Below is a great article on the use of subguard insurance in a construction bond instance. What the article goes through is that of performance bonds, payment bonds and insurance and all of the differences between the three forms of protection.
There are three parties to every surety bond.
1.The Principal – this is the person who is the primary payer on the bond. That is, the Principal is the one that everyone will want to pay FIRST. In a major construction project the General Contractor is the Principal on a large surety bond.
2.The Surety – this person is also known as the obligor. The Surety provides a guarantee that the Principal will not default on the bond; that is, that they will perform the job per the contract requirements. The Surety is generally a large insurance company. They have spent lots of time and resources through their underwriting department (more on that below) to verify that the Principal can perform. But if the Principal can not perform, then the Surety will make good.
3.The Beneficiary – this person is also known as the obligee. This is the person that wants a surety bond. In a major construction project this is the owner – or an agent of the owner (possibly, the developer). The Beneficiary requires that there is a surety bond for several reasons, including the transfer of risk (despite some increased cost), the protection against unforeseen risk.
This is a simple explanation/definition of a surety bond (sometimes called a surety guarantee, or fidelity bond). A fidelity bond / guarantee bond / surety agreement is a promise that someone (i.e., the commercial surety) will pay a specific dollar amount if someone else (called the Principal, e.g., the general contractor) fails to comply with some commitment as spelled out in a contract or other work-site agreement. So, what a surety agreement does is protect the Owner from a default by the Principal. The bond guarantee could also require that the commercial surety will perform, or get someone else who will perform, the job according to the specific terms in the contract.
The fidelity bond commitments are generally set forth in the bid requirements or specified in a contract. One of the places where we see these commitments are in construction contracts. In a typical construction contract, the surety guaranty protects the owner of the job site (sometimes referred to as the Obligee) against potential losses, which can arise from the general contractor’s failure to comply with the terms of the contract/fidelity bond.
In virtually all public projects (and in many private projects), the owner requires the general contractor to post a performance bond and a payment bond. Recently, in some cases, general contractors have obtained subcontractor default insurance or “Subguard” in lieu of or in addition to a performance bond or a payment bond. This article explains the purposes for, and use of, performance bonds, payment bonds and Subguard insurance and the differences between Subguard and performance bonds or payment bonds.
Construction bonds are not a form of insurance. A construction bond is a three-party agreement between a surety, principal and obligee. An insurance policy is a two-party agreement between an insurer and an insured. The bond is generally triggered when the principal defaults on its obligation to the obligee, and is declared in default. Unless the obligee somehow caused the default, the reason for the contractor’s default (e.g. principal's insolvency, abandoning the work, etc.) is usually irrelevant. In contrast, construction insurance coverage is typically triggered only by accidental events or occurrences.
A performance bond pays for pure economic loss, meaning the cost of completing the contractor’s obligation even if nothing is broken or destroyed. In contrast, construction insurance excludes coverage for completing construction contract obligations. Construction liability and property insurance policies generally provide no coverage for fixing or finishing defective or incomplete work or materials but instead usually cover only resulting physical damage to other items. For example, if a window was defectively installed, insurance does not typically cover the cost to replace the window. However, if the defectively installed window allowed water intrusion to damage drywall in the building, then insurance would typically provide coverage to repair the damaged drywall. In contrast, if triggered, a performance bond could provide coverage for the defectively installed window regardless of whether it caused damage to other elements of construction.
The principal on the bond is the party who requests the surety to issue the bond and whose obligations are guaranteed. For example, if a general contractor asks a surety to issue a bond to a project owner, the general contractor is the principal on the bond.
The obligee is the party that requires the principal to obtain the bond and who receives the benefit of the guarantee. If the bond is obtained by a general contractor for an owner, the owner is the obligee. A surety is the party who issues the bond that guarantees the obligations of the principal.
In addition, virtually all sureties require the principal on the construction bond (and sometimes the principal’s owners and officers) to guarantee and indemnify the surety for payments made under a bond. As a result, under most construction bonds, if the surety makes payment of a claim under a bond, these indemnitors will be liable to the surety for the amount of the payment.
Surety bond premiums are based on a percent of the maximum amount for which the surety might be liable which is typically the contract price. Premium percentages range from around one percent to five percent, with the most credit-worthy contractors paying the least. The payments required for the bonds are passed through to the owner in the contract price and for this reason, owners on some, typically smaller, private projects choose not to incur the cost of surety bonds and instead assume more risk in the event of a contractor default, in terms of its performance or its failure to make payments to its subcontractors and suppliers.
