D’Arcy Vicknair founding partner, Andrew Vicknair, recently authored a blog for the American Bar Association and posted on The Dispute Resolver: Subcontractor Default Insurance (“SDI”): What Is It?
While general contractors are planning for successful completion of their projects, they unfortunately must also account for risks associated with subcontractor defaults. General contractors have to understand their options for minimizing losses arising from subcontractor defaults and must take proper steps to protect their interests and ensure project completion. General contractors primarily minimize loss through contracts, bonding, and insurance. While there are many ways to manage and protect against the risk of loss from subcontractors, Subcontractor Default Insurance (“SDI”) is one product that can help.
A. Subcontractor Bonds
At the outset, it is important to note that SDI is not a bond. A subcontractor performance bond is a surety bond required by general contractors for subcontractors to guarantee their performance on a project. It is a three-party relationship between the principal, the surety, and the obligee. The principal (the subcontractor) purchases a bond for a project. The surety provides the bond and assures that the principal will perform. The obligee (the general contractor) is the party protected by the bond. If the subcontractor/principal defaults, the surety will generally step in and complete the work that the subcontractor failed to perform. Unlike insurance, a bond requires a subcontractor that obtains a bond to execute an indemnity agreement with the surety guaranteeing that any losses or expenses incurred by the surety will be reimbursed by the subcontractor.
B. Subcontractor Default Insurance
Unlike a bond, an SDI policy is an insurance policy that generally provides insurance coverage for economic loss incurred by a general contractor due to a subcontractor’s default. In general, it is not for smaller general contractors as it usually only sold to larger general contractors with annual sales in excess of $50 million. General contractors usually purchase SDI as an alternative to surety bonds and use SDI to assist in managing its subcontractors by providing financial protection against the risk of subcontractor default.
It is used to protect general contractors from subcontractors that default on subcontracts because they cannot finish a project, they go out of business, or their work is defective and must be redone. SDI is first party insurance whereby the general contractor is the insured. And unlike bonds, SDI is a two party agreement between the general contractor and the insurer. Under an SDI policy, the insurance company pays the general contractor for the losses incurred due to the subcontractor default.
SDI does not provide “first dollar” coverage for such losses. Instead, it is a type of self-insurance with coverage for catastrophic losses. SDI policy terms may be negotiated by larger general contractors and therefore, the coverages may vary among the different companies writing such policies. SDI policy deductibles and limits also vary based on the general contractor and what amount of risk the general contractor is willing to take. While SDI deductibles vary, it is not uncommon for SDI deductibles to range from $350,000 to $2 million. In addition, most SDI policies require co-pays where the insurer and the general contractor may share up to the first $2 million in costs before the insurer will fully cover the GC’s costs. With these co-pays and deductibles, it is clear that SDI is not for small projects but only meant for larger projects.
Insurers that issue SDI policies also require general contractors to vet their subcontractors to ensure that they can complete their scopes of work and are financially sound. Often general contractors will be required to vet their subcontractors through a prequalification process to ensure the subcontractors’ ability to perform. But unlike bonds, the insurer does not prequalify the subcontractors. Rather, the general contractor is in control of the prequalification process. However, the SDI insurer may prequalify the general contractor’s prequalification process. During the prequalification process, general contractors should evaluate several factors including a subcontractor’s experience/project history, financial well-being, safety record, prior working relationships, and management team. Regardless of what factors are analyzed, a general contractor will have to prequalify its subcontractors as part of the process of obtaining an SDI policy.
SDI policies may run for a term of up to two years and generally cover all un-bonded subcontractors on a project. However, depending on the terms of the SDI policy, certain subcontractors may not be covered or there may be specific aggregate limits for certain subcontractors. An SDI policy will typically cover the expenses incurred by a general contractor in completing the defaulting subcontractor’s scope of work, the costs of correcting defective work, related professional costs, some related indirect costs such as acceleration costs, delay damages, and extended overhead costs incurred by the general contractor. In general, coverage does not end at the termination of the SDI policy period as the SDI policy generally applies through the earlier of the statute of repose or ten years.
The claims process under an SDI policy is much different than traditional surety bond claims. With surety bonds, after a claim is submitted, the surety investigates the claim and determines whether there is a subcontractor default. This is often very time consuming and can be expensive for a general contractor. However, when dealing with a claim under an SDI policy, the general contractor can remain in control of a project and does not have to wait for an investigation as a default is declared by the general contractor. An SDI policy is triggered by a subcontractor default pursuant to the terms of the subcontract. Often, the general contractor will have to prove a default when asserting a claim under the SDI policy. And the general contractor will have to provide the subcontractor with a notice of default pursuant to the terms of the subcontract.
One potential benefit of an SDI policy is that the general contractor can generally start remedying the default pursuant to the terms of the subcontract. However, the general contractor is not required to terminate the subcontractor to trigger coverage. If there is a subcontractor default, then the SDI insurer is obligated to indemnify the general contractor for losses within a set time period from the date the general contractor submits its proof of loss. However, if a default is later determined to be improper, the general contractor may be obligated to reimburse the insurer for costs paid.
While SDI insurance has its advantages, the high deductibles and required copayments can be substantial and expose the general contractor to financial loss. In addition, a general contractor purchasing SDI will have an increased responsibility from having to vet its subcontractor through a prequalification process and having to manage its subcontractors so that it will be able to accurately declare a subcontractor default.
SDI clearly has its benefits, but it may not be the right product for every general contractor. Regardless of whether a general contractor chooses to use bonds, SDI, or other solutions to assist in minimizing risks associated with subcontractors, general contractors must protect themselves from the potential loss associated with subcontractor defaults.