The benefits of subcontractor default insurance in today’s construction economy

By John Wallen, HUB International

Wisconsin’s construction industry – like the industry globally – is operating in a good news/bad news environment. Balancing those forces has never been more challenging, and it requires contractors to make the best use of the right tools to come out ahead.

For larger general contractors and owners, now is the time to get up to speed on subcontractor default insurance, a good option to one of their most concerning risks.

On the plus side for construction, business is booming. In addition to a strong residential market, infrastructure projects like bridge, highway and transportation facilities have been boosted by the $1.2 trillion Infrastructure Investment and Jobs Act. Private sector investment, especially in warehouses, hospitals and other healthcare facilities, is also strong. Total construction starts are expected to advance 9% in 2022 from 2021 levels.

But the backdrop is not so rosy. Start with rising materials costs, up 23.5% during a recent 12- month period. Lumber prices alone tripled since the start of the year. Global supply chain pressures remain intense, but have been easing since December. And the shortage of qualified workers remains a pressing problem.

Circumstances are ripe for subcontractor default, as many may be stretched financially to rebound after their pandemic-driven belt-tightening. GCs need to monitor their subs closely, and make sure they can handle work before it’s awarded as their capacity may be diminished.

Understanding the options

For large contractors, the question is whether they themselves have the capacity to opt for subcontractor default insurance (SDI) over surety bonds, which are the tried-and-true protection.

Surety bonds are almost like pushing the “easy” button, as they transfer the risk of subcontractor default to the surety for risk funding and provide a recourse against related losses or non-payment. The surety guarantees performance and payment based on a comprehensive audit of subcontractors’ financial and operational standing.

They protect the GC for contract completion, and the subcontractor’s subs and suppliers for payment. If a default occurs, the surety arranges for completion up to the bond amount or, upon an independent investigation, may pay for losses. Cost of the bonds hinges on the contract value and credit quality of the risk.

Subcontractor default insurance is a viable alternative, with important provisos. It’s a far better fit with larger firms with, say at least $50 million in subcontractor volume. It takes size, management capabilities and financial wherewithal to build a sustainable SDI framework.

Subcontractor assessments and other SDI requirements

Probably the most onerous aspect of SDI that falls to the GC is the subcontractor assessment. It must be a comprehensive evaluation of the sub’s readiness for the work, from financial viability to resources necessary – money, workers, suppliers and their own subcontractors.. It takes sufficient infrastructure, culture and bandwidth for the GC to undertake and manage this process consistently.

It takes bench strength, and not just for the subcontractor evaluation. The resolution of claims is a more streamlined process with SDI than with surety bonds, but success is not a given. The GC’s own management team must have the knowledge and the collaborative skills to resolve subcontractor issues.

High deductibles – sometimes over $500,000 – and co-payment requirements – three to five times the deductible – are part and parcel of SDI. This makes the GC’s own financial strength and cash reserves essential.

Achieving financial resiliency

What contractors are aiming for these days is resiliency, or the wherewithal to pull all the necessary levers to manage successfully through challenging environments like today’s. SDI is one path to take to achieve it.

Take an electrical subcontractor that defaults on a $100,000 contract. The maximum payment via the surety bond would be the value of the contract – $100,000. With SDI, though, a loss limit is purchased. That $100,000 contract default could actually create a million dollar problem for the project as a whole. Depending on the loss limit, the bigger loss, going above and beyond the contract amount, would be covered by SDI. The GC’s management team and owners would also have better financial protection and control over the risk of default.

Success in construction today demands sufficient knowledge of the right tools to use and when – and that extends to financial and risk management tools. With the right brokers behind them, with knowledge of the options and the markets, contractors can use SDI to gain better control over defaults and build financial resiliency.

John Wallen

John Wallen is Vice President and Wisconsin Construction Practice Leader for global insurance brokerage Hub International, with more than 30 years of experience providing risk management consulting, effective insurance solutions and innovative risk and cost reduction strategies for the construction industry.

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