Will Subcontractor Default Insurance Still Have Value in the Recovering Economy?

The COVID-19 pandemic has burdened subcontractors with workforce shortages, supply chain issues, and financial difficulties. Therefore, as states lift their stay-at-home orders issued to limit the spread of COVID-19 and construction projects resume, subcontractors’ ability to complete demanding, time-sensitive projects might be impacted. Subcontractor default is already a common and costly problem for general contractors. When subcontractors fail to complete their contractual obligations, a general contractor’s profitability and reputation are greatly impacted. Effectively managing the risk of subcontractor default will be increasingly important for general contractors in the post-pandemic economy.

Subcontractor Default Insurance (“SDI”) is a non-traditional insurance product which can minimize a general contractor’s damages resulting from a subcontractor’s default. It is a two-party indemnity agreement between a general contractor and insurer. It was created as an alternative to surety bonds, with the idea that the general contractor controls the default process and remedy to help keep projects on time and within budget. Under a SDI policy, a general contractor enrolls prequalified subcontractors for either a specific project or policy term. Then, the general contractor is indemnified by the insurance company for any covered costs incurred if one of the subcontractors defaults. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.

In addition to direct costs, SDI coverage usually includes indirect expenses such as liquidated damages, acceleration of other subcontracts, increased overhead and the like. The insurer shares the risk with the general contractor through a deductible and co-pay; the general contractor absorbs some of the costs associated with a subcontractor’s default, usually up the deductible amount. SDI coverage extends to the limits of the individual policy rather than being limited to the value of the subcontract.

In order to lessen their risk, SDI carriers require general contractors to prequalify subcontractors before they can be enrolled on the policy. General contractors are in charge of this process. In order to evaluate a subcontractor both operationally and financially, subcontractors must submit the following types of information: financial statements, proof of available lines of credit, safety record, and history of claims and litigation. For subcontractors, the prequalification process is not different than that for surety bonds, except that it is executed by the general contractor instead of a professional surety underwriter.

After the COVID-19 pandemic, insurance carriers will necessarily adjust their outlook on subcontractors due to the increased risk of loss. Therefore, it will likely be more difficult for general contractors to find subcontractors able to prequalify for SDI policies and, in any event, the process will become more tedious. In addition to the aforementioned information, general contractors will probably be interested in subcontractors’ business continuity plans and specific plans to mitigate impacts like loss of employees and/or project shutdowns.

General contractors must be large and sophisticated enough to have the resources necessary to properly pre-qualify subcontractors, including assessing the financial risks of accepting subcontractors, and monitor their schedules and performance for the duration of the project. While the pre-qualification process is necessary, it is insufficient to thoroughly manage the risk. Even a subcontractor who is prequalified at the outset of a project must be managed throughout the entire course of work. A general contractor’s oversight of subcontractor performance will be even more critical in the post COVID-19 economy as subcontractors are more likely to be operationally and financially stretched thin.

In order to even qualify for SDI insurance, a general contractor typically needs minimum annual subcontractor volume in the $50-$100 million range. In fact, for SDI to be cost-effective, carriers say that annual subcontracted values must exceed $75 million. This is because SDI is expensive, usually ranging from 0.4 to 0.85 percent of total subcontract values.

Given the increased risk of subcontractor default, SDI policies will likely be even more expensive as the economy recovers from the COVID-19 pandemic. Deductibles, which are already high, are likely to increase. Currently, it is not unusual for a deductible to be in the $500,000 range. In addition to that, SDI policies have a co-pay which is paid up the retention aggregate—often three to five times the deductible. That said, SDI will still have value and provide cost savings under the right circumstances. For very large jobs, it would be worth taking on part of the financial risk of default for general contractors to accept SDI’s high deductibles because it would cost much less (now typically 50% less) than subcontractors bonding and passing along costs within their bid. Another consideration is whether the costs can be absorbed by the project. General contractors can also strategically utilize SDI to target high-risk subcontractors.

Cost will not be the only determinative factor in evaluating SDI’s value after the pandemic. It is possible insurers will write more exclusions into policies to manage their own risk associated with impacts associated with mandated shutdowns similar to what the United States recently experienced. Accordingly, subcontractor default stemming from such a shutdown (including impacts like workforce shortages and supply chain backlogs) would unlikely be covered. SDI policies also generally do not cover defaults, which result from the following: misrepresentation, fraud, defaults occurring prior to the policy period, material breach of warranty by the contractor, contracts acquired from other entities, war and losses arising from providing professional services.

To determine whether or not SDI is a worthy investment, a general contractor must separately evaluate each project, and carefully weigh the cost, potential savings and risk involved.

