Volume 0, Issue Number 106 September  8, 2009



Contracts Bulletin #106 - Key Differences Between Subcontractor Default Insurance and Surety Bonds

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Understanding Key Differences Between Subcontractor Default Insurance (SDI) and Surety Bonds

Subcontractor default insurance (SDI), first introduced in 1996, is an insurance product that has been marketed as a way for prime contractors to manage the risk of subcontractor failure. SDI currently is sold by only one insurance carrier on a surplus lines basis. Typically, very large contractors—that is, contractors having a subcontractor volume of at least $75 million per year—have used the product. Contractors who use SDI in lieu of subcontract bonds must prequalify subcontractors for admission into their programs and partially self-insure the costs of subcontractor default through substantial co-payments and deductibles. Subcontractors who are considering working on a project covered by a subcontractor default insurance program should understand the implications of such a program on the project and on their businesses. A number of subcontractor benefits provided by contract bonds, for example, are absent under current SDI policies.

Surety Bond Default Insurance Policy
• Regulated by state insurance departments • Sold as surplus lines, not regulated
• Three party (protects obligee, risk stays with principal & surety) Surety has obligations to obligee and principal • Two party (protects insured) Insurer has obligations to insured
• Premium fee for qualification services (no expectation of loss) based on % of contract amount • Premium actuarially determined (calculated pooled risk)
• Coverage project specific • Coverage usually term specific
• Bond forms standard or may be negotiated by owner or surety • Form mandated by insurance company
• Claims – surety has right to contract balance or indemnity • No right to insured’s assets, however companies can subrogate against a third party or another insurer

Managing Risk

Construction is an inherently risky enterprise, and managing risk in construction can be challenging. Insurance is an important tool for construction firms to manage certain risks on construction projects. While insurance and surety frequently are lumped into one general category of risk management tools, surety bonds are a specialized type of insurance with significant differences from other types of insurance.

SDI Policies
A subcontractor default insurance policy is a two-party agreement between the insured (the SDI contractor) and the insurer that indemnifies the SDI contractor for costs incurred as a result of a subcontractor’s performance default. The SDI contractor must self-insure some of its risk of subcontractor default through satisfying policy co-pays and deductibles. Upon exhaustion of policy co-pays and deductibles, the SDI contractor will submit documentation and seek reimbursement for subcontractor default losses. The SDI contractor must expend its own administrative resources to prequalify subcontractors for inclusion in its SDI program and to perform claims evaluation and management. To prequalify subcontractors, the SDI contractor may request that subcontractors supply the contractor with sensitive financial information, which may be an invasive process and which may present opportunities for misuse of such information unless protections are in place. Subcontractors should ensure that the SDI contractor has a policy in place to address the use of such sensitive subcontractor financial information.

Surety Bonds
A surety bond is a three-party agreement under which the surety guarantees to the obligee (in this case, the contractor) that the principal (the subcontractor) will perform a construction subcontract. Surety bonding involves a careful and rigorous process in which an independent surety company and bond producer prequalify the subcontractor, and, if surety credit is extended to the subcontractor, the surety company issues a bond providing the contractor with assurance that the subcontractor will perform according to the terms and conditions of the subcontract. A subcontract performance bond protects the contractor from financial risk should the subcontractor default on its subcontract obligations. A subcontract payment bond protects certain downstream parties, such as subcontractors, suppliers, and laborers, ensuring that they will be paid subject to any restrictions and limitations imposed by statute, the contract or subcontract, or the bond.

Prequalification

Surety Bonds
To qualify for a bond, subcontractors must provide confidential financial data, details of work-in-progress, and a comprehensive business plan to the surety bond producer and surety company underwriter, who determine whether to bond the subcontractor. Through the prequalification process, the surety bond producer and underwriter analyze the contract documents, size and location of the project, as well as, the subcontractor’s financial strength and credit history, experience and reputation, exposure and progress on other contracts, and ability to perform the work. A surety company will issue a bond only if it believes that the subcontractor possesses the needed character, capital, and capacity to fulfill its subcontract obligations. So, when bonds are required, subcontractors will be bidding against other qualified subcontractors with legitimate bids.

