Alternatives to BONDS [Enterprise, The (UT)]

In the wake of the financial meltdown, construction companies are turning to surety bonds and other financial protections like never before. General contractors are seeking out traditional performance and payment bonds when they previously hadn't, and in some cases are looking for alternatives to bonds, with varying measures of success.

According to Phil Walter, a sales executive in the surety division at Moreton & Co., one of the newer bond alternatives is Subguard, a type of subcontractor default insurance that indemnifies general contractors from the costs of a subcontractor defaulting on performance obligations.

"There are some alternatives to bonding. The most interesting is Subguard. That's an actual insurance policy versus a bond," Walter said.

Walter said Subguard, a product of Zurich Insurance, offers opportunities to the right companies but significant risk to the wrong ones. Whereas traditional performance and payment bonds create what Walter characterized as a triangular relationship between owner, contractor and bonding company - or contractor, subcontractor and bonding company - depending on the type of bond, a product like Subguard leaves the contractor with significant responsibility and risk.

"A bonding company guarantees a contract between the owner and construction company. If an electrical subcontractor blows up, the bonding company steps in and assumes the contract between the general contractor and the subcontractor. Between the insurance company, there isn't that three-way arrangement," Walter said.

Like other insurance policies, Subguard requires a deductible that on large-scale construction projects can be quite significant. In the event of a subcontractor default, holders of subcontractor default insurance must be able to absorb the financial hit of both the deductible and the cost of delays before the subcontractor default insurance is paid. With bonds, on the other hand, there is no deductible.

"If you have a $1 million electrical contractor and they end up causing you a lot of financial distress, the bonding company steps in at dollar one, and doesn't have a deductible, like Subguard," Walter said.

"Because the deductible on that policy can be significant, you have to be large enough to financially absorb the hit. If you're not of significant girth, so to speak, [Subguard can be problematical]. Financially, the general contractor has to assume the financial risk until an insurance policy like Subguard steps in. That might be a while, whereas a bonding agent steps in right away."

Walter said Subguard is not that useful for smaller companies, being more geared toward "ENR 400" companies, or those listed by Engineering News-Record as the 400 largest general contractors by revenue.

Utah construction companies Clyde, R&O, Jacobsen, Big-D, Okland and Layton made the 2012 list, coming in at 197, 194, 145, 99, 90, and 85, respectively.

"I don't want you to think that Subguard is a bad policy or a bad product. At the end of the day, it performs, but it's definitely not for the average guy," Walter said.

According to John Paulsen, of Paulsen Construction, the financial collapse completely reordered the way companies like his do business. Hunger brought about by frozen credit markets, project failures and bankruptcies led numerous subcontractors to underbid projects out of desperation. Those untenable bids led to cost overruns and, in many cases, subcontractor defaults that left general contractors eager to protect themselves, Paulsen said.

"The cost to build in 2008 was far less than what we expect in 2013. Fuel prices are up, steel prices are up, copper prices are up. Contractors are desperate. A lot of these prices out there are not covering labor and materials costs. You get to 90 percent completion and problems happen," he said.

"There were a lot of projects that defaulted after the crash. There was an atmosphere of 'just get out, everybody run, we're all going down.' The surety industry was really inactive up through 2008. Ten percent of our projects in 2008 were bonded projects. Right now, we're probably at 90 percent bonded projects. Most private contracts now are demanding it over $50,000," Paulsen said.

According to the U.S. Miller Act, all federal construction contracts worth more than $100,000 must be bonded.

According to Paulsen, the demand for bonded projects is bringing about a new level of scrutiny and oversight.

"When you get to the underwriting, what the bonding agency will say is, 'Who's your team? Who's your mechanical guy? Where's the money coming from?' They ask real detailed questions. It goes back to knowing who your guys are," he said. "We're a fourth generation construction company. Things were done on handshakes. Ten years ago things were done on contracts. Now you cannot cover yourself enough. It's challenging to actually do a construction project nowadays in this market. It's getting very cumbersome to build. Building is becoming a small part of the construction business."

With the pressure ramped up on contractors to cover themselves against risk, products like Subguard, which comes at a lower percentage rate of overall project cost than traditional payment and performance bonds, have piqued considerable interest. According to Paulsen, general contracting companies operate with a 3-4 percent profit margin and bonding against the risk of subcontractor default eats into that margin painfully. Institutions offering subcontractor default insurance at half the rate of traditional bonds are almost impossible to resist, he said.

"Subcontractor bonds are in great demand, but nobody wants to pay for them," Paulsen said.

A new product may supply that demand. XL Insurance is marketing its CapAssure subcontractor default insurance as a competitor to Subguard. According to ENR, CapAssure combines both contractor and subcontractor default insurance, eliminating overlap, with sureties charging contractors between 05 and 2 percent, depending on contractor's credit history.

<p>"[XL] is a policy that is for smaller guys. They're trying to bring in a competitive product to Subguard," Walter said.

Whether CapAssure reaps the benefits of the whirlwind of the "new normal" remains to be seen. Innovative financial products come and go.

"Years ago, there was a company named St. Paul that was basically a mirror of Subguard and it turned out to be a financial disaster and they decided they didn't want to put that out anymore," Walter said.

"I'm going to say it flat out," Paulsen said. "There's no way you're ever going to cheat a surety company. Those guys have covered themselves from left to right. Traditional payment/performance bonds aren't going anywhere."