With the economy in 2021 reporting the fastest rebound (5.7%) since the Reagan presidency, the construction industry must now deal with the downside risks of growth. The potential for subcontractors defaulting on their contracts is a big issue at any time, but especially now when cash flow needs are greatest and with shortages across all the trades.

For subcontractors, the fix lies in smarter financial management. Those that don’t get too greedy have their cash financing in order before they’re spread too thin and remember that overpromising can result in under-delivery will be better positioned for success in this environment.

For larger general contractors—those whose subcontractor volume exceeds $50 million—paying close attention to subcontractors’ financial management practices is an essential underpinning for subcontractor default insurance (SDI). This may be one of the best risk management tools for improving control over risk and also building financial resiliency.

Considering surety bonds versus SDI

Subcontractor surety bonds are the more traditional risk management tool against subcontractor default for general contractors. They represent a risk transfer from general contractor to surety with risk funding and a recourse against losses or non-payment caused by subcontractor default.

Surety bonds provide third-party (the surety company’s) guarantees of performance and payment for subcontractors’ work. Through them, subcontractors must undergo the surety’s comprehensive pre-qualification process where their financial and operational conditions are assessed.

Surety bonds protect the general contractor for the value of the executed subcontract. The bond addresses the subcontractor’s work, their lower tier subcontractor payments and the material purchased from their suppliers. It does not, however, guarantee the full completion of the original work. In the event of a default, the surety arranges for completion up to the bond amount or pays for losses after an independent investigation. The contract amount and credit quality of the subcontractor dictate the cost of the bonds. Because the bond only addresses the default to the amount of the bond, the general contractor may have a substantial cost gap in order to complete the job.

While subcontractor surety bonds have precedence in the construction industry, especially for smaller general contractors, firms that have size, management capabilities and financial bandwidth can find subcontractor default insurance a viable alternative. It’s not necessarily the easier option, as building the qualifying internal controls can take time and dedication from the general contractor’s management team.

Making SDI a viable option

The following three factors guide the use of the SDI option.

1. Subcontractor assessment: Unlike with surety bonds, general contractors must undertake their own subcontractor pre-qualifications to use SDI. This requires the right infrastructure and culture. It’s not merely a matter of evaluating the financial health and track records of 100 or 150 subcontractors that the general contractor might need to use. The strength of the pre-qualification process will determine how the risk of default is valued and underwritten—the limits and costs of insurance protection.
2. Cash reserve adequacy: Reserves are also essential for the effective use of SDI, as they must be available to cover the high deductibles and co-payment requirements in the event of subcontractor losses.
3. Administrative strength: In taking on this responsibility over the SDI process, general contractors also give themselves much more control over the outcomes. With SDI, the claims resolution process is streamlined, encouraging collaboration to resolve issues before a default and certainly without waiting on a month-long third-party settlement investigation.

And where does its impact on a general contractor’s financial resiliency come in?

Say an electrical contractor defaults on a $100,000 contract. The maximum payment via the surety bond would be the value of the contract: $100,000.

But since SDI is an insurance product, a loss limit is purchased. In defaulting on a $100,000 contract, the electrical contractor might actually be creating a million-dollar problem for the project as a whole. Depending on the loss limit, the bigger loss, not just the contract amount, would be covered by SDI. So this option would give the general contractor’s management team and owners better financial protection and control over the risk of default.

It’s counter-productive to pit surety bonds and SDI against each other. Everything product has a place. The trick for contractors is to understand which fits best with their organizations, and why. The right brokerage partner, who knows the product and carriers and has the expertise to help steer the process, can ensure SDI effectively improves the contractor’s control over defaults as it builds financial resiliency.