Builders Warranty Insurance. Victorian Legislative Council Standing Committee on Finance & Public Administration. to the. on the.

Transcription

1 to the Victorian Legislative Council Standing Committee on Finance & Public Administration on the Builders Warranty Insurance 15 January 2010 Page 1 of 22

2 15 January Constitution Avenue Canberra ACT 2612 Tel: (02) Fax: (02) The Secretary Standing Committee on Finance and Public Administration Council Committees Office Department of the Legislative Council Parliament House East Melbourne, Victoria 3002 By Dear Sir/Madam, Inquiry into Builders Warranty Insurance The Housing Industry Association Ltd (HIA) provides the attached Submission which it hopes will assist the Committee in relation to its Inquiry into Builders Warranty Insurance. HIA has expertise in this area. It is Australia s premier construction industry association, representing over 40,000 industry members throughout Australia. Many of HIA s members construct new homes in Victoria and are compulsory purchasers of the Builders Warranty Insurance product (BWI). HIA also has a half share in a joint venture company, HIA Insurance Services Limited, which acts as an insurance broker and is active in arranging BWI policies. Please contact me if you have any query or wish to obtain further information on any point. Yours faithfully, Housing Industry Association Glenn I Simpson Senior Executive Director g.simpson@hia.com.au Housing Industry Association Limited ACN No Northern Australia Queensland New South Wales ACT/Southern New South Wales Hunter Victoria Tasmania South Australia Western Australia/Asia Head Office Canberra

3 Contact Details Glenn I Simpson Senior Executive Director Housing Industry Association Ltd ACN Address: 79 Constitution Avenue, CAMPBELL ACT 2612 Ph: Fax: g.simpson@hia.com.au Page 2 of 22

4 Table of Contents 1.1 Introduction The Nature of Statutory Builders Warranty Insurance Intent and Original Purpose of Builders Warranty Insurance Home Warranty Insurance in Victoria Past Fluctuations in the Market Competition Issues Regulation Issues Consumer Protection Issues What is appropriate consumer protection? Is Builders Warranty Insurance Worthless? Industry Regulation Issues Does Builders Warranty Insurance Provide Effective Industry Management? Other Regulatory Issues Conclusion...16 ATTACHMENT Page 3 of 22

5 1.1 Introduction HIA is the premier industry organisation in the home building sector of the Australian economy, and represents some 44, 000 members throughout Australia. It employs a professional staff of some 350 persons and forms its policies through an internal democratic system of Regional, State and National committees made up of its members serving in a voluntary capacity. Its policies are very thoroughly considered and are not expressed lightly or capriciously. HIA has made submissions to a number of past inquiries on this topic, including the Australian Senate inquiry in The inquiry by the Standing Committee on Finance & Public Administration of the Victorian Legislative Council has the following terms of reference:- To inquire into and report on: the effectiveness of the current mandatory last resort Builders Warranty Insurance scheme in providing necessary and appropriate consumer protection and industry management; the specific role of government agencies in their effectiveness in managing and representing Victoria s registered builders under the current Builders Warranty Insurance scheme; any possible alternatives to the current Builders Warranty Insurance Scheme in Victoria; and any related matters. HIA notes that these terms of reference are very similar to those of the Senate Economics Committee in Those terms of reference were:- Australia's mandatory Last Resort Home Warranty Insurance scheme, including: a) the appropriateness and effectiveness of the current mandatory privatised last resort Builders Warranty Insurance scheme in Page 4 of 22

6 providing appropriate consumer protection and industry management.; b) the reasons for and consequences of the ministerial decisions relating to the removal of consumer protection provisions in respect of Corporations Regulation (2); c) the ramifications for the future supply of this insurance product following the draft recommendation from the Productivity Commission report released in December 2007; d) any potential reforms and their costs and benefits which may lead to appropriate consumer and builder protection and improved housing affordability; and e) any related matters. In particular, the first, third and fourth terms of the Council s terms of reference are almost identical to (a), (d) and (e) of the Senate terms of reference. HIA respectfully submits that the findings of the Senate Committee on these terms should be relevant and persuasive in the Council s inquiry. In that regard, the Senate Committee (majority report) did not conclude that the current builders warranty scheme was inappropriate or ineffective. On the contrary, the Committee found that the scheme did provide consumers with needed protection, and specifically rejected suggestions that it be voluntary rather than mandatory. The Senate Committee also rejected calls for this insurance to be a government monopoly. Instead, the Senate Committee made a number of recommendations for improvement of the existing schemes. Most of these were matters for States and not the Commonwealth to take up. For the record, the Senate Committee recommended that Recommendation The committee recommends that all parties receive a copy of the insurance certificate, summary of product and dispute resolution procedures. The committee recommends changing the name of the insurance. Page 5 of 22

