A Comparison of Construction Surety Bond and Insurance Thesis

Introduction

Different instruments such as insurance policies and surety bonds have been developed in an effort to assist individuals and institutions in managing risks (Grovenstein et al. 356). Surety Information Office argues that how “one evaluates and manages risk on construction projects and makes fiscally responsible decision to ensure timely project completion is critical for success” (1).

Project owners ensure that the selected construction contractors do not fail. Surety bond is one of the instruments used in managing risk within the construction sector (CNA Surety 2). The surety bonds are a source of assurance regarding the completion of construction projects (Bouteiller and Coogan 66).

The demand for surety bonds and trade credit insurance within the emerging economies such as China has increased exponentially over the past few years. The demand has arisen from China’s rapid investment in diverse construction projects in an effort to improve its infrastructure (Middlehurst par. 3).

Subsequently, the demand is expected to be sustained into the future (Swiss Re par. 2). The International Credit Insurance & Surety Association corroborates that the “demand for trade credit insurance and surety bonds is on the rise as a result of increasing trade flows, mostly from high growth markets in an overall ongoing deteriorating risk environment” (p.1).

Therefore, the need for skilled underwriting in the construction industry is high. This study entails a comparison of the construction surety bond and construction insurance.

Literature review; a comparison of construction surety bond and insurance

Surety Information Office defines a construction surety bond as “a risk transfer mechanism where the surety company assures the project owner [obligee] that the contractor [principal] will perform a contract in accordance with the contract documents” (2).

Construction projects should adhere to the set budgetary allocation and period. Failure to adhere to these parameters may expose the project to various risks such as increment in the cost of the project due to the different external variables such as economic fluctuations (Akitonye and Zawdie 233).

Therefore, construction surety bonds are designed to prevent project owners from financial and resource related risks that might occur during the construction (Cummins 25). Consequently, surety bonds play a fundamental role in strengthening the liability relationship between the contractor and the project owners, which increases the likelihood of successful project completion (Dunn and Sedgwick 15).

Types of construction surety bonds

Three main types of surety bonds have been developed, viz. the performance bonds, bid bonds, and the payment bonds.

Performance bonds

These bonds are designed with the objective of “protecting project owners from financial losses that might occur in the event that the contractor fails to execute the project in accordance with the predetermined terms and conditions of the construction contract” (Kelleher and Abernathy 466).

Bid bond

The selection of construction contractors is undertaken through a bidding process. The bid bond is a “guarantee that the contractor has submitted the bid in good faith” (Russell 264). Therefore, the contract between the contractor and the project owner will be based on price bid in addition to providing the payment and performance bonds as required. The bid bond should accompany the bid proposal (Jenkins and Wallace 5).

Payment bond

This bond is an assurance of the surety’s commitment to pay the specified project participants such as labourers, subcontractors, and suppliers in case the principal [contractor] does not make the necessary payment (Schwartzkopf and Tasker 54). The payment bond provides the project participants an opportunity to file a legal claim against the surety without involving the project owners (Schwartzkopf and Tasker 83).

Labor salary guarantee bond

This bond guarantees the project owners that the principal [contractor] will be committed in paying the required salaries in executing the project (Atkin, Borgbrant and Josephson 81). The surety takes the obligation to make labor payment in the event of the contractor failing to make the necessary payments.

Construction insurance

Kelleher and Currie (439) emphasize that insurance is an essential component in construction project planning as it provides an avenue through which project owners can cover potential losses in addition to minimizing disputes amongst diverse project participants. Construction insurance is considered to be relatively complex and highly specialized (Cushman 45).

Furthermore, changes occurring in the insurance industry are stimulating insurance companies to revise their policy language in order to streamline construction insurance.

Bunni defines construction insurance to include “all contracts of indemnity within the activities of the construction industry where insurance is chosen as the medium through which liabilities are shifted” (181). Construction insurance encompasses numerous branches of insurance, professions, and disciplines (Seifert 63).

In order to succeed in offering construction insurance, it is crucial for insurers to develop a comprehensive understanding of the complexities and intricate challenges associated with different aspects such as building, mathematics, and engineering (Hess 56).

Such understanding will increase the effectiveness of insurers undertaking statistical, economic, and probability calculations (Sido and Cushman 154). Cameron (82) is of the view that construction insurance is concerned with providing cover against diverse construction perils.

