Solvency Risks in Construction Projects

The impact of several contractor collapses in recent months has highlighted counterparty solvency as a key risk for construction projects. This article discusses the effect of insolvency on existing insurance policies and the extent to which insurance can mitigate counterparty risk.

Insolvency risk in the Australian construction industry

A perfect storm of rising costs, supply chain delays and workforce shortages continue to put pressure on construction companies battling the ongoing impact of inflation. According to the latest ASIC data, 271 construction companies entered external administration in the quarter ending March 2022, accounting for 25 per cent of all Australian company insolvencies (Source: ASIC)

The impact of counterparty insolvency on insurance policies

The insolvency of an insured is a material event that needs to be advised to insurers. Depending on which party has arranged the insurance, the impact will vary.

Contract works insurance

Some contract works policies can contain “cessation of work” restrictions, which means cover may cease if a project is inactive for a period of time e.g. while the project owner finds a replacement contractor.

If an insolvency results in a construction site being shut down temporarily, the insurers need to be advised immediately and kept up to date with developments, to avoid the potential for a loss not to be covered or the policy to be voided.

Owner controlled / Principal arranged insurance

One of the advantages of a principal-arranged insurance policy is that the impact of a contractor insolvency event is typically easier to deal with. Provided that the insurer accepts the replacement contractor and the new contractor accepts the existing policy cover and deductibles, the replacement of the insolvent contractor with a new contractor should be straightforward.

Contractor controlled insurance

Where insurance has been arranged by the insolvent contractor, the impact is more complex. While project policies cannot be cancelled (provided that the premium has been paid), if the insolvent contractor has used their annual insurance policies to provide the required cover, there are few options for replacement contract works cover.

It will be difficult to insure partially completed work with a new insurer and the best approach is to work with the existing insurer to transfer cover.

Where the insolvent contractor has arranged a project policy, provided that the insurer accepts the replacement contractor and this new contractor accepts the existing policy cover and deductibles, the new contractor should be added to the existing policy. This may require negotiation with liquidators or receivers, but will minimise any restrictions in cover.
Where the insolvent contractor has used their annual contract works policy, existing insurers may be willing to convert the cover under the annual policy into a project policy and continue cover to completion; however this will require negotiation and is likely to need additional premium to be paid. Approaching new contract works insurers can result in significant restrictions to cover relating to any existing defects that have yet to manifest.
Where the insolvent contractor has used their annual public liability policy, the new contractor will only need to declare the work under their annual policy.

The insolvent contractor’s professional indemnity insurance will automatically go into run-off i.e. the policy will continue to respond to services and advice provided prior to the liquidation/receivership, but not afterwards. The new contractor will need to advise their insurers of the works and extent to which the design is novated to the new contractor and how they are peer reviewing the design.

A project-specific professional indemnity policy may be required if the new contractor doesn’t have an annual professional indemnity policy, wants to ring-fence the risk of the project, or their annual insurer doesn’t wish to provide cover.

How contractors and developers can mitigate counterparty risk

From a solvency perspective the main counterparty risks relate to certainty of payment and certainty of performance – the principal/employer (or head contractor) wants to be certain that the work will be performed, and the head contractor (or subcontractor or supplier) wants to be certain that they will be paid for the work they have performed.

Caption: Counterparty risks from a solvency perspective

The main insurance/financial products that address these concerns are surety bonds, which protect down the contractual chain to mitigate against non-performance; and trade credit insurance, which protects up the contractual chain to mitigate against non-payment.

Surety (Bonds)

Bonds are not insurance policies; they are contingent loans where the bond provider agrees to pay on demand but expects to make recovery from the contractor. The insurance company providing the bond becomes a creditor to the contractor in the event that the bond is called, so they are very interested in the balance sheet strength of the contractor as that drives the level of credit risk they are taking in providing the bond. Insurer-provided bonds can supplement bank-provided bonds; however insurers will generally require a turnover in excess of $20m before they are willing to consider setting up a bonding facility.

Trade credit

Trade credit insurance provides cover against a debtor failing to pay amounts that are due to the insured. Policies can be arranged for specific debtors or groups of debtors, or for all trade debtors depending on the risk profile.

Trade credit cannot be used to cover a principal or contractor for the increase in the cost to complete a project following the failure of a contractor or subcontractor, as the increase in cost is not a trade debt (although such losses may form part of a contractual claim against the defaulting party depending on the scope of the indemnity provisions in the contract).

Contractors, subcontractors and suppliers should consider the use of trade credit insurance to protect against the failure of a party up the contractual chain.

Subcontractor default

Subcontractor Default Insurance (SDI) was a product first offered in the United States by Zurich Insurance in the 1990s, providing cover for the cost of replacing a subcontractor following their failure (e.g. the incremental cost of paying a second contractor to complete the first contractor’s work – either paying for the same work twice, or additional work/rework necessary to complete the project).

SDI was developed in an attempt to address the shortcomings of unconditional and conditional surety bonds, however:

SDI is more conditional than unconditional surety bonds
SDI pricing is not competitive in comparison to surety bonds
The product is not as liquid nor responsive as surety
It requires proof of loss
The general contractor who obtains an SDI policy is required to maintain a large deductible

From time to time we have received queries regarding the availability of SDI cover locally and Marsh has attempted to find insurers that are willing to offer this cover in the Australasian market; however there are currently no insurers that are willing to offer this product for Australia or New Zealand.

3 key actions

Developers and project principals should consider controlling their own insurance through a principal-controlled insurance program to protect their interests against counterparty risk
Take steps to mitigate your counterparty risk by considering insurance and finance options such as surety bonds and trade credit insurance
Speak to your risk advisor to understand your specific requirements - your Marsh representative can connect you with our specialty Construction and Credit Specialties experts if required

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This publication is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. The information contained herein is based on sources we believe reliable, but we make no representation or warranty as to its accuracy. Marsh shall have no obligation to update this publication and shall have no liability to you or any other party arising out of this publication or any matter contained herein. Any statements concerning actuarial, tax, accounting, or legal matters are based solely on our experience as insurance brokers and risk consultants and are not to be relied upon as actuarial, accounting, tax, or legal advice, for which you should consult your own professional advisors. Marsh makes no representation or warranty concerning the application of policy wordings or the financial condition or solvency of insurers or re-insurers. Marsh makes no assurances regarding the availability, cost, or terms of insurance coverage.

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Solvency Risks in Construction Projects