July 16, 2020
When the COVID-19 pandemic arrived in Georgia many construction projects were delayed or halted due to new orders and restrictions. Although the CDC has published workplace safety guidelines for job sites, states have been struggling to determine the optimal combination of health and safety requirements. Even so, construction contractors are evaluating better ways to protect themselves from risk in an industry already bogged down by practices that can minimize cash flow. This is evident with the practice of retainage, which exposes contractors to risk when projects suddenly stop.
One recent option has been to pursue a less traditional route to risk management. Subcontractor default insurance (SDI) used to be offered by only one carrier and so its use industry-wide is not as common as traditional surety bonds. Subcontractor default insurance (SDI) was already on the rise before COVID-19 as new carriers entered the market and offered SDI options. In a COVID-19 economy, contractors are looking for new ways to protect against default due to unforeseen project delays or cancellations. However, the market for SDI may not be the same in 2021 as it was in January 2020, or even now for that matter.
Before considering whether SDI makes sense for a given project, contractors need to understand what it is, what value it brings to the project, and how it protects them against unforeseen risk in an industry that is now struggling to remain cash positive.
Unlike subcontractor surety bonds, SDI is an agreement between the contractor and the insurance company. There is no waiting for the surety to investigate a delay or damages claim, and because the agreement is only two-way, the contractor can choose which subcontractor(s) to fit the project. The main benefit is the protection provided from unnecessary risk if the subcontractor defaults. SDI can cost less than traditional surety bonds, with rates averaging around 0.35 or 0.40 percent up to around 1.5 percent of the contract. Policy terms are short and may only last two or three years.
The result is that contractors have more control over the policy than with traditional surety bonds. This is good in the sense that contractors can take out an SDI and then choose a subcontractor and initiate the claim process if the contract is breached. Contractors can determine what constitutes a breach of contract and can get paid faster than traditional surety bonds. Because the claim and payout process are usually much quicker, the rest of the project is less likely to be impacted by delays or extra costs of a lengthy investigation.
One of the downsides to SDI is the high deductible. Because initial costs are lower, the contractor assumes more risk in the event of a subcontractor default. Deductibles can start as low as $250,000 and go up from there. Co-pays can range from 10 to 20 percent. For these reasons, SDI is not appropriate for smaller contracts or projects where the subcontractor has a history of default. The most frequent causes for claims are related to labor, work delay, quality of the work, and financial defaults. It’s important to note this insurance cannot be used on any construction project where public money is involved.
Given the current situation it is expected that work stoppages and delays are likely to still occur for some time. Supply chain disruptions, labor shortages, and government mandates can also impact whether a project is completed on time. In any of these scenarios, if the subcontractor cannot perform the work in the stated timeframe, SDI gives the contractor the assurance of knowing the project cost will be reimbursed quickly. As a result, they can either step in and perform the work or hire another sub without waiting for claims to be resolved.
In addition to covering direct expenses, SDI policies can also cover indirect costs like liquidated damages, accelerating other subcontracts, increased overhead, and more. Legal costs, impact investigations, owner’s delay damages, permit and designer fees are also usually covered. What losses get covered may change as carriers adjust terms to new SDI policies.
Especially amid coronavirus, contractors need to be extra vigilant about their subcontractor pre-qualification process. Not only does a sub’s history get taken into consideration, but historical data from the last recession indicates that insurance carrier losses peaked during the economic recovery period. To keep SDI a cost-effective solution, contractors would be wise to do the following:
One certainty is that subcontractor defaults will increase at least in the short-term. Carriers of SDI report that failure to properly pre-screen subcontractors in normal times often leads to unnecessary defaults and incurred costs. To keep deductibles down and defaults at a minimum, it is important to carefully re-evaluate the process for prequalification.
To keep SDI costs (and other project expenses) down, prequalification needs to include a financial stability review, understanding of any current or potential liquidity concerns, and business continuity planning. Ask about the status and availability of skilled labor. Know what their current overhead is and evaluate their cash flow. Are they currently bonded? What is the sub’s insolvency risk? Be aware of any supply chain risks and ask about whether they’ve sourced viable alternatives. Contractors should also know whether their sub has been party to excessive claims and/or litigation. Taking these extra precautionary steps will help ensure that the project is in good hands and the contractor’s risk level is as low as it can be in such an environment.
Finally, as it relates to COVID-19, work to secure term extensions now from SDI insurance carriers. Engage in conversations about project cash flow, such as reduced retainage, upfront payments when possible, and processing change orders quickly. These can all be options to free up money and potentially avoid a default before it happens. Make sure to follow contract guidelines quickly and formally for any force majeure clauses if work has to stop. This is also where SDI can come in useful; force majeure clauses may protect against risk due to delays in the project schedule, but SDI could fill in the financial gap.
Since the overall cost of SDI (or any type of insurance) is based on past performance, it is imperative to work with construction partners that have excellent records of on-time completion without project delays or work stoppages, or financial issues.
When it makes sense, SDI is an excellent way to keep overall costs down, keep the contractor in control, and ensure the project continues without undue delays if a default occurs. It is too early to tell whether and how much the SDI market will change long-term as a result of COVID-19; in the meantime, contractors need to increase their due diligence and risk mitigation measures, and continue to assess how SDI could add value on a per-project basis.
Contact Us
While not right for everyone SDI provides an additional opportunity to transfer project risks during COVID-19 and beyond. While there are drawbacks it does provide a viable opportunity to surety bonds. If you have questions about the information outlined above or need assistance with a construction tax or audit issue, Wilson Lewis can help. For additional information call us at 770-476-1004 or click here to contact us. We look forward to speaking with you soon.