Construction insurance is based on a number of characteristics, which distinguish it from other forms of insurance (Moelmann and Harris 46). First, the contractor must complete the construction project despite the difficulties that might arise.

This requirement is specified in the terms and conditions of the construction contract. Secondly, construction projects involve vast amounts of money, which means that the cost of failure is very high.

Types of construction of insurance

Different types of construction insurance have been developed as evaluated below.

Builder’s accident and injury insurance

This insurance covers the project owner against potential expense, loss, or claims that might arise from accidents or personal injury that the project participant might experience in the course of executing diverse project tasks.

Glaser, Piskorski, and Tchistyi assert that builder’s accident and injury insurance specifies the contractor’s liability to cover the project owner against personal injury or loss of life that might occur during the construction process (187). However, the contractor is not obligated to assume the liability if the injury is due to neglect by the project owner (Levine and Haar 435).

Construction quality guarantee

Contractors have an obligation to ensure that the construction project outcome is of high quality. One of the ways through which this goal can be achieved is by adhering to best construction practices. The construction-quality guarantee insurance protects the project owner against losses that might arise from the contractor’s failure to adhere to quality standards.

Liability insurance

This is a specialised form of property insurance that is designed to protect project owners from risks such as physical loss and damage to property that might occur during the construction process.

Professional liability insurance

This type of insurance is designed to protect the project owner against liabilities or losses that might originate from the contractors ineffectiveness, for example, due to errors and omissions. The error and omissions policy vary from one industry to another.

In the construction industry, engineers and architects acting as consultants develop the errors and omission policy. Subsequently, the policy safeguards engineers and architects from possible errors and omissions that might be committed by the contractor.

Construction surety bonds and construction insurance

Different countries have appreciated the importance of protecting various stakeholders involved in the construction industry due to the risky nature of the enterprise. This aspect has led to the development of different types of surety bonds and construction insurance policies. The main types of surety bonds in the US construction industry include the bid bonds, performance bonds, and the payment bond.

However, the UK has an extensive number of surety bonds, as evidenced by the inclusion of other types of surety bonds such as the retention bonds, sewer bonds, highway bonds, and advance payment bonds. Consequently, the development of the construction surety bonds market varies from country to country (Lerner and Baum 45).

Unlike the conventional insurance products, construction surety bond is a relatively new concept in China’s real estate sector (Middlehurst par.3). The promotion of construction surety within the real estate sector in China began in 2004 with the publication of File No.137 by the Ministry of Construction. The file outlines the guidelines and regulations on surety bonds within the public construction sector (Yan par. 2).

The construction insurance industry is highly developed in most countries as opposed to construction surety bonds market (McIntyre and Strischek 36). Considering the inherent risks associated with construction projects, most construction companies seek the assistance of insurance companies in order to safeguard themselves from potential risk.

This aspect has led to a significant development of construction insurance in different countries (Ramsey 75). However, Vetsch asserts that construction insurance “is not a ‘one size fits all’ affair” (par.1). Consequently, construction countries must analyze the construction insurance policies offered by the respective companies in order to understand possible exceptions in the contract.

In Canada, numerous exceptions in the various construction insurance policies are offered. For example, the property insurance policy in Canada explicitly excludes the contractor from covering losses arising from various natural occurrences and human causes such as pollution, vandalism, earth movements, and temperature changes amongst other issues.

However, the Miller Act of the United States is not explicit about such issues. Moreover, the Canadian construction insurance describes the components of professional liability insurance and it excludes the contractor from liabilities that might arise from the insured’s non-professional activities.

Conclusion

The construction projects are characterized by numerous risks that might lead to substantial losses. Subsequently, the significance of effective risk management in the construction industry cannot be underestimated. Different risk management plans and policies have been formulated in an effort to assist parties in the construction industry to manage risk.

Examples of such instruments include the construction surety bonds, which are usually issued by financial institutions. Unlike conventional insurance programs, construction surety bonds do not involve transfer of risk.

Some of the main types of surety bonds in the construction industry include the performance, bid, and payment bonds. Additionally, the conventional insurance industry gives participant in the construction industry an opportunity to manage risk through various policies such as the builder’s accident and injury insurance policy, construction quality guarantee, professional liability insurance, and liability insurance.

However, the development of construction surety bonds and construction insurance market vary from one country to another.

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