7 Recommendation The committee recommends that COAG and the Ministerial Council on Consumer Affairs (MCCA) should pursue a nationally harmonised 'best practice' scheme of consumer protection in domestic building. The scheme should include but not be limited to: disciplinary procedures and penalties; clearer definition of defective work; quicker and easier dispute resolution; the proposed 'loss of licence' insurance trigger; the HIA's 'guarantee of completion' and related proposals, and better information for consumers (including information on builders' licence record and average cost of premiums). Recommendation The committee recommends that COAG and the Ministerial Council on Consumer Affairs should pursue a nationally harmonised scheme of detailed reporting of home warranty insurance. Recommendation The committee recommends that home warranty insurance should be included in the National Claims and Policies Database. HIA commends these recommendations to the Standing Committee on Finance & Public Administration. 1.2 The Nature of Statutory Builders Warranty Insurance. Statutory warranties and warranty insurance should not be confused as being the same thing. The first is the legal responsibility of the builder (statutory warranties) and the second (warranty insurance) is consumer protection set up to protect against losses where the builder is unable to meet their legal responsibilities due to death, disappearance or insolvency. Statutory warranties are implied in legislation in each State and are the responsibility and obligation of the builder to the consumer. Warranty insurance is the safety net for consumers where the builder is unable to meet these obligations and responsibilities in the three defined circumstances. There are many reasons why a builder may become insolvent. Attachment 1 sets out some common problems, and explains why Builders Warranty Insurance is needed. Page 6 of 22

8 It is important that the scheme not be mistaken for a dispute resolution vehicle. It is not appropriate for insurers to resolve disputes between builders and consumers - this task must be the responsibility of the State regulator/licensing body. When the two are fused in the same body there is moral hazard, since a finding in favour of one party or the other will have direct financial implications for the regulator. One of the major reasons for the decline of the Housing Guarantee Fund in Victoria and the NSW Building Services Corporation was exactly this confusion of roles. Also, the differences between this form of insurance and other insurances are important. Warranty insurance is not like workers compensation (which allocates risk based on payroll size and claims history) or third party insurance (which aggregates actuarially quantifiable risks to persons who have no control over the occurrence of that event). In the case of Builders Warranty Insurance, the policy cover is against events such as builder disappearance or insolvency that are to a considerable extent within the control of the builder themselves. This aspect needs to be addressed by proper risk assessment as well as by existing licensing controls. 1.3 Intent and Original Purpose of Builders Warranty Insurance Builders warranty insurance was originally introduced as a voluntary scheme in WA and SA. It was established fundamentally to protect homeowners against the financial failure or death of builder and to provide cover for losses attributed to underpricing or defective work. It has now been operating successfully in WA and SA for in excess of 28 years. Following the collapse of HIH in 2001, the scheme was harmonised across all southern states in to reflect the WA and SA experience. 1.4 Home Warranty Insurance in Victoria The privately underwritten Domestic Building Insurance Scheme was introduced in May 1996, replacing the previous government scheme administered by the Housing Guarantee Fund. On 1 July 2002 it moved to being a last resort scheme, as agreed with NSW according to a 10 point plan. Building Advice and Conciliation Victoria (BACV) was established by the Victorian Government in 2002 as a one-stop shop for building disputes. It provides free advice and conciliation services and is jointly delivered by Consumer Affairs Victoria and the Building Commission. Eighty per cent of disputes conciliated by BACV are successfully resolved. Disputes which cannot be resolved by BACV can be taken to the Page 7 of 22

