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.
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.
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 Consolidated Insurance + Risk Management representative to discuss which product best fits the needs of your next project.