006 - Default Insurance Products
Subcontractor Default Insurance (SDI) is an indemnity insurance policy that was designed to protect large general contractors from risks associated with subtrade default. When used in this manner the product can be an effective risk management tool. However, the Surety Association of Canada has recently encountered a group of stakeholders who are attempting to convince construction buyers that this product can be used as a replacement for surety bonds on the head contract. They suggest that with SDI in place, the owner has no need for performance or payment bonds and can enjoy the same level of protection. This advice is misleading and if followed, it can leave owners, subtrades and suppliers completely exposed to the enormous risks associated with general contractor default.
What is Subcontractor Default Insurance?
Subcontractor Default Insurance (SDI) is a product that was created and designed to protect large (sales of $100 million or more) general contractors from the risk of subtrade default. The policy was first introduced in 1996 although it did not appear in Canada until the early 2000’s.
Like most insurance products, SDI does not protect from the first dollar of loss. Typically the insured is required to fund large deductibles and co-payment provisions; often by a side agreement. These deductibles and co-payments can amount to millions of dollars in losses that must be absorbed by the Insured before a claim can be made under the policy.
Also, the policy is what insurers refer to as an “indemnity instrument”. In other words, the insured general contractor initially finances the loss out of its own pocket and then seeks reimbursement from the Insurer under the policy.
For large general contractors with deep pockets and extensive in-house construction management experience, this is not a problem. Not so for end-users. Construction owners; particularly in the public sector are not contractors or construction managers and for the most part are looking for first dollar protection of public money if the prime contractor defaults.
Is SDI an Appropriate Risk Management Solution?
The answer to this question depends on how it’s being used and who you are. For the purposes of this discussion, we’ll review both circumstances; the appropriate approach (i.e. protecting general contractors from subcontractor default) and the inappropriate scenario where the policy is sold to an owner as a substitute for prime contractor bonding.
- SDI – Used for What it was Intended to do
When used for its intended purpose (i.e. to protect G.C.’s from default of subtrades), SDI can be an effective risk management tool for large, financially strong general contractors and provides them with protection that suits their unique needs. The product is appropriate in this context because this class of Insured has the financial strength to absorb the smaller, below-deductible costs and the organizational strength to fix construction problems.
From the perspective of a subcontractor whose potential default is being protected against, the reviews aren’t quite so rosy. Many trades resent being forced into a GC’s SDI program as they are required to provide confidential financial and other information to the general contractors with whom they may be engaged in very sensitive negotiations. Moreover, the policy pays out, even in the event that the G.C. wrongfully declares the subtrade in default; effectively turning the policy into an “on demand” instrument and making the general contractor the sole arbiter.
By contrast, a surety bond will respond only in the event that the subtrade actually defaults under its contract. From decades of experience, surety companies know only too well that wrongful declarations of default are not uncommon; particularly in difficult economic times. More importantly, a declaration of default that results in contract termination can have devastating and even ruinous consequences to a contractor on the receiving end of such a call. It is imperative that the prerogative of pulling that default trigger is used sparingly and judiciously. By providing this “sober second-thought” to the default resolution process, a surety bond helps to ensure that the prerogative of declaring a contractor in default is exercised appropriately.
Finally, from the perspective of the owner, there is very little benefit to be gained from a general contractor purchasing SDI. Theoretically, the owner derives an indirect advantage in that the G.C. has presumably prequalified the subtrade and has financial incentives under the policy to ensure good subtrade performance. However, it can be argued that same indirect benefit can be obtained by requiring the general contractor to obtain bonds from its subs and suppliers.
- SDI – Is this a Risk Management Solution for Owners?
The simple answer is no. The practice of selling SDI to owners as a substitute for prime contractor bonding is completely inappropriate and can leave owner, subcontractors and suppliers unprotected in the event of prime contractor failure.
Over the last several years, SAC has encountered a small group of general contractors and others who have worked diligently to convince construction owners that a bond is not necessary. They assert that an owner can derive all the protection they need by engaging the services of a general contractor who has purchased a SDI policy and that this will result in cost savings as no surety premium will be incurred. In support of this argument, they suggest that in a project where up to 90% of the work is carried out by subtrades, a policy that protects against subtrade default will cover off 90% of the exposure.
This is simply not so. The SDI policy responds only in the event of the default of a Covered Subcontractor and does not provide for any recovery for losses arising from the default of the prime contractor. Indeed, the very first article of the standard SDI policy states that the policy will protect the Insured (General Contractor) from loss “...but only to the extent of Default of Performance by... Subcontractor/Supplier as respects any Covered subcontract or purchase order agreement”.
Sometimes, in their efforts to sell SDI as a substitute for prime contractor bonding, enthusiastic proponents will point to a document referred to as the Financial Interest Endorsement and suggest to owners that by adding this endorsement to the policy, they’re protected from the perils of general contractor default. Again, not so. A quick review of the Financial Interest Endorsement reveals that the document adds the owner to the policy as a “Scheduled Entity” which will effectively allow them to step into the shoes of the general contractor under the policy, should the latter become insolvent. The underlying terms of the policy are not changed and in fact, the Financial Interest Endorsement specifically excludes any indemnity for costs and expenses arising from the default of the insured general contractor.
- Subtrades, Suppliers and Other Considerations
Subtrades and suppliers are also left unprotected should an owner choose to forego surety bonds. Without the benefit of a Labour and Material Payment Bond, protection of trades and suppliers is limited to their pro-rata share of any holdback funds being retained by the owner. This protection can amount to pennies on the dollar.
Despite claims by some SDI proponents to the contrary, Labour and Material Payment Bonds are the only security instruments that provide dedicated payment protection to subcontractors and suppliers of a defaulted contractor.
Finally, the so-called “cost savings” are minimal or non-existent. A 2009 study conducted by Clemson University found that SDI general contractors will pass along the program cost to the owner, typically at a rate equal to or higher than that charged for a performance bond.
In summary, while SDI can be an effective risk management tool for protecting large general contractors from subtrade default, it leaves owners, trades and suppliers completely unprotected in the event of default of the general contractor. Owners should keep in mind that unless and until a Covered Subcontractor defaults, an SDI policy does not pay anything to anyone and no protection is provided should the insured general contractor default.
Without the protection of a surety bond, construction buyers are now completely exposed to the perils of prime contractor default and can suffer catastrophic losses should the head contractor fail.
This paper is intended to serve as a general guideline to assist members and other readers in responding to the issues discussed. Nothing contained herein should be construed as legal advice and readers are cautioned to consult with legal counsel for such advice.