For more information on the efficacy of subcontractor default insurance in a recovering economy or other construction law topics, please contact Nicole Lentini and Becky Juhl.

Gone But Never Forgotten: Antique Insurance Requirements Can Torpedo Your Contract

A long time ago, a law school professor of mine remarked that “transactional attorneys are on the cutting-and-pasting edge of the law.” When structuring contracts, there is much to be said in favor of not rewriting the wheel, so to speak. Good attorneys constantly evolve their contract provisions, whereby lessons learned, changes in the law, and shifting industry practices are captured and incorporated sensibly. But, like biological evolution, contract evolution hates to discard pieces that were once useful. This can result in your contract having the equivalent of the human appendix: a piece no longer of any positive use and that harbors the potential for harm.

A prime example in construction contracts is the insurance requirement that the contractor (or subcontractor) obtain an endorsement for what is commonly referred to as XCU risk—that is, coverage for explosion, collapse, and underground liability. This contract language evolved from the 1986 version of the Insurance Services Office’s (ISO) CGL policy, which excluded coverage for liability arising from explosion, collapse, and underground work. In 1986, contractors could indeed buy an endorsement that extended coverage to these types of risk, and therefore contract language requiring the purchase of such an endorsement was important and valuable. However, it has been many years since the ISO CGL policy form contained this exclusion—XCU coverage is now simply part of the standard coverage afforded by this policy, and has been for over a decade. And yet, many contracts still require contractors to obtain an endorsement that no longer exists, in order to solve a coverage problem that they don’t really have.

These sorts of provisions, which set requirements that cannot actually be fulfilled, create the potential for delays in submitting bids and finalizing contracts, and can convince both sides to not carefully review or enforce the insurance provisions in the contract. Finally, although the current ISO CGL policy includes XCU coverage by default, that coverage can be eliminated via an endorsement. Thus, by asking the contractor to provide a positive XCU endorsement (a request that will be met with “that’s not necessary” by most contractors, and “that doesn’t exist” by sophisticated contractors), the contract language fails to inform both parties about the true risk they should be looking for: an endorsement eliminating the standard XCU coverage.

These sorts of outdated contract provisions linger in the “standard form” contracts used by many contractors and owners. The presence of such a provision in your standard contract is a sign that some additional evolution is necessary in order to bring your contract up to current laws, standards, and industry practices.

Gordon & Rees Partners to Speak at ICC Construction Arbitration Conference

Gordon & Rees partners, Ronan McHugh and Akin Alcitepe will be speaking at a seminar on International Construction Arbitration on June 12, 2015 in Istanbul, Turkey. The seminar will be sponsored by the ICC International Court of Arbitration and will provide insight on the prevention and prosecution of construction disputes in international arbitration and how to best utilize experts in both contexts.

McHugh will be discussing the importance of insurance on construction projects on the first panel which will focus on the prevention of construction disputes. Alcitepe will moderate the discussion on the second panel where the topic will be the prosecution of international construction disputes.

To read more about and register for the seminar, click here.

Insurance Broker Sold You a Worthless Policy? Tough Luck

Guess what? Your insurance broker does not owe you a duty to get you the insurance coverage you need on a project.  According to a recent California Court of Appeal case, San Diego Assemblers, Inc. v. Work Comp For Less Insurance Services, Inc. (2013) 220 Cal.App.4th 1363, an insurance broker is only obligated to procure the insurance you ask for, not necessarily the insurance you need.

Prior to beginning construction, San Diego Assemblers (Assemblers) contacted Work Comp For Less (the broker) to get general liability coverage for a restaurant remodel project.  The broker procured policies and provided them to CON BLOG_policyAssemblers.  After the project was completed, an explosion and resulting fire occurred at the restaurant.  Assemblers tendered the claim to its two insurance carriers; both denied coverage, essentially telling Assemblers that one policy had an exclusion for damages first manifesting during the policy and the other had an exclusion for prior completed work.  In English, the two policies together didn’t cover any of Assemblers’ work on the project.

Although Assemblers told the broker that it needed insurance specifically for the remodel project, the policies the broker sold Assemblers did not actually cover Assemblers’ work.  In essence, the broker sold Assemblers the wrong policies.  Nevertheless, the court held that the broker did not owe a duty to Assemblers to determine what kind of coverage was needed, but rather only owed a limited duty to “use reasonable care, diligence, and judgment in procuring the insurance requested by [the] insured.”

The moral of the story? Know what kind of insurance you need; your broker doesn’t owe you a duty to find out for you.