9 Victorian Civil and Administrative Tribunal (VCAT). According to evidence presented to the Senate, the number of building matters initiated in VCAT has declined from over 1000 in to 824 in The Building Practitioners Board (BPB), a statutory authority, is responsible for registering builders and other building professionals in Victoria. It checks that applicants have the appropriate qualifications and insurance. As in NSW, financial assessment of builders is effectively delegated to insurers. The BPB has disciplinary powers to suspend or cancel a licence or impose penalties. The Victorian Government advised the Senate that it is currently reviewing its builder registration and disciplinary framework with a view to better protecting consumers against problem builders. 1.5 Past Fluctuations in the Market The current withdrawal of Lumley and CGU from the market, and the action of the NSW Government to step in and take over underwriting in that State, is a significant development. However, this situation is not new from time to time in the past insurers have left and entered the market, and the market has coped. HIA is of the belief that there remains adequate capacity in the Australian insurance market to provide cover for builders in Victoria without the need to emulate NSW. For example, March 2001 saw the collapse of HIH Insurances Limited (which of course had no association with HIA). HIA and some insurers had warned in advance of this collapse and that the home warranty insurance cover being offered by HIH was unsustainable at the policy premiums charged, which indeed proved to be the case. The collapse of HIH Insurances, virtually overnight, destroyed that market for a wide variety of Australian risks. As a result of the HIH collapse and the reluctance of insurers to remain in or enter this market, the Victorian and NSW Governments reviewed the operation of their schemes through the mechanism of the Standing Committee of Consumer Affairs Ministers, in an effort to ensure that the scheme remained relevant and viable. This involved a significant public review process including a Report from Prof. Percy Allen commissioned by the Standing Committee of Consumer Affairs Ministers, a Response to the Allen Report by the Standing Committee of Officials of Consumer Affairs, and a Review for the NSW Government by Mr Richard Grellman. These reviews gave very detailed Page 8 of 22

10 consideration to the issues concerned and formulated a consistent theory of how consumer protection was advanced by such legislation. A 2005 inquiry into housing regulation in Victoria by the Victorian Competition and Efficiency Commission (VCEC) considered home warranty insurance among other things. Its main conclusions on Home Warranty Insurance were: the crisis in availability of insurance which occurred in had ended; the market for insurance was competitive and there was no sign of insurers making excessive profits; insurers had responded to concerns that insurance eligibility demands were preventing discouraging people from entering the industry; the number of registered builders showed little change in the period ; owner-builder trend data did not support claims of a major shift to unregistered builders to avoid the insurance; VCEC supported continuing privatised last resort insurance, arguing that 'this [first resort/last resort] debate is almost academic, because private insurers are unwilling to offer such "first resort" cover'. It recommended some improvements: better information to consumers; a code of conduct for insurers; and better dispute resolution services. Importantly, each of these reviews talked about improvements to the system of dispute resolution in the home building industry and the role of the regulator. The Senate Economics Committee in 2008 also addressed these matters. However these aspects of the reforms as yet have not been delivered. After the HIH collapse, there was one major insurer to underwrite an additional 45 per cent of the builder market. As a result, further competition was imperative from both a service delivery and affordability point of view. HIA Insurance Services worked with the insurance industry to encourage the entrance of new insurers to the home warranty market. This was successful. As a result, the industry for a period of years enjoyed strong competition with secure insurers such as Vero, QBE, CGU and Lumley operating in all relevant States. Page 9 of 22

11 The withdrawal of CGU and Lumley should be looked on in this historical context of market fluctuation. It still leaves Vero and QBE operating and providing a competitive marketplace, and the possibility of entry of other insurers into this market remains open. It is very important to maintain that competition, in the interests of Victorian consumers. It is competition and the rigour involved in the insurers underwriting practices that has led to this significant difference between premiums under private insurance and the Queensland scheme, and significant savings to consumers in States outside of Queensland. 1.6 Competition Issues If Victoria were to contemplate following NSW and taking over the underwriting of the scheme, the nature of the scheme would be fundamentally changed. Competition would occur in tendering to the State, but not in relation to individual policies. In these circumstances, an important issue for the Government to consider is whether premiums are to be set on a commercial basis having regard to the risk profile of individual builders or whether all builders are to be treated as equal risks and charged premiums based solely on the value of work done. We understand that in NSW, SICorp has engaged actuaries to assist in developing the underwriting criteria for the new scheme. HIA considers that the Victorian Government should not contemplate a scheme which entitles builders to any level of warranty coverage they want regardless of risk, turnover and performance. Already in NSW, unrealistic expectations have been raised. It is important that individual builder ratings are maintained to reward good (low risk) builders who operate sound and well capitalised businesses, and ensure that they do not cross-subsidise poor risks. Equally importantly, a flat (one size fits all) rate might promote an environment conducive to undercapitalised businesses undertaking larger volumes of work, funded through anticipated future cash inflows. This, in itself, would present an unacceptable business risk to the Government s underwriting arrangements. Factors including gross margin, net tangible worth, costing systems, debtor collection and creditor position can point to an inherent level of risk and potential solvency threat. Ultimately, consumers pay the cost of this warranty insurance and accordingly, risks need to be properly priced to avoid upward pressure on policy premiums. Page 10 of 22

