Contractors’ insolvencies increase risk in the construction sector

Construction Risk
Construction projects rely deeply on the quality of the work delivered by contractors and subcontractors, whose insolvencies can severely impact a development and the insurance policies in place. Insurers are scrutinising construction projects more carefully also because the risk of insolvencies is on the rise.

Recent developments in the booming solar energy sector in Australia can illustrate how quickly claims can rise if several contractors file for insolvency. A number of projects had to be delayed recently, resulting in liquidated damages being imposed, and missed final payments. Among the causes were the selection of cheap imported products that were not fit for purpose and contractors cutting corners and failing to meet the strict standards required to gain registration, or connection approval for a project. This has triggered a wave of insolvencies and collapses of contractors. In a vacuum created by the withdrawal of these contractors, a number of second tier contractors entered the market and performed substandard work. Lockton has seen a number of claims where “backpacker” labour was used on construction projects which later manifested in defects claims for faulty workmanship.

Following Covid-19, the risk of insolvencies has risen substantially. Research by Euler Hermes suggests that global insolvencies are set to rise 35% by 2021 compared to 2019.  

According to law firm Trowers & Hamlins, triggers for insolvencies include: 
•    Cash flow issues caused by late payments, bad debts and most construction contracts providing for stage payments in arrears;
•    Low margins in the sector meaning that profit can be obliterated by unexpected delays or increased costs in the works which the contractor may take the risk of;
•    The collapse of a main contractor triggering a domino effect on subcontractors.

A project developers’ choice of contractor is the most significant issue for the insurance market. Insurers have paid tens of millions of dollars in construction losses for defects or negligent works and as such there have been changes to how insurers look at and provide insurance for contractors. Some examples are:

•    Scrutinizing the proposed engineering procurement and construction (EPC) or operation and maintenance (O&M) contractors before offering any cover. Previously, this was offered automatically;
•    Ensuring that the indemnities between the operator and the contractor are well understood as these are critical to understanding the allocation of risk between project participants; 
•    Detailed contractor reviews ensuring they have the appropriate experience. Where the contractor is a global company new to the local market, their experience on projects overseas will be taken into consideration;
•    If an insurer has concerns in respect to a particular contractor this can lead to higher deductibles, restricted coverage or even refusal to offer terms;
•    Where there have been previous defects or claims on a project, insurers are increasingly seeking to exclude any cover for these issues until they have been fully rectified.

As the insurance market continues to harden, insurers will keep asking more probing questions about the contractual arrangements and the use and selection of contractors. Lockton remains proactively optimistic that broad cover and competitive premiums are available for clients that can articulate a good risk profile and contractor due diligence. When looking to transfer risk to the insurance market, Lockton recommends the following to be considered in relation to contractors:

  • EPC / O&M Agreements: Ensure that there is an appropriate allocation of risk to the Contractor.
  • Risk Engineering: Invest early in quality, independent risk engineering. This will identify any issues on site and allow insurers to satisfy themselves of any defects. 
  • Contractor Selection: Ensure there is a well-articulated and clear process for the selection of any contractor. 
  • Warranties: Understand the warranties on components and equipment and communicate this to insurers. 

Lockton has helped clients with warranty backstops and system performance output guarantees, which increases projects’ bankability and provides comfort to insurers. 

For further information, please contact:
Michael Martin, Manager - Construction Lockton Companies Australia
T: +61 3 9492 6622
David Hayhow, Partner, Real Estate & Construction
T: +442079332624
Bradley Green, Manager - Power & Energy, Lockton Companies Australia
T: +61 (3) 9492 6619

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