Alex Ferrini is a partner at LePatner & Associates, a law firm based in New York.

Project Bonding Alternatives Offer Benefits and Risk

The Subguard insurance policy is becoming a popular alternative to bonding on large projects.

by Alex F. Ferrini

Owners have traditionally relied upon performance and payment bonds as ways to protect against the risk of contractor and subcontractor default. The general contractor and major subcontractors pay for a bond that effectively insures the value of the work they are performing in the event that they cannot complete the job, requiring the bonding company to complete the work at no additional cost to the owner - though the system often breaks down and results in litigation.

As construction cost increases continue to outpace inflation, however, developers, as well as corporate and institutional owners, are increasingly seeking alternatives to avoid rising bond premiums, which owners ultimately pay.

In response, sophisticated construction managers and general contractors are giving owners the option of instead working with a relatively new insurance product, commonly known as "Subguard," which is intended to replace subcontractor bonds. While the five-year-old class of policies known as Subguard may be an attractive option, owners should carefully consider all of the implications of such a program before deciding to accept it as a substitute for traditional surety bonds.

Subguard programs are insurance policies purchased by construction managers that obligate the insurance company to reimburse for costs incurred because of subcontractor default. These policies are typically offered only by construction managers "at-risk" and not by those acting as agents for the owner.

If approved by an owner, the construction manager adds its subcontractors to the policy as a substitute for requiring them to post bonds. As with bonds, subcontractors must qualify on the basis of their past performance and financial strength in order to participate and obtain coverage under the policy.

The policies provide two main advantages over traditional bonds for both owners and construction managers: lower premium costs and greater flexibility in addressing and resolving subcontractor defaults - which in turn avoids potential delays and related problems.

Current bond premiums typically average 2 percent of the contract cost for even the best-qualified trade contractors, and may be higher for subcontractors with short or poor >> track records. By contrast, Subguard premiums are closer to 1.25 percent. On a $50 million project, that translates into savings of $375,000.

When a subcontractor does default, the Subguard program also may provide an expedited response to the problem. With traditional bonds, the surety is entitled to - and routinely does - investigate the alleged default of its principal, typically the subcontractor, before taking any action to resolve the situation.

Such investigations often last more than a month - priceless time in today's aggressively scheduled construction market. And there is no guarantee that the surety will actually step in to complete the project. Negotiations, or a default by the surety, can further delay efforts to get projects back on track.

With Subguard, the construction manager does not necessarily have to wait for insurance company approval before proceeding with a remedy. Instead, so long as the insurer gets timely written notice of the default, the construction manager can implement a resolution, typically by hiring a replacement subcontractor or using its own forces, while submitting proof of the loss incurred - that is, costs associated with remedying the subcontractor's default - for later reimbursement.

Despite the potential benefits, owners should be aware of important differences between these policies and traditional bonds.

Unlike a bonding surety, the Subguard insurer has no primary contractual obligation to step in and complete a defaulting subcontractor's work. By the same token, the Subguard insurer has no primary or direct payment obligation to sub-subcontractors or a subcontractor's suppliers, as would a bond surety.

Instead, these risks are borne solely by the construction manager, which accepts them based on the insurance company's promise of reimbursement - a pledge that is subject, of course, to compliance with all of the policy's terms and conditions. Where a loss is reimbursed, the payout is subject to typically large deductibles, co-payments by the insured, and strict project-specific and overall loss limits.

A carefully drafted owner-construction manager agreement can ensure that the construction manager holding a Subguard policy would absorb the non-reimbursed costs. Still, unlike a bonding company, Subguard insurers actively help the construction manager with subcontractor qualification and oversight tasks in order to help manage the risk.

Prudent owners should take measures to assure that a construction manager offering Subguard can adequately manage the additional obligations inherent in such a program and that it has the financial wherewithal to make it work. With careful planning, Subguard can be a viable and cost-effective alternative to traditional bond premiums.