Reprinted with permission from the original author, Justin Levine, Founder and CEO of TradeTapp.
Over the past twelve months we’ve studied the subcontractor default insurance (“SDI”) marketplace with an eye towards policy changes, loss trends, or topics that have become hot button issues. With TradeTapp’s focus on the prequalification space, we’ve been provided a unique perspective into what matters most to insurers when they are underwriting prospective clients. Today, our users represent several different insurers, brokers, and marketplaces. Based on everything we’ve learned, here are the top 5 things SDI carriers are focused on today [when vetting subcontractors]:
#1) Financial assessment: if you don’t do it, it’s time to start
SDI carriers need to see a formalized approach towards financial vetting. Solvency issues are a primary contributor in many subcontractor default claims, and the vast majority of these losses might have been preventable if a basic financial assessment took place. Access to capital (liquidity) remains the most important area to focus on in analysis, especially on projects where slow pay cycles and cash flow could become a major concern.
Financial assessment will also reveal some important clues into how a company manages their assets. In cases where the subcontractor’s company is behaving largely as a pass through entity (think LLC or S-Corp), it’s important for general contractors to recognize this as an exposure and review who they are signing the agreement with. An additional guarantee (from a parent company or individual) may be appropriate.
#2) Quality: find a way to monitor and measure it
Work quality is a major concern for the SDI marketplace because not all defaults occur during the project (ongoing) operations phase. In fact, some of the largest SDI losses on the books have resulted from defective installations which resulted in substantial “rip and tear” rework claims after the project had already been completed. This is why extended coverage (often referred to as the policy “tail”) becomes such a significant factor in premium calculations. Very often the contractor who installed the defective work has no capacity to repair or fix the issue without being put into default, resulting in an insurance claim.
Coming up with reliable metrics to predict the quality of a subcontractor’s work is actually pretty difficult (we’re piloting a few ideas on this, but it remains a work in progress). As a result, the best approach in many cases is simply to cast a wide net in your prequalification review. Consider prior completed work, internal reviews, frequency and volume of change orders on projects they’ve performed for you in the past, and follow ups on recent completed work references. Of course, it’s best to perform a thorough de-scope during bidding (especially on complex packages), to review personnel and assess the subcontractor’s job experience.
#3) Aggregation: understand their exposure
This is probably the topic we hear the most in the SDI space, from carriers and contractors alike. Subcontractor aggregation, otherwise described as the concentration of awards made to the same contractor or vendor (usually within a particular region), is hugely important because it represents the total amount of exposure to a single company. To state the obvious — when a subcontractor default occurs, it typically results in the default of all or many of their active projects. Furthermore, carriers view aggregation across their multiple clients as compounded risk, and while your SDI policy likely won’t allow them to exclude coverage for a single subcontractor, they will consider their own aggregation when underwriting new accounts or renewals.
Measuring and managing aggregation is a function of monitoring your own awards made to a single subcontractor, as well as keeping up to date on their backlog position. Like a bonding company, you should consider each subcontractor’s backlog commitments in comparison to their capital position when evaluating their ability to meet the demands of current and future projects. It may make sense to throttle back on giving one contractor more work until they’ve completed some of their existing pipeline.
Aggregation is of further concern as the current economic marketplace continues to indicate increased construction spending, while the availability and supply of qualified bidders continues to decrease. Evaluating personnel, project team, and individual experience of your contractors is equally important when backlog becomes a concern.
#4) Timing: when to prequalify
Timing really matters in prequalification. If done properly before a contract is signed, you have time to implement an effective risk mitigation strategy. If done too late, all your leverage is gone, and now you are forced to live with what could be significant risk. Aside from lump-sum projects where awards are strictly based on low bid, it’s key to evaluate risk prior to or in parallel with the bidding process.
In addition, ‘point in time’ data like backlog position, financial assets/liabilities, or safety performance can vary greatly on a year to year basis. Using the most up to date information when considering several bids is key towards selecting subcontractors intelligently. In order to facilitate timely prequalification, it makes sense to make data collection a continuous, annual process.
#5) Accountability: being consistent
Insurance carriers underwrite prospective clients based on a combination of past performance, key personnel/internal protocols, and market conditions. One of the biggest challenges we’ve encountered for companies seeking to utilize an SDI policy for the first time is how to create a level of oversight when the award process is handled remotely by each project team. In many cases, centralizing the review process (to a risk management group, a CFO, a controller, etc.) creates a foundation for greater consistency in risk mitigation decisions, less bias or emotion, and a clear paper trail of accountability for decisions.
It’s important to understand these trends in order to gain favorable treatment from the insurance marketplace. Of course, when leveraged into an effective program to manage and mitigate risk, a shared commitment to these five topics can result in a successful SDI program both for you and your carrier.
One of the keys to success for any subcontractor is to have strong working relationships with the general contractors that they regularly do business with. But if you’re a subcontractor that’s looking to grow your business, chances are you’re going to have to work with some GCs that you not have worked with before. And of course, those GCs are going to prequalify you long before breaking any ground on a new project. It’s not surprising that of the five items that Justin writes about above, the first one has to do with vetting subcontractors based on their financial strength. Growing a subcontracting business presents a huge financial challenge because it requires access to a significant amount of cash – a topic that we’ve written about before.