Subcontractor Performance Security: Questions Answered
By Marla McIntyre, Construction Executive
Stan Halliday, Chief Underwriting Officer for Travelers Bond & Specialty Insurance, Construction Services and National Accounts, answered questions about subcontractor bonds and what the construction industry needs to know about them.
Q: WHY SHOULD GENERAL CONTRACTORS USE SUBCONTRACTOR PERFORMANCE SECURITY?
A: One of the biggest risks for general contractors is how they manage their subcontractors. On most building projects, the general contractor or construction manager (GC/CM) subcontracts 70 percent of the work or more. Given this structure, a mechanism to address potential subcontractor defaults and terminations is vital because there is a lot of competition in the general building market and the profit margins available leave little to no room for loss or dispute.
There might not be a better time to focus on subcontractor performance security, because construction business is booming. According to the Commerce Department, construction spending rose to $1.25 trillion in December, and the Bureau of Labor Statistics reported that 210,000 construction jobs were added in 2017, a 35 percent increase from 2016. But with those increases in spending and jobs comes a decrease in skilled labor, so a GC/CM protecting against subcontractor defaults becomes even more important.
Q: WHAT ARE THE PRIMARY OPTIONS FOR PERFORMANCE SECURITY?
A: The simplest option is for general contractors to self-insure and accept the risk, which many still do. The smaller and more local the general contractor, the more common it is to see that approach.
Subcontract bonds are another common performance security. For many years, subcontractor bonds were almost the exclusive third party risk transfer mechanism for GC/CMs with respect to subcontractor default risk. In a perfect world, the surety always does its prequalification work well and the GC/CM should not expect to have a loss on that scope of work. Over time, if the GC/CM rarely has a loss, they may feel the additional cost of a subcontractor bond is unnecessary, yet they forget about the prequalification service the surety performed for the procurement. Many variables can exist, depending on the circumstances of the default, including:
- the specific language and terms used in the bond;
- the claims handling ability of the surety;
- the claim documentation provided by the GC/CM in the event of a default;
- the GC/CM expectations to the timing of the response from the surety; and
- the ability to maintain the project schedule.
These variables could result in a range of experiences for the GC/CM. This inconsistency led some GC/CMs to grow frustrated with the subcontractor surety product.
In response, subcontractor default insurance was developed. With this product, GC/CMs purchase insurance directly from their choice of carrier. By negotiating their own terms of coverage, many GC/CMs believe they will get more consistent claim handling quality, and some of the delays that were inherent in the performance bond claim process could be eliminated so they can better maintain the project schedule.
Many believed this product would eliminate the need for subcontractor bonds and would address every subcontractor situation, but this is not the case. The product has capacity limitations, especially for larger subcontracted backlogs. Also, in the 2012-2015 period following the Great Recession, subcontractor defaults started to increase and the coverage terms and expectations of both the carriers and the GCs/CMs were tested. This has resulted in more contractors using surety bonding as part of their performance security default strategy.
However, GC/CMs also stated they need a better surety product. It must be responsive and sensitive to the project schedules. These conversations led Travelers to develop subcontractor bonds that are more responsive to the user’s needs.
Q: WHY IS PROMPT DISPUTE RESOLUTION DIFFICULT TO ACHIEVE? WHY IS IT SO IMPORTANT?
A: Disputes may arise on quality, timeliness, work area conflicts, poor drawings, etc. and it’s not always clear who may be responsible. Typically, there are dispute resolution provisions in the subcontract, but sometimes the GC/CM feels strongly enough about the dispute that they actually default the subcontractor. That’s when a surety gets called in. Our job as a surety is to independently assess whether that default declaration is valid. The assessment process takes time and general contractors don’t have a lot of time. They have a project schedule to meet. If the subcontractor challenges the default, the subcontractor surety bond language does not always provide a clear and timely response path for the parties involved. This makes the Schedule Sensitive Subcontractor Surety Bond an appealing option.
Q: WHAT DIFFERENTIATES THE SCHEDULE SENSITIVE SUBCONTRACTOR BOND FROM OTHER SUBCONTRACTOR PERFORMANCE BONDS AND OTHER FORMS OF PERFORMANCE SECURITY?
A: We tried to make this product more prescriptive and eliminate the gray area on key elements so that the user, the general contractor, could feel more certain about the bond responding to its needs. Subcontractors who are providing this guarantee also believe it’s a fair and reasonable product.
So what did we change?
- A quicker time frame for surety response, as quickly as 30 days from receipt of full claim documentation and access to the project.
- Direct access to a claim professional is provided.
- The bond allows a GC/CM to keep the project moving during the claim investigation period.
- There is an allowance for penal sum increases up to 10 percent of the contract price without requiring surety consent.
- Coverage of warranties is provided as specified in the subcontract.
Q: WHAT MIGHT GENERAL CONTRACTORS NOT KNOW ABOUT THE SCHEDULE SENSITIVE SUBCONTRACTOR BOND?
A: It’s available in the market and many sureties will execute it. I can’t speak for other companies, but at Travelers it doesn’t cost more than other subcontractor bond forms. There’s no upcharge. In addition, most sureties require personal guarantees by the owners of the business. Not surprisingly, those who personally guarantee work often bid more prudently.
At the end of the day, don’t underestimate the value of a surety bond guarantee to a GC/CM, what that means to the subcontractor providing the bond and how that makes them approach a bid.