A performance bond ensures contract completion in the event of contractor default. Generally, if the contractor defaults, the surety must hire another contractor to complete the contract or compensate the owner for the financial loss incurred from the original contractor’s default. In contrast, a payment bond ensures suppliers and subcontractors are paid for their work and materials furnished to the project, should the principal on the payment bond default. The language of the performance and payment bonds and the applicable statutes must be carefully analyzed to determine if the claimant and the claimant’s claims are covered by the bond.
The surety’s obligations under a performance bond are not triggered until the contractor is in default and the owner has provided the surety with a declaration that the contractor is in default in accordance with the terms of the bond. The declaration of contractor default may include: copies of the contract, all change orders, an up-to-date summary of the contract accounting and a detailed explanation of the grounds for declaring the contractor in default together with supporting evidence. Although requests from the surety during the investigation may seem onerous, it is generally in the owner’s interest to promptly comply, because failure to comply may be grounds for the surety to claim that it is not liable under the bond due to the owner’s failure to cooperate.
Upon receipt of a declaration of contractor default, the surety under a performance bond has a duty to investigate the alleged default and is entitled to a reasonable period of time to do so plus a reasonable period to remedy any default. If the investigation confirms the default and no legitimate defense, the surety has a duty to complete the work in the most cost effective way. Generally, the surety’s options are: assist the principal to remedy the default; contract with another contractor to finish the work; or pay the owner the amount for which the surety is liable up to the penal amount of the bond. Alternatively, the surety can have the owner put the remaining contract work out for bid and then pay the owner the amount to complete the remaining work, minus the amount remaining unpaid under the original contract. This last approach is sometimes the preferred option for many sureties.
Common defenses to performance bond claims include: that the contractor/principal is not in default; that the construction contract has been materially altered since the surety issued the bond; that the owner has acted to the prejudice of the surety; and/or that the claim is barred by the limitations period stated in the bond or applicable statute. A surety may assert that the contractor/principal is not in default because: the uncompleted work is outside the scope of the original contract; the owner consented to the alleged default; the owner improperly withheld progress payments or was in material breach; and/or the contractor could not work because necessary precedents were not provided (e.g., drawings and specifications were incomplete; or incomplete or defective precedent work or material to be supplied by the owner or others was not provided).
The surety bonds a specific contract and takes the risk that the contractor will not perform under that contract. A material or cardinal change to the contract without the surety’s consent may release the surety. A material change may occur if the contract scope has been substantially altered to change the nature of the contract or the owner has caused a significant delay to the original construction schedule.
Depending on the language of the payment bond and any applicable statute, a claimant under a payment bond may be required to have a direct contract with the principal of the payment bond and usually the claim must be for labor or material or both which was used or reasonably required for use in the performance of the bonded contract.
In some cases, an owner may ask a general contractor to provide or the general contractor may choose to provide Subcontractor Default Insurance or Subguard in place of or, in addition to, a payment bond or a performance bond. Subguard protects a general contractor from a subcontractor default. In 2012, Subguard was used by 40 of the top 50 builders. In 2012, greater than $50 billion dollars of work was covered by Subguard.
Subguard provides the general contractor with the ability to immediately respond to a subcontractor’s default because the general contractor determines when the subcontractor is in default and triggers potential coverage under the Subguard policy. Therefore, Subguard provides a general contractor with a mechanism to limit the impact of a subcontractor’s default and any resulting delay to project completion. The cost of coverage under a Subguard policy is typically equivalent to that of a payment or performance bond providing coverage of a similar amount. General contractors are responsible for gathering financial data regarding each subcontractor and providing it to the insurer under a Subguard policy.
Subguard policies only protect against subcontractor default. Subguard policies do not protect subcontractors or suppliers against the failure of owners, general contractors, or construction managers to make timely payments to subcontractors or suppliers. Unlike a performance bond where the surety has the primary obligation to step in and remedy a default (i.e., takeover the project, finance the principal, or pay the obligee), under Subguard, the insured general contractor assumes responsibility for taking over the project and managing the defaulting subcontractor’s obligations. Under Subguard, the insured general contractor pays the up-front costs of replacing the defaulting subcontractor and then seeks reimbursement for those costs from the carrier under the Subguard policy. Due to the requirement of this up-front cash expenditure, Subguard policies are typically used only by larger general contractors with significant resources and may not be appropriate for smaller contractors with more limited resources.