The rise of subcontractor defaults

The construction sector in the US remains buoyant, with construction spending valued at more than US$1.8 trillion annually. This uptick is resulting in subcontractors bidding on more jobs, with the potential of becoming overextended and carrying a large backlog of jobs.

There is a growing understanding among contractors that it is crucial to prevent subcontractor defaults and, should they occur, remedy the situation quickly to keep complex construction work on track, on time, and on budget.

Subcontractors are at a higher risk of defaulting on their obligations because of significant current issues such as material delays, material price escalation, and labor shortages. Choosing the right subcontractors and understanding their financial health is a priority for general contractors (GC) and can ultimately be a key determinant in the success of the project.

Some early signs that a GC should be aware of in order to recognize if a subcontractor is becoming financially distressed or unable to work include:

High borrowings on lines of credit
Negative cash flow
Increase in debt
High backlog
A significant difference between bidders
Workers not being paid on time
Failure to pay union dues on time.

Subcontractor default can have far-reaching financial and performance consequences. In a worst-case scenario, a subcontractor default could result in project delays and disruption, jeopardize project margins, damage relationships, and even lead to company liquidation. These additional costs and delays can derail the entire project, regardless of value.

Introduction of subcontractor default insurance (SDI)

Historically, contractors have used surety bonds to transfer the risk of subcontractor failure. Today, however, there is added interest and growing capacity for subcontractor default insurance (SDI). This first-party policy indemnifies the general contractor/construction manager for direct and indirect costs relating to a subcontractor default. SDI has addressed some of the shortcomings of unconditional and conditional surety bonds and can be more cost-effective, fast-acting, and provide broader coverage than surety bonds.

Zurich introduced its version of an SDI policy to the marketplace in the 1990s, known as “SubGuard.” Today, seven carriers underwrite this product in the US — Arch, AXAXL, Berkshire Hathaway, Cove, Hudson, Liberty Mutual, and Vantage. SDI allows for GCs to transfer their risk of subcontractor non-completion of work or subcontractor defaults by providing cover for the cost of replacing a subcontractor following their failure to perform.

In the US, the advantages that SDI policies can offer include:

Broader coverage than subcontractor bonding, including coverage for direct costs (performance, payment, replacement, legal, delay damages), indirect costs (extended overhead, delay damages, productivity impact), and up to 10-year tail coverage for substantial completion on enrolled projects.
The ability for insured GCs to control the claim process in the event of a performance default. This is crucial to keep the job on schedule.
A more cost-effective option than subcontractor bonding. An effectively structured and managed SDI program can return millions of dollars to the general contractor/construction manager’s bottom line over the program period.
Given underwriting requirements around prequalification, GCs that purchase SDI coverage can benefit from a potential reduction in losses, which can help keep projects on schedule and within budgets. Defaults usually cost 1.5 to 3 times the subcontract value, per The Surety & Fidelity Association of America (SFAA).

Transferring and mitigating subcontractor default risk should be a priority for GCs and construction managers.

Marsh services can help you build resiliency

Marsh SubSecure

All SDI carriers approve this proprietary financial analysis tool as a viable method of prequalification. By measuring various financial factors, SubSecure can identify subcontractors with a high risk of defaulting. This includes a review of the opinion letter, financial statements, supplementary information, open and closed job schedules, and footnotes to the financial statement to determine if adequate information and disclosures are provided to properly analyze the subcontractor’s financial position.

Quote analysis model

SDI is a profit center; the insured GC has the potential to profit from their SDI program.

The quote analysis model has brought significant value to Marsh’s clients. It details how much profit the insured stands to make in the best and worst-case scenario based on risk transfer rate, sell rate, and retention aggregate.

Using this model to analyze quotes, paired with Marsh’s brokerage expertise, has resulted in several Marsh SDI clients achieving SDI programs with no actual downside.

Marsh Amendatory Endorsement

Marsh negotiates to add the ‘Marsh Amendatory Endorsement’ for all clients. This endorsement revises or eliminates certain exclusions, adds additional time for an insured to submit a claim, and clarifies responsible parties within the insured’s risk management department.

Oliver Wyman actuarial engagement

We collaborate with our colleagues at Oliver Wyman’s dedicated Actuarial Consulting Practice to address client needs efficiently.

Actuarial engagement is key to establishing SDI in a captive and thinking through how to allocate funds from SDI effectively across an organization.

Oliver Wyman can assist clients in reserving for existing claims on their balance sheet, funding for future claims, allocating costs to divisions, and supporting collateral negotiations with insurers.

Retention aggregate tracking

Marsh’s claims and SDI team will track the erosion of the retention aggregate for the policy term should the insured incur any losses. The retention aggregate is the most the client will pay for any losses within the policy term. The rate is adjustable upwards. The retention aggregate will increase if the insured enrolls more subcontract volume than originally estimated for the policy period.

Managing the risk

The current geopolitical, economic, climate, and social risk landscape puts increased pressure on construction companies, causing a rise in defaults and increasing the risk of project cost overruns. As these risks become more complex and intertwined, a robust strategy is needed to help companies identify and manage the risks.

Marsh can offer you access to a highly experienced network of SDI brokers who can help you mitigate, manage, and reduce your total cost of risk through a combination of consultative advice, insurance program design and placement services, and claims preparation and advocacy.

Article

The rise of subcontractor defaults

The rise of subcontractor defaults

Introduction of subcontractor default insurance (SDI)