There is financial risk associated with any commercial venture. This is particularly true of construction projects, most of which involve significant investment and their successful completion requires a coordination of proper technical design with appropriate materials and sound construction practices. The process engages a variety of different participants carrying out complicated operations that are connected to and rely on proper performance by other participants.
These operational risks are compounded by a complex commercial component involving multiple contracts and payment schemes. Given this complicated arrangement, it is not surprising that mistakes are made and disputes arise. The resulting claims can have a devastating effect on the project or the business of its participants. Insurance and bonds are, consequently, two essential aspects of the strategy used to manage commercial risk on construction projects.
Insurance is a contract between an insurance company and its insured involving obligations that are triggered by an event such as a fire or a claim. The two principal forms of insurance on a construction project are property insurance and liability insurance.
Property insurance is obtained to cover the cost of repairing or replacing tangible items that are physically damaged. A project’s owner will typically have insurance for the cost of repairing damage to the building that might be caused by a fire or other peril during construction. This type of policy is called a “Builder’s Risk” or “Course of Construction” policy.
In addition to a policy that covers the building, individual participants in a building project typically will have their own property insurance to protect against damage to their own property that might occur during construction.
Liability insurance is obtained to respond to claims resulting from carelessness or accidents. Individual project participants will each have their own liability insurance to respond to claims or damages caused by negligence in the course of their work. In the case of architects, engineers and other professionals, this will be in the form of a professional liability or errors-and-omissions policy.
Contractors, trades and suppliers will typically have a comprehensive/commercial general liability, or CGL, policy. Most CGL policies exclude from coverage claims for defective work or materials. The liability insurance is intended to cover property damage or bodily injury suffered by third parties as a result of the contractor’s work—but not to repair or replace the contractor’s defective work.
Because a construction project often involves a number of participants, a single claim can engage several different insurance policies issued by different insurers. In order to ensure that each participant has adequate coverage in the event of a claim, and to simplify the claims process, owners will often obtain at their own cost a wrap-up liability policy. A wrap-up policy is specific to a project and can provide liability coverage to all project participants under a single policy.
Bonds are similar to insurance in the sense that they provide financial protection, primarily for a project’s owner, in the event of particular types of non-performance. However, bonds are not insurance. One important difference is that a surety who is obligated to make a payment under a bond has the right to recover the amount paid from the non-performing party on whose behalf the bond was issued. An insurer who pays a claim generally cannot seek to recover that payment from the insured on whose behalf the payment was made.
The three most common forms of bonds on a construction project are the bid bond, performance bond, and labour and material bond.
Bid bonds are obtained to protect the owner during the procurement phase of the project. The bond is triggered if the successful bidder on a project improperly refuses to enter into the construction contract. Should that occur, the owner would call on the surety that issued the bid bond to pay the difference in price between the successful, but non-performing, bidder and the party who ultimately enters into the contract. The surety can then seek to recover this amount from the non-performing party. Typically it is a condition of the procurement process that the participant demonstrates it has secured a bid bond in a specified amount and the cost of the bond will be included in the contractor’s price.
Performance bonds protect the owner during a project’s construction phase. The bond is triggered if the contractor fails to complete the work. Not to be confused with liability insurance that responds to a claim for improper or defective work, performance bonds are designed to deal with unfinished work. In most cases, a performance bond is triggered because the contractor becomes financially distressed or insolvent and is unable or unwilling to complete the project.
As in the case of the bid bond, the surety can seek to recover any amount it is required to pay from the non-performing party. Generally, it will be a condition of the procurement process that the participant demonstrates that it has the financial ability to obtain a performance bond if it is awarded the contract.
Labour and material payment bonds, or L&M bonds, protect subcontractors and material suppliers from nonpayment by the general contractor. If a subcontractor or supplier does not receive proper payment from the general contractor, it can make a claim directly against the surety that issued the L&M bond. L&M bonds are required and paid for by the project owner because they protect the owner from claims and builders liens and facilitate the timely completion of the project.
For more information about construction insurance and bonds, please contact Stephen.