Surety Bonds vs. Subcontractor Default Insurance

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on September 16, 2021.

With construction teams navigating the effects of the COVID-19 pandemic and the world’s material supply chains, securing project performance has perhaps never been at such a premium. If a contractor cannot timely perform, or if a subcontractor simply pulls out of a new project bid in order to pursue a more attractive opportunity, the project owner and/or prime contractor face potentially significant damages. These include corrective work, costs of completion or substitute performance, and delay. Two chief security options exist to protect against such risks: performance bonds and subcontractor default insurance (SDI). Choosing one over the other requires informed decision-making as each type of security carries its own unique characteristics and project consequences.

Security structure and form

A performance bond is a three-party agreement between the principal (the contractor or subcontractor), the obligee (the owner), and the surety. The surety agrees via the bond to answer for the principal’s default in performance. Any damaged party may make a claim. In contrast, SDI is a two-party agreement between the insured contractor and the insurer in which the insurer undertakes to indemnify the insured against loss resulting from a contingent default. SDI only protects against subcontractor default — not default of the prime contractor — and only the general contractor — not the owner — may assert a claim.

History and legal precedence

Suretyship has been around for millennia, with references found in ancient Greece and the Old Testament. In 1884 the American Surety Company began underwriting construction performance bonds, and in 1894 Congress passed the Heard Act requiring surety bonds on federally funded projects. Performance bonds’ long history and statutory frameworks provide considerable legal authority that help predict outcomes of disputes under a bond. Conversely, SDI has a much shorter history. It was first introduced by Zurich N.A. Insurance Company in 1995 and then subsequently offered by others. As such, with SDI there is virtually no legal precedent from which to glean interpretation of disputes, with just a dozen or so reported cases and most not interpreting policy language.

Use

Performance bonds are required by statute for most public projects exceeding $100,000 and are often used for private projects. Although courts have imposed insurance-like duties (such as claims-handling procedures) on sureties, bonds are not insurance policies. Typical SDI projects are large and involve annual volume thresholds in the tens of millions of dollars or projects exceeding $100 million. SDI is also likely not an acceptable substitute for bonds on public projects.

Premiums and personal security

Bond premiums vary but can range from 0.5 percent to 1.5 percent of the contract amount, with the average above 1 percent. While there are no deductibles, bonds require an indemnity agreement and collateral, often with guarantees putting an officer of the contractor personally on the hook. SDI policies do not require collateral. SDI premiums are typically lower and can be 50 percent to 70 percent the cost of a bond, not counting deductibles and co-pays. This lower cost can provide an advantage in bidding a project. However, many SDI policies carry large deductibles, from $350,000 to $2 million with co-pay sharing at $1 million-$5 million.

Subcontractors and risk shifting

A performance bond surety screens and prequalifies subcontractors and investigates and responds to any default. However, the surety also has a self-interest in denying the predicate of a default occurrence. Under SDI, the contractor screens the subcontractors and retains the majority of risk through deductibles and co-payments. The contractor might also run into difficulty with subcontractors reluctant to share sensitive financial data. Still, the contractor retains control of project completion and can maximize efficiencies to avoid further delays and increased costs.

Recoverable damages

On a performance bond damages generally cannot exceed the penal sum of the bond, which can pose a problem in projects involving numerous change orders if the bond sum does not include those changes. Also, delay damages are not typically recoverable on a bond, though courts in Pennsylvania and California have allowed recovery. SDI tends to afford broader recovery for damages, including the cost of completion, losses due to corrections of defective work, indirect losses including possibly liquidated damages, and legal costs.

SDI can provide some advantages in the form of lower costs, control over subcontractor selection, and direct management of default situations. However, there are financial risks to the general contractor, which may also face opposition by subcontractors in the prequalification process. Also, SDI is limited to subcontractor defaults and not those by the general contractor. The dual insurance relationship of SDI is not a clear substitute for the tripartite surety bond setup, and the lack of legal decisions regarding SDIs injects a higher level of uncertainty as to how the policies might be interpreted. Project participants should carefully consider the benefits and risks of all options to best secure project performance.