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.
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.
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.
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.
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:
- 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.
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.
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.
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.