Specialist cover that could be a life saver

An insurance policy that acts as an alternative to subcontractor bonds has proved popular in the US and could take off here. Elaine Knutt reports.

For main contractors reading the drip-drip of subcontractor insolvency stories, the notion of a life-jacket to preserve them from a rising tide of other firms’ financial problems must seem quite appealing. In fact, there is an insurance product already on the market — and adopted by Wates and a second, unnamed major contractor — that offers projects enough buoyancy to survive even the catastrophic insolvency of a key subcontractor.

Subguard, offered by insurer Zurich, arrived in the UK two years ago from the US. In fact, it’s not specifically designed as an insolvency product: payouts can be triggered by other forms of subcontract default, such as design problems, workmanship or falling behind on programme. But in the current climate, it’s the protection against sudden business failure that’s likely to drive most interest.

For a contractor, the policy is essentially an alternative to subcontract bonds, but there are substantial differences — the most obvious being that the contractor bears the cost of the premiums, rather than the subbie. And while a bond offers contractors a cash payout of 10-15% of the subcontract value, Subguard will cover the main contractor’s total financial hit, up to a ceiling of £25m.

The downside is that the contractor has to agree to pay a substantial excess, up to £1m. The premium cost is quoted as 0.3-0.5% of the value of enrolled subcontract packages. Typically, all subcontracts over a threshold value on all projects within a region or business would be covered. So if a subbie is working on several sites, a claim could cover several projects.

Broker Jardine Lloyd Thompson is one of two UK firms approved by Zurich to offer the product. David Cahill, partner in the construction team at JLT, believes Subguard should suit contractors that have good risk management procedures in place and can absorb the excess, but want protection from major events. “The lower-level, manageable risk can be mitigated by risk management, but Subguard covers you against the unmanageable, unpredictable risk,” he says.

“If you’re not routinely bonding subbies, it is an additional cost,” Cahill acknowledges. “It takes a while for contractors to get a good level of understanding. But we have two major clients and a number of large contractors are interested.”

Wates’ London and South-east region adopted Subguard in late 2008, reasoning that the area’s higher-value projects were more vulnerable to subcontractor failure in the downturn, including knock-on delays, disruption and liquidated damages.

“There are bonds for 10 or 15%, but we might be talking about a disaster, on a big-ticket item like cladding,” says Andrew Laird, Wates’ group commercial director and head of legal.

Latent defects protection

A further incentive for Wates is the protection Subguard offers to clients.

The policy remains in effect for six years post-completion, giving the client protection against latent defects. And if the main contractor itself succumbs to insolvency — as was the case with Rok — then the benefit of the policy is transferred to the client. However, this means the client can make a claim for any subcontractor defaults, and isn’t covered for the main contractor’s insolvency.

As Laird explains: “Clients have been really impressed by our risk management regime, including Subguard. Ultimately the aim is not to use Subguard — the value is not necessarily in the payments, it’s in the protection it offers the family business, and the clients.” Wates has, in fact, never claimed, although Laird says it is examining options in relation to an ongoing London project.

Before Zurich underwrites the policy, it undertakes due diligence on the contractor and its risk management and subcontractor selection processes. In Wates’ case, the initial premiums quoted were reduced after Zurich’s checks. “We’ve adopted a ‘closer to fewer’ supply chain strategy, so we know most of our subcontractors’ financial strength,” says Laird.

In the event of subcontractor default, Zurich would first expect the main contractor to pursue its rights under the contract. But if default or insolvency is established, Zurich will pay out, using its rights of recourse against the subcontractor. For a main contractor, Cahill says that another advantage is dealing with Zurich on the claim, rather than seeking a bond pay-out from a third party insurer. However, one caveat is that if the subcontractor subsequently contests the default in court and wins, Zurich would then reclaim the sums it had made to the policyholder.

Given the financial climate and risk of subcontractor insolvency, it’s perhaps surprising that Zurich and JLT have only signed up to two major contractors so far. Clearly, there are cultural barriers: in the US, Subguard has taken off as an alternative to bonds because state legislation on publicly-funded projects require the contractor to protect clients from subcontractor default. But in the UK, bonds are optional, and although the cost might ultimately be absorbed into tender prices and out-turn costs, protection is still seen as the subbie’s financial responsibility, not the contractor’s.

“It does surprise me, to a degree,” says Laird. “Possibly other contractors are happy to cover these losses themselves, but we see it as protecting the family’s money. We review it every year, and certainly will be using Subguard while the financial climate remains volatile.”

Back to basics: Taking on a failed contractor’s contracts

The issue of contractor insolvency has been brought into sharp focus with the recent demise of Connaught and Rok. While contractor insolvency may delay projects and increase clients’ costs, it also raises the question of what happens to that contractor’s contracts.

Building contracts generally provide that either the contractor’s employment is automatically terminated or its employment may be terminated by the employer giving notice. This may depend on the nature of the insolvency – a company in administration may have a business that can continue as a going concern, while a company in liquidation will eventually be wound down.

When negotiating construction contracts, there is always an issue as to what constitutes insolvency. To protect clients, termination provisions should cover multiple insolvency scenarios and should also be kept up to date with current legislation. If insolvency occurs by a route not defined in the contract, then it can leave clients without the contractual remedies they intended.

If the works cannot be completed by the existing contractor, an employer will look to appoint a new contractor, which is unlikely to want to take responsibility for the old contractor’s design or workmanship. The main issues to be considered therefore are:

• Scope of works and any design – what has been done and what is needed to be done to complete the works?
• Goods, materials and plant – are there any existing contracts for the supply of goods and materials, plant and equipment that may be taken over by the new contractor?
• Programme – a new contractor will need to work up a recovery programme and may need a degree of float to protect against unknown time risks.

Rok and Connaught are warnings that insolvency is a very real threat in the prevailing economic climate.

By Alison Rowe, an associate at Nabarro