Subcontractor Default Insurance: SDI Policies Explained

Subcontractor default insurance (SDI) is a risk mitigation tool for general contractors to control subcontractor default risk. It protects GCs and upstream parties from subcontractors who default on contracts because they are unable to finish their work, are no longer in business, or perform work so poorly that it must be redone.

In this article, we’ll explore the benefits of SDI, the factors that affect it and the differences between SDI and surety bonds.

What is subcontractor default insurance?

Subcontractor default insurance (SDI) is a catastrophic insurance policy that protects the general contractor from losses in the event that a subcontractor defaults on the contract. GCs often purchase this type of insurance as an alternative to surety bonds to better manage subcontractor performance and assist in completing the project on time, on budget, and to the specifications agreed. 

Insurers require the GC to vet the subcontractors’ ability to complete the scope of work they will be tasked with completing, through a robust prequalification process that ensures they can deliver the project in line with contractual requirements.

A prime feature of subcontractor default insurance – particularly in comparison to surety bonds – is that the general contractor has more autonomy in managing the risk. Rather than a surety performing prequalification, the GC prequalifies the trades.

Additionally, the GC determines when a sub is in default, as opposed to the surety. If, for example, a subcontractor has financial difficulties and can’t pay their workers or vendors, who subsequently stop work, the GC can start a claim and select a replacement sub to complete the work. 

Another example of default is a subcontractor underperforming work and delaying subsequent parts of the build. When the GC files a claim, it provides timely financial capacity to find a replacement to finish or remedy the contracted work.

Performance Bonds vs. SDI

While SDI and performance bonds have similar goals, they mitigate risk from different angles. Both seek to minimize subcontractor default frequency and financial impacts, but general contractors have different roles in each. Understanding the differences can help GCs choose the right approach for their needs.

Benefits of SDI for GCs

For general contractors, using subcontractor default insurance encourages better subcontractor management, as they have a financial incentive to oversee the quality of the work vigilantly. GCs also have the security of knowing that subcontractor defaults will be covered and that they can decide when to trigger a claim to overcome the obstacle most effectively. 

SDI gives GCs the confidence that they can deliver their projects to owners, which, in turn, is beneficial to owners. As part of an overall risk mitigation strategy, subcontractor default insurance is a financial tool that can be extremely valuable for general contractors.

Project Control

SDI coverage allows the general contractor to stay in control of the project in the event of default. The GC oversees the subcontractors carefully to ensure work is performed well and in a timely fashion to keep the project on track. 

Because SDI is a first-party insurance product, the GC controls when to declare default and, therefore, can more effectively respond to an issue. The SDI policy gives funds directly to the GC, allowing them to deliver the whole project contract to the owner.

Cost Coverage

An SDI policy can exceed the amount of the subcontract, which means that the claim payout can cover the extra costs a GC incurs to remedy a default. While the exact terms are negotiated — always consult your specific policy — damages and resultant or indirect damages due to a default (such as schedule delay) are generally covered. 

Here’s an example: A concrete subcontractor defaults on a $500,000 contract. The general contractor quickly solicits new proposals to find a replacement to avoid holding up other types of work on the project. They select the most qualified bidder, whose bid comes in at $650,000. In addition to the increased subcontract value, the schedule delay also resulted in $400,000 in liquidated damages. After the GC  pays the self-insured retention and copay required, the insurer covers the remainder of the $550,000 in losses.

Prequalified Subcontractors

Because the GC takes the time to examine the finances and prior work of the subcontractor, they will choose highly qualified subcontractors to complete the work. These competent subs are also less likely to default, which helps prevent additional delays or problems for a project.

Proactive Risk Management

The structure of SDI means that GCs have a financial incentive to oversee subcontractors to mitigate risks carefully and avoid a default, which would incur extra costs. These incentives are contingent on proper prequalification, oversight and management of default. Better oversight can lead to a better construction process and outcome overall.

Shared Risk

General contractors pay a deductible and copay if there is a claim on the SDI, meaning they share the risk with the insurer. On the flip side, if the GC selects and manages subs well without default, SDI programs can be financially beneficial.

Cons of SDI

Subcontractor default insurance isn’t necessarily all upside for the GC or other project participants. Understanding the costs and benefits of SDI can help GCs judge whether this is the appropriate financial tool to manage risks.

• Financial risk: Self-insured retention (SIR) and copayments can be substantial enough that multiple defaults could mean burdensome financial exposure.
• Increased responsibility: GCs are given comprehensive responsibility for vetting, managing and ultimately deciding when to declare a contractor in default. If the default is later judged inappropriate, the GC would be on the hook for all costs.
• No recourse for subcontractors: SDI doesn’t protect subcontractors if the GC becomes insolvent.

Purchasing Subcontractor Default Insurance

Subcontractor default insurance is available to large general contractors, typically those with annual subcontract volumes of $100 million dollars (USD) or more. Contractors need a high level of organizational sophistication and management capability to vet subcontractors and be able to purchase SDI. Until a GC is large enough to qualify for SDI, they will need to utilize other risk management strategies, such as surety bonds.

SDI Costs

SDI policies often run for a term of two years, and usually have a per-loss limit. To purchase coverage, the GC pays the SDI premium, which typically ranges from 0.4 to 0.85 percent of total subcontract values. While they may be able to extend coverage beyond the normal term, longer projects may require the GC to obtain underwriting approval in order to enroll the project in the program. 

If a claim is made against the policy, the GC will typically have to cover additional costs. Self-insured retention (SIR) is the amount a GC pays before the SDI insurer starts to pay out for a claim, much like the deductible on car or home insurance. In addition, the GC is also generally responsible for a copay, often 10-20 percent of costs (up to a copay aggregate limit), to remedy the default.

Subcontractor Prequalification

When an insurer considers selling an SDI policy to a GC, the GC’s ability to vet subcontractors is crucial, as the insurer is counting on the contractor to choose and manage the subcontracts well. The subcontractor prequalification process allows GCs to gather information about the sub to determine their ability to perform quality work, complete the job, and identify signs of safety or financial risk.  

GCs vet subcontractors by considering the following factors:

A Proactive Approach to Reduce Risk & Cost

SDI is increasingly popular during periods when subcontractors face heightened default risks. These risks are commonly due to challenges like material delays, price escalations, and labor shortages. Even amid positive industry forecasts and strong project demand, subcontractors often carry expanding backlogs — which can impact their ability to perform work on time and within budget. Given the escalating risk of subcontractor default, SDI policies are expected to become even costlier with potentially higher deductibles. 

To mitigate SDI premiums, contractors often choose to proactively demonstrate to underwriters their effective risk management strategies, track record of working with high-performing subs and thorough procedures for subcontractor prequalification. GCs who use technology may benefit by selecting a construction-focused insurance broker who can facilitate using data to make this process robust and seamless.

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