About SDI

Subcontractor Default Insurance (SDI), also known as Subguard or Contractor Default Insurance, was first introduced in 1995.  This is an insurance product that protects the insured (who is typically a prime contractor) against loss that results from the failure of subcontractors and/or suppliers.

SDI Overview

 The underwriting company issues an insurance policy that reimburses the insured for loss that is incurred as the result of subcontractor/supplier failure.  The prime contractor, decides which jobs they intend to have protected by SDI.  When the prime contractor designates a job as an “SDI Job”, every subcontractor/supplier is covered under SDI, unless that subcontractor/supplier is bonded.  Under an SDI program, the prime contractor becomes the underwriter for the insurance company to the extent that unqualified subcontractors should be bonded or not employed.  Periodically, the prime contractor provides the insurer a schedule of “covered” subcontractors/suppliers.

 Coverage is triggered when the prime contractor places a subcontractor/supplier in default of their subcontract or purchase order.  There could be situations where coverage can be obtained without a formal default of performance.  Coverage is provided for any costs directly or indirectly associated with the subcontractor/supplier default, including costs incurred prior to a formal default.  The insurance company does not have the ability to deny coverage by putting into question the legality of a default[1].  Nor, can a claim be denied if it is determined the prime contractor failed to follow their qualification practices[2] with respects to the defaulted subcontractor[3].  While the insurance company can not direct the contractor how to remedy the default, the contractor has a duty under the policy to minimize the loss.

After placing a subcontractor/supplier in default, it is the responsibility of the insured to document costs and expenses that are the direct and indirect result of the default[4].  The insurance company uses this documentation to reimburse the prime contractor under the coverage terms of the policy.  In the event of a claim, the prime contractor is responsible for a deductible and co-pay retention.  The existence of this “insured retention” is a critical aspect of SDI programs.  The insured retention affords the underwriter the ability to provide broad coverages and give the contractor control over claims remedy and subcontractor/supplier qualification.  It also provides potential financial benefits to the prime contractor.  The Subguard claim’s process has been frustrating to some insureds.  In general, the issues are that Zurich asks for too much information, much of which is not relevant to proving a loss, and the claims process can seem bureaucratic and drawn out.  Zurich has worked to improve the speed and clarity of the claims process.

 
Subcontractor/Supplier Qualification

 The contractor’s ability to qualify subcontractors/suppliers is a focus of the insurance company’s underwriting.  Examination of subcontractor/supplier financial statements is not a underwriting requirement, but the contractor will need to demonstrate that they look into and understand a subcontractor financial capabilities.  Candidates do not have to have a formal qualification in place historically, but should be prepared to evidence a formal Subcontractor Qualification program at the time of underwriting and demonstrate how it will be implemented.

Program Costs

The risk transfer premiums charged by the insurance company for SDI vary predicated on the amount of the deductible retention, the limits purchased, average size of a prime’s subcontracts and the underwriter’s evaluation of the prime contractor’s capabilities.  Generally, the Risk Transfer costs are between 0.3% and 0.7% of the amount of the subcontract/purchase order.  Most SDI users also charge project owners an additional amount to fund for losses within the insured retention.

SDI Markets

Zurich originated SDI with their trademarked Subguard Program in 1995. 

 Arch entered the marketplace in 2010.  While the general concept behind the Arch product is similar to Zurich’s Subguard Program, there are several differences which should be understood before selecting a market.  Arch is partnered with Catlin in providing up to $20 million in program limits.  Their SDI product is underwritten by a third party MGU called Commercial Risk Underwriters.  Arch/Catlin/CRU outsource their claims to a TPA.

XL introduced their “BuildAssure” program early 2012.  While there are some differences, their coverage form is similar to the Subguard policy form.  They have $50 million in limits

SDI vs Subcontractor/Supplier Bonding

A significant difference between SDI and Bonding are the contractual relationships.  Bonding is a three party contract between the surety, the contractor and the subcontractor.  In this contractual relationship, the surety holds indemnity from the subcontractor.  This existence of this indemnity creates a fiduciary responsibility to the subcontractor, which can create difficulties for the surety in responding to claims on the bond.  SDI is a two party contract in which the insurance company reimburses the contractor for costs covered under the policy without any obligations to the subcontractor.

Here are some other important differences:

• Limits of Coverage.  Coverage under a bond is limited to the penal value of the bond[5].  Coverage under SDI can be purchased in amounts up to $50 million per default.  To the extent that the cost to remedy a default can be more than the penal value of the bond, there would be greater protection under SDI.
• Coverage terms and conditions.  Theoretically, costs and expenses that are reimbursable under SDI and Subcontractor/Supplier Bonding are similar.  In practice, sureties tend to default to the courtroom to determine coverage for certain direct and almost all indirect costs that are the result of a default.  Zurich, under their Subguard program provides coverage for all direct costs, and will also reimburse for indirect costs, provided that very detailed documentation can be provided.
• Cost.  The “risk transfer” cost of SDI is significantly less than that of subcontractor/supplier bonding.  However, the contractor needs to fund for the potential of loss within their retention in addition to the risk transfer premiums. 
• Control of the schedule.  In the event of a bonded default, the contractor will likely need to negotiate approval of the default remedy with the surety to maximize the potential claim reimbursement.  Under SDI, the contractor controls how to remedy the default without having to seek approval from the insurer[6].
• Claims.  Both products require the prime contractor to provide significant detailed documentation.  In the event of an indisputable default of a subcontractor/supplier, the surety can sometimes be persuaded to cashflow the reprocurement.  Sureties tend to rely on the courts and case precedent to determine coverage.  There is a degree of negotiation necessary under both SDI and Bonds, especially on more complex claims.
• Financial Stability of Insurance Company.  Under a bonding program, the contractor is relegated to the financial strength of the surety that the subcontractor/supplier has selected to conduct business with.  Under SDI, the contractor selects the insurance company providing the coverage.
• Jobs under FAR.  Subcontractor/Supplier bonding has widely been found acceptable under FAR.   SDI, similar to any “loss sensitive” insurance product requires the user to meet a greater standard of care under FAR.  Depending on the details of the job, contractors should consider utilization of an advance agreement for use of SDI under FAR.
• Jobs with DBE requirements.  Subguard affords the prime contractor the ability to utilize any qualified subcontractor/supplier regardless of their ability to provide a bond.  Otherwise, the prime contractor must rely on the subcontractor/supplier to be able to provide a bond from a quality surety, or self insure the risk.
• Subcontractor/Supplier Qualification.  Under a bonding program, the surety provided the Subcontractor/Supplier qualification.  Under SDI, the prime contractor is responsible for qualifying the subcontractor/suppliers.  Most prime contractors who utilize SDI evaluate the subcontractor/supplier’s financial strength in a variety of ways.  But, the balance of their subcontractor qualification is focused on the subcontractor/supplier’s overall ability to complete that specific job.
• Financial Benefits.  The existence of the insured retention in SDI programs affords the prime contractor an opportunity to increase operating margin if the anticipated losses within the insured retention do not materialize.  The insured retention provides a significant motivation for prime contractors to conscientiously select and manage subcontractors/suppliers.   To the extent that the subcontractor/supplier controls the financial relationship with the surety under a bonding program, it is not possible for the prime contractor to directly share in and take responsibility in the risk of managing subcontractors/suppliers.