PERSPECTIVE The Canadian Surety Industry: Traditional Construction Bonding & Subcontractor Default Insurance

Transcription

1 PERSPECTIVE The Canadian Surety Industry: Traditional Construction Bonding & Subcontractor Default Insurance INTECH PERSPECTIVE v WHITE PAPER

2 ABOUT INTECH INTECH Risk Management is one of the world s leading independent risk management consulting firms. We do not sell insurance or any other risk management product. Nor do we have any affiliation with any insurance company or brokerage. It is through this independence that INTECH is able to remain completely conflict free; guaranteeing that our clients receive advice they can trust. Clients that have used our services for over 30 years will attest that INTECH is a reliable partner with unrivalled experience and expertise. Our intimate knowledge of risk management best practices and the insurance marketplace lets us consistently deliver timely, cost-effective solutions to our clients around the globe. A BRIEF HISTORY Founder Rory Roberts, was trained as a Lloyd's of London insurance broker in Africa and England. In 1968 he moved to Canada and was quickly hired by the Bronfman family in Montréal to manage their risks related to the Fairview Corporation and a myriad of other commercial interests. In 1975 he identified an underserved niche: Lenders were not receiving impartial insurance and risk management advice when making commercial real estate loans. Seizing the opportunity, he launched INTECH Risk Management Inc. in 1976, and quickly gained a leadership position in the industry. Today, INTECH's team of experts advise lenders, law firms, contractors, investors and many other businesses around the world on all matters related to insurance and risk management, keeping the company at the forefront of all new developments in our field.

3 INTECH PERSPECTIVE INTECH s reputation for impartial advice and intimate knowledge of the insurance industry is the basis for this series of published White Papers. Aptly named the INTECH Perspective, these publications provide an independent perspective on issues within the Insurance and Risk Management Industry. The INTECH Perspective is a free publication designed to provide a forum for INTECH Risk Management to share knowledge and foster further dialogue on important issues facing the industry today. INTECH Perspective White Papers are available in both print and electronic versions through subscription online at: The Canadian Surety Industry: Traditional Construction Bonding & Subcontractor Default Insurance In this issue of the INTECH PERSPECTIVE we will guide you through the key elements that make up both Subcontractor Default Insurance (SDI) and Traditional Construction Bonds, as well as illustrate the differences between them. It is clear that both tools have their place in today s construction industry, though due to the unmet needs of lenders, contractors and developers SDI has become a welcomed addition to the tool chest. In some cases SDI may replace traditional construction bonds, but through its existence has also delineated more clearly where and when a traditional bond can be used most effectively. This White Paper will take you through the pros and cons of each and illustrate where one may best utilize either, or both, of these tools. As the topic of performance security and the entire risk management industry is ever changing, we recommend that you contact one of our consultants for the latest news and perspective related to this topic and other risk management issues. We look forward to speaking with you. Fraser Roberts, B.A., CRM President Lisa Speirs, B.A., CRM Senior Vice President Julie Davies, B.SC., CRM Senior Vice President Todd McCleave, CRM Senior Consultant 3

