Subcontractor Default Insurance to Protect Against Risk

The labor shortage in construction has increased the risk of subcontractor default, putting a premium on risk management. In this environment, subcontractor default insurance presents an attractive risk management tool for large projects.

On the surface, it's the best of times for the construction industry, with expected 3.7% growth in 2022, following 1.8% growth in 2021.
But in terms of delivering on that business, larger contractors in particular feel a little queasy. The chronic labor shortage is at the root of their worries: 61% of construction firms report a shortage of skilled workers, citing it as a factor delaying projects and heightening the risk of default.

Traditionally, general contractors and construction firms manage this risk through surety bonds, which are an insurer's performance and payment guarantees for a subcontractors' work.

But for some general contractors, subcontractor default insurance (SDI) has become a viable alternative that can be more financially advantageous than buying a surety bond, while giving greater control to the general contractor.

Under a surety bond, subcontractors must undergo the surety carrier's comprehensive pre-qualification process, assessing their financial and operational condition. The bond also protects the general contractor, and the subcontractor's suppliers are protected for payment.
In the event of a default, the surety arranges for completion of the work up to the bond amount or pays for losses after an independent investigation, which can take weeks or months to complete.

In comparison, SDI is an insurance policy that pays when a subcontractor defaults. As an insurance product, there's a loss limit and a deductible. Because of the loss limit, there is more financial flexibility for the general contractor with SDI than a traditional surety bond.
For instance, if an electrical contractor defaults on a $100,000 contract, the maximum payment via the surety bond would be the value of the contract, or $100,000.

Unfortunately, that $100,000 default might create $1 million in overall losses for the project. As insurance, SDI will cover (depending on the loss limit) the expenses related to the default. That gives the general contractor improved financial protection and control.

Key considerations on choosing SDI include the following:
• Assessing the subcontractors.
• Adequate cash reserves.
• Taking control of outcomes.

With the right partner - who has deep knowledge of the product, carriers and the expertise to help steer the process - SDI can improve the contractor's control over defaults as it builds financial resiliency. Working with a broker can also determine if surety bonds are a better option.

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