THE HONG KONG HOUSING AUTHORITY. Memorandum for the Building Committee. Study on Bond Insurance for Construction Projects

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1 BC 71/99 THE HONG KONG HOUSING AUTHORITY Memorandum for the Building Committee Study on Bond Insurance for Construction Projects PURPOSE The Paper is to inform Members of the findings and to invite discussions and seek endorsements from Members on the recommendations made on the Bond Insurance study for the construction projects. BACKGROUND 2. It had been a requirement for contractors to take out performance bond for Housing Authority construction projects. This requirement was dropped vide Paper No. BC 130/92 from October 1992 onward when Housing Authority decided to follow the Government practice of not requiring contractor obligation to take out performance bond for Government construction contracts mainly on cost-benefit consideration. 3. In view of the increase in cases of contractors non-performance resulting mainly from liquidation in past years, there has been a concern on Housing Authority s increase in risk exposure in this area. To address the concern, the Department s Insurance Advisor, Messrs. Aon Risk Services (ARS), was engaged to conduct a study on the application of bond insurance for Housing Authority construction contracts. This study also includes information on application of the performance bond in Hong Kong, Singapore, Australia, U.K., U.S.A. and Canada and proposed standard bond document.

2 On the same subject, Government reviewed her policy on the use of performance bonds security vide Works Bureau Technical Circular No. 10/97 dated 29 August Performance bonds are not required except on special circumstances, such as entrusted projects and projects of high risk nature, as stated in the Circular. Copy of the Circular is at Annex 1 for Members information. FINDINGS 5. Having reviewed Housing Authority s risk exposure on contractor s non-performance on building contracts in the past five years, i.e. from 1994 to 1998, practice/requirements of local private sector, Singapore, Australia, U.K., U.S.A. and Canada, ARS has the following study findings - (a) (b) (c) In last five years, Housing Authority was exposed to a much higher risk on its NW1 contractor s non-performance as compared to that of NW2 contractors. During 1994 and 1998, there were seven non-performed NW1 contracts, out of the total 38 NW1 contracts, whereas none of the NW2 contracts was found non-performed. Details of the nonperformed contracts are listed at Annex 2. Based on the information as mentioned in (a) above, a cost effectiveness analysis for different contract categories has been carried out and the results are shown in Annex 3. It indicates that effecting performance bond for only NW1 contracts would be more cost effective and could offer Housing Authority a higher degree of loss recovery. In local private sector, performance bonds of both conditional and unconditional type are used with size set at 5% to 10% of the contract value. Conditional bonds require proof of contractor is in default or nonperformance under the contract and payment will only be made for the amount of the actual loss whereas unconditional or on-demand bonds enable the surety to be called upon to pay regardless of whether there has been default or non-performance.

3 - 3 - (d) (e) (f) (g) Conditional bonds are mainly used in government projects in many countries. This reflects the practice adopted on how the bond cover is to be used and also their consideration on its effectiveness. In Singapore, Australia, U.K., U.S.A. and Canada, it is a practice/requirement for contractors to take out performance bonds for construction projects. Types and sizes of performance bonds used for construction projects in these countries are scheduled at Annex 4. No separate bond is necessary for the nominated building services subcontracts because bonds taken out for the main contracts normally cover these subcontract works as well. The standard performance bond document currently used by the Government is considered suitable for Housing Authority except with amendments on terminology, i.e. changing the Government of Hong Kong Special Administrative Region to the Hong Kong Housing Authority and Architect/Engineer to Contract Manager, to meet Housing Authority s requirements. Both the Government and the proposed Housing Authority standard bond documents are at Annexes 5 and 6. RECOMMENDATIONS 6. Based on the above findings and on consideration of the balance of the cost against the non-performance risk, the following recommendations are proposed - (a) Performance bonds should be imposed on contracts likely to be exposed to high non-performance risk. Having considered Housing Authority contractors past nonperformance records, it is advisable for Housing Authority to impose the requirement of performance bond to contracts to be tendered by NW1 contractors.

4 - 4 - (b) (c) (d) (e) Performance bonds of conditional type with size amounting to 10% of the contract value should be used. No separate performance bond is necessary for nominated building services subcontracts. The proposed Housing Authority standard bond document at Annex 6 should be adopted. Implementation of the recommendations in paragraphs 6(a) to 6(d) above to be effected for building contracts tendered by NW1 contractors with tender-out date on or after 1 June FINANCIAL IMPLICATION 7. It is anticipated that should the recommendations proposed in paragraph 6 above be implemented for all NW1 contracts with total estimated value of $1,794M to be let out in 1999/2000, an estimated additional cost of $3.60M resulting from effecting the performance bonds will expect to be added to the tender costs of these contracts. 8. Members should note that by effecting performance bonds as recommended to NW1 contracts, in the worst case, only maximum of 10% of the contract value will be recovered. Using last five year s record as an illustration, this is equivalent to about 34% of the total actual loss on the NW1 contractor s non-performance cases. DISCUSSION 9. At the Building Committee meeting to be held on 29 April 1999, Members will be asked to discuss and endorse the recommendations in paragraph 6 above

5 File ref. : HD(QS) 23/126/3 Date : 23 April