Construction is risky. Cost can be hard to predict, weather, unforeseen conditions, errors, accidents and other issues are around every corner. Construction management is the practice of finding the fastest and most cost-effective way through those events and risks, but sometimes managers encounter unavoidable problems. That is where bonding and other risk mitigation methods come in. There are several methods to help mitigate these risks.
Bonding is a widely used type of insurance, where a third-party surety firm guarantees the performance of a company that is offering a service. Traditional Payment and Performance bonds (P&P Bonds) can be provided for prime contractors, typically employed in public bidding, or for subcontractors and are typical in many construction contracts between contractors and subs. Both bonds perform the same way – in return for a premium payment, the bonding company guarantees that the contractor or subcontractor will perform the given work, and will step in to complete the work if the bonded firm fails to perform its contracted services.
In the risk intense world of construction, how can a financial firm (the bonding company), remote from the construction site, control the actions of a contractor? Well, they cannot. What they can do is assess the risk that the contractor will fail to perform or default and charge a fee or premium that covers that risk as a part of the combined risk of all of their bonded projects. Part of that calculation is financial. The surety firm reviews the contractor books, and transaction information over several years, with a focus on debt levels, profitability, and retained liquid assets. This information tells them a bit about how likely a firm is to fail to perform on a project, and how much cash will be available if the subcontractor defaults or fails to perform. They will also review any previous defaults in a contractor history, and any related subcontractor defaults, to determine fault and effectiveness of the contractor response.
Interestingly, the financial side is only part of the analysis. The surety also reviews the staff and management experience and training, internal business systems, and efficiency, all of which also contribute to a contractor ability to complete a project.
Bonding is an imperfect solution to the management of contractor default risk in construction. One issue is the increased cost from the premium payment for bond coverage. In a competitive market, that small percentage of total project cost may make a large difference to a contractor bottom line and at the very least seems like an additional cost to the owner. Bonding both the subcontractors and the prime contractor seems redundant but is necessary in many cases and adds another layer of cost. Another important issue is surety fraud or failure. Although rare, issues on the sureties’ side can significantly impact projects in cases of default. Finally, the perception of cost to projects from the slow actions of surety firms in reaction to defaults adds delays and friction to projects in crisis, exacerbating losses. The process of moving a bonded project forward after a subcontractor or prime contractor default can be contentious and slow.
The marketplace provides some alternatives:
CCIP/OCIP or “Owner/Contractor Controlled Insurance Programs,” allow a substantial owner or contractor to control or manage the insurance protecting against a range of construction risks, including contractor default. OCIP and CCIP are different.
Under OCIP a large purchaser of construction, typically a large property owner, university, or corporation, can consolidate all of the insurance on a typical project, including Contractor Default, Workers Comp, Builders Risk, General Liability and others. OCIP’s are typically negotiated on a per project basis, although some owners utilize “rolling OCIP” policies for multiple projects.
OCIP's give the owner the ability to quickly respond to default situations and gain a reduction in costs by eliminating overlapping insurance coverage. Owners also have much better understanding of what risks are covered.
CCIP's are similar to OCIP's, although they are necessarily a less comprehensive policy since they cover only Contractor level risk and below, and can includes coverage for General Liability, Contractor Default, and Workers Comp. The greatest advantage for CCIP’s are in large CM managed projects, where the CM has a history and commitment to eliminating subcontractor default. Well managed CM firms can quickly build up reserves to greatly reduce premium costs providing an advantage in the marketplace of reduced cost. The CM is in the best position to minimize subcontractor defaults and OCIP has the effect of incentivizing the CM to avoid these defaults. CCIP offers similar benefits to OCIP with regard to reducing overlapping coverage, and transparency of risk coverage.
Subcontractor Default Insurance (SDI) is essentially the subcontractor default portion of a CCIP or OCIP agreement. Bonding is a three-way contract between the surety firm, subcontractor, and prime contractor, while SDI is a simpler insurance contract between the prime contractor and the insurer. SDI, rather than provide a guarantee of performance, is a high-deductible insurance policy against subcontractor default. SDI reduces risk of default by having stringent pre-qualification requirements both for the prime contractor and the subcontractors.
Bonding vs. SDI The primary difference between bonding and SDI is that in bonding, the surety firm qualifies and rates the contractors, and the risk premium is based on the subcontractor history, while with SDI, the prime contractor applies a pre-agreed standard of pre-qualification to the subcontractors, and the risk premium is based on the prime contractors performance and finances. This and the high deductible tend to push the prime contractor to reduce defaults. Advantages for owners of construction projects include reduced bonding costs, and reduction of overlapping insurance coverage and consistent review of subcontractor financial statements and qualifications. Another advantage is that the subcontractors that can pass through a pre-qualification process are often also better managed and provide higher quality construction results. One perceived downside for SDI is a reduction in the bidding subcontractor pool which may result in slightly higher bids – only subs that can make it through a pre-qualification process are included. This is probably offset by reduced costs of default since the pre-qualification serves a useful purpose in reducing defaults. Contractors can guard against this by requesting bids from non-pre-qualified bidders and may choose to bond an individual subcontractor that is unable to pre-qualify for SDI in instances where it may be necessary.
Self-Insurance is an option for some very large corporations who may have internally managed risk mitigation funds and processes, which allow them to utilize otherwise excess assets as protections against construction or other risks. Self-Insurance is also available as a service with the owner providing the assets, and a third-party firm providing the process and requirements.
Owners and construction managers have many options to mitigate risk and each has a place in the well-managed project.