Surety Bond Quarterly - Winter 2017 - 15

SUBCONTRACTOR DEFAULT INSURANCE
(SDI), or Subguard,™1 was created in
1995 as an alternative to surety bonds.
It is often obtained in connection with a
larger construction project and as a part
of an owner-controlled insurance program (OCIP). SDI has primarily received
attention among larger contractors as
a way to manage risk of subcontractor
failure on private construction projects.
Indeed, SDI was originally marketed to
meet the needs of large general contractors, construction managers, and
design-build firms with expenditures
of $50 million plus.2 However, as SDI
policies are being advertised by more
and more insurers, the industry may
see a shift in the number of contractors opting for SDI as a replacement
for traditional subcontractor bonds.
Whether managing a project with a
subcontractor in default where SDI
is involved or educating others in the
industry regarding the pros and cons
of each, the surety claims professional
needs to be aware of the significant
differences between SDI and bonds. A
number of benefits provided by performance and payment bonds are absent
under SDI, benefits which may have a
significant impact on loss mitigation
and which need to be communicated
to contractor consumers.
Number of Players, Risk,
and Regulation
The primary distinction between SDI
and surety bonds is the type of contractual agreement involved. SDI consists
of a two-party agreement between the
insured contractor and the insurance
carrier. Upon a subcontractor's performance default, the carrier indemnifies
the contractor for costs incurred. The
general contractor retains a portion of
the risk through high deductibles and
co-payments. SDI may be written on
a non-admitted or surplus lines basis;
therefore, if the SDI carrier becomes
insolvent, there is no recovery under
the state guarantee fund.
Surety bonds, on the other hand,
encompass a tripartite agreement
between the subcontractor principal,
surety, and contractor/obligee. In this
arrangement, the surety guarantees
that the subcontractor will perform the

construction subcontract in favor of the
contractor. It is a complete risk transfer
from the general contractor to surety,
with first-dollar coverage. Sureties are
admitted and regulated by state insurance departments, regularly filing rates
and financial information.
Legal Precedent
Surety bonds have been in existence
for millennia. While there are wellestablished statutes and case law
governing surety bonds, which provide generally clear guidelines for
surety claims professionals, there are
few reported decisions on major SDI
disputes. In 2011, the Ohio Supreme
Court addressed the issue of whether
a public works bond statute applied
to a construction manager at risk on a
public works project.3 The owner had
not required that the construction manager obtain performance and payment
bonds as normally would be required
under the Ohio public works bonding
statute. The construction manager did,
however, provide a $20 million irrevocable standby letter of credit and also
purchased subcontractor default insurance. Holding that the statute and its
bond requirement only applied to competitive bids, and did not apply to a
construction manager at risk, the court
held that no bonds were required for
that public project.4
Some in the industry have opined
that this case raises the question as to
whether SDI is a viable alternative to
traditional surety bonds.5 Regardless,
even though SDI has now been in existence for over twenty years, it is still
uncertain how various jurisdictions
will rule on SDI issues in constructionrelated disputes. While some take the
position that the argument of "older
therefore better" is "misplaced,"6 the
fact remains that SDI is still an unknown
quantity in the realm of construction
jurisprudence. Surety claims professionals in the business of risk assessment may undoubtedly find it easier to
evaluate a default when there are legal
guidelines with which to compare it. 7
Cost Comparison
Cost is one of several factors to be
considered in deciding whether to

purchase a performance bond or SDI
to cover the risk of a subcontractor
default. SDI involves deductibles and
co-payments while bonds do not. Aside
from the premium, no additional payments are required by the principal to
trigger bond coverage. Protection is
guaranteed upfront. SDI co-payments
are capped at the agreed upon retention aggregate, which is the maximum
amount the insured will have to pay
for a claim arising during the policy
period.8 It is not uncommon for SDI
deductibles to be as high as $500,000
to $1 million.9 Notwithstanding, cost
is often a major benefit cited for SDI
over performance bonds. SDI can be
purchased for as little as 50 percent
of the cost of bond premiums, which
range from 1 to 1.25 percent of the
value of the subcontract. Whereas
performance bonds are issued in the
equivalent value to the subcontracts,
by comparison, the policy limit on an
SDI policy is often less than the total
value of all of the subcontracts-usually
ranging from .4 to .85 percent of the
total subcontract values.10
What's Covered?
SDI policies are structured to cover five
broad categories of losses: (1) the cost
of completion of a defaulted subcontractor's scope of work; (2) the cost of
correcting defective or nonconforming
work/materials;11 (3) certain legal and
professional fees incurred in connection with a subcontractor's default; (4)
costs in the investigation or adjustment
of the default; and (5) liquidated damages, job acceleration, and extended
overhead costs incurred by the insured
as a result of the default.12 For megaprojects, it usually covers the performance
of all subcontractors on both first- and
second-tier subcontracts. Unlike some
bonds, SDI covers indirect losses from
a default, such as liquidated damages,
acceleration of other subcontracts, and
extended overhead.13 Notwithstanding,
many subcontract bond forms and subbonds based on the AIA A312 allow for
recovery of these damages, including
liquidated damages.
Proponents of SDI contend that
surety bonds have less specificity as to
the type of losses covered, which often

