Understanding what’s up with your Subcontractor Default Insurance? Henry L. Woods, Jr., MBA, CCA, 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 LLP 3

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

Types of Default Insurances 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: Indemnification for direct and indirect costs resulting from a payment or performance default of any enrolled subcontractor or supplier 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 Programs with annual policies that help ensure product cost is known for budgeting purposes Source: Zurich NA Insurance Subguard Consistent “Blanket” Protection for all subs Same coverage for all subs under a single insurance policy Much simpler, faster, less costly claims process Specific broader coverage for indirect costs Subguard 1. “Alignment of Interests” between the Project Owner, the GC and Zurich 2. The GC is Zurich’s client creating just one relationship to manage 3. Claim timeline is dictated by the GC 4. Claims are reimbursed within 30 days after satisfactory proof of loss. © 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. Provides protection for GC/CM when subcontractor or supplier failures happen; Coverage is term-specific. Contractor Default Insurance (CDI): Provides protection for Owner/CM when subcontractor or supplier failures happen; © 2018 All Rights Reserved Brown Smith Wallace LLP 8

WHAT’S COVERED IN MY DEFAULT? SO YOU CAN TELL ME WHAT’S COVERED IN MY DEFAULT? © 2018 All Rights Reserved Brown Smith Wallace LLP 9

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: Accelerated costs; Delay costs; Extended general condition/overhead costs; Liquidated damages; Other costs such as performance default Negotiate Terms to Include Any/All Modifications to the Project Scope • Example - GC unexpectedly takes over scope from another contractor on same Project • Example – Fundamental design changes • Policy should apply to “all” Work performed on the Project through the Project • Modify all term limits to ensure no early expirations • Ensure Coverage for All Subcontracts • Most policies cap coverage of subcontracts that exceed defined dollar amounts • Link Subcontract coverage to base subcontract value specifically ignoring later adjustments (either up or down) Direct Costs: Inside “four corners” of subcontract. Examples:  Scope of work  Performance related  Payment related  Quality (rip and tear)  Attorney and consultant fees  Delay damages owed by sub  Defense cost of default challenge  Acceleration costs of completing sub work  Release of lien bond premiums Indirect costs: Outside “four corners” of subcontract Examples:  Extended overheard of insured, owner, other subs  Acceleration costs paid to other subcontractors  Delay damages paid to owner  Productivity impact Two options for recovery of indirect costs:  Prove costs (Sublimit-ted, typically $5M)  Automatic % of Direct Costs © 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 Reserved Brown Smith Wallace LLP 12

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 Additional Contractor Overhead  Qualification and risk management  Billing and reporting  Deductible and co-payment obligations apply where subcontractor defaults  Per loss  Aggregate  Inadequate Limits  Large subcontracts  Since subcontractor defaults on multiple projects © 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. The insured contractor controls:  Subcontractor qualification  Subcontractor selection  Which jobs are covered  Enhanced protection; Coverage:  For Soft Costs (“Indirect Costs,” subject to sub-limit)  To the statute of repose  Profit Potential  Good risk management and loss control can result in a return of variable premium.  Bond costs cannot be recaptured.  With strong subcontractor pre-qualification and adequate volume, can become self-funding. Limit of Insurance vs. Bond Penalty  Penal sum of bond tied to contract amount  Subcontractor default insurance provides for coverage up to policy limit  Determination of default  GC determines if a default has occurred instead of the surety  Control of default  GC determines how to remedy default instead of surety  Reduced paper (one policy vs. multiple bonds)  Consistency of terms (one policy vs. multiple bonds)  Relationship with own carrier vs. sub/supplier’s surety. © 2018 All Rights Reserved Brown Smith Wallace LLP 14

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

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

Subcontractor Defaults A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation Submit Proof-of-Loss Reimbursement 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 © 2018 All Rights Reserved Brown Smith Wallace LLP 17

