March 25, 2013

Construction buyers beware: surety association

Steve Ness, president of the Surety Association of Canada (SAC), says his organization has encountered a small group of general contractors and brokers who are trying to convince construction buyers they can get protection from the risk of subcontractor default by taking out a subcontractor default insurance (SDI) policy instead of surety bonds on the head contract.

Ness said some organizations are suggesting that, with SDI in place, the owner has no need for performance or payment bonds and can enjoy the same level of protection.

However, Ness said, such advice is misleading and can leave owners, sub-trades and suppliers exposed to the risks associated with a general contractor (GC) default.

SDI is a first-party insurance policy that indemnifies a contractor for costs incurred as a result of a default in performance of one of its subcontractors.

“It was designed to protect very large general contractors,” Ness said.

“When used this way, it can be an effective risk management tool.”

According to a recent SAC report, Subcontractor Default Insurance: An Inappropriate Substitute for GC Performance Bonds, “The very first article of the standard SDI policy states that the policy will protect the insured (general contractor) from loss ‘...but only to the extent of Default of Performance by... Subcontractor/Supplier as respects any Covered subcontract or purchase order agreement’. Nowhere is protection afforded to third parties, such as owners, sub-trades or suppliers.”

The first SDI policy, Subguard, which is sold by Zurich North America through insurance brokers, came into being in 1996, although it did not appear in Canada until the early 2000s.

Nils Sorenson, a San Francisco, CA-based Subguard product manager, said Subguard provides the owner with a liquid source of balance sheet protection, which guarantees projects the best chance of being on time and on budget.

Regarding SAC’s contention that some people in the industry have claimed SDI can be used to replace surety bonds on the head contract, Sorenson said Subguard’s purpose is to provide subcontractor default protection and is not intended to cover the default risk between the general contractor and an owner.

“Subguard provides protection to an owner in that the general contractor has complete control of his subcontractor risk, thereby protecting his financial standing,” he said.

“On average, 80 per cent of a construction project’s costs go to subcontractors, so this is where almost all of a general contractor’s risk lies.”

Fraser Roberts, president of Intech Risk Management Inc., Toronto-based independent risk management consultants, said SDI is a product for only the largest and most sophisticated general contractors, of whom there are only a handful in Canada.

“They need to be large in order to show insurers they have the size and resources to perform a thorough due-diligence of their subcontractors, and who can afford the sizable deductibles – as much as $1 million – on the policy.”

Roberts said SDI is a type of performance security that is an alternative to surety bonds, but not a direct substitute.

“SDI enables GCs to give owners and lenders assurance that they can complete the job,” he said.

“The likelihood the GC will default is greatly reduced.”

Roberts said one of the benefits of SDI to owners and GCs is that it responds faster than surety bonds.

“In case of a default, the GC gets his insurance payout faster than he would from a surety bond, which could be tied up in the courts for years,” he said.

Roberts said another benefit of SDI is that, in case of a subcontractor default, the GC gets to choose the replacement sub.

“But, if there’s a default on a subcontractor’s surety bond, the surety company can bring in its choice of a new sub,” he said.

Roberts said it has also been argued that the use of SDI will lead to lower total financing costs because of its faster pay-out in the case of a default

The use of SDI growing in Canada, Roberts said.

“Zurich used to have the market to itself, but two other insurance companies – Arch Insurance Group and XL Insurance Company Ltd. – have recently started up here,” he added.

“With the entrance of new players in the market, we expect prices for SDI to come down and demand for the product to grow. I also think that some time in the future SDI will start to be marketed to mid-tier GCs.”

Roberts said the surety industry in Canada has started to respond to these developments by designing new products that compete with SDI.

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