Understanding whats up with your Subcontractor Default Insurance

Understanding what’s up with your Subcontractor Default Insurance? Henry L. Woods, Jr. , MBA, CCP, CRIS September 19, 2018

HENRY WOODS, JR. CCA, CCP, CRIS, MBA Supervisor at Brown Smith Wallace Experience: Developing and implementing cost control, safety management, risk management, project management and oversight, and project administration Industries: Construction, Education, Transportation, Casinos, Sports Facilities, High-Speed Rail, Military Housing, Health Care Education MBA in Management from Webster University BS in Civil Engineering from Missouri University of Science and Technology © 2018 All Rights Reserved Brown Smith Wallace LLP 2

How Ignorance Can Lead to Disaster © 2018 All Rights Reserved Brown Smith Wallace

Learning Objectives for SDI • • What is Subguard, CDI, and SDI What SDI and CDI Covers Advantages & Disadvantages of SDI/CDI What’s valid and Claims process How Pre-Qualifications Can Help Owners How Auditors Can Help Owners Top 5 Things Carriers Care About © 2018 All Rights Reserved Brown Smith Wallace LLP 4

Types of coverages surrounding Owners • • • Owner Controlled Insurance Programs (OCIP’s) Contractor Controlled Insurance Programs (CCIP’s) Property Insurance Builder’s Risk Insurance Professional Liability Insurance Traditional Insurance (Worker Compensation / General Liability / Auto Liability) • Subcontractor/Contractor Default Insurance (SDI/CDI) and Subguard Insurance © 2018 All Rights Reserved Brown Smith Wallace LLP 5

What DEFAULT Do You Have in Your Wallet? Types of Default Insurances Subguard Contractor Default Insurance (CDI) Subcontractor Default Insurance (SDI) © 2018 All Rights Reserved Brown Smith Wallace LLP 6

What’s Subguard Insurance? Subguard Insurance (Zurich’s Definition): An two-party agreement between the Contractor/Constructor Manager and the insurer that provides the Contractor/Construction Manager catastrophic insurance coverage for the Subcontractor and/or Supplier default. Coverage may include the costs of completing unfulfilled subcontractor or supplier obligations, including costs related to subcontractor replacement, correcting nonconforming work, job acceleration, extended overhead, liquidated damages and claim preparation expenses. Additional features may include: Ø Indemnification for direct and indirect costs resulting from a payment or performance default of any enrolled subcontractor or supplier Ø Coverage for all enrolled subcontractors and limits that are the lesser of policy limits or an option of 1. 5, 2. 0 or 3. 0 times the subcontract value Ø Programs with annual policies that help ensure product cost is known for budgeting purposes Source: Zurich NA Insurance © 2018 All Rights Reserved Brown Smith Wallace LLP 7

What’s SDI / CDI? Subcontractor Default Insurance (SDI): A two-party agreement between the insured GC/CM and the insurer that indemnifies the contractor for costs incurred as a result of a subcontractor’s performance default. Ø Provides protection for GC/CM when subcontractor or supplier failures happen; Ø Coverage is term-specific. Contractor Default Insurance (CDI): Ø Provides protection for Owner/CM when subcontractor or supplier failures happen; Ø Coverage is term-specific. © 2018 All Rights Reserved Brown Smith Wallace LLP 8

SO YOU CAN TELL ME WHAT’S COVERED IN MY DEFAULT? © 2018 All Rights

SDI - What is anticipated to be “covered”? • • Cost to remedy defect or non-conforming work Cost to complete subcontractor’s responsibilities or obligations Cost to pay suppliers or vendors; Indirect costs that might be associated with default: Ø Ø Ø Accelerated costs; Delay costs; Extended general condition/overhead costs; Liquidated damages; Other costs such as performance default © 2018 All Rights Reserved Brown Smith Wallace LLP 10

SDI cost that might not be “covered”? • • Contracts possibly acquired by other entities; Cost covered by “other insurance’’; Default pre-policy period; Fraud possibilities; Misrepresentations and falsifications; Nuclear reactions and radiation; Professional services provided by the insured. © 2018 All Rights Reserved Brown Smith Wallace LLP 11

The Disadvantages and the Advantages to SDI / CDI Insurance © 2018 All Rights

Disadvantages of SDI and CDI CONTRACTOR’S PERSPECTIVE SUBCONTRACTOR’S PERSPECTIVE • Financial risk • Increased responsibility • Legal precedence • Single insurer/surplus line • Lack of payment protection • Pre-qualification process • Unwarranted defaults • Selection incentives © 2018 All Rights Reserved Brown Smith Wallace LLP 13

Advantages of SDI / CDI? CONTRACTOR’S PERSPECTIVE • • Contractor has control over the qualification process of the Subcontractors; Assists the contractor with improving their subcontractor prequalification process; Minimizes the risks of underperforming contractors/subcontractors; Covers direct and indirect cost associated with work activities being performed; Decreases the delays when subcontractors goes on default; If a default occurs then, there is no waiting period to be investigated by surety; Reduces owner’s or contractor’s premium costs. © 2018 All Rights Reserved Brown Smith Wallace LLP 14