12 Over recent years, most builders have managed their businesses in a positive way, ensuring profits are retained so that adequate capital exists for less buoyant construction periods. Builders have been rewarded through the benefits of better business practices and results, and also from a differentiated premium which acknowledges those results. Maintaining risk based premium settings provides an important and ongoing incentive. 1.7 Regulation Issues Claims management is also a key matter for the Government and for home owners. HIA contends that Consumer Affairs Victoria s responsibility for consumer protection/dispute resolution and the scheme s obligations to address policy liabilities must be kept at an arm s length to appropriately balance the interests of the consumer and the warranty (insurance) fund. The independent role of the Building Advice and Conciliation Victoria in resolving disputes is very valuable function. Such a body gives confidence to both builders and consumers that their disputes will be arbitrated by an independent umpire with no financial stake in any particular outcome. 1.8 Consumer Protection Issues What is appropriate consumer protection? The Working Party of the Standing Committee of Officials of Consumer Affairs which reported on the Percy Allen Review in November 2002 saw the appropriate measure of consumer protection in this area as follows: insurance cover or a guarantee or the like to complete a house that is being built or to rectify any defects which are normally the builder's responsibility as articulated in legislation or a formal contract when the system has broken down and the builder is unable or unwilling to carry out this work (at p.25). That is, the Officials advising Consumer Affairs Ministers advocated a last resort insurance scheme as part of a balanced approach involving contracts, licensing and insurance. The Working Party went on to propose the following: Scope of protection Page 11 of 22

13 Whether this cover/guarantee is provided by a public or private system, for a certain value of building work, it should, if possible, provide for consumer protection due to: i. Non-completion of contract due to: death; insolvency; disappearance; or termination of contract for fault on the builder's part. ii. Defective construction when the defective work was performed by a builder who is: dead; insolvent; disappeared; or. where the builder simply refuses to rectify the faulty building work. This cover/guarantee includes work evident and identified before the death, insolvency or disappearance. iii. Defective work when the builder has failed to comply with a direction by the licensing body to rectify. iv. Defective work which is the responsibility of a builder whose licence is cancelled or suspended but the builder is not dead, insolvent or disappeared. v. Court awarded loss for defective work or incomplete work when the builder has failed to respond to a court award. Setting the value and type of building, for which this protection is afforded, should be a matter for the individual jurisdictions, bearing in mind the different values for houses and variation in cost of building in the different jurisdictions. However, it is considered that the social cost of the problem is sufficient to warrant that this insurance should be mandatory for all housing and preferably for high-rise housing. It is a matter of record that the current schemes, outside Qld, do not embrace all of these aspects. In particular, HIA s submissions at the time drew attention to the need for effective, even-handed dispute resolution procedures. HIA recommended to the Productivity Commission that A new and properly designed ADR process that separates contractual disputes from factual disputes over defects may provide relief without imposing Page 12 of 22

14 additional regulatory burdens on consumers and builders. HIA considers that this is still a valid concept that is worthy of further exploration. HIA also suggested to the Senate the concept of a completion guarantee. This idea formed part of its Recommendation 2 (above). HIA continues to endorse this concept. If such effective procedures had existed in the past, consumers would not have had to resort to legal actions against builders to decide where fault lay, and many of the complaints about the current scheme would have been avoided. The complaints, rather than directed to the nature of the insurance scheme, should rather be directed to the lack of effective dispute settling procedures. If HIA s submission to the Productivity Commission were accepted, it would bring the current model much closer to what was recommended by Officers in Is Builders Warranty Insurance Worthless? Critics of builders warranty insurance have repeatedly stated that builders warranty insurance is worthless and junk insurance. This assessment by consumers is apparently based on a mistaken analogy with home or motor vehicle insurance, with an expectation that every accident claim should be immediately paid by the insurer regardless of fault. Needless to say, this totally misunderstands the nature of builders warranty insurance. Last resort builders warranty insurance currently performs as a safety net, where consumers are protected against losses which stem from insolvency, death or disappearance of the builder. This is certainly not worthless. Consider, for example, the position of home builders who contracted with Avonwood Homes which collapsed in the late 1990s. Avonwood was insured by HIH/FAI. Avonwood went into liquidation with about 800 homes under construction, which were later completed under warranty insurance. There were also about 6000 homes still in the warranty period for which the insurers now carried the risk of defects. Due to the subsequent collapse of HIH, taxpayers ultimately picked up much of the estimated total cost of $35m. The consumers who had their homes completed (at a cost of $35m) without incurring additional cost, are unlikely to consider this insurance worthless. Consider also Real Property Constructions Pty Ltd, a Queensland building company which collapsed in March The Queensland Building Services Authority (BSA) has estimated that the cost of completing its Page 13 of 22

