Q & A – Subcontract Default Insurance with Steve Mainello and Michael Saba
February 6, 2024
In this Surety Today: The Blog post we will discuss Subcontract Default Insurance (“SDI”) or as some refer to it “Subguard.” The format of this post will be in a Q & A form taken from an interview with Steve Mainello and Michael Saba, two extremely experienced and knowledgeable surety professionals who regularly deal with SDI. To listen to the podcast on this topic, click on this link.
Most people in the surety industry will know Mike Saba, he is a Vice President with Guardian Group and has over 40 years of fidelity and surety experience. He has held senior management positions with major surety companies such as USF&G and Transamerica. Mike and Guardian Group are very involved with adjusting SDI claims around the country. Steve Mainello, is a Senior Vice President and Director of RCM&D’s Surety Operations, a Mid-Atlantic surety and construction insurance agency. Steve is a Civil Engineer and former surety underwriter and has over 25 years of experience in the industry. In addition to surety bonding, Steve also brokers SDI.
In this post we will explore the nature, purpose and operation of SDI, the benefits and drawbacks compared to surety bonds and the SDI claims process.
Q: What is SDI?
A: (Mainello) SDI is an evolution of risk management. That is the way you really need to think about it. General Contractors basically have three options to address subcontractor risks on a construction project – (1) they can self-insure, meaning they do not get a bond, they manage the payments, manage direct bills, take waivers, use retention, escrow, whatever those means and methods might be; (2) bonding, getting payment and performance bonds; and (3) get SDI, which is just a specialized insurance policy for subcontractor default.
The evolution of SDI is using the subcontractor prequalification to a new level. It is the three C’s that we all know in the surety world – credit, capacity and character, and then the general contractor adding a lot of management techniques, contract selection, project selection, quality control, quality insurance systems, investment and training. SDI is really meant for the sophisticated general contractor that is investing in its company and its people and the training because the pre-qualification really falls on them in the SDI arena. Typically, we are looking at general contractors that are doing approximately $75 million of subcontracting costs and we generally use a ballpark of $100 million in revenue. Those general contractors are really the best candidates for SDI.
Q: What Does SDI Cover?
A: (Saba) SDI is very similar to surety as far as coverage on the performance side. On the performance side, SDI covers the default of the subcontractor that is enrolled in a particular project, subject to a substantial deductible. The deductibles can be anywhere from $500,000 to a million dollars or more with an aggregate deductible of say, $5 million as an example. So, the coverage is there for the insured (G.C.) and it allows the insured to have free control as to how they want to complete the project after a default of the subcontractor. This obviously differentiates from a bond where you have certain conditions precedent that require certain requirements of the obligee before they could engage coverage under the bond. With SDI, there is simply a notification to the insurance company of default, which is then acknowledged by the insurance company and they send out a proof of loss form or a proof of claim form, and it is more of an effort to work with the insured to quantify and qualify the loss for the coverage that’s provided. So, it is similar in the sense that the insured is covered for the performance or the non-performance of its defaulted subcontractor, but the method that the work is completed and how the project is finished and how the loss is captured is all done by the insured, where the insurer is mainly there to make sure that the coverage that they have provided is properly documented and that the costs are fully captured.
Q: Talk about those high deductibles?
A: (Mainello) The financial capacity of a company is one of the credit concerns that an SDI insurer will look at. As Mr. Saba noted, the deductibles can be very high, so the contractor is going to have to come out of pocket for a lot of the default. But, SDI is a great tool for the right kind of company that has a sophisticated plan of prequalification and financial review. Contractors will look at exposure across the board so you are not overly exposed to one sub or one group of subs on multiple jobs where a default could be devastating to the company. So, it is a very highly qualified prequalification process. SDI is not standard, right? So, what Mr. Saba is referring to is really interesting because all those factors come into play in different ways on every policy. There is no standard form like there is in our surety world where it is an AIA form or in the insurance world where it is an ISO form, and that creates a lot of variation in the market of how these policies actually work. And these sophisticated general contractors, they talk about how they will sometimes on a given project, they will include certain subs into the SDI and other subs on the same job that will require bonds.
