Construction is a risky business, with among the highest rates of failure of any industry. In recent years, inflation, supply chain issues, and labor shortages have only increased the likelihood of project delays, performance issues, and contractor default. While general contractors commonly use performance bonds to reduce the risk of default, a bond ultimately protects the property owner, not the GC. Subcontractor default insurance is one alternative to a surety bond that works to protect a contractor from the financial burden when one of their subcontractors defaults.
What is subcontractor default insurance?
Subcontractor default insurance (SDI), also called SubGuard, is an insurance policy that protects general contractors and property owners from financial risk when a subcontractor defaults on their contractual obligations. SDI helps general contractors cover the expenses that are incurred when a subcontractor fails to perform according to the terms of their agreement.
SDI is offered as an alternative to performance bonds. However, SDI policies are generally not provided on public projects. In addition, SubGuard does not provide protection against mechanics liens from unpaid second-tier subs and suppliers.
If a subcontractor defaults on a project, the general contractor can make a claim with the insurance company to cover costs above their deductible and any loss reserve requirements. Some GCs pass the cost of the loss reserve onto the project owner and claim that amount as additional profit on the project.
To be covered under an SDI policy, a subcontractor must be prequalified by the GC. This is done by reviewing financial statements and requesting a letter of bondability from the subcontractor’s surety company.
Zürich Insurance began providing SDI coverage in the 1990’s, but more companies are now offering this coverage. Zürich’s program required contractors to have $200 million in subcontractor work to cover. This prevented small contractors from applying for coverage.
How SubGuard insurance works
Let’s take a look at an example of how SDI might provide coverage on a project:
ABC Builders is the general contractor building a large office complex and they have an SDI policy covering all their projects. LA Plumbing is providing plumbing work on the project, and their subcontract is worth $2 million.
Halfway through the project, LA Plumbing has significant cash flow problems and they can no longer pay their vendors or employees. Because of this, workers walk off the project, bringing the plumbing work to a halt.
ABC Builders recognizes this action as a subcontractor default, so they start a claim with their insurance company under the SDI policy. To replace the original subcontractor, ABC Builders hires Water Works to finish the project at a cost of $1.2 million. ABC has a $750,000 deductible on the SDI policy, so the total claim payout is $450,000 ($1.2 million – $750,000).
The insurance company reimburses ABC Builders for the claim amount. The $750,000 deductible is shown as a loss on the project.
The cost of an SDI policy is based on the volume of work that will be covered. For example, Zürich insurance has a minimum of $200 million in subcontractor contracts that must be covered under their policy.
Ty Moffett, Bond Department Manager at A.G. Sadowski Company, says that this minimum puts SDI coverage out of reach for most contractors. “It’s not available to small contractors at all,” he says. “Even a lot of contractors you would consider to be quite large don’t make the grade.”
Generally, SDI carries a flat rate for the insurance policy plus a loss reserve, which is an estimate of the cost of future claims. Some carriers allow a policy to be active on select projects, while others require all projects to be covered.
The cost of SDI coverage can be passed on to the owner, but you have to sell them on it first. Some contractors may try to pass on the premium for the insurance and the loss reserve as an owner expense.
Moffett sees this as a bit unfair, as it’s passing along a cost that may not actually be incurred. “That’s how it’s marketed,” Moffett says. “Include X amount of additional profit in your bid.”
- Premiums may be less than the cost of a performance bond.
- Broader coverage than a performance bond, allowing the general contractor to determine when a subcontractor is in default.
- Requires general contractors to prequalify their subcontractors, which can lead to the selection of higher quality subs, who are less likely to default.
- Provides a faster payout than a bond since there is no investigation by the insurance company.
- General contractors get to decide when a subcontractor is in default and when to file a claim.
- There is a large deductible ($350,000-$2 million) under most SDI policies, leaving the general contractor at financial risk.
- Due to the large deductible, smaller contractors are unlikely to be able to afford SDI coverage.
- General contractors may not be able to pass the cost of the insurance on to project owners.
- For subcontractors, the GC gets to determine when you are in default.
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Subcontractor default insurance vs surety bonds
Insurance companies commonly pitch SDI as an alternative to a performance bond. After all, both kick in and resolve costly disputes in the event a subcontractor defaults on their contractual obligations. However, subcontractor default insurance and surety bonds operate in very different ways. It is important that contractors understand the difference between SubGuard and a surety bond.
Parties to the policy
A surety bond has three parties involved: the obligee, the principal, and the surety. An SDI insurance policy, on the other hand, only involves two parties: the insurer and the insured.
Who it protects
A performance bond protects the project owner or obligee, who has the power to file a claim when a contractor defaults on the project. SDI protects only the general contractor – the insured. The property owner cannot make a claim against a GC’s SubGuard policy.
Who pays for claims
If a surety pays a performance bond claim, the principal (usually the general contractor) must pay back any amount paid out with the claim. With SDI, the GC is responsible for the premium as well as a deductible and loss reserve, if any. However, the GC does not have to reimburse the insurer for the amount paid with the claim.
Defective subcontractor performance can trigger a performance bond claim, whether or not it caused additional damage. For example, if a sub installs a window incorrectly, and the GC spots it before any damage occurs, a performance bond claim can cover the expense to remove it and reinstall it correctly.
If a window is installed incorrectly and water damage occurs, a performance bond will typically cover both the correct installation of the window and the repair of the water damage.
An SDI policy generally only covers damage caused by defective performance. So, in the example above, SDI would cover damage repairs and the expense to reinstall the window correctly. If no damage had occurred, it would not cover the cost to reinstall the window correctly.
Other alternatives to SDI
Project loss insurance is a fairly new type of insurance provided by Travelers Insurance that covers all project losses, no matter the cause. This type of policy may provide a way for smaller contractors to protect themselves against contractor default.
To find out if SDI or project loss insurance would be beneficial to your company, contact your insurance agent. They can best determine the type of coverage you need depending on your circumstances.
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