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Table of Contents for the Digital Edition of Surety Bond Quarterly - Winter 2017

NASBP Upcoming Meetings & Events
2017–2018 Executive Committee
From the CEO: Looking Backward to Reach Forward
Relationships for the Long Run
Subcontractor Default Insurance: Relevant Considerations for the Surety Claims Professional
Bottom Line Protection with Job Cost Accumulation & Allocation
Inside the AIA’s New Insurance and Bonding Contract Exhibit
The Calm After the Storm: Managing Disaster Response Contracts
Practical Tools to Help Jump-Start Your Company’s Cyber Plan
Index to Advertisers
Surety Bond Quarterly - Winter 2017 - Intro
Surety Bond Quarterly - Winter 2017 - cover1
Surety Bond Quarterly - Winter 2017 - cover2
Surety Bond Quarterly - Winter 2017 - 3
Surety Bond Quarterly - Winter 2017 - 4
Surety Bond Quarterly - Winter 2017 - 5
Surety Bond Quarterly - Winter 2017 - 6
Surety Bond Quarterly - Winter 2017 - 2017–2018 Executive Committee
Surety Bond Quarterly - Winter 2017 - 8
Surety Bond Quarterly - Winter 2017 - From the CEO: Looking Backward to Reach Forward
Surety Bond Quarterly - Winter 2017 - 10
Surety Bond Quarterly - Winter 2017 - Relationships for the Long Run
Surety Bond Quarterly - Winter 2017 - 12
Surety Bond Quarterly - Winter 2017 - 13
Surety Bond Quarterly - Winter 2017 - Subcontractor Default Insurance: Relevant Considerations for the Surety Claims Professional
Surety Bond Quarterly - Winter 2017 - 15
Surety Bond Quarterly - Winter 2017 - 16
Surety Bond Quarterly - Winter 2017 - 17
Surety Bond Quarterly - Winter 2017 - 18
Surety Bond Quarterly - Winter 2017 - 19
Surety Bond Quarterly - Winter 2017 - 20
Surety Bond Quarterly - Winter 2017 - 21
Surety Bond Quarterly - Winter 2017 - 22
Surety Bond Quarterly - Winter 2017 - 23
Surety Bond Quarterly - Winter 2017 - 24
Surety Bond Quarterly - Winter 2017 - 25
Surety Bond Quarterly - Winter 2017 - Bottom Line Protection with Job Cost Accumulation & Allocation
Surety Bond Quarterly - Winter 2017 - 27
Surety Bond Quarterly - Winter 2017 - 28
Surety Bond Quarterly - Winter 2017 - 29
Surety Bond Quarterly - Winter 2017 - Inside the AIA’s New Insurance and Bonding Contract Exhibit
Surety Bond Quarterly - Winter 2017 - 31
Surety Bond Quarterly - Winter 2017 - 32
Surety Bond Quarterly - Winter 2017 - The Calm After the Storm: Managing Disaster Response Contracts
Surety Bond Quarterly - Winter 2017 - 34
Surety Bond Quarterly - Winter 2017 - Practical Tools to Help Jump-Start Your Company’s Cyber Plan
Surety Bond Quarterly - Winter 2017 - 36
Surety Bond Quarterly - Winter 2017 - 37
Surety Bond Quarterly - Winter 2017 - Index to Advertisers
Surety Bond Quarterly - Winter 2017 - cover3
Surety Bond Quarterly - Winter 2017 - cover4
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