Surety Bond Quarterly - Winter 2017 - 16

results in litigation (that is, disputes over
delay damages and attorney's fees).14
Nevertheless, unless there are endorsements for additional insureds, under
an SDI policy, no coverage is provided
to an owner,15 other subcontractors,
suppliers, and/or laborers. An owner
can be added to an SDI policy through
a Financial Interest Endorsement,16
with dedicated limits specific to the
owner. This endorsement ensures the
owner still has coverage in the event
the general contractor is not bonded
and becomes insolvent. Without this
endorsement, the owner can only seek
recourse through the general contractor under the contract or through the
general contractor's surety. With it,
however, if the general contractor
becomes insolvent, the policy reverts to
the owner to enable it to make a claim.
It is still generally untested, however,
whether these endorsements function
to allow the owner to recover the full
amount of the loss just as the general
contractor would or whether the insurer
would treat the claim differently.
While SDI protects against subcontractor default, there is no protection
offered to subcontractors and/or suppliers against the failure of an owner,
general contractor, or construction
manager to make timely payments.
Those in favor of bonds would argue
there really is no one-to-one comparison. SDI is simply not a replacement
for payment bonds.
SDI proponents counter that the
insured still has the ability to claim
losses, which would satisfy downstream payments to tiered subcontractors and that those subcontractors still
have their lien rights.17 Hypothetically,
an insurer and general contractor could
agree to cover pass-through claims of
major trade subcontractors. The general contractor would still bear the
responsibility for the deductible and
co-pay, and the subcontractor would
qualify the lower-tier subcontractors.
The cost of the premium would likely
be split between the general contractor and primary subcontractors. But it
is unclear how many insurers would
allow these types of claims under their
policies. The general contractor is also
unlikely to submit subcontractor or

16

supplier bills to the carrier unless: (1) the
general contractor still needs that entity
to complete its work and therefore get
paid; or (2) that entity has filed a lien
and is forcing the pass-through claim
in exchange for a release. Finally, if the
general contractor becomes insolvent,
it will not be able to cover the deductible; and the lower-tier subcontractors
and suppliers have no remedy.18
The bottom line is, in its current form,
SDI has no payment bond equivalent.
SDI does not meet state and federal
(Miller Act) statutory requirements for
public projects, which require payment
protection, in the form of a payment
bond issued by a surety, to subcontractors and/or suppliers.19 Although the
court in Pavarini allowed the substitution of SDI for a statutorily required
surety bond,20 that case was limited
in its application to that state's public
bidding statutes; and no other cases are
known to have addressed this topic. In
certain jurisdictions, SDI's lack of coverage for lower-tier subcontractors
and suppliers may not even satisfy
performance surety requirements.21
Therefore, while we may be seeing
a trend of increased use of SDI policies among larger general contractors
on private construction projects, that
may be the only context in which they
are used.22
The Prequalification Process
The surety's issuance of a performance
bond equates to an assurance of the
subcontractor's performance of its
scope of work on the project. Prior to
providing this guarantee, the surety
must prequalify the principal subcontractor through the underwriting process. This process involves analyzing
financial viability, credit history, project
experience, reputation, progress on
other subcontracts, management capability, equipment, size, geographic location of work, and the subcontractor's
overall capacity to perform the job.23
If a subcontractor is deemed too small
or lacking in sufficient performance
history, typically it will not qualify to
be bonded.
By comparison, under an SDI policy,
the general contractor has the responsibility to prequalify its subcontractors.

SURETY BOND QUARTERLY | WINTER 2017

The general contractor, rather than the
surety, will gather financial data and
conduct its own testing to determine if
the subcontractors have the resources
to perform the job they are being hired
to complete. The insurance carrier
plays no role in this process. The issue
of confidentiality is at play. While the
subcontractor has a confidential and
on-going relationship with the surety,
many subcontractors are uncomfortable providing private financial data
to a general contractor that may be its
competition on a later project.
Placing this onus on the general
contractor also requires a substantial
investment of resources to ensure
proper prequalification of subcontractors. This responsibility arguably
incentivizes the general contractor
not to use "new" subcontractors or
vendors, which goes against the public policy behind supporting Small
Disadvantaged Businesses or other
MBEs.24 Because the general contractor has the freedom to choose the
subcontractors it feels are right for
the job, subcontractors with the most
experience and whose trades have the
lowest risk of default are those who
prequalify.25 In addition, subcontractors that normally would not qualify
for a performance bond may still be
covered under SDI.26 While this may
seem like good news for contractors,
this is a potential pitfall for the surety
claims professional. As an example,
a general contractor may accept into
its SDI program a subcontractor with
a lower net worth because its price is
so low. The general contractor takes
on the risk of hiring that subcontractor because it has its SDI carrier to fall
back on. Thereafter, a claim is made on
the general contractor's performance
bond; and the surety has to step in. It
turns out the SDI-covered subcontractor performed non-conforming work
that costs millions. Even though the
surety may have enough in contract
funds to cover the repairs, liquidated
damages are still being assessed as
time passes.
The general consensus among
surety bond producers is that a general
contractor's prequalification vetting
process is more relaxed and, therefore,