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

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

Subcontractor Defaults A typical SDI Claim Process (cont’d) Subcontractor Defaults Insured Incurs Loss Documentation Submit Proof-of-Loss Reimbursement 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; Insured or SDI carrier subrogates against defaulted subcontractor. © 2018 All Rights Reserved Brown Smith Wallace LLP 20

SUBGUARD CLAIM EXAMPLE: Subguard Claim Preparation: Proof of LOSS - Example calculation ADDITIONAL COMPLETION Pre-Default   Post Default Category Amount Original Subcontract Amount $20,000,000 Labor Costs $ 2,800,000 Changes to Scope/Change Orders $ 2,000,000 Material Costs $ 1,600,000 Revised Subcontractor Value $22,000,000 Equipment and/or Tool Costs $ 800,000 Amount Paid to Subcontractor $16,000,000 Subcontractor's Costs $ 5,000,000 Legal / Consulting $ 1,000,000 Unpaid Vendors Indirect Costs $ 2,400,000 Subcontractor Balance= $ 6,000,000 Total Costs Incurred= $14,400,000 TOTAL CLAIM AMOUNT= $ 8,400,000 he SDI is a very simple insurance tool that works when the general contractor acquires the policy for a determined amount of money over a specific period of time. The insurance company and the contractor establish a deductible that must be paid by the general contractor. before the policy cover claims related to the work being performed by the subcontractor. Both, the contractor and the insurance company agree on a co-pay, the percentage related to what the insured will pay after the deductible and will establish an aggregate value, the maximum amount the insured will have to pay for a claim arising during the policy period. Once this has been established, the contractor will qualify subcontractors, typically after a rating and qualification process, that will present the lower risk for that particular project. There is no payment bond right of subcontractors and suppliers. © 2018 All Rights Reserved Brown Smith Wallace LLP 21

Who’s Pre-Qualified and Why Should I Do It? © 2018 All Rights Reserved Brown Smith Wallace LLP 22

This Is Why – 00:50 © 2018 All Rights Reserved Brown Smith Wallace LLP 23

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 By performing the factor analysis/ Qualification analysis, a total of seven factors significant to contractors’ performance were extracted, namely (1) soundness of business and workforce; (2) planning and control; (3) quality management; (4) past performance; (5) risk management; (6) organizational capability; and (7) commitment and dedication. Multiple linear regression models reveal that technical expertise, past success, time in business, work methods and working capital significantly impact on contractors’ performance across time, cost and quality success. With a clear understanding of a contractor’s performance, these findings could potentially contribute to development of a company’s procedures or enhance existing knowledge in relation to the pre‐qualification practices in contractor selection in projects. © 2018 All Rights Reserved Brown Smith Wallace LLP 24

How Auditors Can Help Their Owners / Clients / Customers © 2018 All Rights Reserved Brown Smith Wallace LLP 25

Auditors can help their customer…… 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 SDI protects owners by placing the general contractor in a position to individually manage a subcontractor default situation and to provide financial relief to the general contractor for losses incurred as a result of the default. As such, risk of the general contractor not completing the project within the planned budget and schedule are greatly diminished. Similar to subcontractor payment and performance bonds, the intent of SDI is to cover the general contractor for these risks. An available endorsement to the SDI policy provides the owner access to the policy only in the event of general contractor insolvency. Otherwise, the owner must seek recourse direct with the general contractor through the general contractor contract (e.g. LD’s, the courts) or through a general contractor surety. An internal auditor can assist management in the decision to avoid, share, reduce, mitigate or accept risks (and can identify costs and benefits associated with each option). Owners can gain insight for improving processes, performance, controls, and risk management — and for reducing expenses, enhancing revenues, and increasing profits. © 2018 All Rights Reserved Brown Smith Wallace LLP 26

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

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

The information provided in this session is not financial, insurance or legal advice. Consult a professional about your unique situation. © 2018 All Rights Reserved Brown Smith Wallace LLP 29

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 CityPlace 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 1.888.279.2792 │ brownsmithwallace.com Brown Smith Wallace is a Missouri Limited Liability Partnership © 2018 All Rights Reserved Brown Smith Wallace LLP 30