A Tale of Two Opportunities: Financing of Risk Through Subcontract Bonds

Two Opportunities in SuretyLast month I met with two contractors where subcontract bonds were a central topic. The first was a paper general contractor, meaning they administered the construction contract with the project owner and planned the project construction schedule. The execution of the work would be subcontracted to trade contractors. Two gentlemen had recently formed the company after having worked for larger companies and run some very large jobs in the past. They were key contributing employees but had never had an ownership stake in the companies for which they worked. Their enthusiasm for the opportunity before them was infectious. I was enthused with the opportunity as well since the contractor represented new business to Old Republic with a promising future.

As we discussed their immediate bond needs their confidence in their own abilities was evident. Very evident. Though they knew they were asking for a lot of surety capacity given the capitalization of their fledgling business enterprise, they explained how the bonded jobs they were pursuing fit within their experience and capabilities. I agreed. These two men had the know how to prosecute the work. Also, the negotiated contract terms were favorable. The discussion turned to mitigating the risk presented by the possible default of trade contractors. They felt that their chosen subcontractors were solid companies with good reputations and thus were qualified to perform the work.

I explained that the level of capitalization of the general contractor would not withstand the financial impact of a subcontractor default. They could mitigate the risk by requiring their major subcontractors to provide subcontract bonds. When underwriting a performance bond for a general contractor it is not uncommon for the general contractor’s surety to require subcontractors to be bonded back to the general contractor. This decreases the likelihood that a subcontractor default could impact the general contractor so severely that it causes the general contractor in turn to default on its contract with the project owner.

This in essence is a financing of risk to remove the risk of subcontractor default from the general contractor and transfer it to the subcontractor’s surety company. The subcontract bond surety would respond in the event of a subcontractor default. This would likely entail the completion of the defaulting subcontractor’s scope of work by another trade contractor procured at the expense of the subcontract surety. While any subcontractor default, bonded or un-bonded, may disrupt the construction schedule, the subcontract bond would provide an avenue of recovery for any damages or loss caused by delay. With the requirement of subcontract bonds on the major subcontractors, I saw a path to providing the performance bond to the general contractor. The meeting ended on a high note with arrangements made to walk the job site in the near future.

 A week later I met the second contractor who was also a paper general contractor and an existing Old Republic account. We reviewed his year end results which reflected the successful completion of a large but difficult job. A condition of approval for the bond on the large job for our general contractor was bonding back of critical path subcontractors. The general contractor had reluctantly agreed to the condition, knowing the additional cost of subcontract bonds would ultimately increase the amount of his bid to the project owner as compared to other bidders. While the contractor made an overall profit for the year, the large job finished at a sizeable loss. The contractor attributed more than half of that job loss to the default of his electrical subcontractor. As we discussed the job, it became apparent that the general contractor was well acquainted with the owner of the electrical contractor. He shared an anecdote that he was hunting with the owner of the electrical sub on Saturday and on Monday was surprised to encounter the owner towing his job trailer down the highway away from their construction site as the subcontractor abandoned the job without notice. The electrical subcontractor had provided a subcontract bond. Our general contractor expected to recover a substantial portion of his loss on the job from the final settlement with the subcontractor’s surety. He stated he would not resist bonding back subs in the future.

Old Republic ultimately did not write the first contractor. A different agent brought in another surety which agreed to write the bond for the fledgling general contractor without the condition of bonding back subcontractors. As our agent tried to salvage the relationship, he asked that Old Republic only require bondability letters instead of actually requiring the subcontract performance bonds. As I considered this request I recalled the following lines from Peter Bernstien’s excellent book; Against The Gods; The Remarkable Story Of Risk.  “Risk is no longer something to be faced. Risk has become a set of opportunities open to choice.”

In this situation there were three choices that presented two opportunities.

  1. The general contractor could simply face the risk of subcontractor default and hope for the best. The opportunity in this choice is the savings on the cost of the subcontract bonds contributing to the possible profit on the job.
  2. The second choice was to prequalify the subcontractors as best they could. Checking references and reputation in the marketplace is always a good practice. In addition, requiring bondability letters would indicate that a surety, privy to the financial condition of the subcontractor, thought well enough of them to provide a bond if required. This was what the agent was requesting. Here again, the opportunity was the savings of the subcontract bond premium which may increase the possible profit on the job. But the actual risk of subcontractor default is not mitigated. Prequalification, even with bondability letters, merely decreases the likelihood of the default based on the subcontractor’s past performance. Should a default occur, the impact and loss is as though there was no prequalification at all.
  3. The last choice was to finance the risk by obtaining subcontract bonds. Performance bonds generally cost 1% to 2% of the subcontract price. For the second contractor, financing the risk of subcontractor default through subcontract bonds on major subs had amounted to a total of a few tens of thousands of dollars in total bond premiums for all the subcontractors against the possible job profit. Yet this relatively small cost provided the opportunity for a recovery in the hundreds of thousands of dollars. Even though the second contractor knew and trusted the electrical subcontractor well enough to roam the woods hunting together, the unforeseen default still occurred. However, the risk of default had been transferred to the subcontract surety rather than remaining as a possible hit to the second contractor’s capitalization.

I wish the first contractor well.  They may well complete the bonded project without a subcontractor default. They fully perceived the risk of lost profitability on a job due to subcontractor default. But they did not perceive that same risk to threaten the solvency of their fledgling business as I did. I hope to have a future opportunity with them once their confidence has been tempered by the larger experience of managing the full business enterprise. Perhaps by then they will better appreciate the opportunity of greater certainty of outcomes in financing risk transfer through subcontract bonds.

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Dan Pope

Dan Pope is the Regional Vice President for the Southwest Contract region. He oversees the Phoenix, Denver, Kansas City and Dallas Contract offices. Dan has over 25 years of surety experience. Dan has a Bachelor of Arts degree from the College of Wooster and his Juris Doctor from the Cleveland Marshall College of Law.