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Subcontractor default presents a high level of risk for contractors. With a recent rise in default due to the industry’s financial downturn and increasing claims of insolvency, as a contractor, you must understand how to adequately protect yourself. An alternative to steer you clear of this monetary pitfall is subcontractor default insurance, commonly referred to as SDI.
Like surety bonds, SDI is an indemnification policy wherein you purchase insurance to protect yourself in the event a subcontractor fails to complete a project timely and effectively, and plunges into default.
What began more than two decades ago as an alternative to purchasing performance bonds has subtly emerged into a contending insurance policy. Through an SDI program, a two-way relationship is developed between you and your subcontractor. You purchase an SDI policy and then monitor your subcontractor’s prequalification process to help you better “insure” the performance of your subcontractor. If a default occurs, you must demonstrate payments have been made to complete a contract beyond the remaining subcontractor balance as of the date of default. After a proof-of-loss claim is verified, the policy calls for a reimbursement of lost funds from a contract defaulted on within 30 days. It’s important to note that only a policy enacted during the subcontractor’s enrollment can address the claim.
Unless bonded, all contractors and subcontractors can be covered under an SDI program. Due to the flexibility in managing this insurance program, you can bond subcontractors who are considered risky. Subcontractors working on more hazardous projects such as water intrusion, roofing and window installations, or pose the potential to draw out the default claims process, often pose higher risk. Limitations to SDI coverage do apply and are determined by two outweighing factors:
Direct costs, indirect costs and actual costs of completing the contract are all covered under an SDI claim. However, excluded from all SDI policies are defaults incurred before the start of the policy, or fraud, misrepresentation and losses acquired from the insured providing professional services. In addition, any inducement of bodily harm as a result of the project under the contractual agreement is not covered.
The longstanding popularity of surety bonds has cast a shadow over the rise of SDIs, but perhaps it is time to stop overlooking them. SDIs are fairly new compared to surety bonds. They were developed nearly 20 years ago to withstand the shortcomings of surety bonds – primarily, their lack of contractor control in the default process. Unlike surety bonds, an SDI is implemented and managed by the insured contractor only. With a bond, the surety serves as the regulator of the bonding process. Once a contractor requires bonding, a subcontractor must undergo a rigorous screening process through a surety. This procedure involves an assessment of a subcontractor’s credit history, financial strength and work performance. This same process is applicable to an SDI, but you have the control of tailoring the regulatory process to your liking. Having one party fewer to monitor the insurance process, costs are cut as well. An SDI can cost up to 50 percent less than a surety bond.
There are few SDI policies to choose from on the market. Currently, about 150 contractors are enrolled in an SDI policy. Programs are generally geared toward contractors with a subcontractor volume of $75 million and offer policy limits ranging from $25 million to $50 million per loss up to $150 million in the aggregate.
Each program has premiums, deductibles and co-pays. There are two components of standard premiums under SDI policies, which are tax deductible, including:
1. Risk-transfer premiums go to the carrier for covering the risk transfer cost for losses above the deductible.
2. Loss fund/retrospective premiums are paid to the insurer to pre-fund losses under the deductible layer. This is similar to the premium process in a retrospective rated workers’ compensation policy. In this premium however, the worker does not retain these funds if a default does not occur during the policy term.
Self-insuring some of the risk associated with subcontractors defaulting, you must satisfy a certain amount of deductibles and co-pays. SDI deductibles are primarily adjusted by terms and conditions desired and the risk profile size of the contract company. Ranging anywhere from $250,000 to $1 million, they can be purchased aggregately in the event of multiple claims. However, you are obligated to make co-pays that amount to a percentage of each loss in a default for values in excess of the deductible.
After a predetermined value is met on a claim, you are required to pay 100 percent of the remainder. Ultimately, by selecting a higher co-pay, the premium on the plan will be reduced.
Taking measures to ensure effective management of your plan is essential to the policy’s success. If you’re enrolled in a bonding policy, you may already have procedures in place that can be applied to implementing an effective SDI plan. However, a few adjustments and modifications to the prequalification process would be needed, including:
As a contractor, SDI appears to provide advantage over surety bonds, giving you complete control of who is selected under your insurance program and when a subcontractor is determined in default. The prequalification process can be modified at any time to your liking without reliance on a surety to define stipulations within the policy. There are many other benefits to note:
But as SDI has its perks, it is accompanied with a few drawbacks, including:
With subcontractors at complete will of the contractor’s requirements to become insured, many are weary of the contractor’s aptitude to monitor such an extensive process because:
Although SDI policies provide you with more control in comparison to surety bonds, many national trade organizations such as the American Subcontractors Association oppose SDI. They argue that sureties, not contractors, are most adept at regulating the insurance policy coverage and default process.
In knowing the advantages and disadvantages of SDI, you can make an educated decision on whether using this insurance is suitable for your specific needs.
Whether SDI is the best choice, knowing how to protect against default will help prevent harsher financial consequences in the future.
Doeren Mayhew’s Troy, Houston and Ft. Lauderdale CPAs specialize in the construction industry, offering traditional CPA services as well as assistance with cash flow management, labor/subcontractor issues, industry benchmarking and more. For more information, contact us.
This publication is distributed for informational purposes only, with the understanding that Doeren Mayhew is not rendering legal, accounting, or other professional opinions on specific facts for matters, and, accordingly, assumes no liability whatsoever in connection with its use. Should the reader have any questions regarding any of the news articles, it is recommended that a Doeren Mayhew representative be contacted.
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