15 outstanding home building contracts will exceed $20 million, a cost which will be fully met by compulsory home warranty insurance. That is $20m that the affected consumers will not have to pay, a sum which is funded by builders warranty insurance premiums. It is noteworthy that, although this collapse occurred in Queensland under its government-operated first resort scheme, exactly the same compensation would have been paid by private insurance in other states under their last resort schemes. This is just the sort of catastrophic occurrence that builders warranty insurance was set up to deal with, and clearly illustrates the value which consumers receive from it. It is also worth observing that, as BSA reinsures most of its insurance risk with the private insurance industry, the risks and losses are in the long term carried by private insurers under all builders warranty insurance schemes, including Queensland. In addition, premiums for builders warranty insurance have fallen dramatically since 2002, demonstrating the value to consumers of a competitive market. 1.9 Industry Regulation Issues Does Builders Warranty Insurance Provide Effective Industry Management? One aspect of private sector management of builders warranty insurance is that the number of occurrences of such home builder collapses, and their cost, has significantly declined in the last 7 years in States with private insurance. In HIA s view, this is very substantially due to the risk assessment carried out by underwriters and the limiting of insurance cover on the basis of that risk. Arguably this has been a more successful way of managing the industry than the Queensland licensing model. Strong industry criticisms of builders warranty insurance have arisen from many high-quality builders who were accustomed (pre-hih collapse) to obtaining a cheap annual insurance policy without proper underwriting assessments. These builders were outraged to be told by insurers how much building work they were allowed to take on in the light of their risk profile under a series of job-specific policies. This was made worse by the administrative problems which occurred in when Royal and Sun Alliance (RSA) attempted to service all the previous HIH builder clients. Builders pointed with enthusiasm to the situation in Queensland where any licensed builder could obtain as much builders warranty insurance as they required from the BSA, which in turn attempted to manage the risks Page 14 of 22

16 involved through their administration of builder licensing, which included financial assessments. The Queensland system, while providing insurance cover to all who are licensed, does not cull out poor and failed builders through refusal of insurance. Rather, this culling is (in theory, at least) done through builder licensing, which is also operated by BSA. This system does not necessarily prevent a bad/poor performing builder from undertaking building work, but rather seeks to fix the problem after unacceptable building work has been done and the consumer adversely affected. Builders Warranty insurance in Queensland offers the same premium to all builders irrespective of the builder s past work record, financial status or business health. There is no price incentive to maintain a good building record. As the BSA does not discriminate for insurance, the BSA has introduced a range of complex reforms in recent years in an attempt to address this shortfall. While some builders in Victoria have been asked to provide Deeds of Guarantee to obtain warranty insurance, that was done on the basis of a risk assessment by the underwriter. While HIA does not support Deeds, we acknowledge the fact that builders must have sufficient material and financial resources to present an acceptable insurance risk. Those builders who object to having to provide a Deed point to the situation in Queensland where Deeds are not required. They are apparently in ignorance of the fact that all directors of building companies are personally liable under the Queensland Building Services Authority Act to pay for insurance debts, costs of doing work and fines, without signing a guarantee. The high degree of regulation has associated administration costs for both Government and business, which is ultimately borne by consumers. The system in other States achieves the same effect, not through licensing, but through curtailing builders access to insurance on commercial grounds. In those States, the decision on whether particular builders were good insurance risks, or needed to secure some assets as a guarantee, is a commercial decision for the insurer having regard to the circumstances of the individual. Given a reasonable degree of competition in the insurance market, this is not unfair or unreasonable. A further reason for such complaints was again the false perception that builders warranty insurance was insurance against workmanship defects. Page 15 of 22

