We often get asked about subcontractor default insurance (SDI) and how it compares to bonding. Some people just call it “Subguard”. Subguard is Zurich’s proprietary product that was first introduced to the market, and that many contractors are familiar with that term. However, many insurance companies have entered this product field over the years. SDI is a growing product and can be a valuable way for contractors to protect themselves. However, it may not be right or affordable for all contractors. It’s important for contractors to know what it is and how it may or may not provide the protection they are looking for. Because SDI is an insurance policy, each carrier will have its own policy languages, deductibles, etc. We will speak in general terms with the information available at the time of this writing. You can see examples of limits and deductibles for three SDI carriers in Exhibit A at the end of this article. We will also compare subcontractor default insurance against performance and payments bonds. First let’s take a quick look at the chart below:
Surety or Insurance
The first difference you will notice is the agreement. Surety is a three-party guarantee and more likely resembles credit than insurance. The subcontractor is the surety’s customer, not the GC. This is an important distinction. The surety bond underwriter must therefore be responsible for prequalifying the contractor. Surety bonds are written on the assumption of “no losses”. That means the underwriter assumes they are qualified both from a financial and capability standpoint before they will issue the bonds. It also means that the GC incurs no deductible or loss. Should a valid claim occur, the surety will have to remedy the situation and seek reimbursement from their contractor through the indemnity agreement. In other words, the surety bears all the direct cost risk but not all the indirect which we will discuss later.
Unlike surety bonds, SDI is an insurance product (it’s in the name after all). That’s not a bad thing but it does change the relationship. As an insurance product, it’s a two-party agreement between the general contractor and the insurance company. Like most other insurance products, the GC shares in the risk through deductibles and Co-Pays. As of this writing, most deductibles are $250,000 or greater but again this depends on the carrier (see Exhibit A at end of the article). This also makes the GC directly involved in prequalifying their subcontractors as a measure of loss control. This is an expensive step as the GC will either need to keep qualified professionals on staff or outsource this to a 3rd party.
Another important distinction we see in our chart is that SDI may or may not provide coverage for 2nd tier subs and suppliers. In other words, if the subcontractor’s sub or supplier makes a claim, there may not be coverage under an SDI policy. Contractors using SDI would be wise to purchase this coverage if available from the carrier.
We also see cancelability provisions. Contract surety bonds cannot be canceled once written. Therefore, the obligee is assured that protection is in place throughout the project. SDI mostly can’t be canceled. However, there are a couple of tricky caveats in there. As someone who has suffered loss from a contractor not paying their insurance premium, I can tell you it does happen and it’s not fun.
Now if you stop reading here, you may assume this is another one-sided article bashing SDI and that’s not the case. There is a reason that SDI is a growing product and replacing surety bonds in many cases. The biggest reason is the claims process. One obligation of surety bonds that protects their principals is the responsibility to investigate claims before paying them. Unfortunately, many bond forms use the phrase, “reasonable time.” The reality is that this can often be a long, time-consuming process. Surety companies often must send out consultants to go through the contract, paperwork and project information. “Reasonable” can be a few weeks or months. This can create significant delays for the GC and project owners, especially if the sub was a critical path sub. It can also increase indirect costs such as holding up other trades, additional overhead, delay damages, etc.
Some innovative sureties have come out with bond forms to speed up the process, such as giving only 30 days to investigate and respond.
On the flip side, SDI generally makes the claims process faster for the general contractor and why many of them like the product. The GC only must default the sub under a valid policy condition to make a claim and receive payment from the insurance carrier. This payment typically must be made within 30 days and the project can continue. This can be a significant and valuable benefit to the GC and Owner. There is also some opportunity for cost savings if the claims experience meets certain criteria. GCs can qualify for returned premiums with most carriers.
Subcontractor Default Insurance Only Protects the General Contractor
Subcontractor default insurance does have some flaws as well. First, it is not acceptable on projects with public money involved. The reason is that SDI only benefits the GC and not the project owner. If the GC gets in trouble, there is no protection to the owner against mechanics liens. Keep in mind that the GC can put up their own bond to the project owner and then use SDI as a measure of protecting themselves.
On private projects, if the GC does not put up a bond, there is no protection for the Subs and Suppliers on the project. Again, SDI protects the GC and subs and suppliers performing work for an unbonded GC should consider that payment risk and factor that into their bids.
Claims Activity and the Current Market Conditions
Another consideration is claims activity and how that will affect the future of both industries. Surety bond carriers generally make money when they keep losses below 40%. The industry is well below that currently and the market continues to be very “soft.”. The property and casualty insurance industry has been “soft” also, but SDI is one of the few exceptions. Losses regularly exceed 100%, which has driven up deductibles and led to tougher conditions. Reasons for high loss experience include the following:
- GCs are responsible for prequalifying contractors and those standards vary
- GCs are awarding contracts to subs with substantially lower prices than other bidders
- GCs are increasingly putting high-risk subs trades such as “glaziers” into SDI
- There is an incentive to overload sub by repeatedly using the same ones. This saves on prequal expenses and deductibles.
The entrance of new insurance carriers into SDI has helped keep costs down. Their experience in the market bears watching as that will determine the pricing and viability of the product for many contractors in the future.
Because of the “soft” surety market, we are seeing other trends that benefit the SDI market. One of these is adverse selection. To keep losses in their SDI program minimal, GCs are routinely asking for performance bonds and payment bonds from subcontractors considered “high risk” from a financial standpoint. These bonds are usually easily obtainable under current market conditions. However, if we see a “hardening” of the surety market, GCs may be incentivized to put these into SDI and risk further losses.
Another current issue for the surety industry is the free prequalification of subcontractors for SDI. Underwriting and prequalifying is expensive. We are seeing some GCs use the surety industry for this process. Most brokers and bond companies do not charge for bid bonds even though a contractor must go through underwriting to get one. As a result, some GCs are asking subcontractors for a bid bond and if they can obtain one, put them into SDI assuming they are a good risk. Should this practice continue to grow, some bond companies may decide to start charging for this bid bonds and shift the costs back to the GC.
Wrapping It All Up
We believe both surety bonds and subcontractor default insurance can serve a purpose and we don’t believe either product is going anywhere. We really think is important for contractors and owners protect themselves, their projects and their balance sheets. Both products are better than using nothing at all. Also, where you stand depends on your circumstances. Large GCs that can absorb the deductibles and premium should consider SDI. Smaller contractors likely can’t afford the risk and should bond their subcontractors and suppliers. On many projects, it makes sense for both. In these instances, the GC bonds to the Owner and uses SDI to protect themselves from Subcontractor default. At MG Surety Bonds, we are surety experts and want to help you protect your balance sheet so we can maximize your bond capacity. We are always standing by to provide you with the best advice for any situation. Contact us today.