Surety Bonds vs.Subcontractor

Default Insurance

Surety Information Office (SIO)www.sio.orgsio@sio.orgThe Surety Information Office (SIO), formed in 1993, disseminatesinformation about the benefits of contract and other forms ofsurety bonding in private and public construction. SIO, a virtualoffice, is supported by the National Association of Surety BondProducers (NASBP), www.nasbp.org, and The Surety & FidelityAssociation of America (SFAA), www.surety.org. For informationon the benefits of surety bonds in construction and in othercontexts, contact the Surety Information Office at sio@sio.org.

National Association of Surety Bond Producers(NASBP)1140 19th St. NW, Suite 800Washington, DC 20036(202) 686-3700(202) 686-3656 Faxwww.nasbp.orginfo@nasbp.orgThe National Association of Surety Bond Producers (NASBP),founded in 1942, is the association of and resource for suretybond producers and allied professionals. NASBP producersspecialize in providing surety bonds for construction contracts and other purposes to companies and individuals needing theassurance offered by surety bonds. NASBP producers engage incontract and commercial surety production throughout the U.S.,Puerto Rico, Guam, and a number of countries. They have broadknowledge of the surety marketplace and the business strategiesand underwriting differences among surety companies. As trustedadvisors, professional surety bond producers act in many keyroles to position their clients to meet the underwritingrequirements for surety credit.

The Surety & Fidelity Association of America (SFAA)1101 Connecticut Ave., NWSuite 800Washington, DC 20036(202) 463-0600(202) 463-0606 Faxwww.surety.orginformation@surety.orgThe Surety & Fidelity Association of America (SFAA) is a District of Columbia non-profit corporation whose members are engagedin the business of suretyship worldwide. Member companiescollectively write the majority of surety and fidelity bonds in the United States. SFAA is licensed as a rating or advisoryorganization in all states, as well as in the District of Columbia and Puerto Rico, and it has been designated by state insurancedepartments as a statistical agent for the reporting of fidelity andsurety experience. SFAA represents its member companies inmatters of common interest before various federal, state, and local government agencies.

© 2014 Surety Information Office

ImportantDifferences

subcontractor to completion, or negotiate a financialsettlement with the contractor and issue payment. Inaddition, subsubcontractors, laborers, and suppliers underthe subcontract are guaranteed payment by the paymentbond. Sub-subcontractors may file a claim for paymentdirectly with the surety.

With SDI, the GC is responsible for handling all aspects ofa default situation. The prime contractor is expected to payall losses initially and then seek reimbursement from theinsurer. This effect on the principal’s cash flow can have asignificant impact on the ability to pay its subcontractors.Also, if a subcontractor suffers a loss due to thecontractor’s failure to pay, he or she has no right to file aclaim directly with the insurer. If the prime contractordecides not to, or is unable to, pay a subcontractor, he orshe has no recourse to file a claim for the money owed.

Final Thoughts A surety bond is a comprehensive risk transfer mechanismthat provides the prequalification of subcontractors; shiftsthe entire risk of the principal’s default from the obligee tothe surety; requires the surety to manage defaultsituations; and provides 100% payment protection tocertain subcontractors and suppliers. SDI is oftendescribed and marketed as an alternative to traditionalperformance and payment bonds, but it is merely atraditional insurance policy and provides no paymentprotection for subcontractors, suppliers, and laborers.

on its contract. A payment bond protects certainsubcontractors, suppliers, and laborers, ensuring that theywill be paid subject to any restrictions and limitationsimposed by statute, the contract or subcontract, or the bond.

Surety Bonds Provide a Level Playing Field What if the prime contractor requires subcontractors toobtain a performance bond? In order to obtain a suretybond, subcontractors undergo a rigorous prequalificationprocess. Prequalification is a major underpinning of thesurety bond product. To qualify for a bond, subcontractorsmust provide, among other information, confidentialfinancial data, details of work-in-progress, and acomprehensive business plan to the surety companyunderwriter, who determines whether to bond thesubcontractor.

Through the prequalification process, the underwriteranalyzes the contract documents’, size and location of theproject, as well as the subcontractor’s financial strength andcredit history; experience and reputation; exposure andprogress on other contracts; and ability to perform the work.

