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Subcontractor Default Insurance...Demystified!

Nov 2, 2015 6:30:00 AM

Subcontractor Default InsuranceWhat is it? Can you use it? Why would you want to use it or not? If you are a subcontractor, do you want to be in an SDI program? So many questions…

Most people know subcontractor default insurance (SDI) by its most notable brand name, Subguard. Subguard is actually Zurich’s offering of SDI. There are only a handful of insurers out there that offer SDI, and Zurich is the leading carrier.

Subcontractor default insurance is a tool some general contractors or at-risk construction managers can use to mitigate the risk of default of their subcontractors. It is a potential alternative to surety bonds, but rather than being a guarantee like a bond, it is an insurance product. Its application is limited.

In this situation, a surety bond is a three party agreement between the general contractor, subcontractor, and surety. The surety guarantees the performance of the subcontractor and guarantees the payment of lower tier subcontractors and suppliers. A bond provides first dollar coverage to the general contractor for a default.

Alternately, SDI is only a two party agreement – it is between the contractor and the insurer. SDI does not provide any guarantee of performance or payment. Rather, in the event of a default by an enrolled subcontractor or supplier, the SDI insurer provides a high-deductible insurance policy to reimburse the contractor for costs resulting relating to the default of the subcontractors or supplier. The general contractor must absorb some of the costs associated with rectifying the default -– up to the high-deductible dollar amount. The deductible is negotiable, but ranges from several hundred thousand dollars up to several million dollars per loss.

SDI can potentially provide a cost savings to the general contractor vs. bonding subcontractors. It also is deemed to provide the general contractor more control in the event of a default of a subcontractor. Any savings generated is contingent on the general contractor’s ability to adequately prequalify and manage its subcontractors, and in the event of a default, to minimize the cost of rectifying that default, due to having to share in the cost via the high-deductible.

Every situation is unique, but the perception is that sureties don’t move quickly in the event of a default. SDI is deemed to provide the general contractor the ability to react quickly to correct a situation and keep the project on track. In a surety bond default, the general contractor risks being in breach of the surety bond agreement if they unilaterally act, even if the general contractor deems its actions to be in the best interest of the project.

For SDI to be cost effective the carriers say the general contractor or construction manager (CM) needs annual subcontracted values in excess of $75 million. This is due to the deductible designs and policy limits offered. That itself eliminates many contractors. A general contractor can implement SDI on a per project basis or on a global basis. The general contractor/CM needs to have a relatively sophisticated management and accounting team, a high risk tolerance due to the inherent risk associated with basically self-funding a portion of losses, and has to be financially strong (in order to absorb the high deductibles). Due to sharing/self-funding a portion of the costs of a subcontractor default, SDI does provide a financial incentive to improve a general contractor’s subcontractor prequalification process.

There are some concerns for a subcontractor participating in an SDI program or the sub of a subcontractor that is enrolled. Several of these include the loss of a competitive advantage in having a great bond rate and/or program; lack of payment protection to sub-subcontractors/suppliers; and potential unwarranted default.

As a contractor with subcontractors, you have risk associated with the potential non-performance of your subcontractors or your subcontractors not paying their subs and suppliers. Regardless of the size of your organization, proactively managing these risks is critical. Prequalification of these companies (both their capabilities and their financial strength) should be done regardless of what other tools are used to mitigate these risks. Whether you are a prime contractor with subs, or a subcontractor, be mindful of contract terms, in particular the definition of default. Know your options for mitigating your risk and involve your risk advisors and surety professional in the conversation.


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Bill Cerney

Written by Bill Cerney

Bill is a principal at Gibson. He is an integral member of the construction team and the surety practice leader. In addition to elements of insurance and risk management, he is responsible for overseeing in-house analysis and financial statement underwriting, working with staff and clients on bid requirements and specification analysis, and meeting with clients' accountants and surety representatives. His construction-specific knowledge and expertise compliment Gibson’s strong construction team and bolsters the ability to bring value to all types and sizes of contractors.

Prior to joining Gibson in 2012, Bill worked for over 14 years in public and private accounting, gaining experience in performing and managing assurance, tax, and management and owner consulting services. In addition to the compliance areas of assurance and taxation, he has experience with job cost validation, process consulting, internal control strength and weakness identification, succession planning, incentive compensation plans, contract administration, construction accounting systems, state pre-qualification reporting, employee stock ownership plans, and various types of employee benefit plans. Read Bill's Full Bio