4 The Industry in Brief Much has been written on the problems facing contractors in Canada with respect to obtaining construction bonds, both Performance and Labour & Material Payment Bonds. We will not attempt to reconstruct that work, but to give a current analysis of where the industry is today, and what options are available to owners and lenders. Traditionally, project owners and their lenders managed the risk of contractor default by simply requiring each general contractor to provide a Performance Bond and Labour & Material Payment Bond for not less than 50% of the total contract price. Through this arrangement, the surety company guaranteed satisfactory completion of the project under the Performance Bond and the payment of sub-contractors and suppliers under the Labour & Material Payment bond. Historically this was the only way in which an owner and a general contractor could protect themselves for the performance of subcontractors. Today, the decision to require bonding is not as clear-cut. The heart of the issue is that the surety industry s capacity has not grown in lockstep with increased demand coming from the construction industry. At the same time, project delivery methods have become heavily focused on on-time delivery, which is in conflict with the lack of responsiveness that has become synonymous with traditional surety solutions. The capacity issue has been largely driven by an increase in the number of large projects happening across the country, and has been exacerbated by the fact that there are very few domestically owned Canadian sureties. Therefore much of the capacity is coming from larger U.S. based companies that have experienced poor results and are preparing for the ill effects of the US recession by more cautiously approaching new requests for surety. The result of this dynamic has been a dramatic rise in the cost of bonds. During the 1970s, 80s and 90s, bonds were easily obtained at a cost of approximately $4 - $5 per $1000 of contract price, but today, the cost is at least $10 per $1000 and as much as $17 per $1000 for even the largest and best operated contractors. Making matters worse is the fact that the Contractors who are actually able to secure bonds are being limited by a ceiling that caps the amount of work they can undertake. This ceiling is typically twenty-five to thirty times their asset base for general contractors, and seven Performance Bond Cost Per Thousand to fifteen times the asset base for subcontractors. Given 20 the enormous amount of construction happening in 18 Alberta, British Columbia, Ontario, and Quebec, many of 16 the larger contractors are now experiencing capacity 14 constraints with some even hitting their ceiling for 12 surety capacity. Dollars Per Thousand Of course, capacity issues are only part of the story. Over time, the industry has come to realize that there is a conflict of interest inherent in surety bonds. This conflict exists because the surety company s client is the contractor, but the actual settlement is owed to a third party owner or lender. In other words, the surety 4

5 company s allegiance falls with the contractor, not the third party owner or lender. This relationship has manifested itself in the way surety companies have responded to claims. Instead of stepping in and completing the project as promised, some surety companies have been known to vehemently defend the contractor by arguing in every way possible that they were not in default and therefore no settlement is owed to the owner or lender. Months, and in some cases, years go by before a settlement is made, leaving the surety industry with a significant black eye, and owners and lenders questioning the benefits of bonding. Unfortunately, even when the surety company did step in to complete a job, the surety did not pay for liquidated damages and the owner/lender had no influence over the selection of a replacement contractor, meaning they could end up with an inferior building. The issues surrounding the industry are compounded even further by the fact that general contractors have been requiring their major sub-contractors to provide bonds as well. As a result, additional performance security costs are built into the contract price, further inflating the costs to the owner. In response, owners and lenders are now frequently looking for alternative ways to manage the risk of contractor default. One such alternative is Subcontractor Default Insurance. 10 Year Surety Chart * Year Contract Values Losses % ,325,200,000 21,466, % ,739,366,667 25,431, % ,780,641,667 43,629, % ,813,791,667 84,624, % ,515,825,000 80,452, % ,088,966,667 91,962, % ,788,800,000 64,904, % ,912,641,667 62,563, % ,529,391,667 48,391, % ,154,525,000 53,119, % Totals 313,649,150, ,521, % * Losses shown are actual results, actual contract values are not available, but are represented here with reasonable extrapolations based on industry premium levels and average surety premiums. 5

