What is the better option to manage subcontractor risks?
Getting subcontractors adds a new dimension to a construction project. Construction companies, whether large or small that can mitigate subcontractor risks are far safer and more secure. Contractors that do not manage risks are often vulnerable to subcontractor defaults. As a contractor, you owe it to yourself to get security and comply with state statutes to benefit not only you, but also your subcontractors, suppliers, and other laborers working on the awarded construction project.
In managing subcontractor risks, subcontractors have the option of posting a Surety Bond or obtaining a Subcontractor Default Insurance (SDI).
What is the difference between Subcontractor Bond and SDI?
A surety bond involves three parties where the Obligee requires the bond to guarantee the performance of the Principal through a Surety. Surety bonds are available in many different types. But they are mostly used for construction. Under the construction surety bonds line-up, Subcontractor Performance, and Payment Bonds are utilized on construction projects.
Subcontractor Bonds protect the contractor where it ensures the subcontractor performs their contract obligations. These bonds also serve as payment risk to the subcontractor’s suppliers (and any second-tier subcontractors).
Subcontractor Default Insurance
The Zurich American Insurance Company developed the original SDI product (SubGuard®) in 1996 as a way to respond to subcontractor defaults. The SDI is a two-party agreement between a contractor and an insurer. The insurer offers the contractor catastrophic insurance coverage for the cost of subcontractor and supplier defaults. The policies of SDI cover high deductibles, co-payment layers, and submission of proper documentation.
Unlike Subcontractor Bonds, SDI does not provide the same level of protection.
Here is a comparison between the two options:
- Regulated by the State Department of Insurance
- Three-party (Obligee – state agency/project owner, Principal – contractor, Surety – bond provider)
- The premium rate depends on the calculated risks and probabilities. There is also a fee for prequalification services based on the contractor’s three C’s of bonding
- Coverage limited to the penal sum
- Use of standard bond forms (from Surety or obtained through the project owner)
- With claims, the Surety has to pay the amount as agreed in the contract, and the contractor will reimburse that amount to the Surety
Subcontractor Default Insurance
- Two-party (Contractor and Insurer)
- The premium rate determines calculated risks and probabilities
- Coverage not restricted to the subcontract value
- Insurance company form
- With claims, there is no right to the insured’s assets, but companies can pursue subrogation against a third party
The purpose of Surety Bonds and SDIs
A Surety Bond serves two key purposes: prequalification and payment risk transfer. Surety underwriters perform a comprehensive review of the financial capacity of a subcontractor. Looking exhaustively at the financial documents is part of the prequalification process to ensure that the subcontractor has the financial capacity to perform its contractual obligations. In addition to the prequalification process, subcontractor bonds offer protection in case subcontractors are incapable of performing the job.
A Subcontractor Insurance Default provides the contractor with greater flexibility and control in managing subcontractor defaults. SDIs cover risk management insurance policies that allow the contractor to maintain variable degrees of risk – from risk transfer to risk retention.
Three main factors differentiate surety bonds from SDI: prequalification process, payment protection, and claims.
Under surety bonds, the prequalification process is the primary protection against financial losses and defaults. The Surety will avoid subcontractor risks by issuing bonds only to contractors whom they believe are qualified to perform the job.
The Surety will take into account the three C’s of bonding: the subcontractor’s capital, capacity, and character. The Surety evaluates a subcontractor’s financial statements, reviews a subcontractor’s experience, and gauges the subcontractor’s organizational qualities and even equipment.
Furthermore, underwriting will be a continuing process for the surety, and that it often develops long-standing relationships between subcontractors and their sureties. A Surety company that has established a relationship with a subcontractor will be more willing to issue bonding credit on a project.
Subcontractor Default Insurance
Under an SDI program, a subcontractor must submit to a contractor’s prequalification process before signing up for an SDI program. The process may entail the subcontractor disclosing critical information that can be damaging to the subcontractor’s reputation or unfavorably impact its competitive standing.
Subcontractors and suppliers have garnered mixed responses to SDI. Enrollment in an SDI may not require personal indemnity nor tap into their available bonding capacity. However, with SDI, the subcontractor, supplier, and other second-tier subcontractors lack payment protection from the insurer and have lesser protection against unjustified default claims.
A Subcontractor Payment Bond offers 100% security to second-tier subcontractors because it covers the subcontractor’s payment obligations. This bond also protects the project owner (Principal) and lead contractor from risks related to non-payment.
While possible cost savings is a significant contractor incentive influencing SDI’s use (Bausman 2009), its policy lacks substantial payment protection for second-tier subcontractors or suppliers. Enrolled SDI subcontractors will have no recourse against the program if the general contractor refuses to pay or becomes bankrupt.
Sureties have experienced risk management personnel that can respond to claims made against the bond and provide assistance to remedy subcontractor default (Nelson 2007a). Also, the Surety performs an independent investigation and collects proof to determine if a subcontractor is really in default.
When a subcontractor happens to default, the Surety will take full commitment in dealing with unpaid second-tier subcontractors, suppliers, creditors, and sees the contract to completion (this is the guarantee of the Subcontractor Payment Bond).
In the event of default, with SDI the contractor does not need to wait for a surety’s investigation before a response. It can take immediate action to implement a remedy it deems appropriate to resolve the default (McIntyre 2007).
SDI places the responsibility on the contractor to address issues regarding subcontractor default. Somehow, this method sidetracks the focus of the contractor from completing the project. SDI only allows monetary compensation to the insured – not services or support – when the subcontractor defaults.
The purpose of this comparison between Subcontractor Surety Bonds and Subcontractor Default Insurance is to make explicit the processes, risks, and benefits to everyone involved in a construction project. On a closer assessment of both options, getting bonded is the better option in managing subcontractor risks and promising payment (since SDI lacks payment protection). Also, Zurich American Insurance Company is the sole insurer that provides SDI, so there is some concern about the continuity and viability of the product. Most contractors perceive, however, that even if Zurich stopped offering SDI, they would continue their subcontractor prequalification process. Besides, a subcontractor’s bondability is a preferred prerequisite for enrollment in SDI.