Contractor’s Default Insurance Vs. Performance Bonds

By: Tina Paries, Income Member

A major concern of any general contractor on a project is whether its subcontractors will perform their work adequately and in a timely manner. In the past, general contractors relied on performance bonds to protect themselves in the event a subcontractor defaulted on its obligations. However, a new type of insurance has recently surfaced. Contractor’s default insurance can be purchased by the general contractor to “insure” the performance of its subcontractors.

In the event a subcontractor defaults, the insurer will reimburse the general contractor for having to fulfill the subcontractor’s contractual obligations. Coverage may be afforded for the following: (i) cost of completing the work; (ii) cost of correcting defective work; (iii) legal and professional fees; (iv) cost to investigate the default; and (v) liquidated damages, job acceleration and extended overhead costs.

But what makes default insurance different from performance bonds and how do you know when to procure one over the other? Here is a summary of the major differences between default insurance and performance bonds:

Cost: With default insurance, the general contractor is responsible for procuring the insurance and paying the premium as well as any applicable deductibles. Performance bonds are procured by the subcontractor and the subcontractor typically must provide some collateral in order for the surety to issue the bond.

Default/Performance: Where there is default insurance, the general contractor is responsible for determining whether the subcontractor is in default and is also responsible for repairing and/or completing the subcontractor’s work. With a bond, the surety is afforded the opportunity to investigate whether there is a default and, if so, whether a replacement contractor will be retained to complete the work.

Recoverable Costs: These are clearly identified in the default insurance policy and can include a wide variety of costs such as attorneys’ fees and overhead. Most bonds typically lack specificity about what costs can be recovered.

Subrogation: Where funds have been paid to a general contractor under a default insurance policy and the insurer later finds out in litigation that the subcontractor was not in default, the general contractor may be required to pay back those funds to the insurer. With a bond, the surety typically defends the subcontractor’s claim against the general contractor and then seeks to recover any costs from the subcontractor.

Exclusions: A typical default insurance policy will identify a number of exclusions – i.e., misrepresentation, fraud, default prior to policy period, material breach of warranty, professional services – that can be applied to preclude coverage. Although there are a number of conditions required to be met in a bond, there are no exclusions.

As you can see, default insurance and performance bonds are not a “one size fits all” solution for dealing with defaults on a project. Before procuring one over the other, a general contractor should consider, among other things, the size and complexity of the job as well as past relationships with the subcontractors.

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