused by inflation. For example, if a contractor suffered a total loss on a project valued at and insured for £1 million, and costs have increased due to inflation since the policy was taken out, a Day One Uplift of 10%, would mean that the cover would in fact be £1.1 million. However, in the current inflationary environment, even a Day One Uplift clause may not be sufficient to cover contractors, with some prices increasing way beyond a 10% increase.

For example, the Department for Business, Energy and Industrial Strategy (BEIS) calculates that the cost of aggregates (e.g. gravel, sand, clays and kaolin) has increased by 56% year-on-year. It is important, therefore, that contractors speak with their brokers to ensure they are covered against the risk of inflation moving into 2023.

Focus – here to help with competitively priced policies

As a Managing General Agent specialising in construction insurance for over 25 years, we are here to help our brokers manage their clients’ increasing need for inflation-beating insurance cover. Our wide range of construction products (see here) provides coverage for contractors of all sizes, ensuring they can move into the New Year with confidence.

To chat about our product range and how Focus can help your clients manage the risk of inflation, please get in touch with your Dedicated Underwriter, call our sales team on 0345 345 0777, or email sales@focus-insurance.com.