By Craig Tappel
The good news for the North American construction industry these days is that business is booming. In the U.S., a growth rate that’s been running annually at 4.5% is expected to push output to $1.2 trillion by 2020. In Canada, planned infrastructure investments should help grow production to US$304.6 billion by 2023 – a significant rally following last year’s dip when residential construction fell off dramatically.
The not-so-good news is the pressure that it puts on the industry. The abundance of work contributes to the “fear of missing out” and the temptation to take on more contracts, increasing the risk of subcontractor defaults. Although claims are rare, Subcontractor Default is the most costly type of dispute that General Contractors experience. The added stress creates a domino effect of project backlogs, leading to over-extension on capital and manpower, and plugging up cash flow. Other subcontractors may be affected, and sometimes costly rework may be required.
Managing that risk comes down to one of two tools: The time-honored subcontract surety bond or subcontractor default insurance. Both rest on the crucial subcontractor pre-qualification component, but each has different features and advantages. It takes understanding the basics and advice from a trusted surety and risk management partner to judge the suitability of either for the project at hand.
Subcontract Surety Bonds: Third-party pre-qualification and complete risk transfer
For hundreds of years, surety companies have offered in-depth subcontractor pre-qualification services for general contractors (GC). Subcontractors that “pass” the surety’s rigid underwriting standards receive guarantees of performance and payment in the form of subcontract surety bonds, three-way contracts that are provided to the GC with bid bonds during the bidding process and performance and payment bonds when the contract’s awarded.
Surety bonds, which are typically a statutory requirement for publicly funded investments in construction, represent a risk transfer from general contractor to surety with risk funding and recourse against the subcontractor. The GC is protected for contract completion and the subcontractor’s subs and suppliers are also protected for payment. In the event of a default, the surety arranges for completion up to the bond amount or pays for losses after an independent investigation. The cost of the bonds are dictated by the scope of the project (size and type of project), as well as the experience and credit quality of the subcontractor. Performance and payment bonds provide protection for the entire contract period up to the contract amount.
Subcontractor Default Insurance (SDI): DIY pre-qualification, with different risk/reward issues
For GCs whose subcontractor volume is greater than $50 million this insurance product may be regarded as a viable option to surety bonds. It’s not necessarily an easy one, though. Typically conducted by the GC, the pre-qualification process, for example, is as vital with SDI as it is with surety bonds, and that requires an investment in infrastructure and culture to do the job right.
Further, insured GCs must build the necessary reserves to cover the high deductibles and co-payment requirements that may arise from enrolled subcontractor losses. The administrative burden for claims falls on the GC. In exchange, the GC receives more control over the outcome, a streamlined claim resolution process and a collaborative effort to work through issues instead of waiting for default to be investigated by a third party. When the SDI program is done right – managed well against losses – the GC is also likely to see significant benefits in terms of substantially improved margins with a lower premium cost over time and increased flexibility in how the program is funded.
SDI, which has become more accepted since its 1996 introduction, has gained more traction as a tool that has a place in the construction industry’s approach to risk management. It’s good to have options – and to know if this is one you should consider for your business.
HUB International’s consultants are available to work with you on trends and developments that may impact your risk posture today and in the future.