Construction insolvencies, rising inflation and impacts on insurance

The construction sector records more insolvencies than any other industry. In recent times a myriad of issues have evolved, many of these have their genesis in COVID-19, as set out in our article of August 2021.

In the last 12 months there has been a series of publicised collapses including Probuild in February and Condev in March. It is rumoured that other residential construction operators also going into voluntary administration.

Privium is facing investigation by ASIC following allegations of trading whilst insolvent last year and the collapse of Snowdon has also impacted hundreds of homeowners with incomplete projects.

There are a few factors contributing to these insolvencies. We have known that labour shortages and increased cost of materials (emanating from COVID-19) are the genesis of the trend. These are now being exacerbated by rising inflation and higher cost of debt.

Simultaneously, Federal and State Governments have made record investments into building and construction to boost the post pandemic economy. The result is increased demand and subsequently further pressure on labour.

Fixed priced contracts continue to present risk to builders. Many find themselves locked into projects which, 18 months ago, would have yielded a margin of 15-25%. Due to inflated costs, those projects will now be completed at a loss.

The consequences for this turbulence in the construction industry are far reaching. They also have implications for insurers across construction placements and further afield, impacting a variety of product classes.

Many industry experts believe the worst is yet to come, with a greater number of insolvencies expected towards the end of 2022 and into 2023.

The sector is likely to go through a period of resetting its pricing to meet the cost inflation experienced. Pricing is likely to increase to reflect the additional costs in the market.

Contractors will need to closely monitor their own financial performance but also monitor the stability of their subcontracted trades – ensuring that they can weather the storm and complete their contracted works.

The state regulators who provide consumer protection in the form of home warranty insurance for residential building works are likely to undertake more stringent reviews to reduce consumer exposure to insolvency.

In the commercial sector, contractors who have signed up to fixed price contracts will be looking to complete them with their margins being squeezed. It is becoming more common that contractors and principals with strong relationships are negotiating commercial outcomes to manage the trend of cost escalation. Many, we understand, are working closely to ensure the successful completion of projects and even share project losses.

Consumer sentiment is also a concern for the industry. Prospective purchasers who were considering buying a new apartment or house, are now looking to purchase existing stock to remove any risk of insolvency (and in some case mitigate against the publicised defects on new developments). We would submit that media coverage has been particularly unkind in this regard with publicity around stalled and incomplete projects suggesting a wider scale problem than what really exists.

Contract works policies will have a limitation on maximum contract value. Policies will also often have a “escalation provision” or “inflation provision” within them which covers escalation in the original construction value following loss or damage. Insureds should review their escalation cover – which is usually expressed as a percentage of original contract value – to ensure that such cover is adequate given the acceleration of construction costs.

Construction policies may also include assignment provisions, allowing one insured party to have coverage assigned to them following the insolvency of a contractor. Such assignment can reduce the cost of purchasing duplicate insurance cover when a project recommences with a new contractor.

It is important that you have a record of the insurance cover in place during construction, particularly where insolvency has occurred. A future claim made in relation to third party property damage or personal injury arising during the construction by a now insolvent contractor against the owner of a site could be uninsured if you are not able to provide details of the policy in place at the time of occurrence.

Many Insureds choose to pay their premium in instalments using funding. In the event of insolvency of a contractor, the funder may seek to cancel any policies on foot to seek refunds of premium to cover their debts. If this occurs the policy may be cancelled without reference to the principal or homeowner, despite them being insured under the policy. Again, it is important for principals to take immediate action to understand the insurance in place and how it may be able to be assigned to them – even if it means having to cover the cost of the premium to achieve this.

If a project is substantially complete it is likely that cover will cease due to cessation of work on site leaving the owner completely exposed to any losses occurring once insurers have cancelled cover.

The insurance market for design and construction contractors, principal arranged professional indemnity and more generally, construction professionals remains ‘hard’ (see our July 2022 market update here as regards professional indemnity for same). Appetite is limited, cover is narrow and premium and excess structures continue to increase.

This has been driven predominantly by losses from product defect (cladding amongst others) and project delay claims. The trends has caused insurers to apply cost escalation and contagious diseases exclusions on new policies. We continue to see the narrowing of cover including revision back to negligence based policy wordings. It remains that the imposition of broader duties of care imposed by the Design and Building Practitioners Act 2020 (NSW) are impacting all within the industry from developer to sub-consultant. The insurance market has seen these obligations as onerous and in-turn appetite is further impacted (see our article here).

Insolvencies impact the operation of a professional indemnity policy considerably. The move toward principal controlled cover is becoming more common in the wake of the recent collapses. The claims made nature of professional indemnity presents significant issues particularly around notification of claims.

It is also presenting issues around the breadth of cover: what was intended at the start of a project to be insured, may now possibly be excluded given the narrowing of cover in the insurance market. In the event of a claim – this may leave the principal and other third parties relying on the insurance policy to transfer the risk of indemnities given in the design and construct/sub-consultants agreements) – with uninsured losses.

Furthermore, given the breadth of some indemnities given in contract upstream, liability assumed by contractors and consultants, such as contracting out of proportionate liability, express fitness for purpose, liability for novation of third-party consultants, etc may also be uninsured. As regards these issues, reference is made to our article here.

The insurance market for directors’ and officers’ liability may be stabilising, however in the wake of recent insolvencies across the construction industry, insurers’ appetite across this class (as it relates to the construction industry) continues to wane.

Insurers were already stemmed deploying capacity across the class specific to the construction industry as a result of employment (sham contracting claims) and regulator (health and safety/environmental) exposure.

There are now more onerous underwriting questions being asked pertaining to financial exposure. These include to the proposing insureds:

Whereas in the past insurers would be willing to underwrite the class with no financial statements, it is very rare they will do so at present. Please, beware of the cover provided by online management liability policies. Do understand that mostly these will contain an insolvency or financial impairment exclusion, and, we have experienced many that fail to disclose with the specificity required to comply with the duty of disclosure, the precise nature of the policyholders’ operations.

Surety providers have been adversely impacted by high profile contractor insolvencies, with rumours of more than $200M in surety losses in the past 24 months. This has resulted in a cautious approach from insurers to avoid further losses to their portfolios.

Contractors who have existing surety facilities in place are likely to be able to maintain their current facility limits if their annual review demonstrates financial stability, and acceptable contract performance. Surety providers are likely to ask more questions as part of the annual review and when making individual applications as part of their risk management assessment.

There is very limited appetite for new facilities from insurers, and any successful applicant is likely to require a very strong application to achieve an approval from surety providers. It is likely that weaker applicants will need to source bank guarantee cash backed facilities in lieu of a surety solution which is more likely to be unsuccessful.

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