Subcontractor default insurance

Performance bonds or SDI: how they work and what’s the difference

The financial health and stability of subcontractors is a constant concern of general contractors. To protect against subcontractor default, contractors traditionally have relied on performance bonds. But with cost increases in the bond market and the time-consuming investigation that comes with subcontractor default, there has been interest in alternatives.

For the last 10 years, general contractors have had the option of purchasing Subcontractor Default Insurance, or SDI, as an alternative to performance bonds. The product also is called Subguard, the trademarked name given by Zurich U.S. Construction. While there is talk of other insurers offering their own version of SDI, Zurich remains the exclusive seller of the product.

The nature of SDI and bonds first must be understood to evaluate these benefits.

SDI vs. performance bonds
The fundamental difference between SDI and performance bonds comes in the relationships created by the two products. Bonds create a three-way relationship between the contractor (the obligee), the subcontractor (the principal) and a surety. When a construction contract requires bonding, the surety initially screens subcontractors through a rigorous review process. The surety analyzes such things as the subcontractor’s financial strength, credit history and ability to perform the work. Once the subcontractor is bonded, the surety assumes the risk of the subcontractor defaulting. If the subcontractor defaults, the surety is required to investigate the claim. If it accepts the claim, the surety may decide to finance the defaulted subcontractor in completing the work or pay the contractor the additional cost of hiring a replacement subcontractor. The surety, however, is in a potentially adversarial relationship with the contractor.

SDI, on the other hand, involves only the insurer and the insured contractor. The contractor purchases SDI to “insure” the performance of its subcontractors. Contractors generally purchase one policy and bring all of their subcontractors under that policy. The insurer then directly indemnifies the contractor for costs resulting from a subcontractor’s default. Some SDI products also indemnify for defective performance and liquidated damages.

Contractors may prefer SDI to bonds because insurers and brokers selling SDI say the claims process is faster and more reliable. With bonds, if a subcontractor defaults, the contractor has to wait for the surety to investigate the claim to determine its merit. This delay can frustrate a time-sensitive project.

In contrast, SDI allows contractors to fashion their own remedies without third-party intervention. The SDI insurer cannot deny coverage for a default by a subcontractor covered by the policy; rather, the insurer is obligated to reimburse the contractor for the remedy it has chosen.

But, with this control over the claims process comes additional contractor responsibility. Contractors, not the SDI insurer, have the initial burden of pre-qualifying subcontractors. In most cases, only large contractors have the administrative resources to pre-qualify and manage subcontractors. The advantage of this responsibility, though, is broader subcontractor coverage. Subcontractors that are too small or that do not have a track record to qualify for a surety bond still can be covered under SDI.

Cost-savings with critics
The major benefit claimed for SDI is cost-savings. SDI products can be priced as low as 50 percent of the cost of bond premiums, which generally are 1 percent to 1.25 percent of the subcontract value. The deductible for SDI, however, may prevent smaller contractors from taking advantage of the product. SDI deductibles usually are in the $500,000 range while performance bonds have no deductible.

Another key distinction is the extent of coverage that SDI provides — typically only a fraction of the value of all subcontracts. For example, a general contractor with $200 million in subcontract costs may have a policy limit of $20 million to $25 million. Bonds, on the other hand, are issued in the same value as the subcontracts.

SDI has its critics. Subcontractors strongly oppose the contractor screening process. Privately-held subcontractors are reluctant to disclose confidential financial information directly to the contractor. For this reason, the American Subcontractors Association opposes SDI. The Surety Association of America similarly argues that sureties, not contractors, are in a better position to determine a subcontractor’s financial stability.

Subcontractors also must consider that they are not protected by SDI. SDI only reimburses the contractor for the costs of a subcontractor default. The policy does not include payment bond-like provisions to ensure that subcontractors are paid.

Even so, as many as 80 contractors have purchased an SDI policy from Zurich. Large contractors such as Turner Corp., Hunt Construction and Perini Corp. are known to have utilized the product. SDI also has been particularly popular in the San Francisco Bay Area. SDI seems to work best for contractors that subcontract more than $100 million of work a year.

James Higgins is an associate in the San Francisco office of Thelen Reid Brown Raysman & Steiner LLP where he works in the firm’s Construction and Government Contracts Department. He can be reached at 415-369-7714 or at jhiggins@thelen.com. This article has been reprinted with permission from the May 22, 2006, edition of www.ConstructionWebLinks.com.

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