Table of Contents for the Digital Edition of Surety Bond Quarterly - Winter 2017

NASBP Upcoming Meetings & Events
2017–2018 Executive Committee
From the CEO: Looking Backward to Reach Forward
Relationships for the Long Run
Subcontractor Default Insurance: Relevant Considerations for the Surety Claims Professional
Bottom Line Protection with Job Cost Accumulation & Allocation
Inside the AIA’s New Insurance and Bonding Contract Exhibit
The Calm After the Storm: Managing Disaster Response Contracts
Practical Tools to Help Jump-Start Your Company’s Cyber Plan
Index to Advertisers
Surety Bond Quarterly - Winter 2017 - Intro
Surety Bond Quarterly - Winter 2017 - cover1
Surety Bond Quarterly - Winter 2017 - cover2
Surety Bond Quarterly - Winter 2017 - 3
Surety Bond Quarterly - Winter 2017 - 4
Surety Bond Quarterly - Winter 2017 - 5
Surety Bond Quarterly - Winter 2017 - 6
Surety Bond Quarterly - Winter 2017 - 2017–2018 Executive Committee
Surety Bond Quarterly - Winter 2017 - 8
Surety Bond Quarterly - Winter 2017 - From the CEO: Looking Backward to Reach Forward
Surety Bond Quarterly - Winter 2017 - 10
Surety Bond Quarterly - Winter 2017 - Relationships for the Long Run
Surety Bond Quarterly - Winter 2017 - 12
Surety Bond Quarterly - Winter 2017 - 13
Surety Bond Quarterly - Winter 2017 - Subcontractor Default Insurance: Relevant Considerations for the Surety Claims Professional
Surety Bond Quarterly - Winter 2017 - 15
Surety Bond Quarterly - Winter 2017 - 16
Surety Bond Quarterly - Winter 2017 - 17
Surety Bond Quarterly - Winter 2017 - 18
Surety Bond Quarterly - Winter 2017 - 19
Surety Bond Quarterly - Winter 2017 - 20
Surety Bond Quarterly - Winter 2017 - 21
Surety Bond Quarterly - Winter 2017 - 22
Surety Bond Quarterly - Winter 2017 - 23
Surety Bond Quarterly - Winter 2017 - 24
Surety Bond Quarterly - Winter 2017 - 25
Surety Bond Quarterly - Winter 2017 - Bottom Line Protection with Job Cost Accumulation & Allocation
Surety Bond Quarterly - Winter 2017 - 27
Surety Bond Quarterly - Winter 2017 - 28
Surety Bond Quarterly - Winter 2017 - 29
Surety Bond Quarterly - Winter 2017 - Inside the AIA’s New Insurance and Bonding Contract Exhibit
Surety Bond Quarterly - Winter 2017 - 31
Surety Bond Quarterly - Winter 2017 - 32
Surety Bond Quarterly - Winter 2017 - The Calm After the Storm: Managing Disaster Response Contracts
Surety Bond Quarterly - Winter 2017 - 34
Surety Bond Quarterly - Winter 2017 - Practical Tools to Help Jump-Start Your Company’s Cyber Plan
Surety Bond Quarterly - Winter 2017 - 36
Surety Bond Quarterly - Winter 2017 - 37
Surety Bond Quarterly - Winter 2017 - Index to Advertisers
Surety Bond Quarterly - Winter 2017 - cover3
Surety Bond Quarterly - Winter 2017 - cover4
https://www.nxtbook.com/naylor/SBPQ/SBPQ0118
https://www.nxtbook.com/naylor/SBPQ/SBPQ0417
https://www.nxtbook.com/naylor/SBPQ/SBPQ0317
https://www.nxtbook.com/naylor/SBPQ/SBPQ0217
https://www.nxtbook.com/naylor/SBPQ/SBPQ0117
https://www.nxtbook.com/naylor/SBPQ/SBPQ0416
https://www.nxtbook.com/naylor/SBPQ/SBPQ0316
https://www.nxtbook.com/naylor/SBPQ/SBPQ0216
https://www.nxtbook.com/naylor/SBPQ/SBPQ0116
https://www.nxtbook.com/naylor/SBPQ/SBPQ0415
https://www.nxtbook.com/naylor/SBPQ/SBPQ0315
https://www.nxtbook.com/naylor/SBPQ/SBPQ0215
https://www.nxtbook.com/naylor/SBPQ/SBPQ0115
https://www.nxtbook.com/naylor/SBPQ/SBPQ0414
https://www.nxtbook.com/naylor/SBPQ/SBPQ0314
https://www.nxtbook.com/naylor/SBPQ/SBPQ0214
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