Lanak & Hanna
What is Subcontractor Default Insurance (“SDI”)?
SDI compensates the general contractor in charge of the project for both direct and indirect expenses which have been incurred as a result of default in the performance by a subcontractor. Although other surety companies have recently begun offering similar products, SDI is most commonly referred to as Subguard®, the policy developed by Zurich Surety. While these policies are sometimes advertised as a better alternative to the traditional, age-old bonding of projects, are they really a viable alternative?
Is SDI Really a Cheaper Alternative for Contractors?
Like other insurance policies, the general contractor purchases a SDI policy for a set dollar amount of policy limits during a set period of time. Although the premiums are generally lower than premiums for payment and performance bonds, there are other costs associated with these policies. The carrier and the general contractor must agree upon the deductible the contractor must pay out before the policy will cover claims. Notably, these deductibles are large, generally between $250,000 and $500,000 per claim. In addition to this deductible there is also a co-pay (a percentage of each dollar after the deductible is met that will be paid out by the contractor). Co-pay is paid up to the “Retention Aggregate”. The Retention Aggregate is normally three to five times the deductible and is the maximum amount the insured contractor will have to pay for a claim arising during the policy period. While on its face the insurance policy may be “cheaper”, in the event a default does occur, contractors face large out-of-pocket liability.
Does the Contractor Benefit from Increased Control?
Rather than individual policies for each subcontractor, SDI policies generally cover all subcontractors, and the contractor decides which entities are qualified to perform work on the project. It is the task of the general contractor to qualify its subcontractors to determine who poses the least risk of default. This qualification process is determined by the general contractor rather than the surety.
One of the attractive aspects for contractors is that default may be declared and the general contractor may immediately respond rather than wait for investigation by the surety—which takes time and may further delay the project. Once a general contractor determines a subcontractor is in default they are able to trigger potential coverage under the SDI policy (although the insurer will not begin paying until the contractor meets its deductible). Because the general contractor bears the responsibility for prequalifying the subcontractors, this generally requires substantial time and effort on the part of the general contractor. Similarly, the general contractor pays the up-front costs of replacing the defaulting subcontractor and later seeks reimbursement for those costs from the carrier. Due to the requirement of this up-front cash expenditure and the resources required to investigate and vet subcontractors, SDI policies are typically used only by larger general contractors with significant resources. By and large, SDI seems to work best for large contractors that subcontract more than $100 million of work a year due to the design of the deductible and the policy limits offered. For smaller general contractors, the investment does not make sense. For this reason alone, SDI is not a viable replacement for payment and performance bonds on projects.
Is SDI is a Viable Alternative to Subcontractor Performance Bonds?
In short, no. In the event the general contractor declares a default it is the contractor and the contractor alone who can make a claim on the SDI policy. Unlike the performance bond, the owner has no right to make a claim. The insurer is responsible for paying the claim within 30 days of receipt of evidence that the general contractor has already paid out its deductible. Until that time, the insurer bears no responsibility for making any payment or taking any action whatsoever. Practically speaking, if the contractor cannot meet its deductible and files for bankruptcy, the owner (as well as subcontractors and suppliers) will be left no recourse against the insurer. This not only leaves the owner with an incomplete project but also potentially with liens that will only be removed through payment directly to the claimants (for work which the owner may have already paid the contractor for).
BOTTOM LINE: Clearly, comparing SDI and bonding is like comparing apples to oranges. SDI does not present a viable alternative to bonding on projects and does not guarantee performance or payment of the subcontractor. In fact, SDI leaves owners and subcontractors, vendors and suppliers unprotected as the contractor is the only party with a right to make a claim on the policy.