17 Accordingly, some believe, access to and the cost of builders warranty insurance should recognise the good workmanship standards of (the very many) builders who had not experienced a consumer claim against them. From the insurer s point of view this was largely irrelevant, because it is the builder s responsibility to rectify workmanship faults. More critical is the financial stability and capital resources of the builder to ensure they have ongoing capacity to meet these responsibilities. Builders that have insufficient capital as a proportion of work outstanding, or have opaque financial and management information systems, are not seen by insurers as good risks. Such builders may therefore be limited in the risk coverage which insurers were prepared to extend to them. Compared with the industry pre-2001, home builders as a group are significantly better capitalised and have better financial management structures. Subsequently, far fewer home builders have suffered financial collapse since 2002 as compared with the past. It has effectively ensured one of the objectives identified by the Consumer Affairs Officers in 2002, that of consumer confidence in the industry, has been largely achieved Other Regulatory Issues HIA notes that there has been a campaign on the part of the Builders Collective of Australia and some individuals to paint the current builders warranty insurance regime as junk insurance and misleading and deceptive conduct. These claims have been made in complaints to the ACCC, VCAT, NSW CTT, and the Victorian Small Business Commissioner, among others. In every case the complaints were investigated but not upheld. The latest Report by the Senate Economics Committee also found there was no basis to these misconceived claims, including some of a scurrilous nature against a Senator which were proved to be completely false. It is difficult to deal rationally with views that were not formed on the basis of reason but on the basis of prejudice. The Committee should be slow to give any credit to claims from this source Conclusion Builders warranty insurance as currently operating provides statutory warranties and other rights which consumers can exercise against a defaulting builder; inadequate dispute resolution procedures which have led to complaints that builders warranty insurance is not working properly; Page 16 of 22

18 an affordable solution to protect consumers where their builder is unable to meet their legal obligations. It is our position that a dispute resolution process is logically separate from the warranty safety net process and that dispute resolution should be the responsibility of the government regulatory body. It is also our position that builders warranty insurance is best provided by free and fair competition in the private marketplace. At present, the private insurance market in Victoria is still working effectively to provide the required level of statutory cover at an affordable price. The market is informed as to the prices and the product is a standard one so that comparisons and choices can easily be made. Price competition in the private market is providing consumers with significant savings on their home purchases compared with the position in Queensland. HIA considers that there is no justification in the Victorian Government taking the provisioning of builders warranty insurance back under their control, and HIA believes that the Government shares that view. However, we consider that the Government should take a much more pro-active position in regard to the introduction of a more robust and accessible dispute resolution process for home buyers and home builders. Disputes are essentially juridical in nature and are best handled by governments, while insurance is basically commercial in nature and best handled by commercial organisations operating within a competitive marketplace. In sum, Governments should look after disputes and insurers should look after the safety net. Housing Industry Association Ltd 15 January 2010 Page 17 of 22

19 ATTACHMENT 1 Common financial risks in the housing industry the reason for Warranty Insurance Economic Environment Construction activity in the housing industry is very cyclical, meaning periods of high levels of construction can be followed by periods of depressed trading. Builder insolvency levels follow similar trends. Boom activity precipitates the greatest number of insolvencies amongst larger companies higher activity levels can lead to greater demand for material and labour resources. On the other hand, smaller companies generally last through the boom times but fail shortly afterwards - profit margins often become tighter when home construction activity starts to fall. Common Features of Failed Businesses The housing industry is highly competitive. Profit margins, purchasing power and overheads are three of the key factors that builders look at when analysing their competitive position. Profit margin is often reduced in order for builders to price their product competitively in this highly competitive environment. Boom cycles distort margins due to rising labour costs. Overhead costs as a percentage of turnover are also affected as production and cash flow slows down. Conversely bust cycles reduce margins due to competition. A common situation amongst failed builders is that they allowed the market to determine their profit margins, rather than setting their margins based on the financial needs of their business. Builders often rely on financial figures generated for taxation purposes instead of producing and relying on proper management accounts information. Page 18 of 22