6 Subcontractor Default Insurance - What Is It? In 1996 Zurich s construction insurance group developed subcontractor default insurance ( SDI ), and registered their product as Subguard. Unlike a bond, this product is an insurance policy and is designed to indemnify a general contractor in the event one of their sub-contractors defaults. In other words, under Subguard, the contractor actually insures the performance of its subcontractors, such that, in the event of a loss, the insurer directly indemnifies the contractor for costs resulting from the subcontractor s default. In order to make a claim under SDI, the general contractor has to call the sub-contractor into default, correct the problem by finding another sub-contractor to complete the work, and then request indemnification from the insurer. This process ensures that the project keeps moving along even after a default occurs. The general contractor meanwhile, has a very real incentive to get the work completed without making a claim, because the SDI policies have a significant deductible, usually $500,000 to $1,000,000, and, typically, a 20% co-pay provision, meaning the general contractor shares in the loss settlement with the insurer. This skin in the game provides enormous financial incentive to the general contractor to be prudent with whom they engage on the project as well as ensure adherence to best practices and quickly respond to difficulties with on-site subcontractors. This arrangement works well for owners and lenders, because in most cases the deductible and co-pay arrangement with the insurer is pre-funded by the general contractor as projects and/or subcontracts are enrolled. This is outlined by the Retrospective Agreement, which allows the insured to provide a policy to third parties that shows no deductible and no co-pay requirements (i.e., no retentions). Therefore, the insurance company is responsible for funding the losses from the first dollar up to the policy limits. As a result, if the general contractor defaulted on the project, the owner/lender would still benefit from the subcontractor default insurance policy and would not be required to pay any deductible in the event of a loss. Contractor skin in the game Aligns the general contractor s incentives with that of the insurer. Aligns contractor interests with those of the project owner and lender. Prevents subcontractor losses or at least mitigates them as quickly as possible. Any claim affects contractor bottom line. Interestingly enough, the request for such a solution came from the general contracting community who were specifically pointing to the lack of responsiveness in subcontractor bonds and the impact these delays were having on their ability to achieve on-time, on-budget projects. Early on, Zurich only allowed a very small group of the largest general contractors in the United States of America, and then Canada, to participate in the Subguard program. The Subguard list of qualified Canadian contractors remains quite small, but new competition in the market, thanks to the arrival of Arch Insurance in 2010, means the list is likely to grow in the coming years. 6

7 For the purposes of the rest of this document we will refer to the product as Subcontractor Default Insurance (SDI) in recognition of this recent competition. The Pros and Cons of SDI To our way of thinking, SDI is a good product. It has been proven to be very cost effective (i.e., can be as low as 50% of the cost of a traditional Performance Bond), with timely settlements, making owners and their lenders happy. However, one must look at what SDI does, and doesn t do, to see if it is appropriate in every situation. Firstly, it is important to clarify that SDI is a form of performance security and not necessarily a form of loan security. This is because SDI simply indemnifies the general contractor for the designated failure of his sub-contractors. It does not cover any default by the general contractor itself, nor does it provide any real collateral. As such, when accepting SDI on a project, lenders must still look at the credit worthiness of the general contractor, in the same way they would when using traditional surety bonds. Furthermore, since SDI only covers the subcontractors, there is still a need to have protection from the general contractor, for any self-performed work or general conditions (e.g. coordination risk). This protection can come in the form of various solutions, including surety (a low penalty bond in an amount sufficient to cover the general contractor s own work and general conditions), a Letter of Credit or Parental Guarantee. Ultimately the owner and its lenders will determine which prime contract protection is ideally suited to their needs. It should be recognized that, today, for most building projects (i.e., social infrastructure), about 85% to 90% of all building construction is undertaken by sub-contractors, and this is where the real risk is, making SDI a most attractive product. It should also be noted, that the SDI policy limit is a practice limit, and applies to all of the declared work undertaken by the contractor across North America. So, while a specific project may be considered somewhat benign, the contractor could well exhaust their limit on other job sites, rendering the SDI policy impotent. In order to counter this situation on a number of larger projects, the General Contractors, at an additional cost to the project, have been required to provide a dedicated Project Specific limit to those job sites. Therefore, if the practice limit was eroded there would be specific cover for those projects and those specific limits could not be called into contribution on any other job site. These project specific limits sit above the blanket policy and only come into play if the blanket policy is fully eroded. Thus consideration should be given to the underlying blanket policy, as well as the project specific policy limits, when determining adequacy of coverage relative to project profile. Now, when comparing SDI to traditional surety bonds, there are certain advantages that must be considered. One such benefit is that SDI provides cover for liquidated damages and acceleration or extended overhead, also known as indirects. These indirects usually are a sublimit to the policy limit (either $ amount or % depending on the carrier). A key point to be made on the indirect coverage is that coverage is based on a per loss basis. That means you would have access to that indirect sublimit for each subcontractor loss, up to the overall policy limits. This could provide significant security to ensure on-time completion of the project. Other benefits of SDI are that it provides warranty protection for up to 10 years (i.e., latent defect cover), covers legal and professional costs and the cost of correcting defective or non-conforming work or materials. 7

