A performance guarantee: an important component of a construction project

Specialist Business

A performance guarantee: an important component of a construction project

Published: 03 August 2021

There have been shockingly hard lessons and knocks for a broad range of contractors over the past five years. For those that survived the pre-Covid-19 economic meltdown, the pandemic may have been the final straw, thus causing many defaults of contracts. And all this is on top of the standard or unique risks associated to, particularly, construction work.

These disruptions have really challenged project execution and vastly changed attitudes towards the acquisition of Performance Guarantees, which have generally been considered a grudge purchase despite being an integral part of the construction/performance documentation that underlies a project.

It’s considered a grudge purchase because unlike traditional insurance which is between one party seeking insurance against a risk or risks with an insurer, a third party is involved. Consider that all projects are based on the agreement between a contractor, who is the principal debtor, working on behalf of a beneficiary, otherwise known as an employer/owner/creditor. Should a contractor fail to meet its obligation in fulfilling that contract, the project is at risk of complete collapse.

This is where a Performance Guarantee comes into play. It indemnifies the beneficiary of the project against a default or non-performance by a contractor, which in return for a premium, puts an obligation on a guarantor (the insurer) to make payment should a specific event occur. What must be borne in mind, is that although the contractor facilitates and pays for the premium on a guarantee, they do not realise any direct financial benefit should there be a claim. 

Clinton Spence, Head of Santam Guarantees provides us with some idea of the pressure contractors have been under in recent times. “In the past year alone, we have serviced some R3-billion worth of construction-related bonds. Although it may appear to be a sweet spot for us to be in, this is a highly specialised and incredibly technical, risky business. We have also faced our fair share of guarantee claims resulting from contractor insolvencies, which can be attributed to the economic and Covid-19 climate we find ourselves in.

“A guarantee issued today really pushes our resources because the underwriting is made that much more intensive. For example, we can’t judge how a company will be performing in a year, let alone in six year’s time.”

Further is that unlike traditional insurance that is renewed annually, there are no renewals on guarantees, meaning that Santam Guarantees starts from a zero base every January, writing new guarantees based on new budgets, performance, and other variables.

So what does a performance guarantee cover? “In simple terms, it protects the beneficiary against the risk of the contractor not fulfilling contractual obligations in terms of the contract, and the risks are multifold in the built environment. For Santam Guarantees, the construction sector comprises 90% of its underwriting, with 70% of that performance-based,” explains Spence.

There are three types of guarantees that together contribute to the majority of Santam Guarantees: Performance; Advance; and Retention. In terms of performance, a policy will cover elements of quality, specification, and scheduling.

Advance covers the expenses incurred to create the facilities that a site requires, such as a batch plant, office and even securing a site. It also addresses initial negative cash flows relating to the procurement of capital goods, such as imported material components.

Retention comes into play at the end of the construction period, and addresses employer risk associated to defects. Traditionally there is a 12-month defects liability period during which the contractor must rectify and make good any snags or defects relating to the installation or scope of work. “It is a form of warranty, if you like,” says Spence.

“This full spectrum offering makes it incredible difficult for underwriters. They have to consider whether the contractor has the financial and technical means to complete a job, and NOT fail. Ultimately that’s is what we are guaranteeing – non-failure, so it falls on us to ensure the project succeeds.”

This does not mean that Santam Guarantees is a project manager, but it does require it to fully investigate whether the contractor has capabilities it can leverage. Underwriters will be looking at, for example: how liquid the contractor is; the loan obligations; performance over the past five years from which they can gauge a trend; application of build standards; risk ratings; technological and finance audits; overdraft facility; the order book; and appetite variables. 

“We don’t know how any contractor is going to perform going forward, but by looking at the past we gain a better picture of the risks. It’s an immensely complicated list of checkboxes and this is only the first of two parts of the underwriting,” says Spence.

This first stage proves the ‘potential’ of the contractor, which will result in, for example, an approved limit of a R100-million guarantee, but it does not guarantee the risks associated with a single or multiple project/s. The facility of R100-million could translate, for example, into 10 projects of R10-million, each requiring separate guarantees. And so the underwriting enters a second phase: what type of project, where it is, its value etc.

“It is only once those individual project guarantees are issued, that the risks come into play, says Spence.

Timeframes vary, but generally from the day the application is submitted to when the guarantee is issued, can take as long as a month. This, however, only applies to the local market. Foreign clients can expect the process to take up to three months because of the interactions between local and international banks, varying and differing security checks and compliances. This is where Santam’s strength lies … in the foreign market!

Currently only 40% of the business Santam Guarantees underwrites is local; the balance is foreign. “We have issued into 40 international markets to date. At any one time we have some 30 foreign guarantees in play and of that 60% only 25% is motivated through South African companies that look for support of their projects in other nations.

“Foreign markets are also proving to be a better investment for us strategically,” says Spence. “Compared to our competitors we really only handle 15-20% of the local market but we are issuing far bigger guarantees. For example, to reach R100-million a competitor would issue, say, 1 000 guarantees. By comparison it is possible for us to issue only 200 individual guarantees to reach that same R100-million.

“Then again those deals are highly complex and we might be working on them for over a year, but the result is a big value guarantee.”

On this strong backbone Santam Guarantees is anticipating new volume, which adds to its development strategy for growth. It is also increasing its range of products. One such is a commodity-related product that is associated to the Advance Payment Guarantee. “We’ve also patented a number of products that use guarantees to facilitate capital-intensive project financing. 

“There is always a point in processing this type of insurance, where you sort of hold your breath because the risks are so great, so difficult to anticipate, and so complicated,” says Spence. “Ultimately at Santam Guarantees we abide by the decades-old mantra, that is to provide insurance good and proper. We believe we do that right, and do it well.”