The construction sector has always been one of the most vulnerable to insolvency. A new report from Red Flag has predicted that a “perfect storm” of factors could lead to more than 6,000 company insolvencies in the UK construction sector during 2023 and that bad debt in this sector would rise from £300m to £1bn by early 2024. This is expected to increase further once the government pulls commercial energy subsidies from April 2024.

As reported by the Insolvency Service in 2022, the construction industry experienced the highest number of insolvencies of any sector in England and Wales with 4,143 company insolvencies reported, which accounts for 19% of all company insolvencies. Red Flag has warned that for 2023 over 100 firms in the sector could collapse each week raising fears that the total number of UK company insolvencies across all sectors could rise to 32,000.

Insolvency wide-spread across the UK

Of the 30 construction companies falling into insolvency in February 2023, a notable number of high-profile casualties were based in the North of England. Metnor collapsed in February 2023, its focus was on projects in the leisure, student housing and healthcare owing more than £9.3m. Tolent Construction entered administration in February 2023, the largest in the North-East and March 2023 also saw Newcastle based cladding contractor Jesella Limited calling in administrators. Despite what seemed to be a spate of high-profile collapses in the Northeast, regional construction output data from the Office for National Statics suggested that activity in the Northeast is not performing any worse than other regions, indicating, that insolvency is a wide-spread problem in the UK.

Several Factors facing the construction sector

Several factors have contributed to this “perfect storm” including the long-term effects of the COVID-19 pandemic, the Russian-Ukraine Conflict, inflation, and the increase in energy prices. According to ONS, in October 2022, just over 12% of Business Insights and Conditions Survey (BICS) respondents from the construction industry perceived energy prices as the main concern for their businesses between late February and early October. In this period, almost 41% of respondents saw inflation of goods and services as the primary concern for their business. Contractors and construction professionals need to be wary of fixed price contracts and make sure they are keeping a close eye and control on project materials costs. Profit margins are suffering as fixed price contacts have often failed to factor in the 40-year high inflation levels that we are now experiencing in the UK.

The industry is also still suffering from labour and material shortages. COVID-19 and Brexit has led to reduced access to materials such as steel, timber, plaster, bagged cement, and roofing products across the UK. Research by recruitment specialists found that 83% of construction businesses are feeling the strain from a lack of skilled workers, with bricklayers and carpenters among the hardest to hire. Short supply and increased demand result in rising costs meaning prices for in-demand materials have increased by 10-15% (and 50% for timber alone) and wages for skilled construction workers have risen by almost 10%.

Insolvency, Professional Indemnity Insurance and Collateral Warranties

Often it is the case that not only are main contractors threatened with their own insolvency, typical Professional Indemnity Insurance II polices will cover those for whom the insured has vicarious liability. In the construction industry, this includes subcontractors and suppliers who themselves share many of the same difficulties as that of contractors. Where an appointed subcontractor or supplier enters insolvency, any claims against that company will hit the main contractor, whose claim record is at risk. That is why Collateral Warranties are a vital step in ensuring protection in the supply chain. However, the drafting of such liabilities often give rise to complex legal issues, for example, if they are drafted as a deed and there is reference to joint and several liability (meaning one party will be left with the entire damages) effectively widening your obligations. To prevent this, the parties should be ensuring that a net contribution clause is included which caps your liability.

Key questions to consider:

Has the Insured robustly interrogated the solvency of the subcontractor, their experience, and evidence of professional indemnity cover in place (and checking the extent of such coverage). In addition, Underwriters will be recommending to their Insureds that any collateral warranty has a net contribution clause which, effectively caps their liability.

From a claims perspective, early risk management is key. Never has it been so important to ask for a copy of the contracts of the various parties to understand the contractual matrix but also the insurance matrix – have all the parties to the contract and dispute notified their Insurers? It is important to stress the importance of key documents and personnel especially if there is a concern that one of the contractual chain is likely to enter insolvency and staff are leaving the business. Consideration should also be given as to the relationship with the insolvency practitioner, administrator and liquidator and the impact this will have on costs and subrogated recoveries.

Emerging Insolvency Claims Trends

The emerging trends which are being seen across the industry from a claims perspective is an increased use of adjudication in contracts. This is designed to offer a quick cash-flow remedy during the process of a construction project without the need to issue proceedings, adjudication decisions can be made within a month.

There are also more direct claims against insurers because of insolvency with third party claimant’s relying on The Third Parties (Rights Against Insurers) Act 2010. In terms of the practicalities of bringing a claim against an insolvent party, if insurance is in place, a third party can bring a claim directly against the Insurer. This is a major change from the earlier 1930 Act, where the insured’s liability had to first be established (either by judgment or an arbitration award) before a claim could be brought. Whilst the third-party claimant will still need to establish the insured’s liability in the usual way, there will now only be in one set of proceedings. It is also important to remember that third party claimants are still subject to the same policy terms and conditions that would have applied to the insured so coverage issues are still at play.

There are also more speculative claims materialising given the uncertainty surrounding the construction industry and the easier route to pursuing insurers meaning that there could be a surge in construction related insurance claims.

There are also additional policy implications to consider where there is an insolvent insured – Insurers will no longer be able to pass on the VAT on defence costs, this immediately adds 20% to the defence cost budget. The insured would also be unable to meet its excess and it is more than likely that insurers will receive more requests for security of costs where claims are being pursued by third parties.

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This article was adapted from an article by Zurich which can be found here.