Q: It is my Understanding that Contractors Using SDI on the same Project will Designate some Subcontractors for Inclusion in the SDI Policy for the Project and other Subcontractors for Bonding?
A: (Saba) That is not uncommon. It is not uncommon to see that the contractor will assess its risk, as Mr. Mainello referred to previously, and those where there may be more at risk for potentially a large or substantial exposure, they will bond those contractors almost on a regular basis. It is not uncommon to see the mechanical contractor and the plumbing contractor and the electrical contractor to be bonded. Whereas the landscaper and the painter and the more less at risk subcontractors will be enrolled into the SDI. So, it is a matter of, as Mr. Mainello said, assessing your risk and making a determination on what amount of risk you want to carry on your operations. The advantage that SDI has is that one of those subcontractors going to default, the insured (G.C.) has the full option or the full ability to take over and complete the work and re-let the project and bring in a new sub or supplement that sub’s work and finish the work without having to deal with the condition precedence requirements of a bond and allowing the surety to conduct its investigation.
The other thing that the insured takes a risk on is that if there is a wrongful termination arising out of the defaulted subcontractor, it does not prevent the coverage from still being in effect. The only caveat is that assuming that the wrongful termination turns into litigation and it is adjudicated and found that the termination was improper, then the insured would be required to reimburse any money that they collected from the insurer to be reimbursed for those costs that were advanced. But, other than that, the insured has pretty much the ability to complete the project in the manner that they feel is most equitable for them, and that is what the advantage over a surety bond would be. But again, they are subject to that very high deductible that allows them that flexibility.
Q: If you are Underwriting Surety Bonds on a Project and you see that the GC doesn’t want to include certain subs in their SDI program, does that give a surety cause for concern? As the surety are you more attuned to what is going on in that circumstance?
A: So, from that perspective, you are asking me from being a surety rep for a subcontractor, am I concerned that they are asking for a bond on an SDI program? Okay, that is interesting because I tend to worry about the opposite, right? We have a lot of great subcontractor clients, and I worry sometimes when they are on projects that I may not even know about until I get a WIP schedule six months after the fact that they had signed up for an SDI program, which is not like an OCIP. There is no formal signing process. You are not trading a credit back to the G.C. You may or may not even know that you are enrolled, and there is no claim process in an SDI program, as Mr. Saba has suggested, that claim goes back through the insurance under the theory of loss in insurance, and it is segregated by the carrier. So that carrier, Zurich Excel, Berkshire Hathaway, Liberty, Hudson, Arch, a lot of variance there. So, we really worry about the opposite more than somebody placing a bond. We recognize because of managing SDI programs that they have to diversify their risk, and what they are really trying to do is protect the loss fund, right, that they have created to manage an SDI program.
Q: It is my understanding with SDI that the insured Contractor must establish a loss fund, explain the loss fund:
A: (Saba) Every company handles it differently or requires it differently. But the loss fund is generally a fund that’s set up that the insured is able to pay into, which will allow them to capture most of the losses they may incur, which would be less than their deductibles or their Self Insured Retention, so that it allows the insured contractor some flexibility so that they know this is a substantial amount of money that is being held in trust or being held in an account that can be used at any time by the insured to reimburse themselves for losses in less than their deductibles or up to their deductibles. And it gives them some flexibility. There are some tax considerations for that. And there are other considerations with the insured uses for, again, part of their overall risk management assessment, the account or of the risk. And it is something that I think, and you see it across the board now, not every account takes advantage of the loss fund, but the majority of them do. Guardian helps its insureds to manage those loss funds if they require it. That is something that we have been able to do for a number of accounts, and we have also done it for our insurers as well, who asked us to manage the loss funds so that everybody has an idea of how much money is available through the loss fund to offset the various losses or how they need to replenish the loss fund if they deem it necessary. So, it is just another tool to manage the risk and the loss.
Q: What is the cost of a bond versus SDI?
