Don't Take the Loss for a Subcontractor's Default

General contractors for big-budget construction projects look for ways to manage risks, including the possibility that subcontractors won't perform the work they were hired to do.

Generally, that has meant shifting the performance risk to some guarantee form such as a surety bond. But there might be an alternative for risk transference: subcontractor default insurance (SDI).

There are some major differences between a surety bond and SDI:

1. Coverage. With a surety bond, each subcontractor provides a bond. That means your company has as many bonds to deal with as subcontractors and each bond has its own coverage terms. Subcontractor default insurance can provide uniformity of coverage because it involves just one policy that covers all subcontractors. In addition, SDI coverage can continue for as long as 10 years after the project is completed. Surety bonds often expire as early as one or two years after completion.

2. Claim resolution. If a subcontractor defaults under SDI, your company and its insurer can immediately take steps to remedy the situation. With a surety bond, the bond company must investigate the situation and determine a remedy, essentially acting as a mediator between your firm and the subcontractor. This can result in project delays and cost overruns.

3. Costs. Surety bonds represent a fixed cost, while SDI is an insurance product with deductibles and co-payments. That means a company assumes a portion of the risk. SDI also includes a retrospective rating component, so if there are no defaults, the insurer will return a portion of the premium amount.

4. Prequalification. A significant drawback of SDI is that, unlike surety bond companies, insurers don't offer prequalification services. It is the insured company's responsibility to determine a subcontractor's suitability to perform and manage the completion of the work. (See below for the elements involved in a typical prequalification.)

SDI policies have some coverage limitations and under certain conditions, the carrier could charge a 15% administrative cost for losses charged against the initial premium.

Additionally, your company may not be able to use subcontractor default insurance for public projects because it may not meet the requirements of the federal Miller Act and state public bond statutes.

When considering SDI, consult with your accountant or insurance broker to review the alternatives for managing subcontractor risks and find the most effective program for your business.