Contractor Default Insurance: A Subcontractors Dilemma
By STEVEN D. NESS, President, Surety Association of Canada

The first contractor default insurance policy was rolled out in late 1996 in the United States. The product was marketed to large general contractors who were seeking an alternative to the surety approach that would give them more control over the completion process upon the default of a subcontractor. 

Since its inception, the product has had some success in penetrating the U.S. construction market and as of 2005, more than 90 policies were in force. Sellers claim that 25 of the top 100 North American general contractors have now purchased the product. The vast majority of policies are issued by one carrier which has virtually cornered the market and the policies in force almost exclusively cover large general contractors with more than $100 million in subcontracted values. Indeed this was the market for which the product was designed. 

In Canada, while contractor default insurance (CDI) has been less successful, largely due to the smaller size of the marketplace, it has still made inroads and has been purchased and utilized by the country’s two largest general contractors. 

The sellers of contractor default insurance are quick to point out the advantages that the product provides to general contractors. They strongly emphasize the greater measure of control that CDI affords generals over the construction process and suggest that by taking this approach, the general is now in a much strong position when it comes to “managing” the performance of its subtrades. 

From the perspective of the subcontractor being so managed, this control in the hands of a general can be a double-edged sword at best and can lead to serious problems; particularly should disputes arise with respect to the execution of the work. A default insurance policy allows its “Insured” (the general contractor) to be the judge and jury in the issue of subtrade default. Thus, in the event of a protracted dispute, the trade contractor is at the mercy of the general and may find their contract unilaterally terminated with no leverage or recourse available beyond litigation. 

Consider the same scenario with the subcontractor’s performance guaranteed by a performance bond in lieu of a default insurance policy. When a bonded subtrade is declared in default, the bonding company acts as an objective third party to assess merits of the claim. It investigates the circumstances to ascertain that a default activity exists before acting under its performance bond. This objectively protects a subcontractor from frivolous and precipitous actions. 

A more critical consideration, at least from the subcontractor’s point of view is payment assurance. A default insurance agreement by itself provides no protection to subs or suppliers should the general contractor be unable or unwilling to extend payment for work done. Payment protection is available to the trades only if a labour and material payment bond is provided by the general contractor to the owner. The situation has become more complicated recently as a number of large contractors who carry default insurance have attempted to get around the payment bond requirement by approaching the owner with a cost saving proposal that involves adding the owner as an insured under its policy. 

Under the proposed arrangement, the general contractor would not be required to post a performance or payment bond for their contract, but only a “gap” bond which would respond only to a default of their project management/administration responsibilities. It’s usually suggested to the owner that they are now protected by a combination of the insurance policy and gap bond while saving the premium a full performance security and the payment bond. In fact an arrangement such as this can be problematic both for the owner and subcontractor. We suggest that the owner would not be fully protected should the general default on its contract. What’s more, any savings are realized on the backs of the subs as no labour and material payment bond would be in place to protect them in the event that the general defaults on its payment obligations. 

There are other reasons for subcontractors to be wary of default insurance arrangements. One condition of the policy requires to the general to pre-qualify subcontractors before entering into a contract. As part of this pre-qualification process, subs are often asked to provide confidential information including their financial statements to the general contractor for review. Many subs are understandably reluctant to providing such sensitive information to a party with whom they may be involved in sensitive negotiations. Under the surety bond scenario, the trade contractor provides this information to the bonding company in the same manner as they would a bank with confidentiality being assured. 

Establishing a relationship with a professional surety company can provide a contractor with a powerful competitive edge over less qualified competition. Yes, your surety will insist on being kept up to date with a steady flow of timely information sometimes to the point of being maddening. Such minor frustrations are well worth the effort as your bonding company is truly a business partner who can provide invaluable assistance in protecting your interests. Performance and payment bonds work for subcontractors.

 

For more information, contact the Surety Association of Canada at (905) 677-1353 or visit the organization’s web site at www.surety-canada.com.