The construction industry runs on tight deadlines, so choosing the right contractors for the job can make all the difference in the world. But what happens when a subcontractor defaults on a contract?
Though not an ideal situation, there are ways to prevent this from happening—or at least minimize the impact if it does. Published estimates indicate that more than half of subcontractor default insurance (SDI) claims filed in 2015 were related to subcontractors that were selected using “improper qualification procedures.” This means, despite upfront review and confirmation, general contractors had acceptable qualification processes in place, they circumvented their own procedures on a regular basis.
One of the most effective ways to avoid eventual subcontractor defaults is through successful subcontractor selection—a result of a thorough qualification process. General contractors considering a subcontractor default insurance program should follow these 10 steps to reducing subcontractor risk.
- Make it a company-wide commitment. Creating subcontractor qualification processes cannot be the brainchild of any one person or department. The financial, operational and risk implications of this switch require buy-in from all levels. Company leadership needs to champion the selected qualification procedures and ensure all employees understand the reason for the implementation (including the potential costs of not following it).
- Communicate the intent of the process. While many large subcontractors have undoubtedly come across a request to be enrolled in a subcontractor default insurance program—and the related qualification step required—this may be the first instance for many subcontractors. The contractor should communicate to them why he has elected to assume a portion of the default risk and explain how successful subcontractor selection will positively affect all project participants. Provide subcontractors with contact information for any questions—whether it’s an internal resource or a program facilitator at the insurance brokerage.
- Be consistent with all subcontractors. Apply systematic requirements across the board to ensure a consistent review is performed, which is key to avoiding “improper qualification.” Uniform application is also the best way to counter any accusations of preferential treatment. However, this doesn’t imply that the contractor needs to perform the same procedures on every size and class of business. For example, the information required and reviewed for a large subcontractor doesn’t need to be applied to a small trade contractor.
- Follow a defined approval workflow. Consistently plan, manage and execute the flow of information to approve or decline a subcontractor partner. From data collection to the ultimate decision, use a technology platform to manage the approval process and ensure consistent and correct flow of information.
- Use objective measures to drive the process. A third-party review along with clearly defined, objective measures are the best ways to drive processes. Regardless of the company’s operational structure, let objective measures drive the review and approval process.
- Plan for contingencies. Take the time upfront to outline likely scenarios and make a plan to address them. One such scenario would be a bid from an unknown contractor that hasn’t completed a qualification process. A fast-track review process would help evaluate the risk that subcontractor may pose, present options to avoid the risk entirely, or accept it with (or without) any necessary risk mitigating tools.
- Remain flexible. This is not meant to be contrary to a number of the suggestions above—but the processes in place can’t work 100 percent of the time. While sticking with established systems is imperative to a consistent and effective process, a situation will arise that will not be a fit. In these cases, revert back to the real goal of the process and get creative in securing relevant information to make an informed decision.
- Move toward continual qualification when possible. An active, ongoing qualification profile of subcontractors provides real-time insight into their ever-changing qualifications. Catching potential problems early allows the contractor to manage the related risk most effectively, and can be the difference between an incremental and total default loss.
- Make definitive decisions and set timelines for reconsideration. If all pertinent information on a specific vendor has been reviewed and the decision is to not move forward with them, communicate that decision and explain the reasoning. Provide a timeline for reevaluating their qualifications. If the risk uncovered was because of financial reasons, ask that they wait until their next CPA statement is received before revisiting the process.
- Utilize other business partners. Don’t overlook the collective knowledge of bankers, insurance and surety brokers, and joint venture partners. Most construction companies have most likely grown and prospered with their help. When struggling to gather information on a new potential partner or vendor, reach out and ask for access to credit reports, advice and anything else that can help make a correct business decision.
A thoughtful vendor selection process is the first step toward developing a successful and profitable subcontractor risk management process, but only if the process is carried through and consistently implemented. Even the most basic of processes will provide a platform for continual improvement.