A surety company will issue a bond only if it believes thatthe subcontractor will fulfill its contractual obligations. So,when bonds are required, subcontractors will be biddingagainst other qualified subcontractors. However, with SDI,the prime contractor must perform its own prequalification,

Surety Bonds vs. Subcontractor Default Insurance

Subcontractor default insurance (SDI) has received attention,

primarily among very large contractors, as a way to manage risk of

subcontractor failure. The product, introduced in 1996, is marketed to

contractors who are willing to accept and manage risk of subcontractor

default. However, subcontractors on these projects may end up in a

precarious position, as a number of benefits provided by performance and

payment bonds are absent under current SDI policies. Before working on

a project covered by SDI, owners, general contractors (GCs), and

subcontractors should consider the potential risks of default insurance

and benefits of surety bonds.

Managing RiskConstruction is a virtual minefield of risk, and owners andcontractors always are looking for ways to identify, assess,and manage it. While insurance and surety are frequentlylumped into one general category of risk management,surety is a unique type of insurance with significantdifferences. Contract surety bonds are highly effectivetools for owners and contractors to shift the risk ofcontractor and subcontractor failure, and for ensuring thata qualified contractor or subcontractor that is capable ofcompleting the contract is on the job.

An SDI policy is a two-party agreement between theinsured (the contractor) and the insurer that indemnifiesthe contractor for costs incurred as a result of asubcontractor’s performance default. SDI provides nocoverage to an owner and no protections to othersubcontractors, suppliers or laborers. A surety bond is athree-party agreement in which the surety guarantees tothe obligee (in this case, the contractor) that the principal(the subcontractor) will perform a construction contract.Surety bonding involves a rigorous process in which asurety company prequalifies the contractor orsubcontractor and provides assurance that the contractoror subcontractor will perform according to the terms of the contract.

A performance bond protects the owner and GC fromfinancial risk should the contractor or subcontractor default

Surety Bond Default InsuranceRegulated by stateinsurance departments

Three-party (protectsobligee; risk stays withprincipal and surety). Suretyhas obligations to obligeeand principal.

Premium is actuariallybased and takes intoconsideration the potentialfor loss, but also is a fee forprequalification services;based on size and type ofproject and contractor’sbonding capacity

Coverage is project-specific.

Bond forms are standard ormay be negotiated byowner or surety.

Claims – Surety has right tocontract balance orindemnity

Sold

Two-party (protectsinsured). Insurer hasobligations to insured.

Premium – actuariallydetermined (calculatedpooled risk)

Coverage usually is term-specific.

Form is mandated byinsurance company.

No right to insured’sassets; however,companies can subrogateagainst a third party oranother insurer.

Performance & Payment Bonds vs. SDIIssuesPrequalification Process

Structure

Payment Protection forSubcontractors & Suppliers

Default Management

Risk

Legal

Performance & Payment Bonds• Conducted by surety

• Three-party agreement

• Yes, covered by 100% payment bond• Direct payment protection

• Claims investigated by surety to ensurelegitimacy

• If subcontractor defaults, surety completes,arranges for, or pays for the contractcompletion up to the amount of the bond

• Shifted to surety for contract completion& payment to subcontractors & suppliers

• Required by federal & state law on publicprojects

• Long history of case law and legalprecedents

Default Insurance• Left to policy holder

• Two-party insurance policy

• No• Unable to file a direct claim with insurer

• Contractor declares default subject to laterjudicial review

• Contractor manages default, includingcompletion of the contract, & files claimwith insurer

• Contractor retains portion of risk throughdeductibles & co-payments; sub-subcontractors & suppliers bear risk ofnonpayment

• Does not satisfy federal or state bondrequirements

• Little history of case law or legalprecedence

which is unlikely to be as thorough as the surety’s.Although the prime contractor can determine asubcontractor’s ability to perform the work, without theconfidential data and information provided to the suretycompany, it is difficult for the prime contractor to evaluatethe subcontractor’s entire workload, status, andprofitability when awarding the contract.

ClaimsAccording to Bizminer, of 532,756 specialty tradecontractors in business in 2010, only 410,808 were still inbusiness in 2012, a 23% failure rate. Given these odds, it isimportant that owners and contractors have a safeguard inplace to protect against subcontractor default. A suretybond, with its prequalification process, should eliminatethose “likely to fail” subcontractors.

SDI allows the contractor to declare a default and replace asubcontractor on a project, subject to repayment if thedefault is determined to have been unjustified. On abonded project, the surety conducts an independentinvestigation to determine whether a subcontractor truly isin default.

Should subcontractor default occur, the surety takes theresponsibility to deal with certain unpaid creditors,suppliers, and laborers, and sees that the contract iscompleted. The surety may bring in a replacementsubcontractor to complete the work, finance the present