A subcontractor default on a construction project is one of the greatest risks faced by the general contractor in constructing a project. Generally, contractors protect themselves from that risk by purchasing bonds, and now, also subcontractor default insurance. An example best contrasts the differences between bonding and insurance.
1. Contrast Between Bonding and Default Insurance.
Assume on a high end condominium project the drywall contractor uses non-compliant drywall screws to fasten the GWB to the studs. This error is not discovered by the general contractor until the project is virtually complete.
When confronted with the oversight, the subcontractor refuses to redo the faulty work and walks off the job. Now, the general contractor is on the hook, not only for replacing all the wall coverings, granite, tile, paint and other finishes, but also for the indirect costs associated with the overall project delay.
If the general contractor had bonded the subcontractor, the loss is capped at the penal sum of the bond (the bond amount limits the recovery), and generally no liquidated damages associated with project delay will be reimbursed by the bond. Generally, the project will be delayed further while disputes between the general contractor and the bonding company are being settled. If on the other hand, the general contractor had purchased subcontractor default insurance, the insurance companies are generally able to promptly mitigate the damages, complete the project quickly, without the limitation of a penal sum, and with coverage for indirect damages (liquidated damages).
2. Default Insurance.
There are three commercial products on the market for subcontractor default insurance, Zurich’s “Subguard®,” XL Insurance’s “ConstructAssure®,” and a product from Construction Risk Underwriters (CRU). Subcontractor default insurance, an alternative to surety bonds, protects the general contractor from losses arising from defaults by unbonded subcontractors. The general contractor enrolls all prequalified subcontractors for a specific project or policy term and is indemnified (held harmless) by the insurance company for any direct or indirect costs incurred if one of those subcontractors defaults on performance.
Subcontractor default insurance operates under a high deductible, high co-pay model offered at a significant discount to bonds. It protects the general contractor against losses well above the penal sum of the bond and also rewards those general contractors with the best risk management procedures.
The premium for subcontractor default insurance includes an option to collect the potential deductible and co-pay responsibilities in a loss fund. If the general contractor does not incur any losses, and therefore does not withdraw against the loss fund, that money is profit to the general contractor. Under a bond, the premium money is paid to the bonding company never to be seen again, even if the general contractor manages the job and subcontractors perfectly. Thus, subcontractor default insurance provides a significant financial incentive that compensates general contractors for the risk management work they are already doing day in and day out.
Reference: The Grayling Report, Vol. 2, Issue 1 (January 2012).