A: (Mainello) So, the market for subcontractors that are small and are using small markets and are less credit worthy, they are paying in the range of 2%, two and a half percent. I have heard of 3% and 4% in the marketplace. We would never go there because it is just signaling all the wrong signals. But that is a good ballpark. Solid contractors, mature, lots of good history, they are going to be less than 1% to 1 1/2%. So, they are in that range. With respect to an SDI program, you will purchase based on tranches. So, a hundred million dollar contractor might buy a, I don’t know, 75 million tranche, which lasts a year, and it can enroll subcontractors into that program. There is a cost, what they call the risk transfer premium, that is the cost that they buy the policy for before anything else. Think of insurance. The insurance company knows you are going to have an accident, they know you are going to have a problem, they know you are going to have a default. The insurer has to bake that in. It is not surety where it is a three party agreement, it is a first insured type agreement. So, that risk transfer premium is the cost of it. That is generally a half a point. So, we are already far cheaper than even the best surety. And then there is a combined premium that you build on top of that and that has your loss fund cost, that has your management cost, that has your systems cost, that has the cost to your company to run this thing. And then there is an SDI administration cost, which is basically internal, and that is usually in that half a point or something like that. And that is for the prequalification costs because now the contractor is in the business of pre-qualifying your subs like you have never done before, and there is a cost to that training systems management oversight. But, at the end of the day, if there is no loss, that risk transfer cost and some of that loss fund can be far less than what you would have cost to bond every sub. And that money at the end of the day can be captured as profit in a captive. That is typically where we see it ending up at. So, very economical. That is one of the benefits, it is very efficient. It is one of the advantages of it. It is very effective and there is a lot of control and consistency in a timely claim process. Okay. And it is really dependent on if you control those losses, if you have the losses though, it can throw the cost much higher than bonds.
(Saba) Yes. If you have a situation, where you have multiple subcontractors on a project happen to get in trouble, and that has happened at times, so you have two or three or more subcontractor defaults on one project with each loss subject to a half a million dollars, let’s say deductible. That could add up pretty quickly, where next thing you know your cost or your out-of-pocket cost could be three or $4 million, which would be less than the aggregate still. So, while you may have losses, and none of them may be above the individual aggregate of say, half a million dollars for the deductible amount. So, you could have a situation where you could have a $2 or $3 million loss, which I’ve actually seen on one project, and none of it would be reimbursable by the SDI policy. So, there is that risk. Now, that is the exception, not the rule. Generally, you will have one contractor on one job that may be in trouble, but there are situations where you could have multiple losses on one project with multiple contractors being in claim or being in default, and none of it would reach the threshold for coverage under the SDI policy. So that’s part of the risk assessment again, that the insurer needs to make when they decide to go with the SDI policy.
Q: Getting back to the coverages, so this SDI policy, will it cover indirect losses such as acceleration, overhead, LD’s, those kinds of things?
A: (Saba) Yes, but it’s limited to some policies. As Mr. Mainello said, every carrier has a different interpretation of indirect losses. Some will have a percentage limitation, it is just a flat 10% or whatever percentage number they elect to choose, which is automatically included in the coverage or the loss coverage. So, you would get an automatic 10% for those types of losses. Other policies have defined what an indirect loss is, and they will spell them out in the policy. Some policies require that you have to make that election at the time that you submit your proof of claim. Others, you have to make that decision within 30 days from the notice of loss. So, there is different levels of that. But generally speaking, indirect claims, delay impact, liquidated damages, those type of claims are covered under an SDI policy.
Q: What are some of the differences between bonding and SDI?
A: (Saba) One of the differences between SDI and bonds that I have seen talked about is that SDI does not provide payment coverage like a payment bond would. So, if a subcontractor is not paid, the payment bond would step in and whereas in SDI, you do not have that directly, but if there is a claim by the payment bond claimant against the owner through a mechanics lean or something like that, there might be coverage.
