After a pace of growth that’s kept the construction industry under heavy pressure in recent years, backlogs are starting to shrink and some sectors, such as residential, have slowed enough to raise concerns.
But that may be a good thing from several perspectives. For one, subcontractor defaults in this heated market happen more often than anyone would like.
And then there’s this: Even a temporary lull in work gives general contractors some breathing room to do some serious future planning. A good place to start is by evaluating risk management efforts going forward and the tools used to protect the organization against subcontractor defaults.
There are more options today with subcontractor surety bonds or subcontractor default insurance than even a decade ago. Stay up-to-date on the basics, but don’t neglect bringing in an expert to ensure the company has the right tools for its circumstances moving forward. Here’s an overview:
Subcontractor Surety Bonds: Third-party pre-qualification and complete risk transfer
Surety companies have traditionally been the primary resource for in-depth subcontractor pre-qualification services for GCs. Their rigid underwriting standards guarantee subcontractor performance and payment in the form of subcontract surety bonds. These three-way contracts are provided to the GC with bid bonds during the bidding process and performance and payment bonds when the contract’s awarded. They typically are required by statute for publicly funded investments in construction.
Surety bonds represent a risk transfer from general contractor to surety with risk funding and recourse against the subcontractor. The GC is protected for contract completion and the subcontractor’s subs and suppliers are also protected for payment. In the event of a default, the surety arranges for completion up to the bond amount or pays for losses after an independent investigation. The cost of the bonds are dictated by the scope of the project and subcontractors’ experience and credit quality. Performance and payment bonds provide protection for the entire contract period up to the contract amount.
For 2020, there are new entrants to the surety market, which is effectively loosening underwriting. That increases capacity for underqualified players and creates significant counterparty risk for contractors—a pressure likely to intensify as construction spending slows further and margins shrink. A strong surety broker will help contractors develop a strategy to prequalify subcontractors and avoid high-risk contracts.
Subcontractor Default Insurance: DIY pre-qualification and different risk/reward issues
If subcontractor volume is greater than $50 million, this insurance product may be regarded as a viable option to surety bonds. It’s not necessarily an easy one, though. The pre-qualification process alone is as vital with SDI as it is with surety bonds, and since it is done in-house by the GC, doing it right requires an investment in infrastructure and culture.
It’s also key for the insured GC to build the necessary reserves to cover the high deductibles and co-payment requirements that may arise from enrolled subcontractor losses. The GC bears the administrative burden for claims. In exchange, however, they have more control over the outcome: A streamlined claim resolution process and a collaborative effort to work through issues instead of waiting for default to be investigated by a third party. When the SDI program is done right—managed well against losses—the GC is likely to see significant benefits in terms of substantially improved margins with a lower premium cost over time and increased flexibility in how the program is funded.
For 2020
Over the last eight years, SDI has grown into a competitive market, which gives contractors more options and has kept pricing and terms attractive for those with positive loss experiences. The exception may be contractors with exposures to causes of recent subcontractor defaults, or subcontractor performance that’s been strained by the residential spending slowdown, framing scopes of work and higher backlogs.
Whether through subcontractor surety bonds or SDI, any contractor that intends to make it long-term wants to make sure that its team of subcontractors is set up for success to meet the same objective. A robust prequalification process and either one of these tools provide critical protection to make it happen.
