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Contractor insolvency: All change for construction companies?

As inflation rises, the chance of contractor insolvency increases. Discover how construction companies are dealing with the situation.

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By Andy Desmond , 

Head of UK Business Development, UK Construction

18/07/2022 · 6-minute read

The threat of contractor insolvency could be a driver for change in the way construction firms operate.

As inflation rises, the chance of contractor insolvency increases. Rising materials prices and increasing labour costs, combined with supply chain issues, mean that already thin margins become even slighter, increasing the risk that a contractor might cease trading. A focus on lowest price tenders is also exacerbating the situation.

In 2021, 2,579 construction sector firms across England and Wales became insolvent. At almost one in five (19%) of all insolvencies, construction accounted for more company failures than any other industry. Meanwhile, in the first three months of 2022, some 545 UK construction firms were adjudged to be in critical financial distress, an increase of 51% on the figures for the same period in 2021.

Not only does this economic turbulence impose severe challenges on contractors, it could be a driver for change in the way owners and developers approach projects.

Could a change in the insurance procurement strategy help?

Owners and developers are increasingly taking control of their construction insurance with the use of owner controlled insurance programmes (OCIPs) in order to offset the current state of economic turbulence.

Currently, a common approach to insuring works is for the main contractor to arrange project cover utilising their annual insurances, typically being CAR and TPL.

However, the weakness of this during turbulent economic times is that, should a contractor cease trading, their insurance will cease too, and subcontractors will not be able to access the site. The owner then has the inconvenience and cost of selecting a new main contractor to take over the project mid-build, with the issue that there is little insurer appetite to cover a partially completed build. Additionally, on larger projects where there is shared construction equipment, such as tower cranes, the risk of physical loss or damage to the equipment could pass to the developer.

The current volatile financial situation means there is a case for owners and developers taking on the insurance of a project themselves. An OCIP is a single insurance programme arrangement whereby the owner takes control and purchases the construction all risks (CAR) and third party liability (TPL) insurances with the option to purchase Delay in Start Up (DSU), in the form of a bespoke, all-party cover for the project. Ancillary coverage can include non-negligent liability, terrorism, contractual liability, construction pollution liability, latent defects, and legal indemnities.

By procuring an OCIP, owners and developers can receive the following benefits:

  • Reduction in the administrative burden of insurance through a tailored policy that covers all of the appropriate parties working on a project for the entire period of the project, eliminating the need to verify renewal of any annual insurances traditionally relied upon by the contractor.
  • Ability for the employer to maintain cover even if the contractor becomes insolvent or the employer replaces a contractor for poor performance.
  • Total control of the premium, scope of cover and claims management, which helps satisfy the requirements of financiers, simplifies the claims process and delivers transparent premiums, as the owner is not reliant on the contractor taking out construction insurance and then charging additional administrative fees.

Crucially, the OCIP ensures continuity of cover, meaning the project is insured even if the main contractor ceases trading, and therefore the sub-contractors can continue working on site with the owner paying them for their services directly until a new main contractor is found.

Lenders will also be interested in the financial strength of the supply chain, and will appreciate the merits of an OCIP, and the certainty of cover it will bring.

Developers should note that increasingly underwriters are asking what flexibility is built into the contract position with regard to the contract sum. Is it fixed or unfixed? A fixed sum can put pressure on the supply chain over time, particularly if inflation continues at the current rate. The loss of a contractor is not a good outcome for any party.

Whatever their choice of insurance procurement approach, developers should establish robust due diligence procedures to ensure the main contractor has adequate supply chain protocols and is likely to be solvent throughout the project.

The Carillion collapse – continuing knock on effects

It has been more than four years since the collapse of Carillion, but the after-effects are still being felt. There was a significant effect on major contractors in joint ventures with Carillion, where they had to take over the company’s work, employees, and administration. They also had to shoulder a larger proportion of the risk. This could have led to a more cautionary approach before entering into joint ventures.

An increase in surety bonds?

Economic uncertainty is also one of the main factors increasing the demand for surety bonds.

When this increases, the likelihood of contractor insolvency also increases and employers look to protect their projects by making it a condition of contract award that the chosen contractor puts in place a performance bond, which is normally for 10% of contract value.

With the deteriorating economic conditions forecast for the remainder of 2022 and into 2023, Marsh expects there to be an increase in demand for surety bonds as employers look to protect themselves from the growing risk of contractor insolvency.

While surety underwriters have been cautious over the past two years of the pandemic and have taken a more rigorous underwriting approach, capacity for surety bonds in the construction sector has been maintained. It is, however, important for contractors to work closely with underwriters and specialist brokers to ensure bond facility capacity is available for future projects.

The state of the construction insurance market

The construction insurance market has gone through a clear transition, moving from a market that experienced stable or declining pricing for over a decade, to one in which prices have been rising, but with some moderation in 2021.

The market is expected to remain challenging for the near future, with underwriters continuing to heavily scrutinise each project. Insurers will seek detailed risk information, which will undergo in-depth review. As ever, early engagement and quality information remain key to attracting the optimum terms and premium.

How to gain optimum insurance terms

Work with a broker who has expertise in both construction and in wider specialties, including the capabilities to properly respond to the challenging economic and business risks faced by developers and contractors. With their technical expertise, market knowledge, and close relationships with underwriters, brokers come into their own during a period of tightening insurance markets. In order to gain the most effective insurance for their projects, clients should start working with their brokers as early in the process as possible, to ensure their contractual structure reflects the optimal insurance programme design and enables sufficient time for terms to be negotiated.

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