Subcontractor default, bonds versus SDI and claims on bonds

On a typical building project, subcontractors perform most of the work, often 70 to 90 % of the contract value. A general contractor's performance therefore depends on dozens of firms, many of them small, some with weak balance sheets and several working for other contractors on other projects at the same time. When one fails, the general contractor must finish its work, usually at higher cost and with delay, while still owing the owner the original price and completion date. CON-330 lesson 11 covers the practical steps of managing a struggling subcontractor and terminating one that defaults. This lesson covers how that risk is transferred, through subcontractor bonds or subcontractor default insurance, and how claims on bonds work for owners, contractors and unpaid subcontractors.

The cost of a subcontractor default

The direct cost of a default is the difference between what the defaulting subcontractor would have been paid to finish and what a replacement charges, plus the cost of correcting its defective work. The indirect costs are often larger: delay to other trades, acceleration, extended site overhead, liquidated damages owed to the owner, additional supervision and legal fees. A replacement subcontractor brought in mid-job, often under time pressure, rarely charges less than the original.

Prequalification (CON-330 lesson 3) is the first defense: checking each subcontractor's finances, backlog, safety record, references and capacity before award. But prequalification only lowers the probability of default; it cannot remove it. Contractors therefore transfer the remaining risk in one of two ways: by requiring subcontractors to provide performance and payment bonds, or by buying subcontractor default insurance (SDI) and enrolling their subcontractors in it. Some do both, bonding some trades and insuring others.

Subcontractor bonds

A subcontractor performance bond works like the general contractor's own bond, with the general contractor as obligee. If the subcontractor defaults, the general contractor calls on the surety, which may arrange completion or pay up to the penal sum. A subcontractor payment bond protects the subcontractor's own suppliers and sub-trades, which in turn protects the general contractor from lien claims and from having to pay twice to keep the job moving.

Bonds have strengths: the subcontractor pays for them (in its price), the surety prequalifies the subcontractor, and the general contractor carries no deductible. They also have weaknesses. Many small but capable subcontractors cannot obtain bonds or charge a significant premium for them, narrowing the bidder list. The surety's response to a default can be slow, because the surety investigates whether the default is genuine and whether the general contractor has met the bond's conditions, and it may dispute the claim. The surety's liability is limited to the penal sum and, depending on the bond form, may not cover the general contractor's indirect costs such as delay and liquidated damages.

Subcontractor default insurance

Subcontractor default insurance is a policy bought by the general contractor that reimburses it for the costs of a subcontractor's default, including both direct and many indirect costs, above a deductible and within the policy limits. The contractor, not an outside surety, decides when a subcontractor is in default and how to remedy it, which allows a much faster response. The product was developed in the United States in the 1990s and is now also offered in Canada; brokers' 2026 reports noted that demand for SDI was growing faster than the market had historically, with pricing broadly flat to modestly rising.

SDI policies are usually written annually for all of a contractor's projects, with a per-loss deductible, often a co-payment layer above the deductible in which the contractor pays a share, a per-loss limit and an aggregate limit. Because the contractor keeps a meaningful retention, SDI suits larger contractors with strong balance sheets and disciplined prequalification programs; the insurer will review those programs before writing the policy. Owners of large projects sometimes ask contractors with SDI to name them as beneficiaries or to provide bonds anyway, because SDI protects the contractor, not the owner directly.

# Bonds versus SDI over a portfolio of subcontracts (illustrative, seeded)
import numpy as np
rng = np.random.default_rng(10)
subs = np.array([9.2, 6.8, 4.1, 3.5, 2.9, 2.2, 1.8, 1.5, 1.2, 0.9]) * 1e6   # enrolled subcontract values
p_default = 0.02                       # annual chance each sub defaults
cost_ratio = (0.08, 0.18, 0.45)        # default cost as share of subcontract (min, mode, max)
bond_rate, sdi_rate = 0.015, 0.0095    # cost as share of subcontract value
deductible, copay_share, copay_layer = 350_000, 0.20, 1_500_000
N = 50_000
bond_cost = bond_rate * subs.sum()
sdi_premium = sdi_rate * subs.sum()
retained = np.zeros(N)
for v in subs:
    hit = rng.random(N) < p_default
    loss = hit * v * rng.triangular(*cost_ratio, N)
    above = np.clip(loss - deductible, 0, copay_layer)
    retained += np.minimum(loss, deductible) + copay_share * above
sdi_total = sdi_premium + retained
print(f"Bond premiums built into sub prices: {bond_cost:,.0f}")
print(f"SDI premium: {sdi_premium:,.0f}; mean retained losses {retained.mean():,.0f}; mean total {sdi_total.mean():,.0f}")
print(f"SDI P95 total cost: {np.percentile(sdi_total, 95):,.0f}")