20 Other factors that challenge building business solvency include: Poor Job Costings Information A lack of reliable job costing information will lead to individual jobs being inappropriately priced. If jobs are not priced correctly, in order to achieve a profit and meet overhead requirements of the job, the business will go backwards and will have to utilise retained profits to fund overhead costs, rather than investing the retained profits back into the business to support future growth. Inaccurate Job Costing Information Often builders who become insolvent do not spend the time, budgeting and planning for specific jobs to ensure a job will make a profit. When actual costs are involved, the same builders do not monitor these actual costs against the related job in order to monitor overruns. Therefore the builder is not able to foresee a problem on a particular job in advance and determine an approach to solve the situation prior to the completion of the job. Overstating Assets Overstated balance sheet assets relating to work in progress and realisable debtors (book debts for tax reasons from related companies or principles are not working capital) mislead the true position of the builder s business. If assets are not realisable, the cash flow of the business will be effected in a negative manner. As a result the balance sheet should only contain profit generating assets. Monitoring Cash flow Invoices relating to actual costs are usually not aged by the insolvent builder via an accurate aged creditors listing, restricting the builder s ability to properly monitor cash flow and to ensure funds are available when invoices become due and payable. In conjunction with this, the same builder may not have a reliable aged debtors listing which allows the builder to effectively manage the flow of funds back into the business, in a timely manner, to meet creditor commitments. It is particularly important to track progress payments because if these payments are not received by the Page 19 of 22

21 builder, then the builder may find it difficult to fund the next stage of the building development and pay creditors on time. As a result, bbuilders should ensure all management information is available to them so that they can assess the true position of their business to ensure jobs are making a profit and debtors are being recovered in a timely manner so that suppliers can be paid on time. Financial Records Failed builders often only produce financial information once a year and usually well after year end. Often information is in the form of a financial report which has been produced for taxation purposes. As a result, the same builder is unlikely to have reviewed any financial management information during the year, to indicate how the business is tracking and whether there are any financial issues to be addressed. Other issues leading to Builder insolvency Investments in non-core business activity using cash flow rather than earned profits. Uncontrolled under-capitalised growth. Lost production due to boom trading or adverse weather. A major contractual dispute often with a client. Time delays. Cost Variations. The Australian Bureau of Statistics Data directly states that 60% of new businesses disappear within 3 years. Not all Builders become insolvent or bankrupt - some simply shut their doors in order to meet outstanding obligations rather than incurring additional costs. 90% of business failures are attributable to poor management and more precisely - poor financial management The primary financial concerns for builders include: 1. Failure to plan properly before commencing construction work; 2. Failure to monitor the financial position through monthly management information; 3. Failure to understand the relationship between price, volume and costs; 4. Failure to manage cash flow; 5. Failure to manage growth; Page 20 of 22

22 6. Failure to borrow properly; 7. Failure to plan for some transition; 8. Failure to compare actual job results with budgets or forecasts. Often growth in the market will allow builders to have an increased cash-flow for a short term period which allows them to build up their business accordingly. However, a downturn in the market is inevitable and as a result all efforts to increase activity during previous periods may be pointless. Usually, effects of an economic downturn are indicated in current management accounts and financial information long before the time the builder becomes insolvent. If the builder maintains adequate management information, growth patterns should be evident in order to pre-warn Builders of potential downturn in growth. Therefore, the major area of risk comes from growth and the builders response to boom/bust conditions in the market. There is widespread belief in the building industry that progress payments alone, will fund growth. Growth in cash flow can only be achieved through fundamental changes to the business or an injection of capital. It is also a common belief of Builders that greater turnover levels lead to a more profitable business. Unfortunately, this is not always the case, as the generation of more turnover is not always better for business unless the increased turnover is adequately managed. Successful management involves implementing strict disciplines over margin and production so that turnover growth is funded out of retained profits or additional equity. (This implies that jobs are accurately costed through up-to-date construction cost estimates and there is adequate provision for likely price increases during the life of the job). It is imperative that builders manage turnover growth to ensure business expansion is supported by retained profits or additional equity not working cash flow which could be to the detriment of their business. Builders should also review external information to ensure their business is tracking in line with their competitors. The Housing Page 21 of 22

23 Industry Association (HIA) is able to provide forecasted economic data specific to the building industry to help builders better predict the building cycle. The most commonly asked question from builders is: how am I actually assessed in terms of the financial and nonfinancial information which I submit? The financial component relates to approximately 80% of the assessment and approximately 20% of the assessment relates to non-financial information. The reason for this is that the Home Warranty Insurance policy only comes into effect as a result of the insolvency, death or disappearance of a builder. As such the primary risk to the Insurer, and the client, is the insolvency of the builder, and therefore the financial performance of the builder is the main focus of the assessment. The non financial elements of a building business, (time in business, complaint free trading and technical competence) can add weight to the financial criteria, however in the absence of adequate financial strength and performance, these non financial factors alone will not be enough to qualify the builder for warranty insurance. Page 22 of 22