Are you being overcharged for subcontractor default insurance?
INSIGHT ARTICLE |
A subcontractor was engaged to provide the concrete needed for a major construction project. The total cost of the concrete work was estimated to be $8 million, but after providing only $3 million worth of the work, the subcontractor defaulted. The general contractor (GC) offered to complete the work for the full $8 million, and the owner consented.
But the owner was unaware that the GC received funds from the surety as their agreement included subcontractor default insurance (SDI). The GC was assuming responsibility through the SDI, which provides catastrophic insurance coverage for the GC for the cost of subcontractor and supplier default. The GC received $3 million to cover the default and because the owner had consented to pay the $8 million, the GC was ultimately paid $11 million for the work. The GC had initially refused to share the SDI information with the owner, and the overpayment was not uncovered until auditors later reviewed the agreement.
The scenario is not unprecedented. In a survey of more than 400 contractors, owners, bond producers and others1, most participants agreed that owners do not understand the advantages and disadvantages of SDI. (GCs participating in the survey remained neutral on the topic.) But owners need to be aware of the various ways that general contractors can use SDI as a hidden source of revenue.
- Negotiated rate of subcontract costs: A common scenario takes place during contract negotiations. The GC will charge between 1.2-1.9 percent on subcontractor costs, with terms that do not allow for adjusting or even auditing at a later date. But the actual cost to the GC may be half that rate. In one real-life example, a GC not only charged the owner for a rate that was higher than the 1.2 percent fixed rate, but also applied the SDI to materials paid for directly by the owner (and which were not subcontracted costs subject to SDI compensation).
- Charging for all subcontractors: A subcontractor not enrolled in the SDI program, but the owner is charged for all subcontractors nevertheless.
- Not submitting claims: A subcontractor was engaged to provide plaster and gypsum board materials needed for a large construction project. The GC subsequently terminated the subcontractor and did not submit an SDI claim for the cost of materials in order to preserve the profit made through on the fixed rate charged to the owner.
What should owners do?
Owners will want to keep the following issues in mind the next time they are involved in negotiations and addressing subcontractor default insurance:
- Do not agree to a fixed rate. At the end of a project, auditors should be able to substantiate the costs being paid and the actual costs of the premium. Auditors should be able to determine whether or not claims and losses are within the policy, as well as to identify other factors that may have increased the costs of the premium.
- Agreement should only apply to those enrolled in the program. The insurance should not be applied to all subcontractor costs, thereby avoiding paying the general contractor for subcontractor work.
SDI may not be appropriate for all projects or even for all subcontractors, but with the growing popularity of SDI programs (due in part to their lower costs compared to payment and performance bonds) owners will need to know more about the details behind how SDIs are used.
It is not enough to be satisfied that a project is covered by insurance. While it may be too late to adjust current contracts, owners should be aware of how SDI, a relatively new product, works and the ways in which general contractors can take advantage of owner naiveté.
1 Bausman, D. "Subcontractor Default Insurance: Its Use, Costs, Advantages, Disadvantages and Impact on Project Participants," Sept. 2009, Foundation of the American Subcontractors Association, Inc., and the National Association of Surety Bond Producers.