As we all know in the construction industry, surety losses are a lagging indicator of the tough economic struggles we have been facing. As surety losses have moved well below the annual averages of 29%, underwriters are expecting loss ratios to significantly decline in the next 12 – 24 months due to a weakened sub-contractor community that has been impacted by two to three years of deteriorating results and/or outright losses.
Because of the performance of the construction industry the past 36 months, bonding agents’ increased concerns for subs include the following:
- Impaired balance sheet from losses, uncollectible or slow AR, unapproved change orders
- Little or no available bank credit
- Small backlog of work containing little or no profit
- Price inflation impacting steel, copper, concrete and other materials (could be 40-50% of job costs)
- Significantly reduced availability to materials which can cause scheduling delays
- Impaired bonding availability
When these factors are combined with weakened pricing power (that is GCs have to win bids with lower contract prices), GCs can become careless with their sub selection and can become vulnerable to losses from sub default.
So what can GCs do to mitigate the risk of subcontractor defaults? The following is a list of simple steps a GC can take:
Prescreen all subs through rigorous prequalification process
– This should include detailed financial info, project and credit references, and confirmation of bondability from the sub’s bonding agent. (Note: each job is independent from the next meaning subs can perform well in the past but doesn’t necessarily mean they’ll perform well in the future)
– GCs can force subs to prove their ability through a bond bid which will ensure the surety underwriter supports the scope of the project
– Obtain a letter from the subs bonding agent, including a follow up phone call to the agent to verify
- GCs should obtain performance and payment bonds to transfer their risk to the surety. Prices on these types of bonds are very well priced right now
- GCs can purchase subcontractor default insurance to transfer a majority of the risk to the insurer and limit their liability
- GCs can also purchase materials outside of the subcontract but open themselves up to pricing risks and joint payments to supplier and sub
These practices will help GCs withstand the last stages of the recession and be in position to leverage the company as the economy recovers.
Have questions about conducting subcontractor due diligence? Post a comment below or contact our Real Estate and Construction Group at 440-449-6800 for our Subcontractor Prequalification Form.