An Alternative to Performance Bonds — Advantages and Disadvantages of Subcontractor Default Insurance for the General Contractor

Peckar & Abramson
July 7, 2008 — 2,423 views  

Over the last 10 years, the insurance industry has produced a product that, in some situations, provides an attractive alternative to performance bonds. Subcontractor Default Insurance (SDI) can provide security for contractors when a subcontractor breaches its contract and is terminated. There are many potential advantages to the contractor: (1) lower premium costs; (2) control over the prequalification of subcontractors; (3) no investigation period by a surety after a subcontractor defaults; and (4) coverage of entities otherwise unqualified for a bond. From a contractor’s perspective, there are also shortcomings with SDI, especially on public projects. This article will attempt to describe the pros and cons of SDI, as well as explain the workings of this relatively new product in the construction industry.

Conventional Performance Bonds Compared With Subcontractor Default Insurance

The deductible on an SDI policy is usually in the $500,000 range, whereas performance bonds do not have a deductible. Additionally, on public projects, SDI policies may not meet the requirements for payment bonds, as mandated by the federal Miller Act and state public bond statutes, and SDI may not satisfy the performance surety requirements in certain jurisdictions. As a result, SDI has been used primarily for private projects.

On a large construction project, conventional performance bonds set up a relationship between three parties — the bonding company (the surety), the subcontractor (the principal) and the contractor (the obligee). Subcontractors must be prequalified by the bonding company, and the bonding company assumes the risk of the subcontractor defaulting. In essence, the bonding company guarantees satisfaction of the subcontractor’s obligations, and the bond constitutes protection for the contractor. The subcontractor pays the bond premiums, typically 1 to 1.25 percent of the subcontract value,1 and that cost is passed directly onto the contractor.

Once a contractor terminates a subcontractor, the bonding company’s duties are triggered, and it is required to investigate the claim. Upon acceptance, the bonding company has certain options, including forfeiting the bond’s penal sum, tendering a new subcontractor, financing the defaulted party or allowing the contractor to proceed at its own discretion (and at the bonding company’s expense).2 Many contractors have experienced the frustration of having to terminate a subcontractor, followed by a lengthy investigation by the bonding company. In a complex, time-sensitive project, any delays by a bonding company’s investigation can be extremely expensive.

On the other hand, an SDI policy involves only two parties, as the contract specifies that the insurance company will compensate the contractor for losses resulting from a subcontractor’s default. And rather than individual policies for each subcontractor, most SDI policies cover all subcontractors, and the contractor is free to decide which entities are qualified to perform work on the project. SDI policies usually cover first-tier subcontracts (subs in direct contract with the contractor), and second-tier subcontracts (“sub subs” in direct contract with first tier subcontractors, including suppliers). SDI also provides coverage for losses that are the indirect result of a default, such as liquidated damages, acceleration of other subcontracts and extended overhead. SDI pricing is negotiable, usually ranging from 0.4 to 0.85 percent of total subcontract values, depending on the general contractors’ experience and track record on similar projects.3

Three-party suretyship has been around for millennia, as have two-party insurance contracts. However, default protection and risk allocation in the U.S. construction industry has been primarily achieved through three-party bonding. Well-established statutes and case law govern surety bonds in a wide variety of contexts, therefore providing clear guidelines to all parties in each jurisdiction. In contrast, there are no reported decisions on major subcontractor default insurance disputes, and it remains unclear how judges will treat SDI issues on construction projects. Regardless of how prominent default insurance becomes in the construction industry, this type of risk allocation is headed into uncharted territory.

Development of Current Policies

The most prominent policy on the market is Subguard®, a product of Zurich Financial Services. Subguard® was designed to address the needs of large general contractors, construction managers and design-build firms with annual subcontractor/supplier expenditures of $50 million or more. Zurich’s promotion of Subguard® highlights the following:

  • Completion costs for unfulfilled subcontractor or supplier obligations — including costs related to contractor replacement, job acceleration and extended overhead
  • Correction costs for defective and/or nonconforming work product
  • Legal costs resulting from a default
  • Coverage for disadvantaged or small business enterprises that may have difficulty qualifying for standard performance and payment bonds
  • Coverage for local and other business enterprises that may have difficulty qualifying for standard performance and payment bonds4

Under Subguard®, Zurich negotiates the deductible and co-payment amounts of the policy based on the particular project and the contractor’s history with subcontractors. All subcontracts signed after execution of the policy are covered, and suppliers can be included by endorsement to the policy. A contractor can therefore manage and control risk by including, for example, suppliers of concrete, construction materials and equipment all under one policy.5 When a claim arises, contractors notify the insurer in writing of the subcontractor’s default, and then proceed independently to remedy the situation. Contractors are reimbursed for their costs, less deductibles and co-pay amounts.

