Surety Bond Quarterly - Spring 2016 - (Page 25)

Feature Managing Subcontractor RISKS OF NON-PERFORMANCE AND FINANCIAL FAILURE A Flash Guide to Subcontract Bonds and Subcontractor Default Insurance THE PRINCIPAL MEANS of mitigating subcontractor default risks is through a process of subcontractor prequalification. For more than a century, surety companies have provided regular, in-depth third-party prequalification services to general contractors by extending surety credit to subcontractors through bid, performance, and payment bonds. Those subcontractors that merit surety credit receive guarantees of performance and payment in the form of subcontract surety bonds, three-party contracts, which are, in turn, provided to prime contractors upon subcontract award. Only a subcontractor determined by the surety under its underwriting criteria to be fully capable of performing its subcontract obligations is accorded surety credit. The surety closely examines the wherewithal of each subcontractor: its financial strength, credit history, project experience, reputation, progress on other subcontracts, management capability, equipment, size and geographic location of work, and other factors. It is a thorough and confidential process centered on the subcontractor's history of performance and its on-going work program and focused on the crucial tenet of preventing incidences of subcontractor default from the onset. Bonded subcontractors are further incentivized to complete subcontract obligations, as sureties, believing their bonded subcontractors are capable of performing, require personal and corporate indemnities from those subcontract firms in the event that the sureties have to pay out under the bonds. Subcontractor prequalification also is a component of a two-party, catastrophic insurance policy, subcontractor default insurance (SDI), first developed approximately 20 years ago, to provide general contractors with insurance coverage for direct and indirect costs of trade contractor default. Some general contractors, generally those with subcontract volume exceeding $50 million, that are eligible for SDI coverage see it as an alternative to the purchase of subcontract bonds. Unlike subcontract bonds, SDI is traditional insurance that presumes some level of losses; and general contractors that purchase SDI coverage must bear a significant level of self-insurance for such risks through high deductibles and co-payment requirements. The burden of subcontractor prequalification is borne by the insured general contractor, which must make a substantial investment of resources to create an adequate company infrastructure and culture to ensure proper prequalification of subcontractors. Such a structure is incented by the fact that the insured general contractor will need to build a reserve to pay for deductibles and any co-payments arising from enrolled subcontractor losses in its SDI program. Little or no losses in the SDI program eventually translate into higher margins for the insured general contractor. On the other hand, significant losses can jeopardize the operational ability of an insured general contractor that will bear the expenses of the deductibles and the co-payments and the significant burden of administering claims. The benefits of SDI flow only to insured general contractors, but such benefits can be significant if the insured contractor strictly maintains a well-managed, sophisticated SDI program, with few or no losses. It is critical to understand that SDI, as a product very different from surety bonds, never is a replacement for statutory federal, state, or local bond NATIONAL ASSOCIATION OF SURETY BOND PRODUCERS | WWW.NASBP.ORG 25 http://WWW.NASBP.ORG

Table of Contents for the Digital Edition of Surety Bond Quarterly - Spring 2016

NASBP Upcoming Meetings & Events
2015-2016 Executive Committee
From the CEO – It’s Spring and a Season of Change for Surety
Practical Insights: What You Need to Know – Joint Ventures in Construction
Making a Difference: NASBP Members support Breakthrough in Trauma Treatment for Vets
Susan Hecker Recognized for Contribution to Heavy-Construction Industry
Evolving Compliance Requirements: Addressing Human Trafficking
Subcontractor Surety Bonding and Default Insurance
Managing Subcontractor Risks of Non-Performance and Financial Failure
SDI Insured Must Shoulder Burden to Pursue Claims Against CGL Policy
One Contractor’s Transfer Preference: Subcontractor Bonds
Facilitating International Commercial Surety

Surety Bond Quarterly - Spring 2016