Coping strategies in a post-surety bond market.

Owners have traditionally relied upon performance and payment bonds as ways to protect against the risk of contractor and subcontractor default. As construction cost increases continue to greatly outpace inflation, however, developers, as well as corporate and institutional owners, are increasingly seeking alternatives to avoid rising bond premiums.

In response, many sophisticated construction managers are offering a relatively new insurance product, commonly known as "Subguard," which is intended to replace subcontractor bonds.

While Subguard may be an attractive option, owners should carefully consider all of the implications of such a program before deciding to accept insurance as a substitute for traditional surety bonds.

Subguard programs are insurance policies purchased by construction managers that, according to policy terms, obligate the insurance company to reimburse the construction manager 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 for the project to the policy as a substitute for requiring the subcontractors to provide bonds.

As with bonds, subcontractors must be qualified on the basis of their past performance and financial strength in order to participate in the program and be covered under the policy.

The policies provide two main advantages over traditional bonds: lower premium costs and greater flexibility in addressing and resolving subcontractor defaults, and the potential delays and other problems associated with such defaults.

Current bond premiums typically average 2 percent of the contract cost for even the best-qualified trade contractors, and may be substantially 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 may expedite a response to the problem. With traditional bonds, the surety is entitled to, and routinely does, investigate the alleged default of its principal (the subcontractor) before taking any action to resolve the situation.

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

With a Subguard policy, the construction manager need not necessarily wait for the insurance company's approval before proceeding with a remedy. Rather, so long as the insurance company is provided timely written notice of the default, a resolution can be implemented and proof of the loss incurred (i.e., costs associated with remedying the subcontractor's default) can be submitted for later reimbursement.

Although Subguard may offer considerable savings in premium costs and project completion time, owners should be aware of some important differences between these insurance policies and traditional bonds.

Unlike a bonding surety, the Subguard insurance company 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 materialmen, as would a payment bond surety.

Instead, these risks are borne solely by the construction manager, who accepts them based on the insurance company's promise of reimbursement (subject, of course, to the construction manager's 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. Provided that the owner/construction manager agreement is carefully drafted, non-reimbursed costs must be absorbed by the construction manager. Considering these differences, prudent owners should take measures to assure that the construction manager offering Subguard can adequately manage the additional obligations inherent in such a program, and has the financial wherewithal to make the program effective.

Thus, with careful planning, Subguard can be a viable and cost-effective alternative to traditional bond premiums.

By ALEX F. FERRINI,

LEPATNER & ASSOCIATES