Managing subcontractor risk: Today's business climate requires contractors to handle their subs properly

When the recession started in 2007-08, general contractors faced a new reality in managing the risk level on their jobs. Whether the risk was caused by thin margins or subcontractors closing their doors, nobody wants to re-live that difficult time. Some of the lessons learned about managing subcontractor risk can and should be continued, even during good times. Subcontractor risk is always there but sometimes it can be hidden when there is a lot of work.

Every contractor should have standard procedures in place to manage subcontractor risk. The primary standard procedure is the written subcontract. It’s important to have those strong relationships with your partner subcontractors but the written subcontract is now mandatory. Failing to take this important step increases your risk and may forfeit some insurance coverage, too. Some insurance coverage is contingent on having a written contract in place. No written contract — no coverage.

The next level of risk protection may come from the ability to transfer that subcontractor risk. There are two available third-party products to transfer subcontractor risk:

    • Subcontractor Performance and Payment Bonds.
    • Subcontractor Default Insurance (SDI).

Each product has its own history and process, but both products rely on the underlying subcontract. Therefore, consideration for bonds or SDI is secondary to ensuring you are first satisfied with the rights and responsibilities under the subcontract.
    
Surety Bonds

Surety bonds have been available to GCs for more than 100 years. While use of subcontractor bonds varies throughout the country (more usage where economic conditions are more volatile), many GCs incorporate selectively bonding subs into their risk management plan.

When a bonded subcontractor has defaulted in their performance, the process requires the GC to adhere to the subcontract terms as well the bond form terms. Bond forms vary. Therefore, it is important to understand what requirements must be met to substantiate a bond claim.  Surety bonds provide “first dollar” coverage whereas SDI requires a deductible like other insurance products.

A major benefit of subcontractor bonds is the prequalification efforts undertaken by the subcontractor’s bonding company. This is one of the key differences to SDI, where the GC performs all of the prequalification work.
    
Subcontractor Default Insurance

SDI entered the risk management scene in 1996, serving as an alternative to bonds for third-party risk transfer.  Today, approximately 300 GCs have incorporated SDI into their risk management program. Many of those GCs continue to selectively require bonds from subcontractors. Note that any bonded subcontractor is excluded from SDI coverage, avoiding overlap of default tools.

SDI is an indemnity policy; therefore when default occurs, the GC cash flows the resolution and then seeks reimbursement by submitting a claim to its carrier. Similar to other insurance lines, SDI has a premium cost and also deductible and co-payment components in the event of loss. This differs from bonding, where premium is the only cost to the GC.
Establishing an SDI program is a significant commitment of time and resources for a GC. The underwriting process is extensive and involves assessing areas including your:

    • Business plan.
    • Prequalification systems.
    • Historic general liability loss experience.
    • Quality programs.
    • Financial statements.

The main attraction for SDI is the ability for the GC to control the resolution of the defaulted subcontractor. With both margin and reputation on the line for projects with condensed schedules, some prefer SDI over surety bonds, believing it supports faster resolution to a default.

While SDI has grown substantially since its inception (now covering approximately $40 billion in subcontract costs annually), there are inherent limitation on further growth. SDI applicants must have in place a robust internal prequalification process to be eligible.

Summary

As bidding and construction heats up this year, it’s important to use the lessons learned from the past to manage the financial risk of hiring subcontractors. Use a strong subcontract agreement. Do your due diligence when hiring a subcontractor, especially if you are unfamiliar with them.  Implement a strong list of standard procedures that your project managers are expected to follow. Consider appropriate transfer of some of that risk either through bonding or SDI. While many do not qualify for SDI, best practices can be learned from those that built quality and prequalification programs to lower the risk of subcontractor default. Each product can serve the GC well in managing subcontractor risk.

Finally, don’t feel like you have to do this alone. Build a team of professional advisors that are construction specialists to draw upon. Utilize your legal, financial, insurance and surety advisors to stay current on the tactics others are using as it may lead to improvements in your own risk management program. As your company changes and evolves over time, so should your management of financial risks.

Grady Dotson is the Vice President of Cobb, Strecker, Dunphy and Zimmerman in Utah, a construction focused insurance and bonding agency. He has been working in bonding and insurance for 30 years.