Daniel McLennon | Smith Currie & Hancock
Subcontractor default insurance (“SDI”) may be described as an alternative to bonding subcontractors. SDI is first-party insurance that compensates the general contractor insured in the event a covered subcontractor fails to fulfill its contractual obligations. Under SDI policies, general contractor insureds are obligated to develop and implement rigorous subcontractor prequalification procedures.
Basic questions and answers about how SDI might come into play and impact the construction industry in response to COVID-19 follow:
Who may make a claim on an SDI policy?
The general contractor may make a claim. An Owner may make a claim if the general contractor becomes insolvent in many cases. Subcontractors may not make claims on SDI policies.
Does SDI replace payment and performance bonds?
Many general contractors use SDI (now in its 20th year) instead of subcontractor performance and payment bonds. Some general contractors use a combination of the two.
However SDI is not a replacement, on public work, for the required bonding of the general contractor. That law has not changed. When a general contractor provides performance and payment bonds, such as required for most public works projects, the owner receives assurance that funds will be available to complete the general contractor’s performance, and the subcontractor receives assurance that funds will be available to pay for the subcontractor’s performance. When the subcontractor provides the bonds, the general contractor receives assurance that funds will be available to complete the subcontractor’s work, and the lower tier subcontractors and suppliers receive assurance that they will be paid.
SDI, on the other hand, ensures funding to the general contractor. The owner generally benefits indirectly, and the subcontractors and suppliers not at all.
Why purchase an SDI policy?
Primarily, general contractors purchase SDI to protect against catastrophic losses caused by a subcontractor’s significant failure to perform. When triggered, SDI is intended to provide funding needed to correct and/or complete the work, and cover incidental costs, without the need for and delay inherent in litigation.
According to Jim Reichert, Risk Engineering Manager, Subcontractor Default Insurance at AXA/XL, a division of SA/AXA, in New York:
When a subcontractor does default, it typically costs about 65% more to complete the work they were contracted to perform, Mr. Reichert said. About 32% of those extra costs relate to physically completing the work, 21% relates to the costs of correcting poor-quality work, 12% goes to unpaid lower tier subcontractors, 9% goes to legal costs, 5% relates to staffing costs, and 21% are indirect costs, such as adjusting the schedule of the job, he said.
Subcontractor defaults require decisive risk management, by Gavin Souter, Business Insurance, November 8, 2019. SDI potentially protects the general contractor from all of the costs mentioned by Mr. Reichert.
Who pays for SDI policies?
Typically, the insured general contractor pays for the policy as a cost of its work, to help ensure the project will be built on time and on budget, by ensuring–through the required prequalification process–that quality subcontractors perform the work.
What is covered by an SDI policy?
Presently, seven insurance carriers offer SDI coverage, including Zurich, Berkshire Hathaway, Arch, AXA/XL, Cove, and Hudson. Their policies are all similar, but like most insurers, they have differences. An SDI policy typically covers the cost of completing and/or correcting the subcontractor’s work; legal costs of handling the default; investigation of impacts from the default; and other indirect costs, including Owner’s delay damages and/or liquidated damages, designer’s fees, and permit costs, among others.
Will SDI cover defaults by enrolled subcontractors due to COVID-19?
It depends. Generally the coverage grant is broad enough to include the type of losses a general contractor will suffer due to the subcontractors’ inability to complete the work caused by labor and materials shortages. However, SDI contracts vary, and some contain more limitations and exclusions than others. At least one policy expressly excludes coverage for loss caused by an epidemic. Others preclude losses for “acts of God” or actions by government authorities. However, because COVID-19 presents new issues, no case law has interpreted SDI contracts in light of these issues, and opportunities to recover for such losses may be available. The language of the applicable contract must be reviewed carefully to determine what coverage may be available.
How does SDI interact with other insurance?
Although it is called “insurance” it is not insurance in the classical sense, because the insured and the insurer under an SDI policy have a much more involved and interdependent relationship than under traditional insurance. Under SDI contracts, the insured takes on great responsibility to prequalify subcontractors and shares in the risk through high deductibles and copays. Unlike commercial general liability policies, SDI can provide funding where there is no physical injury to tangible property. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.
Thus, the policies cover different risks. Also, due to indemnity and subrogation clauses, the insured may bear a substantial burden to pursue coverage under a CGL policy to reimburse the SDI carrier for amounts paid under the SDI policy. See for example, Pavarini Constr. Co. v. Ace Am. Ins. Co., 161 F. Supp. 3d 1227 (S.D. Fla. 2015). For these reasons, SDI may not be considered “other insurance” within the meaning of typical Commercial General Liability Insurance policies, and SDI may not be called upon to share in a covered loss with the CGL policy. Thus, to the extent general liability applies, it should provide the primary layer of coverage.
How will COVID-19 impact subcontractors enrolled in SDI?
Because general contractors bear the risk of subcontractor default in any case, in this uncertain time general contractors may be expected to be extra vigilant in monitoring performance and stability of their subcontractors. The prequalification process is rigorous. SDI subcontractor prequalification focuses upon the subcontractor’s financial wherewithal. Areas of inquiry by general contractors include:
- Financial Ratios – how does the subcontractor’s ratios, working capital, current ratio, debt to equity, days in accounts receivable, and days in accounts payable, stack up against similarly-sized companies in the same industry?
- Bondability – is the subcontractor currently bonded and at what level?
- Claims and litigation history – is the subcontractor a troublemaker or subject to excessive claims and litigation?
Sample information required of subs includes:
- Financial statements for most recently completed fiscal year
- Proof of bonding capacity
- Proof of available line of credit
- Credit information authorization
With current threats to workforce availability and supply chain interruptions, subcontractors participating in SDI programs may expect general contractors to become even more concerned about the financial well-being of their subcontractor partners. Subcontractors should expect frequent meetings and calls with general contractors, and discussions may now include issues such as business continuity, contingency, and resiliency plans, actions subcontractors are taking to keep doors open, subcontractor risk mitigation actions, and contingency plans in event of loss of staff and/or project shutdowns.