Subcontractor Default Insurance
With SDI, the prime contractor, not an independent surety, prequalifies subcontractors for admission into its SDI program. The contractor’s prequalification process may or may not be as thorough as the process undertaken by sureties. At the core of their business, sureties typically focus on long-term relationships with construction firms, giving them unique insights into their performance over the long-term and in different markets and economic periods. Such relationships are mutually beneficial for the surety and its principal.

Claims Management

Surety Bonds
On a bonded project, the surety conducts an independent investigation to determine whether a subcontractor truly is in default. The surety will not pay a bond claim unless it is satisfied that its principal, the subcontractor, materially breached its subcontract obligations. If a subcontractor default does occur, the surety takes the responsibility to deal with unpaid creditors, suppliers, and laborers, and frequently administers the subcontract to completion. The surety may obtain a replacement subcontractor to complete the work, finance the present subcontractor to completion, or negotiate a financial settlement with the contractor and issue payment. In addition, sub-subcontractors, laborers, and suppliers under the subcontract are guaranteed payment by the subcontract payment bond. Such firms have a direct right of action against the subcontract payment bond.

Subcontractor Default Insurance
With subcontractor default insurance, the contractor has the flexibility to declare a subcontractor in default and the power to unilaterally replace a subcontractor on a project, subject only to later judicial scrutiny. If the declared default later is determined to have been unjustified, the insured must repay the insurer. There is no initial independent third-party assessment of the propriety of the default decision.

Further, with SDI, the contractor is responsible for handling all aspects of a default situation. The contractor is expected to pay all losses initially, then seek reimbursement from the insurer. SDI also does not afford payment protection for lower-tier project participants, such as sub-subcontractors and suppliers. Such parties have no direct right of action against the SDI policy for payments due. The SDI policy only exists for the benefit of the insured contractor.

Summary

A contract surety bond is a comprehensive risk transfer mechanism that provides independent prequalification of subcontractors according to established criteria; shifts the entire risk of the principal’s default from the obligee to the surety; requires the surety to manage default situations; and provides 100% payment protection to lower-tier parties, such as subcontractors and suppliers. SDI is often described and marketed as an alternative to traditional contract surety bonds, but it is merely a catastrophic insurance policy, and provides no payment protection for lower-tier subcontractors, suppliers, and laborers.

Performance & Payment Bonds vs. Subcontractor Default Insurance

Issues Performance & Payment Bonds Default Insurance
Prequalification Process • Conducted by surety • Left to policy holder
Structure • Three-party agreement • Two-party insurance policy
Payment Protection for Subcontractors & Suppliers • Yes, covered 100% payment bond
• Direct payment protection
• No
• Unable to file a direct claim with the insurer
Default Management • Claims investigated by surety to ensure legitimacy
• If subcontractor defaults, surety completes, arranges for, or pays for the contract completion up to the amount of the bond
• Contractor declares default subject to later judicial review
• Contractor manages default, including completion of the contract and files claim with insurer
Risk • Shifted to surety for contract completion & payment to subcontractors and suppliers • Contractor retains portion of risk through deductibles & co-payments; subcontractors and suppliers bear risk of nonpayment
Legal • Required by federal and state law on public projects
• Long history of case law and legal precedents
• Does not satisfy federal or state bond requirements
• Little history of case law or legal precedence

This article was prepared by, and in cooperation with, the National Association of Surety Bond Producers (NASBP), a trade association of professional surety bond producers, headquartered at 1828 L Street, NW, Suite 720, Washington, DC 20036-5104.

SMACNA wants the Contracts Bulletin to serve our members. Your feedback or topic suggestions are welcomed by contacting Mike McCullion at 703-995-4027 or mmccullion@smacna.org.

 

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