As a subcontractor, what do I need to know about Subcontractor Default Insurance?

Subcontractor Default Insurance... The Subcontractor’s Perspective

The last ten years have seen the increasing emergence of Subcontractor Default Insurance, which has been marketed as an alternative to the conventional bonding approach. Subcontractor Default Insurance, or Subguard®, the trade name used by Zurich North America for its Subcontractor Default Insurance, has become fairly common on larger construction projects, and subcontractors must be aware of its potential effect on them and on the project.

Subcontractor Default Insurance provides the insured contractor with insurance funds upon the default of a subcontractor. In order to obtain payment, the contractor must pay in the first instance and then provide a proof of loss to the insurer.  The amount of recovery available to the insured is subject to deductibles and co-payments proportional to the limit of liability, and many policies include a per loss deductible.

Subcontractor Default Insurance is not without its critics. The Surety Association of Canada has summarized its views on the relative benefits of surety bonds and contractor default insurance and has noted some of the shortcomings of contractor default insurance on its website: see www.surety-canada.com.
Despite the criticisms of contractor default insurance, the product seems to have some definite advantages over traditional construction bonds from the point of view of the contractor. After paying its deductible, an insured general contractor may be entitled to compensation for costs that would not be covered under a typical performance bond. For example, the insured general contractor may be entitled to compensation for additional legal and other professional services required because of the subcontractor’s default. Typical performance bonds do not provide compensation for these sorts of costs.

In fact, Subcontractor Default Insurance will likely continue to prove very attractive to the general contractor on a larger project, for, as noted by the Surety Association of Canada, it may provide lower premium costs, greater control over prequalification of the subcontractor and project management, and coverage for entities otherwise not covered by a bond, while eliminating any surety investigation period after subcontractor default.

From the perspective of the subcontractor, however, Subcontractor Default Insurance may not be ideal. The first problem from the subcontractor’s viewpoint is that Subcontractor Default Insurance is intended to protect owners, general contractors and construction managers against defaults of subcontractors.  It is not intended to provide assurance that owners, general contractors or construction managers will make timely payments to subcontractors.  In order to reduce its costs, a general contractor may suggest to the owner that it need only post a ‘gap’ bond that will respond to default of general contractor’s own work, and need not provide the owner with the usual labour and materials bond.  While this arguably exposes the owner to increased risk, it clearly constitutes a savings made on the back of sub-subtrades and suppliers to the project, who will have no payment protection whatsoever in the event the subcontractor that retained them defaults.

Furthermore, the general contractor can now act as both judge and jury when determining a subcontractor’s default, as a subcontract can be unilaterally terminated by the general contractor with litigation being the only leverage remaining to the subcontractor.  Where there is a performance bond, on the other hand, the surety or bonding company may act as an independent third party in determining whether subcontractor termination is warranted. 
A further concern that subcontractors may have arises out of the prequalification process associated with Subcontractor Default Insurance. To qualify under the construction bonding process, subcontractors must provide confidential information to the surety, which may include financial information, details of other projects, and other company information. Subcontractors may be less willing to provide this type of information to the general contractor under the Subcontractor Default Insurance prequalification process knowing that they may soon be involved in negotiations with the same party.

David Mckenzie is a lawyer practicing construction and commercial litigation at Jenkins Marzban Logan LLP in Vancouver. He is called to the bar of British Columbia. David can be reached at dmckenzie@jml.ca.

DISCLAIMER: The author does not intend to form a solicitor-client relationship with a reader of this article.  This article is for information purposes only. It should not be relied upon for legal advice. If you require legal advice, you should seek counsel authorized to practice law in your jurisdiction.