Commentary: Risk Stacking With Subs
Currently, the construction industry is showing modest signs of a rebound. Architectural billings are starting to rise modestly, secondary commercial financing is beginning to give bankers an outlet for moving commercial real estate loans off their books and some of the Fortune 1000, spurred by a friendly bond market and low interest rates, are floating debt or simply spending their mountains of cash and beginning to invest in plant and warehouse expansions (Caterpillar, Whirlpool, Amazon, etc.) In addition, the automobile business is expanding again after two-plus years of contraction and consolidation. All in all, the industry outlook appears to be improving.
Additionally, according to the Surety Association of America, surety losses are running well below annual averages of 29%. For the full year 2009, industry losses were only 18.5% and preliminary loss estimates for 2010 are 17.4%. All is well that ends well right? Wrong.
Surety losses are a lagging indicator, and therefore, industry underwriters expect loss ratios to climb for the next 12 to 24 months as a significantly weakened subcontractor community is negatively impacted by two to three years of deteriorating results and/or outright losses. We believe this leaves subcontractors vulnerable to further attrition (business failures) due to:
- Impaired balance sheets from losses, uncollectible or slow accounts receivable, unapproved change orders, etc.
- Little or no available bank credit as banks have pulled back from the industry
- Backlogs of work containing little or no profit and no contingencies
- Serious material price inflation impacting steel, copper, concrete and other building materials. For some subcontractors such materials can account for 40 to 50% of their job costs. In such cases, a spike in a key material component can be disastrous.
- Significantly reduced material availability, which can cause schedule delays or increased costs due to expediting expense as the market recovers
- Impaired bonding availability
When you combine this weakened foundation with lower pricing power at the top of the pyramid (for the GC), careless sub selection will leave GC’s vulnerable to losses on projects arising from subcontractor defaults (primarily from insolvencies). These failures can combine to cause project delays (resulting in actual or liquidated damages) and cost escalations arising from such default(s).
General contractors can combat this heightened exposure by rededicating themselves to rigorous subcontractor selection, prudent risk management and appropriate risk transfer.
During the run-up to the industry crash of 2007-08, many contractors were less concerned with such prudent business practices. After all, in some cases, they were just happy to have more than one subcontractor from whom they could get a price. If a company was too rigorous, it might not have adequate sub coverage to put together a complete estimate. Now that the shoe is on the other foot, it is important that general contractors remain true to good business practices by thoroughly pre-screening their subcontractors through a rigorous pre-qualification process.
This should include detailed financial information, project and credit references, confirming relevant experience and bond-ability. Remember that each job a sub performs for you is an independent event. Just because that sub has performed well in the past does not mean they can be counted on now. On this last note, we urge contractors to institute a process under which a subcontractor has to prove its ability to bond that particular project under consideration, preferably through providing a bid bond. This ensures that the surety underwriter is aware of and supports the size and scope of the project in question.
Alternatively, you can use a letter from the subcontractor’s bonding agent, though this should speak directly to the carrier, the carrier’s rating and the subcontractor’s bond rate. A letter such as this should also be confirmed through a direct phone call to the agent or underwriter. Unfortunately, many times subcontractors will pressure their agent to produce a “good-guy” letter when bonding has not been formally established or the parameters of which do not encompass the contract under consideration. Do not accept or rely on such letters. It is also too late to tie this down after you have used the sub’s price and won the project.
Simply determining that a sub can bond is not enough. We strongly recommend that GC’s implement actual risk transfer with performance and payment bonds set according to conditions determined by management. Due to the relatively inelastic cost of surety credit, one can argue that the value of such protection is extremely well priced currently, as the risk of default has risen substantially over the past two years but rates have not. Recognize that the premium you pay actually transfers the risk to the surety from you and your balance sheet. This is worth the cost.
An alternative to bonding is to insure the risk through a subcontractor default insurance (SDI) program. Under such a program, the company insures the risk of subcontractor default above a significant layer of self-insurance (a large deductible) and then a layer of co-insurance, where the GC might be on the hook for 10 to 25% of the next layer. This product and structure tends to work best for larger contractors (above $75 million in sales) with a good spread of risk across their backlog. Both work best when combined with the rigorous prequalification program outlined above.
Other risk mitigation techniques include buying materials outside a subcontract; however, this subjects the GC to pricing risk it might not want to bear, jointly paying supply houses and never paying subs before being paid by the owner. Occasionally, a subcontractor may be able to provide an irrevocable L=letter of credit (ILOC) as a partial (10-to 25% of contract value) financial guarantee of contract performance and payment. This is more difficult to make work in today’s banking environment wherein the ILOC must be secured with cash.
All these tools serve to lower the risk profile of the GC in respect to its subcontractors. Without tools or techniques such as these, the contractor is putting itself in a position of “stacking” the risks of all its weakened subcontractors. Since GCs are also in a position wherein they have less pricing power, most are unable to build in any cushion into their price or budget contingencies. By employing these techniques in addition to good liability risk management, the GC will be better able to withstand the last stage of the recession and be in a position to leverage the company as the economy fully recovers and business failures finally dissipate.