Construction projects are kind of like dominos. Knock one piece down and it can have a ripple effect on the entire project. Subcontractors in particular are one of the most important links in every job’s domino chain. You might have a dozen or more subs working on-site, but it only takes one to bring a job to a standstill. This outsized risk is why some general contractors buy subcontractor default insurance.
So what is subcontractor default insurance, and how can it support your risk management strategy? Let’s get into the details.
Key Takeaways
- Subcontractor default insurance protects GCs and other upstream parties from losses if a subcontractor “defaults”, or fails to fulfill the obligations of, a contract.
- Some GCs choose to buy an SDI policy over performance bonds because it offers more control over managing subcontractor risk, and allows GCs to define when a sub defaults (instead of the surety company setting the parameters).
- When looking at SDI coverage, it’s always best to work with an insurance company that specializes in the construction industry.
What is Subcontractor Default Insurance?
Subcontractor default insurance (SDI) is a type of construction insurance policy that protects general contractors if a subcontractor defaults on their subcontract. In this case, a subcontractor “defaulting” simply means they’ve failed to meet the contract terms.
For some general contractors, SDI offers a better alternative to subcontractor surety bonds. Where a surety bond protects the project owner from the GC defaulting, subcontractor default insurance protects the general contractor. SDI policies also provide GCs with much more control over subcontractor risk mitigation. For example, instead of the surety company performing the subcontractor prequalification process, SDI allows general contractors to prequalify subs.
Another benefit of subcontractor default insurance is that GCs get to make the final call on whether or not a sub has defaulted, unlike surety bonds. If a contractor defaults, the GC can go ahead and start the claims process.
What Does Subcontractor Default Insurance Cover?
Thankfully, you don’t have to buy a separate policy for every subcontractor on a project. Subcontractor default insurance covers all prequalified subcontractors, either on a per-project basis, or for a specific policy term. Once you’re covered under an SDI program, you have “indemnity” (or, protection) for any covered direct or indirect expenses incurred by subpar subcontractor performance.
Some typical scenarios SDI covers include:
- A subcontractor abandons the construction project
- Failure to perform or meet performance obligations
- Inability to complete the work
- Subcontractor insolvency or bankruptcy
One benefit of this type of insurance policy is that it typically covers losses related to either first-tier subcontractors (those you’ve directly hired), as well as second-tier subs (those contracted by first-tier subs, including suppliers). Basically, regardless of how far down the chain someone is, you’re still covered for losses related to them.
This coverage can include:
- Replacement costs for defaulted subcontractors
- Costs associated with project delays
- Potential additional coverages or endorsements
- Indirect losses related to liquidated damages, acceleration of other subcontracts, and extended overhead.
Parties Involved in SDI Policies
There are two main parties to every SDI policy: The party holding risk (either the general contractor or construction manager at-risk), and the insurance company. By holding an SDI policy, you’re not only protecting yourself from subcontractor default, but everyone upstream, including the project owner.
What Does the Underwriting Process Look Like For SDI?
When you apply for an SDI policy, the insurance company will assess your company’s level of risk to see if you qualify - and if so, how much your specific level of coverage will cost.
Usually, the person underwriting your construction company will look at the following things to determine your risk:
- Your company’s financial capacity and overall health
- (For project-based policies) the size and complexity of the build
- Your subcontractor prequalification process and track record
If you can proactively show the insurance company that you have a solid subcontractor vetting process in place, it’ll be easier to get a better premium.
Advantages of Subcontractor Default Insurance
If you’re a proactive general contractor, there are a lot of advantages to having an SDI policy. Some of the biggest highlights include:
Control over prequalification: Instead of a surety company pre-qualifying subcontractors, you get to have full control over the process. By vetting them yourself, you can be sure you’re only bringing on the most qualified folks.
Quick response: If a default happens, you don’t have to wait for the surety company to declare it. You get to decide when to declare default, which means you can move much faster to remedy the issue if something does happen. And the faster you can replace the subcontractor, the quicker the project can be completed.
Cost coverage: Oftentimes, your SDI policy will be more than the subcontracted amount. This means if a default happens, the payout will not only cover the losses from the default, but the extra costs it takes to hire another sub.
Extra profit: If you manage your subcontractors well, an SDI program can turn into a profit center. It takes time to build an amount over your self retention reserve, but a GC with enough volume can eventually add 0.5% to their profitability.
Cons of SDI
While subcontractor default insurance has plenty of benefits, there are a few potential drawbacks too. For example, copays and self-insured retention are expensive. If you’re unlucky enough to experience multiple defaults, you could end up paying much more out of pocket than you expected. Plus, if you become insolvent, you won’t be covered.
The control SDI gives you in deciding whether or not a subcontractor has defaulted can also come with a downside. If the insurance company decides that your judgment is incorrect, you become responsible for shouldering the cost.
Before you decide to buy this kind of insurance, make sure it makes financial sense for your company.
Best Practices for General Contractors
Having subcontractor default insurance doesn’t automatically protect you from issues on the job site. To get the most out of your policy, you’ll need to stay proactive. Here are a few best practices to keep defaults to a minimum:
Make sure your subcontractor prequalification process is airtight: A solid prequalification process shouldn’t just consider a subcontractor’s capabilities, but their “soft skills” like communication and collaboration.
Develop good risk management strategies: An ounce of prevention is worth a pound of cure, right? Staying proactive here will help prevent issues from getting out of hand - and will provide a good track record for insurance companies to reference.
Keep an open line of communication with project stakeholders: Good communication is one of the most underrated skills on the job site. Keep in consistent communication with those downstream and upstream from you to make sure everyone is aligned on expectations.
How to Get Subcontractor Default Insurance
Once you’re ready to purchase a subcontractor default insurance policy, the first thing you’ll want to do is research certified construction business insurance providers. Unfortunately, it’s become much harder over the years to find an insurance company that offers SDI programs, because many that have experienced large losses.
If you do find a good match, you’ll need to make sure you have all your documentation and processes in place. Basically, you need to prove that you have the ability to successfully mitigate subcontractor issues if something goes wrong. You also need to be doing enough volume for the insurance company to even be interested in doing business with you.
Once you qualify for coverage, you’ll work with your insurance agent to pick out the specific insurance products you want, and potentially explore cost savings from bundling multiple policies together. You’ll also agree upon a copay and deductible, and go over your policy's terms and conditions.
Note: Because SDI is becoming more popular (and more risky for insurers), expect to see a higher deductible than you may be used to.
Wrapping Up
Subcontractor default insurance isn’t about whether or not you trust your subs - that’s what the prequalification process is for. Your SDI policy is an extra layer of defense for your profitability. If one domino falls, subcontractor default insurance prevents the entire project from tumbling down, so your business can stay afloat in the meantime.
👉 Check out our full guide to construction insurance for more info on protecting your business.