Protecting Against Subcontractor Default

Since the creation of Subcontractor Default Insurance (SDI) in 1995, contractors have developed many informed and uninformed perspectives about this insurance product and how it functions. Much of the information has been speculative or conceptual in nature as a result of the product’s proprietary status and its unique positioning between the insurance and surety industries. Multiple insurance carriers now widely use and offer SDI as a risk management tool to secure subcontractor performance. While many of the misconceptions and misunderstandings have been minimized, some remain in place.

Misconception 1: SDI is too new to have been tested.

Although SDI has been in existence for more than 18 years, some still perceive it to be a new and untested product. While SDI is a newer product than surety, many large general contractors in the U.S. and Canada have used it. SDI insurers have handled thousands of claims and enrolled billions of subcontractor values. The policy remains largely untested in the courts, but this points to policy language that is performing as it was intended. Because subcontractor defaults make it difficult to finish projects on time and on budget, both the arbitration provision and claim-handling processes are designed to expedite resolution to mitigate as much delay and cost escalation as possible. All case precedents that have been set in case law for litigation among subcontractors, general contractors and owners/developers remain intact. Each of these parties is able to assert their legal rights in all venues available based on the contracts they sign, regardless of the use of SDI.

Misconception 2: The SDI insurer helps determine default.

One of the founding SDI premises was to base the coverage on the contracts in place between the subcontractor and general contractor as well as between the general contractor and a project owner/developer. Many have assumed that SDI and, consequently, the insurer make judgments as to a subcontractor default and take action unilaterally. This is not the case; the decision to default a subcontractor is made by the general contractor alone, based on the underlying contract. The SDI insurer might not have rights beyond the scope of that contract, and the subcontractors’ rights under their subcontract are not changed. 

The subcontract clearly spells out the scope of what constitutes a default. The fact that the policy provides broader coverage to the general contractor does not mean the general contractor can look to the subcontractor to recover costs that were outside the scope of the subcontract. An SDI claim does not end with the general contractor’s determination. Should a court later determine that a subcontractor was improperly defaulted, not only could the general contractor be subject to pay damages, but the general contractor would also be required to repay the insurer for any funds advanced for the claim, since the court determined the subcontractor default never occurred.

Misconception 3: Claims can be denied by the insurer.

The evaluation process conducted by an SDI insurer at the time a policy is written is time-intensive and requires demonstration by the general contractor that they adequately prequalify and manage their subcontractors. As a result, some may assume that if the general contractor fails to abide by their own established procedures, the SDI insurer could deny subsequent claims. No policy language allows for such a denial. The SDI insurers place their trust in the general contractor and, as a result, they provide coverage for all covered subcontracts until policy expiration, termination or cancellation. Once a subcontract is determined to be covered, the coverage is not extinguished, excluded or changed if the policy expires, terminates or is cancelled. You would face the same situation with a surety who honors bonds already issued but declines to issue future bonds to a contractor. 

The SDI and surety offerings have many similarities, though a typical assumption is that a surety excels at analyzing financial exposures, while contractors are best suited to evaluate operational exposures. This makes sense given the nature and background of each group, but as SDI has developed into a widespread risk management tool, general contractors have bolstered their prequalification efforts to use many of the surety evaluation techniques. Many general contractors have developed in-house teams with finance and accounting backgrounds, in some instances hiring individuals from the surety industry. The SDI insurer evaluates the general contractor’s prequalification and subcontractor management capabilities. Surprising to some, SDI insurers do not typically conduct their own prequalification of subcontractors, as they allow the general contractor to run the program once a program is in place.

Misconception 4: SDI coverage benefits only the general contractor.

SDI coverage is a first-party indemnity policy and is intended to cover losses incurred by the insured general contractor. This dynamic leads some to assume the value of the product ends at the general contractor level. However, SDI provides multiple benefits for an owner/developer as well as applicable lending institutions. Since SDI insurers conduct intensive due diligence on the general contractor and often provide recommendations to bolster subcontractor selection and management capabilities, the product can improve the overall risk for the construction industry. 

SDI claim trends have confirmed inadequate prequalification, as the primary result of loss has decreased dramatically since the product’s creation. As all owners, developers and lenders can agree, the primary goal of every construction project is to be on-time and on-budget. The SDI policies have time frames to complete payment for documented claims within 30 days, so upstream parties can be assured that the general contractor is protected against large cash flow and schedule disruptions from its supply chain. When requested by the general contractor, coverage is also available to upstream parties in cases when the general contractor becomes insolvent. The ability to file a claim and receive payment for loss incurred is extended to the scheduled entities identified and allows for consistent protection. While some misconceptions remain, today the SDI providers and those who use the product have a better understanding of how the product works and where it may be successfully applied. SDI is not for every contractor and every project, but it will continue to be a risk management tool that will evolve and become more ingrained in the construction industry in the future.