On Guard: A Look at Subcontractor Default Insurance

Public and private project owners are increasingly presented with the option of obtaining protection from subcontractor default through subcontractor default insurance – generically known as “SDI” and as “SubGuard” when offered by its most frequent issuer, Zurich Insurance Company. Because SDI is a relatively new product – it was first offered for sale in 1996 – there is minimal precedent concerning its use, making it difficult for owners, prime contractors, and subcontractors alike to comprehend the impact SDI may have on the consequences of subcontractor default.

Historically, owners obtained protection from prime and subcontractor default by requiring payment and performance bonds, in which a surety guarantees the contractor’s performance and payment of subcontractors and suppliers. Payment and performance bonds are required on federal government projects with a contract price over $150,000. Most state and local jurisdictions have similar bonding requirements. Both performance and payment bonds are typically issued in the full amount of the contract price. The issuance of performance and payment bonds creates a three-party relationship between the surety (as guarantor), the contractor (as principal), and the owner (as obligee).

SDI is not a bond. Instead, SDI is an insurance policy issued to a prime contractor covering the losses incurred by “enrolled” subcontractors who default on their contract. An SDI policy covers: (1) the cost of completing and/or correcting the subcontractor’s work; (2) the resulting legal costs; (3) the related investigation; and (4) other indirect costs, such as liquidated damages. The policy is a contract between the insurer and the insured contractor. An owner is not a party and has no rights under the policy. However, prime contractors typically pass the costs of SDI – roughly 1 percent of the contract price – to the owner.

Insurers offering SDI laud several advantages.

First, they claim that SDI gives prime contractors greater control to remedy subcontractor default. Whereas a bond generally requires that the surety complete its investigation prior to implementing a remedy, SDI permits the prime contractor to immediately implement a remedy and requires the insurer to issue payment to the prime contractor within a predetermined timeframe.

Second, by eliminating the necessity for surety investigation, insurers claim that SDI provides faster remediation of subcontractor default.

Third, because the prime contractor – and not a surety – prequalifies subcontractors for SDI enrollment, there are greater opportunities for minority and small subcontractors that might not be bondable.

Fourth, SDI often offers greater coverage limits than bonds.

While these and other characteristics of SDI are sure to provide a benefit to project participants under the right circumstances, critics suggest several considerations that weigh against payment for SDI by owners. Public owners in particular struggle to understand how SDI adds value to projects that already are protected by statutorily required payment and performance bonds. Private project owners, who commonly do not require bonds on their projects, struggle to understand why they (as opposed to the prime contractor) should pay for SDI to cover subcontractor default, a responsibility and risk traditionally borne entirely by the prime contractor.

In one of the few court cases addressing SDI, Waterscape Resort LLC v. McGovern, 967 N.Y.S.2d 368 (App. Div. 2013), New York’s intermediate appellate court held – consistent with basic contract law principles – that an owner did not have a right to bring a claim under a SubGuard policy because the owner was not a party to the contract between Zurich and the prime contractor.

As this decision shows, prime contractors may ask owners to share the cost of subcontractor risk by paying the cost of an insurance policy that confers no direct rights to the owner. And although a “financial interest endorsement” may be available, the endorsement may also present an additional cost.

Further, while SDI could in some cases eliminate delay and provide prime contractors with greater control, it is, after all, an insurance policy containing typical insurance contract jargon. Thus, what is marketed by insurers as a streamlined alternative to bonding might not be so straightforward in practice.

Lastly, critics point out that the flexibility given contractors to enroll unbondable subcontractors for SDI coverage may result in increased risk of subcontractor default. Sureties invest significant resources and have greater experience prequalifying subcontractors than do contractors.

However, while SDI may not always provide the benefits championed by insurers, that is not to say that SDI is without value under the right circumstances. For instance, SDI may be appropriate for a private project owner on a cost-plus contract without bonding when the contract requires the owner to absorb the costs of subcontractor default. SDI can also be strategically utilized to target only the high-risk subcontractors, providing owners with risk protection, while limiting unnecessary costs by excluding lower risk subcontractors from enrollment.

As this commentary suggests, every project requires separate evaluation when considering whether SDI is a worthy investment. All project participants are encouraged to carefully weigh the implications when determining whether SDI is appropriate for a particular project.

“On Guard: A Look at Subcontractor Default Insurance” was originally published by the Daily Journal of Commerce on August 19, 2016.