Protecting Against Subcontractor Default

As a contractor, you count on subcontractors to execute on the construction contracts you enter into with property owners. That contract calls for the timely and complete performance of work. When you subcontract with various trades, you are placing trust that the subcontractors will timely perform their work. However, the potential for nonperformance, payment to lower tier subs/suppliers, and default is always there. In addition to carefully screening your contractors, it is imperative to protect your business against risks associated with these exposures. The two best resources available to protect you are subcontractor default insurance and surety bonds. The following information will help you decide which of these options works best for your circumstances.

Subcontractor Default Insurance (SDI)

SDI is just one of the many tools that can be used to mitigate the risk of default by subcontractors. It is a potential alternative to surety bonds, but rather than being a guarantee (like a bond), it is an insurance product.

An SDI is a simple insurance tool available to a general contractor for a determined amount of money over a specific period of time. This tool is commonly used by general contractors and construction managers to protect against risk. This two-party agreement between the contractor and insurer provides a high-deductible insurance policy that reimburses the contractor for costs resulting from default by a subcontractor or supplier. The deductible is negotiable, but can range from several hundred thousand dollars up to several million dollars per loss. This option is dependent on the general contractor’s ability to adequately prequalify and manage its subcontractors.

Surety Bonds

Surety bonds are three-party agreements between the general contractor, subcontractor, and surety. These bonds are a risk-transfer mechanism whereby the surety company assures the project owner that the contractor will perform in accordance with the contract specifications. A bond provides first-dollar coverage to the general contractor for nonperformance/default, and delivers the project free and clear of liens.

There are two types of contract bonds:

1. Subcontractor performance bonds – This option protects the contractor and owner in case of default, with the surety bond company’s promise to ensure the completion of the work.
2. Subcontractor payment bonds – This option is a project-specific agreement under which the surety guarantees payment for the labor and materials contracted and used by the subcontractor on the project.

So, what are the main differences between SDI and surety bonds?

1. Timing of claims: With a surety bond, once a general contractor makes a claim, the surety company has to conduct an investigation to verify the claim and ultimately decide if it is substantiated or falls under a breach of contract. With subcontractor default insurance, the general contractor is responsible for handling all aspects of a default situation. Once a default has been identified, a claim can be filed immediately. The SDI claim process can be more efficient.
2. Responsibility after a breach of contract: With a surety bond, the responsibility to fulfill the contract stipulations falls on the surety company. With SDI, the insurance company will pay out the agreed upon proceeds, and the contractor is ultimately responsible to fulfill the remaining contract stipulations.
3. Screening of subcontractors: With a surety bond, the responsibility of prequalifying subcontractors falls on the surety company. With subcontractor default insurance, this responsibility falls on the contractor.
4. Cost: The cost difference between a bond and an SDI policy is often debated. Contractors should contact their insurance brokers to explore both options and determine the cost of each.

While the success of each option will depend on the specific circumstances, both can serve a purpose and ultimately protect you in case of breach of contract. It is important to understand both options to proactively manage future risks.

For questions about these programs, or assistance with planning for your construction business, contact Colette Hounshell at 216-242-0819 or email Colette.