Subcontractor Default Insurance: Avoid Taking the Fault on Default

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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.

How SDIs Work for You

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.

Who and What is Covered By SDI?

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:

  1. The largest payment that can be made on single subcontractor default. This can occur over more than one project.
  2. The maximum total payment available over an entire SDI policy. This is known as the aggregate limit. Depending on which policy you choose, aggregate limits are as high as $150 million.

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.

SDI vs. Surety Bonds

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.

SDI: Cost Savings at a Small Price

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.

Implementing an Effective SDI Plan

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:

  • Do your homework. There are many technicalities involved in the default claim process that may be unfamiliar as you enter into this role for the first time. Understanding the process of implementing an SDI program and how it should be managed will be key to your success.
  • Identify and put in place the additional resources needed to manage the SDI program processes with ease.
  • Ensure your program has the proper steps in place to assess subcontractors and their associated risk before you enroll them in your SDI program.
  • Use the risk engineering assistance offered by SDI insurance companies in formulating the prequalification process.

Peaks and Pitfalls of SDI Insurance

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:

  • Faster default claim process: Many proponents of SDI favor the insurance option because the quick claims process in comparison to surety bonds. With a surety bond, you have to wait on the surety to investigate the credibility of a claim, rather than take measures into your own hands, whenever deemed necessary. Those who have a time-sensitive project may not feel comfortable waiting on a surety to lead the default process.
  • Less expense for smaller contractors: Smaller contractors can find relief in enrolling in a program that is less expensive while more flexible than a surety bond.
  • Same policy standards for all projects: Under a surety bond, each project facing default can have a separate surety with a different set of policies and standards. This is not the case with an SDI. All projects fall under the same policy and adhere to the same terms and conditions.

But as SDI has its perks, it is accompanied with a few drawbacks, including:

  • Lack of coverage for second-tier subcontractors.
  • No third-party ascertaining in the SDI process.

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:

  • More resources are required to ensure a default claim is successfully executed.
  • SDI policies are not regulated by the state, meaning no guarantee you are protected against insolvency.

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.

SDI: Is It Right for You?

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.

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