Contractor default insurance catches on in Canada

It’s called contractor default insurance or sub-contractor default insurance and provides general contractors with an alternative to traditional surety bonds.

First offered in the U.S. in 1996, the appeal of the product is largely based on the speed with which the insured receives insurance payment in the case of a sub-contractor’s failure to perform. The general contractor merely needs to identify the sub-contractor default situation and bypass a potentially long and contentious claims process that might follow with traditional surety bonds.

“To obtain payment, the contractor must pay to cover the costs of the default and then provide a proof of loss to the insurer,” said Robert Jenkins, a partner with Jenkins Marzban Logan LLP in Vancouver.

“The amount of recovery available to the insured is subject to deductibles and co-payments proportional to the limit of liability. Many policies include a per-loss deductible.”

Canadian general contractors have been warming up to the insurance product, primarily offered by Zurich North America under its Subguard trade name.

“Subguard is one of our growth lines,” said Hannah Brown, VP of marketing and communications with the Zurich Insurance Company in Canada.

“We’ve certainly had a lot of success with the product in Canada and sales are increasing month to month.”

Simon Fenn of Fenn & Fenn Insurance Practice Inc. in Newmarket, Ont. said that increased interest in the product was sparked between four and five years ago with the advent of large P3 and AFP projects.

“There was a lot of high-value work being offered and bond limits were being challenged, so this became a bit of a solution to providing security around the sub-trades,” he said.

But, while it’s possible that contractor default insurance can save money versus traditional surety bonds, such policies aren’t suited to all contractors.

“It’s a product that primarily suits the major contractor because smaller and mid-sized contractors don’t have the staffing and experience required to manage the enrolment and pre-qualification of the sub-trades,” noted Fenn.

“With surety bonds, pre-qualification is the responsibility of the surety.”

Often, general contractors, who purchase the product, have sub-contractor volume valued in excess of $100 million.

Under surety bonds, the surety holds the risk for completion and payment to the sub-contractors and suppliers, while with contractor default, the insured retains some risk through deductibles and co-payments.

The deductible for which the contactor is responsible is usually very large, often $500,000 or more, which discourages claims under the policy, unless the potential loss is extremely large.

“After paying its deductible, however, an insured general contractor may be entitled to compensation for costs that would not be covered under a typical performance bond,” said Jenkins.

“For example, the insured general contractor may be entitled to compensation for additional legal and other professional services required because of the sub-contractor’s default.”

Sub-contractors may find this form of insurance less ideal, because it requires them to provide confidential pre-qualification information to the general contractor instead of the surety.

Contractor default insurance also puts general contractors in the power position in determining default.

“It is possible for a sub-contractor, depending on the terms of the sub-contract, to dispute the default, but that will not take away from the contractor’s ability to carry on and bring others in to complete the sub-contract work,” said Jenkins.

“As well, commonly on Subguard projects, there is no labour and material payment bond under which a sub-contractor can claim payment if a general fails to pay.”

Owners may also be confused as to who can benefit from contractor default insurance.

“Many owners have a mistaken impression that they can claim under the Subguard policies,” said Jenkins.

“They cannot. Only the general is able to declare a default and call on the insurer.”

Jenkins noted that there’s no Canadian case law to date involving contractor default insurance.

While that may mean the product is successfully meeting the needs of the insured, Jenkins noted that, untested by law, it may be too early to determine whether contractor default insurance will adequately remedy perceived problems with traditional construction bonding.

On the other hand, Canadian jurisprudence does recognize the obligation of a company offering first-party insurance, such as contractor default insurance, to act in good faith throughout the assessment of the claim.

“While some U.S. states recognize it, this duty of good faith with respect to surety bonds has not been recognized in Canada,” said Jenkins.

“Canadian courts have awarded very high punitive damages against an insurer. The risk of these punitive damages is a strong incentive for any insurer to fulfill its obligations of good faith in assessing the claim. Whether Canadian courts will conclude that a surety owes a duty of good faith is far from certain.

“Ultimately, time will tell whether contractor default insurance is a suitable substitute for traditional bonding.”