Bond premiums built into sub prices: 511,500
SDI premium: 323,950; mean retained losses 80,876; mean total 404,826
SDI P95 total cost: 849,277

In the illustration SDI is cheaper on average than bonding every subcontract, because the premium is lower and most years produce no default. The 95th percentile shows the price of that saving: in a bad year the contractor keeps deductibles and co-payments that can exceed the bond cost. Whether SDI makes sense depends on the contractor's ability to absorb that retention and on the quality of its prequalification. The comparison also ignores the bonds' hidden benefit, the surety's own prequalification of each subcontractor.

Claims on performance bonds

When a bonded contractor or subcontractor defaults, the obligee must follow the bond's conditions closely to preserve its rights. Courts in both countries generally enforce those conditions, and an obligee that terminates without notice, fails to give the surety a chance to act, or pays the principal amounts it should have held back may weaken or lose its claim.

Once default is established, the surety usually has several options. It may finance the principal so it can finish, if the problem is temporary cash flow. It may arrange a completion contractor, either by tendering the remaining work and paying the difference between the new price and the contract balance, or by taking over the contract and completing it itself through a completion contractor. It may pay the obligee an agreed amount, up to the penal sum, and leave completion to the obligee. Or it may deny liability if it believes there was no default or the obligee breached the bond's conditions. The choice depends on the bond form, the amount of work remaining and the surety's view of costs.

Claims on payment bonds

On federal projects, the Miller Act payment bond protects first-tier subcontractors and suppliers of the prime contractor, and second-tier subcontractors and suppliers who contracted with a first-tier subcontractor. A first-tier claimant can sue on the bond without prior notice once 90 days have passed since its last labor or materials; a second-tier claimant must give written notice to the prime contractor within 90 days of its last work or supply. Suit must be brought within one year after the claimant's last labor or materials, in the name of the United States, in the federal district where the work was performed. Little Miller Acts on state and local projects have their own notice and suit periods, and because liens are generally unavailable against public property, the payment bond is usually the main security for unpaid parties on public work.

# Miller Act payment bond deadlines from the date of last labor or materials (illustrative)
from datetime import date, timedelta
last_supply = date(2027, 3, 14)
print("Last supply:                     ", last_supply)
print("Second-tier notice deadline:     ", last_supply + timedelta(days=90), "(90 days)")
print("Earliest first-tier suit date:   ", last_supply + timedelta(days=90), "(after 90 days)")
print("Suit deadline (one year):        ", last_supply.replace(year=last_supply.year + 1))

Last supply:                      2027-03-14
Second-tier notice deadline:      2027-06-12 (90 days)
Earliest first-tier suit date:    2027-06-12 (after 90 days)
Suit deadline (one year):         2028-03-14

Deadlines are counted from specific events defined in the bond or statute, and the difference between 'last work' and warranty or punch-list visits has been argued in many cases. Unpaid claimants should calculate their deadlines from the earliest date that could count and act well before it.

Choosing the right protection

General contractors usually match protection to the risk of each trade. Critical, high-value trades with long durations, such as mechanical, electrical, structural steel and curtain wall, carry the most default risk and the largest consequences. Small trades with short durations and many alternative suppliers may need neither bonds nor enrollment. Owners, for their part, rely on the general contractor's bonds for their own protection and generally do not need to dictate how the contractor manages its subcontractors, although some public owners require subcontractor bonds above a set value.