The failure of a contractor or key subcontractor during the construction period can have severe consequences for the developer or main contractor, potentially causing delays and reputational harm or leading to damage to incomplete works and materials. Amid challenging economic climate extra steps need to be taken to prepare for such a scenario. This briefing note reviews the key issues from the developer’s perspective. However, where there is an insolvency case in the supply chain many of the issues and remedies discussed herein apply equally from a main contractor’s perspective.
Construction firms have struggled with high inflation, labour shortages and higher wage costs for some time and this is placing significant pressure on margins. More recently, rising interest rates have caused further financial trouble for firms, as debt servicing costs have increased significantly. This is forcing record numbers of businesses into administration.
In May 2023, construction-related insolvencies in the UK rose by 65 per cent (opens a new window) compared with the previous month, and by 34 per cent compared with May 2022, according to latest official data from the Insolvency Service. Elevated insolvency rates in the construction sector show little sign of abating (opens a new window). Data collected by insurance firm Atradius revealing a 41% increase in late and failed payment claims in Q2 2023 compared with Q1, and a 178% increase year-on-year.
Potential consequences of a contractor’s failure
Where the insolvent firm is a contractor, it creates significant complications for any project in which they were involved. For developers this can bring a number of potential consequences, such as:
Project delays and halting of work while a new contractor is selected
Concerns around the quality of works prior to the contractor’s failure, complicating the process of hiring a new contractor and allocating liability
Unbudgeted additional project costs such as rectifying issues discovered post-insolvency, the increased costs of finding a replacement contractor and increased debt service costs through lost construction time
Impact on available building warranties
Supply chain disruption as a consequence of reduced cash flow
Maintenance of relationships with the existing supply chain to ensure programme continuity, including the relationship with any replacement contractor
Redemption of callable surety bonds where contractor failure is specified as a condition
Uncertainty regarding impending or current claims, including notification issues where claims have not been notified promptly or have been avoided, potentially resulting in an inability to recover the loss
Security issues if the site is dormant, inviting unwanted visitors and subsequent theft, damage or liability exposure
Developers who had relied on a contractor’s annual contractors all risk (CAR) policy may now need to procure new cover. This can result in cost duplication, worse pricing conditions, or even an inability to find cover
Developers who had relied on a contractor’s third-party liability (TPL) cover will assume liability for any injury or damage of material
General reputational damage to the project and its owners arising from any of the points above and their own perceived failure to deliver
Insurance considerations upon contractor failure
These can be split into two risk areas:
Insurance of risk and work post insolvency
Claims arising out of the work already carried out/completed
Insurance of risks and work post insolvency
Replacement of an insolvent contractor is seldom completely straightforward and issues around indemnity and insurance are just another of the myriad of issues. The design of the insurance programme prior to insolvency will influence considerations in the post insolvency environment. Which insurances, if any, have survived the insolvency event and does the developer need to replace any cover where previously they had relied on the contractor?
Additionally, any new contractor will have concerns around picking up liability for the design and workmanship of a newly insolvent contractor who may have been treating risk differently. Often this leads to new costs being incurred to check the adequacy of designs and/or investigate the quality of workmanship performed to date. Sites that have become dormant may also develop new issues, especially where there has been unplanned exposure to the elements.
Where placement or replacement of any element of the insurance programme is required, prospective insurers will have similar concerns. Underwriters may wish to understand the potential for further supply chain issues, especially if existing subcontractors have been impacted by non-payment or need to be replaced. New insurers will therefore scrutinize requested project information to ensure they are not picking up any problem elements left behind as a result of the insolvency.
Claims arising out of already carried out work or completed
Following contractor insolvency, the developer inherits risks that were previously owned by that contractor. For example, the insolvent contractor will no longer rectify issues and any potential third-party claimants will now direct their claim against the developer. The developer must therefore maintain a dual focus on exposures arising out of the work undertaken to date as well as project completion. Unfortunately, where workmanship failures are subsequently identified and damage has not yet manifested, the developer will struggle for recourse against the Contractors All Risks policy.
Prior to insolvency the contractor may also have failed to comply with the claim notification procedures under their policy of insurance – typically these may be strict and require immediate notification or within a specific time limit. The failure to notify may have arisen due to a number of factors. These may include lack of adequate controls, greater focus on other business critical activities, or simply a decision to put off notifying claims or circumstances in order to avoid increased premiums at renewal. Whatever the reason, any failure to notify may have breached notification requirements which may in turn lead to the claim being rejected.
Following insolvency, administrators will usually act quickly to secure any funds they can against the business. This usually includes cancellation of existing insurance policies and securing return premiums where possible. Unfortunately, this creates a position whereby developers and other claimants join the line of unsecured creditors and lose the benefit of the safety net that had been provided by the contractor’s insurances.
Mitigating against contractor failure
Much of the risk highlighted above can be mitigated through a combination of tracking financial strength and, for contractors, continual supply chain monitoring. Measures to protect against and limit the impact of contractor failure include:
Follow a tight and transparent qualification and contractual process
Procure owner-controlled project insurance to ensureall parties are fully protected (backed by contracts that provide those parties with access to the cover). This offers full control of the insurance programme while ensuring continuity of cover until project completion
Continually monitor finances of contractors and key supply chain members
Regularly review contractors’ key performance indicators (KPI’s)
Maintain payment discipline to ensure supply chains hold a healthy cash flow
Track and carefully review supply chain insurances annually to manage quality control and reduce claims cost
Keep detailed records to assist in lodging claims
Notify or require notification of claims under construction insurance policies promptly, or at least as soon as it is reasonably practical
Where claims or circumstances arise that may lead to a claim against a contractor or supplier, confirmation should be sought that their insurers have been notified. This is especially true for professional indemnity insurance and any others that respond on a ‘claims made’ basis. If an issue is not notified prior to insolvency the policy may be cancelled by administrators and the opportunity to claim lost.
Contractually oblige Contractors and/or critical Sub-Contractors to provide a performance bond. This would usually be for 10% of the contract sum. Consider the benefits of use of a Latent Defects insurance as it ensures that the project is properly audited/surveyed at all key stages and defects are identified early.
If debt is involved in the project, consider requesting that the owners purchase delay in start-up (DSU) insurance along OCIP as an increasing number of lenders are requesting it
For further information, please visit the Lockton Global Real Estate and Construction page (opens a new window), or contact:
Richard Alford-Smith – Senior Vice President Global Real Estate & Construction
Michael Bogdan – Partner, Lockton Global Energy & Power (LGE)