Bad-Faith Claims

Default insurance like Subguard® is bound by the traditional implied covenant of good faith and fair dealing in insurance contracts. Therefore, a contractor has the legal remedies under an insurance contract, including punitive damages, if an SDI provider does not fulfill its obligations after a contractor has established a claim. In contrast, surety interests have fought hard against the ability of a contractor, as obligee, to recover against the surety company on bad-faith claims. While there is a developing line of cases holding sureties liable for bad-faith refusal to pay and delay in processing claims, not all jurisdictions have followed suit. A surety company successfully argued in a 1999 California Supreme Court case (Cates Construction, Inc. v. Talbot Partners) that a surety’s obligations to a contractor are distinguishable from the obligations under a two-party insurance contract.6 Thus, in terms of bad-faith claims and punitive damages, a contractor may have more rights under a two-party insurance contract.7

The National Association of Surety Bond Producers has characterized SDI as a “big gamble” because there may be no extensive checks on subcontractors.8 Surety interests emphasize the merits of the subcontractor prequalification process, and suggest that the three-party nature of bonds helps mitigate potential losses. And proponents of surety bonds point out that SDI is no replacement for payment bonds, as there is no protection afforded to subcontractors or suppliers.

Informal disputes involving public projects highlight the potential for litigation. Major construction companies have used SDI while employing various project delivery systems. When a general contractor or construction manager at-risk relationship is established with public entities, federal and state surety laws must be carefully examined. Surety interests have sought to prevent the use of SDI in lieu of performance bonds on public projects, yet no formal litigation has led to a reported judicial decision on the issue.

The Miller Act and similar state laws are designed to protect taxpayer funds and ensure timely completion of public projects. The legal mechanisms for achieving these goals evolve, and it may turn out that SDI may come into prominent use on public projects. As proponents of surety bonds continue to promote their interests, however, there will no doubt be litigation on the applicability of SDI with the use of public funds. Similarly, with private projects, there are bound to be lawsuits regarding coverage issues and other provisions in SDI policies.

Conclusion

SDI can provide a good alternative to performance bonds in many settings. Large contractors that have the resources to investigate subcontractors and suppliers will benefit from the lower costs of default insurance. Indeed, the contractor is often the best party to evaluate the strength of a subcontractor, based both on balance sheet factors and intangible qualities, and make key decisions about project participants. On the other hand, smaller contractors may be better served by the established three-party surety relationship when addressing the risk of subcontractor default. A bonding company’s prequalification of a subcontractor can be a valuable loss-prevention measure for many contractors.

1Jeffrey A. Ford, Esq., “Subcontractor Default Insurance,” presentation to the Construction Law Section of the State Bar of Texas, March 8-9, 2001.

2Klinger, Marilyn, and Diwick, James P., The Contract Performance Bond, The Law of Suretyship, 7-5 through 7-11 (Edward Gallagher, ed., 1993).

3Notebloom, Lowell J., Esq. From the website of Leonard, Street, and Deinard, Minneapolis, MN. Subguard® Subcontract Insurance — What is it? Is it an appropriate alternative to surety bonds? 2001.

4Gray, Terry. Vice President, Construction Risk, Zurich N.A. Insurance Co. Point/Counterpoint; Default Insurance — An Alternative to Traditional Surety Bonds. 22 WTR Construction Law 17. 2002.

5Id.

6See Cates Construction, Inc. v. Talbot Partners, 980 P.2d 407, 427 (1999).

7In the event that the Florida Supreme Court permits its bad-faith actions against sureties by bond obligees, such as owners, this will likely result in judgments greater than the face amount of the bond that could ultimately lead to increase bond premiums as well as an increase in the amount of collateral required to be posted by bond principles. The implications to Florida’s construction industry cannot be overstated. We will keep you advised in future editions of the newsletter.

8Cashion, Matthew K. Jr., President, National Association of Surety Bond Producers, June 9, 2003 Opinion Letter , McGraw Hill Companies, Inc.

Peckar & Abramson