(Mainello) Yeah, that is correct. And Mr. Saba can probably talk about some specific examples of that, but that is where the conversation really becomes interesting with our owners. So here at RCM&D, we not only do surety for contractors and subcontractors, but we also do surety for manufacturers and colleges, universities, hospitals and large owners that are managing construction projects. Talking about the advantages to an owner about how to use SDI versus bonds for the general contractors is really the conversation we are having. Where is your protection? This is a first party protection for a GC that does not necessarily translate to an owner. And so if a GC goes out of business, let’s say in the middle of a project, what’s the protection for the owner? So, Mr. Saba can probably tell me the forms that are out there, but there are in a lot of cases, riders that in that specific case where a GC goes out of business or goes into bankruptcy, that the policy will transfer the single policy for that project, we can transfer to the owner where they can make a claim. However, if it is a dispute on a job that does not necessarily trigger that rider, it leaves the owners making some very difficult decisions about how much risk transfer they want to have in a contract.
(Saba) Right, as Mr. Mainello said, the SDI policy is first party coverage, it is for the benefit of the named insured, and that is where limitation is also. Moreover, if the insured (G.C.) goes into liquidation or goes into receivership or bankruptcy, that policy is canceled. So, the owner then is exposed to those types of potential claims that could come down. What I have seen in a lot of instances, and again, I am not an underwriter and I don’t know how they are all fully addressed, Mr. Mainello could talk about that, but I have seen where the owner is still requiring the general contractor to post a bond to protect the owner, whereas the subcontractors may be fully enrolled in the SDI program, protect the general contractor. So again, it is part of the risk management assessment that the owner of the insured and the companies need to make those decisions if it is something that it is right for their circumstances.
Stover: So one of the things when you talk about the relative pros and cons between bonds and SDI, one of the things that people speak of in terms of the benefit of surety versus SDI is that the law relating to SDI is really undefined. I can say that I did some searching on Westlaw to try to find what is out there on SDI and really there is not much out there at all about the claims process and all of that.
Q: One of the things that I thought was interesting in the policies, apparently the whole prequalification aspect of the SDI policy is really important and one of the reasons it is important to the G.C. is because apparently these policies will have a provision that says if you fail to properly pre-qualify as the GC in the SDI policy that the insurer can deny coverage. Mr. Saba, you have handled over 200 SDI claims. Have you seen that come up yet?
A: Yes and no. Yes, I have seen it come up, but I have yet to see an insured invoke it. But I have seen it come up where they have had conversations with the insured for them to improve their prequalification process. But yes, you are right. The policy does have the requirement and I think insurers are getting better at educating their clients or their general contractor clients of the prequalification process. And I am aware that most of our general contractors actually have people on staff that are doing that for them or they are outsourcing it to other companies that will do the prequalification process for them. That is then included with a package when they submit the request to their agent or broker for coverage. So, it is an issue and it is something that is looked at and the companies are taking harder looks at.
Q: One question for the claims folks out there in the surety world is – okay, you’ve got that situation where there’s a surety bond mixed in with an SDI coverage situation on a project and things go bad. Can the surety through its equitable subrogation rights come after an SDI policy?
A: (Saba) Well, the policy, again, it’s not assignable. Can they subrogate to the proceeds? Yes, they could certainly be entitled to collect the proceeds against their principal under their indemnity, but they do not have a right of bringing a claim against the policy directly because the policy excludes it. There is one reported case on this, it is a California case. I am aware of a couple of actions right now that are pending. We are sure these are attempting to subrogate against the SDI policy and they are being vigorously opposed right now because of the plain language of the policy and it is non-assignability provision of the policy. So, it is something that the companies are very guarded on is to make sure that that policy is not another source of recovery for a third party.
(Mainello) Being a surety claim person for years, we always relied on general liability policies to cover what we could from the second party, defective work, the hole in the roof, the issues that we had. This is not one of those coverages that we have seen successfully pierced yet, if I can use that word. So, it is going to be really interesting to follow those cases in the courts.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com), Mike Saba, V.P., Guardian Group (410-838-5370/Michael.Saba@guardiangroup.com) or Steve Mainello, Sr. V.P., RCM&D (443-921-2517/ SMainello@rcmd.com).