8 Of course, there are also some drawbacks to SDI that must be understood as well. One such drawback not found in surety bonds is the Other Insurance clause that reads: This insurance shall be excess only and non- contributing over any other valid and collectible insurance available to you, whether such other insurance is stated to be primary, pro rata, contributory, excess, contingent, or otherwise, unless such other insurance is written only as a specific excess insurance over the limits of insurance provided in this Policy. Our concern with this clause is that in the event of an insured loss, it is easy to foresee a situation whereby the various insurers on a project obfuscate settlement and engage in a pitched battle over whose policy is primary and therefore responsible to pay the claim. With that said, it is our understanding that Zurich is examining this clause closely to see if they can offer a solution, or possibly remove the clause altogether. Another possible drawback to SDI is that it does not provide any labour & material payment security for first tier subcontractors as is provided for under a Labour & Material Payment bond. That being said, the use of Labour & Material Payment bonds are quickly becoming a thing of the past, thanks to a growing trend towards managing the risk of non-payment through other means. For example, lenders are able to control the flow of funds to a project through the use of a cost consultant. Under this model, the general contractor is paid as the work is completed and verified by the cost consultant. If coordinated properly, this ensures that the maximum exposure to the project is days of work or materials supplied, which have not yet been invoiced at the time of default. The Alternatives SDI is not a panacea. It is a tool, and a valuable one at that, to aid in the protection of major projects. Another alternative to bonding used today is the European model that involves the use of Letters of Credit, typically for at least 10% of the total contract price. Of course, this method also comes with its risks. While the owner and its lenders have liquidity, they are ultimately left with 10% of the contract value and no third party expertise on how best to complete the project. In that vein, both surety and SDI do provide third party expertise to project stakeholders. However, it can be argued that, with cash in hand, one can hire all of the expertise required. We are also seeing a greater use of risk management techniques, predetermined financial analysis, captive insurance facilities, a greater emphasis on project management systems, and an ever increasing use of cost consultants to ensure that the work is being carried out on time and on budget, and that everyone who has to be paid is, in fact, paid. Clearly, with 85% or more of most major building construction projects being in the hands of sub-contractors, a great deal of analysis of their operations is paramount, unless they have been pre-qualified under SDI. In addition, risk controls could be put forward through contract to mitigate this fiduciary risk (i.e., segregation of accounts). Given larger projects are usually bid by Joint Ventures, account segregation is already baked into the project. 8

9 Up until a couple of years ago, the surety industry s counter to both subcontractor default insurance, and the criticisms of the non-responsiveness of their product, has been non-existent. That said the industry is now beginning to recognize the importance of responsiveness in adoption of their product. Leading the way is the largest surety market in the world, Travelers, with their partially liquid surety bond known as a P3 Bond. The P3 Bond provides a 10% loss advance within 10 days of the filing of a notice of default and also has the traditional performance bond coverage for the remaining 40% of the contract price. Despite their attempt to innovate, the owner and lender community continues to be hesitant to accept these new solutions based on previous track record. With all of the major infrastructure work being carried out, or to be carried out, over the next several years both in Canada and around the world, there simply isn t the capacity to bond all of these exciting projects. In addition, the traditional incarnation of the surety product s responsiveness and scope of protection leaves some owners/lenders with concerns as to its effectiveness on time is of the essence contracts. In Conclusion While traditional bonding has had a 100-year plus career, its inability to adapt to changes in the Canadian construction industry, where on-time delivery is paramount, has led owners, lenders and contractors to look for new alternatives to manage the risk of contractor default. Certainly bonding will continue to have its place in the industry, but the use of SDI and other alternative products and tools will become much more common. While close attention should be paid to the surety industry s new innovative liquid performance bond offerings as they could provide a responsive solution comparable to SDI; an investigation is required in order to determine the likelihood of the surety company upholding their commitments made through these liquid surety solutions. As for SDI, under current market conditions, we believe it is an excellent product in the hands of the right people. While it is not a cure-all solution, there are many benefits that are not provided for under a traditional surety bond solution. Please review the appended Quick Reference Table that identifies the relative, major differences between bonds and SDI. INTECH does not sell insurance in any form, nor is it associated in any way, with any insurance broker or insurer. The Company works independently, without conflict of interest, in providing meaningful insurance risk management advice and management. For any further information, please visit our website at: Or contact any of the following: Fraser Roberts President froberts@intechrisk.com Lisa Speirs Senior Vice President lspeirs@intechrisk.com Julie Davies Senior Vice President jdavies@intechrisk.com Todd McCleave Senior Consultant tmccleave@intechrisk.com September 2011 v

