Written by: Adam W. Cook
Construction projects in Alaska and elsewhere are often protected by a surety bond and are also often covered by more than one insurance policy. Although a bond and an insurance policy are two very different things, they are often confused with each other. This confusion is somewhat understandable. Both are essentially “emergency protection” in case the contractor encounters a major problem or cannot finish the project. Both are usually required by the owner before the start of work, as a way of making sure the job gets done. Very often the insurance company and the bonding company are the same large business entity.
Anyone who owns a car or gets health care is familiar with the concept of insurance. An insurance policy is a contract which obligates an insurance company to pay the policy-holder in the event of a loss. In construction projects, there are various layers of insurance purchased by the owner, the contractor, or both, before the project even begins. “Builder’s risk” insurance protects the insured from actual physical damage at the jobsite, such as fire or flood. “General liability” insurance covers the contractor for loss caused by serious and sometimes dangerous mistakes made in performance of the project, such as a collapsed scaffolding or electrical accident. Worker’s compensation insurance is required by Alaska state law, and covers the workers themselves in the event of injury or death. In every case, insurance is purchased through premiums and is paid out by the insurance carrier once the type and quantity of the loss is confirmed.
By comparison, a bond is essentially a line of credit. In the case of a performance bond, the contractor purchases the bond, and the bonding company agrees to guarantee the satisfactory performance of the project. If the contractor runs into a problem such as bankruptcy or legal liability, and can’t finish the project, the bonding company is obligated to spend whatever it takes, up to the amount of the bond, to get the project to completion.
Importantly, the builder is not off the hook once this bond coverage is triggered. If the bonding company spends one million dollars finishing the project, it will demand that the contractor pay back the million dollars once the project is complete, through a legal requirement called indemnity. In this way, the bond has acted as a sort of loan, with the bonding company loaning the money needed to finish the project, and then expecting to get paid back by the contractor. Of course, if the contractor is bankrupt or has other serious financial problems, this “loan” might never get repaid.
The confusion between insurance and bonds comes from the fact that both are utilized by an owner to make sure that the project is finished after something goes wrong. For example, if a worker makes a mistake and causes a fire which seriously damages the project, the first thing the owner and/or the contractor will do is contact the insurance company and see if the loss is covered. In this situation, the bond plays no role, because even though a loss has occurred there is no indication (yet) that the contractor will not be able to eventually finish the project.
Bond coverage, unlike insurance coverage, is often triggered by a “quiet problem” rather than a catastrophic loss. For example, an owner might believe that there is nothing wrong at all but then unexpectedly learns from a subcontractor or supplier that the contractor is having trouble paying its bills. Nonpayment to other parties is often a sign of a problem, and it may be that the contractor is in financial trouble and unable to finish the project on time and on budget.
After receiving notification of nonpayment, the owner will contact the bonding company. The owner will advise the bonding company that if the contractor is not going to be able to complete the project, then the bonding company will be expected to take over the job. Unlike in the example with fire and the insurance policy, this is not a situation in which the owner or contractor will be “made whole” following a loss. Instead, the contractor’s “line of credit” with the bonding company is essentially being tapped because the contractor does not have the financial means to proceed. The bonding company now has to pay to finish the project and must accept the fact that it may not recover what it has paid out from the troubled contractor. As one might imagine, the bonding company will be very focused on minimizing the cost of completion in this situation.
It is important for both contractors and owners (as well as architects, subcontractors, and suppliers) to understand both insurance and bonding before they get started on a project. All projects can take an unexpected turn. Unfortunately, cost overruns and mistakes on the jobsite are a common occurrence. Insurance and bonding will protect the owner in the event that things go wrong, but only within certain limits and under certain circumstances. Legal advice is almost always a good idea both before the project is underway and after something goes wrong.