Insolvency risk within the construction sector is rising due to high levels of inflation, supply chain issues, labour shortages, and the looming threat of recession (opens a new window). Businesses will need to manage the insolvency risk across the supply chain to reduce vulnerabilities and to make their risk more attractive to insurers.
A difficult operating environment
The rising tide of inflation coincides with a sharp slowdown in gross domestic product (GDP) growth – a fact reflected in the decreasing volume of new orders within the construction sector (opens a new window). While higher interest rates are expected to push down inflation, they also make credit more expensive, impacting investment sentiment and consequently slowing down economic growth further.
Lingering supply chain challenges, plus continued increases in the cost of key materials (opens a new window), including concrete, cement, and plastics, are further exacerbating companies’ difficulties. This is being augmented by ongoing geopolitical uncertainty – namely the Russian invasion of Ukraine – which is driving up energy prices. Meanwhile, labour costs in the UK have increased by 30% since 2015 (opens a new window), correlating with a post-Brexit shortfall of workers.
The construction industry also suffers from an almost unavoidable lag between work being performed and payment being received, with contracts often providing for payments by instalments or in arrears. As other factors threaten companies’ liquidity, this can push companies into insolvency.
Insolvencies remain frequent
Owing to the above challenges, insolvency represents a very real risk for construction companies. In the UK, the sector witnessed 2,165 insolvencies in the first half of 2022 alone (opens a new window) – only 568 less than the entire total for the preceding year.
Where insolvency occurs, it imposes a series of risks upon the relevant firm. For instance, reputational and legal issues may arise in relation to potentially unfinished projects. Directors and officers may also have personal liabilities to settle.
In the case of main contractors, the majority aren’t just threatened with their own insolvency. Typical professional indemnity insurance (PII) policies will cover those for whom the insured has vicarious liability. In the construction sector, this includes subcontractors and suppliers, who currently share many of the difficulties facing construction firms themselves.
As such, where an appointed subcontractor or supplier enters into insolvency, any claims against that company will come against the main contractor, whose claims record is therefore at risk. Although subcontractors and suppliers may purchase run-off cover extending to any claims made in the wake of liquidation, this cannot be guaranteed.
Mitigating risk ahead of renewal
The pressures incumbent upon those across the construction sector, combined with the liabilities set out under PI policies, underline the need for firms to mitigate against the various threats of insolvency. How they do so, will also have implications for firms’ ability to source cover.
Where PI policies are due for renewal, firms are likely to face heightened scrutiny from insurers, many of whom are likely to demand evidence of robust risk management actions. Such actions are likely to resemble best practice when it comes to supply chain management, including client selection, contracting terms, and sub-consultant appointments. Firms should also expect to have to demonstrate take-up of these strategies across their operations, with protocols reviewed on a regular basis.
As ever, firms undertaking higher-risk work will face the greatest difficulty upon renewal. Most heavily publicised among these is fire safety and cladding work, but basements, waste-to-energy projects, and stadiums all present challenges, and will make renewal more difficult. Size, variety of work, and claims record will also factor.
As scrutiny increases, the negotiation of renewal terms will require longer to complete. With this in mind, and in light of low capacity among insurers, it’s crucial that firms engage early with their insurers. This will give firms enough time to pull together the inevitably greater volume of information required of them.
Conduct rigorous due diligence checks of all subcontractors and suppliers to ensure legitimacy and capacity to fulfil responsibilities
Maintain close and regular correspondence with all parties for whom you have vicarious liability
Advocate with subcontractors and suppliers for transparency with regards to potential obstacles, such as delays to payment or material shortages, and collaborate where necessary to incorporate price increases
Demonstrate responsible client selection policies
Maintain strong visibility of incomings and outgoings to ensure adequate cashflow
Seek clarity on the indemnity cover purchased by subcontractors and suppliers
Where appointing a replacement for an insolvent company, ensure clarity on how and why liabilities attach to the new company and communicate any changes to implicated PII policy insurers
Contact insurers in advance of renewal to ensure adequate time to prepare and meet requirements
For further information, please contact:
David Isherwood, Senior Vice President, Global Professional and Financial Risks
T: +44 (0)20 7933 2195