When is a SDI/CDI valid Ø When a contractor/subcontractor is placed into default; Ø When the contractor/subcontractor is at fault; Ø When a default results in an a loss/claim to owner or general contractor; Ø When a claim is documented or reported. Source: AON Risk Solutions © 2018 All Rights Reserved Brown Smith Wallace LLP 15

A typical SDI Claim Process Subcontractor Defaults Subcontractor defaults on its Subcontract obligations Insured Incurs Loss Insured submits written notification submitted to SDI carrier within SDI policy timeline Documentation Insured mitigates risk to prevent additional loss Submit Proof-of-Loss Reimbursement © 2018 All Rights Reserved Brown Smith Wallace LLP 16

A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation Insured incurs costs resulting from Enrolled Subcontractor’s default E. g. , Insured spends money to maintain schedule and to complete or correct defaulted Subcontractor’s work Submit Proof-of-Loss Reimbursement © 2018 All Rights Reserved Brown Smith Wallace LLP 17

A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation Insured prepares written documentation to support loss incurred as a direct result of Subcontractor’s default Submit Proof-of-Loss Reimbursement © 2018 All Rights Reserved Brown Smith Wallace LLP 18

A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation No pre-approval required by SDI carrier on replacement subcontractor; Submit Proof-of-Loss Reimbursement © 2018 All Rights Reserved Brown Smith Wallace LLP Insured maintains control and flexibility to manage project effectively; Can be submitted on rolling basis 19

A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation Submit Proof-of-Loss SDI carrier reviews proof of loss, requests additional information as necessary; SDI carrier reimburses promptly – often within 30 days of receipt proof of loss; Process could include multiple payments; Reimbursement © 2018 All Rights Reserved Brown Smith Wallace LLP Insured or SDI carrier subrogates against defaulted subcontractor. 20

SUBGUARD CLAIM EXAMPLE: Subguard Claim Preparation: Proof of LOSS - Example calculation ADDITIONAL COMPLETION Pre-Default Category Post Default Amount Category Amount Original Subcontract Amount $20, 000 Labor Costs $ 2, 800, 000 Changes to Scope/Change Orders $ 2, 000 Material Costs $ 1, 600, 000 Revised Subcontractor Value $22, 000 Equipment and/or Tool Costs $ Amount Paid to Subcontractor $16, 000 Subcontractor's Costs $ 5, 000 Legal / Consulting $ 1, 000 Unpaid Vendors $ Indirect Costs $ 2, 400, 000 Subcontractor Balance= $ 6, 000 800, 000 Total Costs Incurred= $14, 400, 000 TOTAL CLAIM AMOUNT= © 2018 All Rights Reserved Brown Smith Wallace LLP 800, 000 $ 8, 400, 000 21

Who’s Pre-Qualified and Why Should I Do It? © 2018 All Rights Reserved Brown

This Is Why – 00: 50 © 2018 All Rights Reserved Brown Smith Wallace

Pre-Qualification Process Eliminates redundancy and helps reduce significant financial risk Helps identifies subcontractors’ quality exposures & risk management factors Identifies past experiences and performances Classifies the organizations capabilities Recognizes how their assets are covered (insurance) Recognizes who is committed and dedicated to the process © 2018 All Rights Reserved Brown Smith Wallace LLP 24

How Auditors Can Help Their Owners / Clients / Customers © 2018 All Rights

Auditors can help their customer…… © 2018 All Rights Reserved Brown Smith Wallace LLP Assisting with direct and indirect costs with re-work and scope gaps Assisting with pointing out lack of policies and procedures Assisting with identifying fraud risks with inaccurate paperwork Assisting with operational risks and information technology controls 26

Top 5 Things Carriers Care About Most Financial Assessments A. Cash flow B. Pay cycles C. Asset management (don’t do it, then it’s time to start) A. Understand subcontractor’s exposure B. Measuring and managing C. Availability of qualified contractors Aggregation (understanding their exposures) A. Prequalify before contract is signed © 2018 All Rights Reserved Brown Smith Wallace LLP Quality Control Measures (ways to monitor & measure) Timing Accountability (when to pre-qualify) (be consistent) 27 A. Review the quality control measures B. Re-work from defective work C. Process for selecting new contractors A. Past performance B. Key personnel/ protocols

Conclusion Questions? © 2018 All Rights Reserved Brown Smith Wallace LLP 28

The information provided in this session is not financial, insurance or legal advice. Consult

The Firm for Growth Henry Woods, CCA, CCP, CRIS, MBA Supervisor, Advisory Services Brown Smith Wallace LLP 314. 983. 1266 (Direct) hwoods@bswllc. com 6 City. Place Drive, Suite 900│ St. Louis, Missouri 63141 │ 314. 983. 1200 1520 S. Fifth St. , Suite 309 │ St. Charles, Missouri 63303 │ 636. 255. 3000 1254 University Drive, Ste. 110 │ Edwardsville, Illinois 62025 │ 618. 654. 3100 1. 888. 2792 │ brownsmithwallace. com Brown Smith Wallace is a Missouri Limited Liability Partnership © 2018 All Rights Reserved Brown Smith Wallace LLP 30