National Association of Surety Bond Producers
The Surety & Fidelity Association of America
The Surety & Fidelity Association of America (SFAA) is an organization of some 600 companies which underwrite surety and fidelity bonds. The National Association of Surety Bond Producers (NASBP) is an organization of firms that specialize in surety bonding and, as agents, represent surety underwriting companies.
Recently, a new insurance product has been introduced that is being marketed to general contractors as a substitute for subcontractor performance and payment bonds. The product is a finite risk insurance policy that purports to protect prime contractors against the financial risk of subcontractor failure. Following the review of a version of this policy -- underwritten by a non-admitted insurance company -- SFAA and NASBP concluded that this product does not offer the protection to prime contractors that is provided by sub-contractor performance and payments bonds.
Very importantly, the financial exposures incurred by a general contractor defaulting a subcontractor under this policy are unknown because there is virtually no case law, state or federal statutes, or regulations governing this policy as there are for surety bonds which have been protecting project owners, general contractors, subcontractors, material suppliers, and laborers for over 100 years.
Since the only known version of this product is being offered in the excess and surplus lines market, filing of a standard form is not required and the actual policy sold to a prime contractor could differ from one customer to another. The following is a list of characteristics of and comparisons with surety bonds of the version of this new insurance policy that we have reviewed:
The contractor has to establish and follow Standard Qualification Procedures for Subcontractors/Suppliers. Due diligence and maintenance of these Standard Qualification Procedures is the sole responsibility of the contractor. Any deviation could void the coverage.
This qualification process casts the contractor in the role of the pre-qualifier. To be effective, the contractor would have to obtain from the subcontractor/supplier at least three years of audited financial reports which include work-in-process and other supporting schedules. The subcontractor/supplier must meet certain tests and ratios based on those financial reports as analyzed and determined by the contractor. Yet the contractor cannot disclose the existence of the policy to the subcontractor/supplier
The application for the policy is a warranty. If any of the information is later determined to be incorrect in any way, the insurer could declare the policy to be void.
The policy is an indemnity form. The contractor first must pay the loss and then seek reimbursement from the insurer by establishing that the loss was and is a "qualifying loss."
A "qualifying loss" is subject to a substantial deductible and then a co-payment percentage.
There is some question whether the funding mechanisms offered (such as a Finite Risk Insurance Program) will meet the tests for deductibility by the I.R.S. Definitions are vague and many terms are undefined. For example, the contractor must submit a "satisfactory" proof of loss, but the term "satisfactory" is not defined.
The contractor must pick a limit of liability and hope it is adequate to cover exposure to losses from all subcontractors/suppliers in its work program. The contractor must report its twenty largest subcontractor exposures on a quarterly basis.
The contractor is not permitted to cancel the policy. The insurance company can cancel if there is any change in the composition of the contractor. When the policy is canceled, it is not clear what happens on open jobs -- would the subcontractors still be covered?
Unlike subcontractor bonds, with this policy there is only partial transfer of risk. The contractor is funding the risk with deductibles and finite risk mechanisms. It appears the concept, as presented, would have an adverse impact on a contractor's cash flow as both the premium and the deductible must be prepaid.
Comparison of Finite Risk Insurance Products With Subcontractor Surety Bonds
|Definitions are vague or non-existent||Terms and Conditions are generally understood|
|No legislative support||State and federal legislative support|
|Untested in court; No precedence||Long history of case law clearly established|
|Deductible and co-payment required before coverage is activated||Coverage applies from first dollar|
|Insured must pay losses then try to recoup||Surety pays losses|
|Insured must takeover and manage defaulting subcontractors' obligations||Surety may be called upon to takeover, or otherwise arrange for, performance of the contract|
|Insured is responsible for gathering finacial information and determining which subcontractors/suppliers are acceptable||Surety provides underwriting and prequalification|
|Coverage can be voided if procedures aren't followed or if incorrect information is developed||Once executed, a bond remains in force|
|Policy can be cancelled by the insurance company||A bond cannot be cancelled|
|Insured commits to a 3- to 5-year term||Prime contractor not locked into an ongoing agreement|
|Questionable degree of risk transfer||Risk of subcontractor default transferred from prime contractor to surety|
|Insured must pick aggregate limit of liability and hope its sufficient||Prime contractor can elect to have performance or payment bonds each equal to 100% of the contract price|
|Insured is prohibited from disclosing exsistance of insurance contract to subcontractors/suppliers||Subcontractors are responsible for procuring their own bonds|
|Administrative burden on prime contractor to secure financial information, review it and determine acceptability||Minimal adminstrative burden: set bond requirements and make sure subcontractor complies|
|A claims made policy -- requires claims to be made during policy period; Defective work discovered after the policy expires or is cancelled probably would not be covered||Bond continues to provide protection against legitimate claims until time for filing suit as stipulatted in the contract or bond or the statue of limitations runs out|
|The contractor presumably could incur a concentration of risk with a potential unfunded liabilty which may require a CPA to footnote the audit||No such condition exists with a bond|