We started a conversation on our Facebook page the other day about the differences between surety bonds and subcontractor default insurance. We wanted to delve in a little more to help you decide if a subcontractor default insurance (SDI) or surety bond is the best way to protect your business.
SDIs have become popular since 1996 as a way for contractors to manage the risk of working with subcontractors. Basically, through SDIs, the contractor is accepts and manage risks that occur if a subcontractor defaults on their contractual obligations. The trade off is, that the benefits of a performance or payment bond are not applicable in SDIs.
Below we break down the different benefits and risks.
One of the differences between surety bonds and SDIs are that there are specific regulations in the surety bond industry, which the state insurance department enforces. Bond forms are also standard (although are negotiable) in a surety bond. Whereas, the insurance company mandates which form the parties will use with an SDI. A surety bond also has the benefit of protecting all three parties (obligee, principal and surety). An SDI is a two party contract between the insurer and principal.
The premium is also calculated differently in each case. For the surety bond, it takes into consideration the potential for any sort of loss, but also has a pre-qualification services fee (which is based on size and type of project). In an SDI, the pooled risk of the group determines the premium. To continue, claims, in a surety bond, allows the surety to contract balances or indemnity. In an SDI, there is no right to the insured’s assets. Finally, a surety bond’s coverage is project-specific whereas a SDI is term specific.
Performance and Payment Bonds vs SDI
It is also important to know the difference between a performance and payment bond. A performance bond protects the general contractor and the owner from any financial risk if the contractor or subcontractor are not able to fulfill their contractual obligations. A payment bond protects certain subcontractors, suppliers and laborers, in making sure that the contractor will pay them according to the terms in the surety bonds. Below we will compare performance and payment bonds against SDIs.
The difference between the two entities begins during the pre-qualification process. With performance and payment bonds (PPB), this process is carried out by the surety. The subcontractor submits financial documents to prove competency to carry out the terms. Whereas with an SDI, the pre-qualification process is left to the policy holder. This means, that, a PPB approval process is more thorough due to the required documentation requested by the surety bond producer. A PPB fully covers the subcontractor and suppliers, but not so in a SDI. In a SDI, the subcontractor or supplier is unable to file a direct claim with the insurer.
If a party files a claim, the SDI allows the contractor to declare and manage the default whereas in a PPB, the surety decides the legitimacy of the default as an independent party. If the surety decides that the subcontractor is in violation of the contract, then the surety completes and arranges for (or pays) the contract completion, up to the bond amount. As far as legality, a PPB is a requirement by federal and state law on public projects. It also has a long history of case laws and legal precedents. Therefore making it more established than a SDI.
- When applying for a surety bond, it is often a requirement to provide more financial information than SDIs.
- The surety is an independent party in the contract, therefore they are unbiased.
- Surety bonds have a longer legal history, with precedents and case laws.
- Surety bonds offer more protection than subcontractor default insurance because they are regulated.