Bonding Tips and Tactics: Contractor Default Insurance
October 2001
In this article, Rolf Neuschaefer examines
default insurance—a recent development designed as a substitute for the traditional
surety performance guarantee—and discusses its shortcomings from a surety producer's
perspective.
by Rolf A. Neuschaefer
Robert E. Harris Insurance Agency, Inc.
In my last article "All Guarantees Are Not Created
Equal," we examined some of the alternatives available to an owner/lender
for shifting the performance risk from themselves to some guarantee form or
mechanism. The intent of the article was to raise awareness of the pros and
cons of some of these alternative guarantee forms and help focus on the many
advantages of corporate surety performance and payment bonds.
Default insurance, also known as subcontractor default insurance, the subject
of this article, is a recent development and has been designed to substitute
for the traditional surety performance guarantee.
An Insurance Product
Default insurance is typically purchased by the general contractor to "insure"
the performance of its subcontractors on all their prime contracts. It could
also be purchased by the owner to cover the general contractor and all the first-tier
subcontractors on a specified project. This concept or approach is similar to
a property/casualty "wrap-up" program designed to include all project participants
under one insurance program.
The allure of default insurance for a general contractor or owner rather
than requiring performance and payment bonds from the general and/or the subcontractors
are primarily the touted potential premium/cost savings and greater control
in managing the performance of the construction parties. While the prospects
of saving money and having greater control always sound attractive, there are
a number of issues/concerns with default insurance that must be considered before
selecting this risk-shifting option.
Pricing
On the issue of cost, default insurance is priced based on such factors as
the contractor's experience, profitability, financial condition, reputation,
and history of subcontractor defaults. The premium for a well-established general
contractor with $200 million per year in subcontract volume would be a maximum
of .85 to 1 percent of the annual subcontract costs. Half of this premium is
termed an "experience" premium, meaning that all or some of it could be reimbursed
depending on actual loss experience. Therefore, under ideal conditions, with
no losses/defaults by any subcontractor, the general or owner would be reimbursed
50 percent of their total premium.
Considerations
How does this compare to the cost of surety performance and payment bonds
on $200 million of subcontracts? In broad strokes, a like amount of surety subcontract
bonds would cost somewhere around 1 percent, depending on the size of the subcontracts,
the type work, and the quality of the subcontractor. Before you leap to your
feet and declare that default insurance is more cost advantageous, consider
the following factors:
- In the example above, default insurance for a general contractor with
$200 million in subcontract costs would have had a limit of $20 to $25 million.
If bonds had been issued, there would have been $200 million of subcontract
performance bonds and $200 million of payment bonds. Obviously, the dollar
value of the default insurance doesn't come close to the penal bond guarantees
provided by the bonds.
- If an owner had purchased default insurance on a $200 million general
contract for a specific project, the bond premium would probably have been
closer to .60 percent or less, depending on the quality of the general and
the nature of the work being performed. In that instance the cost of the
bonds (each for $200 million) would have compared favorably with the cost
for default insurance where the experience portion is fully refunded.
- What is the likelihood that on $200 million of annual subcontracts there
would be zero defaults? From my personal experience, such a scenario would
be most unlikely in the best of times. If the general were willing to financially
support a troubled subcontractor to avoid outright default, it might be
possible, but then you have the time, effort, and money spent by the general
to avoid or mitigate default.
Exclusions
The cost aspect in evaluating default insurance may not be the most critical
consideration. What coverage does default insurance actually provide? To begin
with, you need to take notice of the following eight exclusions:
- Misrepresentation
- Fraud
- Defaults occurring prior to the policy period
- Material breach of warranty by the contractor
- Contracts acquired from other entities
- Nuclear reaction or radiation
- War and other hostile actions (Does this include terrorist activities
such as those recently experienced?)
- Losses arising out of providing professional services
While these may be considered fairly routine exclusions for property/casualty
policies, they are not included in standard performance and payment bonds.
Coverage
Default insurance reimburses the named insured general contractor or owner
(depending on who purchased the insurance) in fulfilling a defaulting contractor's
contractual obligations. This means that the named insured has to first expend
its own resources before it can submit a request for reimbursement. This can
create cash-flow issues and places the named insured in the unenviable role
of managing a default/claim situation. A conflict-of-interest situation could
develop for the named insured if the alleged defaulting contractor has a legitimate
dispute or claim with the named insured.
Limitations
When the default insurance policy is closely examined, you will find that
it includes an aggregate limit of insurance, a qualifying loss limit, a qualifying
loss indirect cost sublimit, a non-qualifying loss limit, a deductible for each
qualifying loss, a co-payment percentage for each qualifying loss, and an advanced
claims payment percentage. Losses charged against the initial premium may also
include a 15 percent administrative loading under certain circumstances. None
of these limitations and surcharges exist under traditional performance and
payment bonds.
Subcontractors Not Covered
Default insurance also provides no direct benefits to subcontractors or suppliers,
as does the payment bond. If suppliers' claims are not appropriately addressed,
they may file a lien (and/or a stop-payment action in California) on the project.
The cost of release of lien or release of stop-payment bonds may be costly and
difficult to obtain if the project was not itself bonded. Many subcontractors
and suppliers take comfort in knowing a project is bonded because they know
they will be paid if they fulfill their contractual obligations.
No Prequalification Service
One of the biggest shortcomings of default insurance is that there is no
prequalification service provided by the insurer. The burden to prequalify and
manage the subcontractors falls entirely on the named insured. My initial article,
"To Risk or Not To Risk," discussed in some
detail the difficulty involved in an owner or general contractor effectively
prequalifying subcontractors. Regardless of how diligent the owner or general
may be in trying to perform the prequalification process, they are always under
pressure to secure competitive bids. This creates a dynamic that makes it difficult
to be truly objective in the prequalification process.
Conclusion
Coming full circle to the cost issue of default insurance, I believe that
the product is one-dimensional in scope, provides substantially less in limits,
provides no prequalification services, provides no real claim service, imposes
numerous exclusions and limitations, provides the purchaser no true performance
guarantee, and places the named insured in potentially conflicting and difficult
claim handling issues. Given the many shortcomings compared to traditional performance
and payment bond guarantees, default insurance does not appear to be a bargain
at any price.
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