Understanding Subcontractor Default Insurance
The financial well-being and stability of subcontractors is an ever-present concern for most general contractors. When subcontractors fail to complete the full scope of their work, projects can stall, leading to frustrating and costly delays.
To protect against subcontractor default, general contractors have traditionally relied on performance bonds. However, given increases in cost to acquire performance bonds and the prolonged investigation process required should a subcontractor default, more and more general contractors are turning to subcontractor default insurance (SDI) to help manage their risk.
What Is Subcontractor Default Insurance?
SDI, which entered the U.S. market in the late 1990s, is an insurance product designed to protect businesses from losses arising when a subcontractor defaults on its obligations.
Under an SDI policy, a general contractor enrolls all prequalified subcontractors for a specific project or policy term. The general contractor is then indemnified by the insurance company for any covered direct or indirect costs incurred if one of the subcontractors defaults on performance. It’s not uncommon for contractors to have annual subcontracted values of $75 million or more, so, when a subcontractor defaults, it can seriously impact a general contractor’s profitability.
SDI policies generally cover losses related to first-tier subcontractors (contractors in direct contract with the general contractor) and second-tier contractors (contractors in direct contract with first-tier subcontractors, including suppliers). SDI policies also provide coverage for losses that are the indirect result of a subcontractor default, such as liquidated damages, acceleration of other subcontracts and extended overhead.
SDI vs. Performance Bonds
The fundamental distinction between SDI and performance bonds relates to the relationships created by the two products. Surety, including performance bonding, is always a three-party relationship between the contractor (the obligee), the subcontractor (the principal) and a surety company.
When performance bonds are used, the surety company initiates the process by thoroughly screening the subcontractor. The surety reviews a number of factors, such as the subcontractor’s financial well-being, credit history and ability to perform the work. If a subcontractor passes scrutiny, it is bonded, and the surety assumes the risk of the subcontractor defaulting.
SDI, conversely, only involves two parties—the insurer and the insured general contractor. The general contractor purchases SDI to insure the performance of its subcontractors. Contractors typically purchase one SDI policy and enroll all of their subcontractors under that policy.
SDI policies do not provide a guarantee of performance or payment. Rather, in the event that an enrolled subcontractor defaults on its obligations, the insurer directly indemnifies the contractor for costs related to the subcontractor’s default. Typically, the general contractor must absorb some of the costs associated with resolving the subcontractor’s default, often up to the deductible amount.
One of the reasons contractors may prefer SDI to bonds is because, with SDI, the claims process is faster and more reliable. Whereas with bonds, if a subcontractor defaults, the contractor has to wait for the surety to investigate the claim, which can create frustrating delays on time-sensitive projects.
Benefits of SDI for General Contractors
SDI can provide a number of important benefits to general contractors. The following is an overview of what SDI can bring to the table:
- Coverage limits—Unlike surety bonding where coverage is limited to the penal sum of the bond, SDI coverage is not tied to the value of the subcontract. SDI coverage extends to the limits of the policy, which can be as high as $50 million. Accordingly, in instances where the cost to remedy a subcontractor default is more than the penal value of a bond, there would be greater protection for the general contractor under SDI.
- Consistency—As previously mentioned, bonds are a three-party agreement. Using bonds, general contractors are left having to manage agreements across multiple sureties and projects. SDI replaces this complicated system with one policy and one set of terms and conditions. As a result, SDI reduces administrative costs, improves the effectiveness of a response to a default and enhances the efficiency of the claims process.
- Broader coverage—In addition to direct costs, SDI includes coverage for indirect expenses. This can include things like liquidated damages, acceleration of other subcontracts and extended overhead. With SDI, a contractor’s loss is not capped by a bond, and default insurance typically has higher limits.
- Control—SDI policies allow general contractors to control which subcontractors are enrolled under the policy. Policies also permit general contractors to exercise judgment on how to remedy a subcontractor’s default. Contractors that are suitable for an SDI program will often have a well-developed process to screen unqualified subcontractors and suppliers.
Finding the Right Fit
SDI can provide a sound alternative to performance bonds for general contractors in many settings. Large general contractors that possess the resources to properly vet subcontractors’ qualifications can benefit from the cost savings generated by SDI.
It is important for all general contractors to remember that both performance bonds and SDI have their place in the construction industry and each services a different purpose. Be sure to contact your Borden Perlman representative to discuss which product best fits the needs of your next project.