10 Summary Table of Key Differences Between Surety and SDI ISSUE Parties to Policy Policy Trigger Control of Remedy Limits Coverage Retentions / Deductibles Responsiveness SURETY Three - Contractor, Owner and Surety. Contractor in default and acceptance by surety that Contractor is in default. Surety controls remedy. Usually 50% - 100% of contract value. Surety has options on coverage provided and those usually include: * Allow owner to complete and indemnify up to limit of bond * Control completion themselves, through awarding to new contractor or financing existing contractor Note: Surety anticipates they are only responsible for hard costs associated with completing contract (LDs, legals, acceleration, are usually not afforded through surety). No Deductible - Dollar 1 Coverage. Medium - depends on key factors: * Surety Company involved * Clarity of default * Whether principle (contractor) is insolvent or a going concern * Clarity of project documentation It is a three party agreement, which is reliant upon the contractor to indemnify the surety for costs associated with remedy. This does create potential for delays. SDI Two - Insured (usually Contractor) and Insurer. Notice of default issued by Insured to Subcontractor. Insured controls remedy. Annual practice policy limits (per loss limit and aggregate): * depends on Insured's program parameters * Dedicated limits are available Subcontractor Default Insurance policy covers: * Cost of correcting defective / non-conforming work (potential warranty cover for up to 10 years) * Legal and other professional expenses * Cost incurred to find remedy to default * Indirect costs - acceleration costs, extended overhead costs, and even liquidated damages costs associated with general contract (to $5,000,000 limit) Depends on policy terms and conditions. Most have retrospective program in place and insurer provides Dollar 1 Coverage. Requires policy review. High - Insured controls: * Trigger of policy (default) * Choice of remedy for default Contractor and two party agreement provide for high degree of responsiveness. 10

11 Summary Table of Key Differences Between Surety and SDI ISSUE Cover pertains to: Subcontractor Payment Can the policy be cancelled? Coverage for Prime Contract Obligations Other Insurance Clause SURETY Can cover general contractor and subcontractors, depending on owner's requirements. If general contractor obtains Labour and Material Payment Bond, coverage for non-payment of 1st tier subcontractors is available. Ultimately reduces risk of trust fund breach by general contractor and reduces lien risk. No. Surety can deny coverage based on their interpretation of obligation through the bond and contract. Both prime contract performance bonds and subcontract performance bonds are available. No. SDI Covers subcontractors only. Does not provide coverage for general contractor breach of trust funds. Though the policy can be cancelled, it is only to the detriment of future subcontractors to be enrolled, or future projects to be enrolled. For instance, if the insured has a project enrollment SDI policy, coverage for subcontractors enrolled for that project cannot be cancelled. Also, depending on the amendatory endorsement utilized by the SDI policy, the insured could have significant time to enroll projects or subcontracts prior to finalization of cancellation. Review of such policy cancellation provisions should be carried out in order to ensure there is sufficient time to enroll all subcontracts under the project in the face of cancellation. SDI only covers subcontractor default risk. Though general contractors with SDI programs likely have strong best practices, the SDI policy does not cover their default. Yes. 11

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