Rob Rapp is the national co-director of CDI for Aon Construction Services Group, overseeing the surety and CDI business in the New York region. His e-mail is robert_rapp@ars.aon.com.

Contractor Default Insurance Grows in Prominence

The latest construction boom has opened the door for CDI as a performance protection alternative.

by Rob Rapp

While the construction industry has greeted the promise of continued growth with open arms, there is a strain on the insurance and capital markets to support the performance guarantees that general contractors, project owners, and lenders desire.

Historically, the primary source of performance protection has been surety bonds, but pressure on the industry to supply all of the necessary capacity has opened the door for other approaches. Now, a method called contractor default insurance has become a prominent alternative - and is changing the construction industry's insurance landscape.

In the New York-New Jersey market, as well as other markets across the nation, the use of CDI, surety, and sometimes a combination of both is becoming essential. In many cases, the capacity of a single risk mitigation tool is no longer a viable option given limited surety capacity and a booming construction environment.

CDI is a combination of risk transfer and self-insurance first developed in 1995 by Zurich North America that aims to help general contractors and construction managers mitigate their exposure to subcontractor and supplier defaults by generally offering increased project control, broad coverage terms, and competitive pricing.

The program allows the contractor to determine which subcontractors will be enrolled and to quickly determine the most advantageous default remedy. Such control is granted to the contractor because its financial interests are aligned with the insurance carrier through the deductible and co-pay obligations.

The program operates as an insurance policy in which the contractor is able to resolve subcontractor default issues on its own and get reimbursed through CDI. While CDI usually has strict policy terms that a contractor must follow, the insurer typically plays a significant role in helping the contractor establish controls to prevent problems from arising and take measures to minimize the financial impact of a failure.

To qualify for CDI programs, a general contractor or construction manager must have "best in class" subcontractor prequalification and operational practices. These risk control practices, along with financial protection afforded by the program, allow the contractor to more effectively ensure successful project completion.

In the past, if no performance guarantees were in place, general contractors utilized job profits, a bank line of credit, or working capital to finance a subcontractor failure. And if a bond were in place, the contractor still might face the possibility of project delays while the surety determined its response to a subcontractor default. A significant advantage of CDI is that it enables the general contractor or construction manager resolving a subcontractor failure to retain control of the project schedule and to be indemnified for the costs associated with the remedy.

While contractors assume some financial risk under CDI from subcontractor default, they also are encouraged to implement practices that minimize the likelihood of a default. General contractors have the flexibility to choose and enroll a subcontractor based solely on its qualifications to perform the work.

In addition, general contractors are encouraged under CDI to proactively manage a default situation and lessen the impact on the project schedule and budget. They are empowered to determine adjustments to the critical path and the best course of action to keep the construction schedule on track, all while relying on CDI to support the cash flow needs of the project.

CDI has become a commonly used tool over the past five years due to the surge in private sector construction and an increase in understanding about the product. The advantages of CDI have attracted not only those directly in the construction community, but private sector project owners and lenders as well.

With their eyes on the bottom line, owners and lenders see an advantage in the general contractor's ability to immediately respond to a subcontractor default without jeopardizing the schedule of completion.

For example, we recently discussed the performance protection options available to an owner of a large, New York City-based, mixed-use development, whose greatest concern was that a subcontractor failure would ultimately lead to a budget overrun and project completion delay.

The owner studied the pros and cons of both surety bonds and CDI, including two common tradeoffs. The first is that CDI requires more management versus the hands-off nature of using a surety. The second is that CDI offers more project control if a subcontractor were to fail, versus a likely longer and uncertain surety bond response. The owner ultimately decided the use of CDI by the general contractor was the most effective way to mitigate its risk.

Though CDI has been viewed as an unproven alternative to subcontractor bonding, today the operational enhancements demonstrated by those who have successfully implemented the program have become its biggest selling point.

A case in point is a large New York City construction project on which a steel subcontractor began to fall behind on its schedule. The general contractor quickly recognized this problem, taking moves to supplement the steel erector's labor and more closely manage the payment process of lower-tier subcontractors and suppliers. The contractor mitigated a potentially significant project delay while also recovering the related costs under its CDI program.

As an alternative and even a supplement to surety bonds, CDI is quickly becoming a preferred mechanism for mitigating subcontractor default risk in the construction marketplace.