For certain large projects, this insurance can be an effective alternative to performance bonds.

For some construction management firms, subcontractor default insurance policies offer a viable alternative to performance bonds. These policies are designed for the “at risk” construction manager (CM), general building contractor and design-build firm with an annual subcontract volume of $75 million or more. Often, subcontractor default insurance policies are procured in connection with a single large project and as a component of an owner-controlled insurance program. In addition to offering CMs better options in the event of a default, subcontractor default insurance coverage is often significantly less expensive than a bond of equivalent liability limits. However, the insurance does have common problem areas.

Subcontractor default insurance (SDI) is structured to allow a CM to avoid some of the difficulties that plague claims against sureties. These programs cover the following categories of losses:

  • The cost of completing a defaulted sub’s scope of work
  • The cost of correcting defective or nonconforming work or materials
  • Certain legal and professional fees incurred in connection with a sub’s default
  • Costs incurred in the investigation or adjustment of the default
  • Liquidated damages, job acceleration and extended overhead costs incurred by the CM as a result of the default

In contrast, performance/payment bonds typically lack specificity as to the categories of costs covered. This frequently engenders litigation.  

Additionally, with SDI, CMs do not have to wait for a surety’s investigation of the merits claim. Instead, the CM is entitled to unilaterally determine that a sub has breached the contract and is now in default, which would trigger the policy. However, if the sub is later found not to be in default, the proceeds paid to the policy holder must be returned.

One potential drawback to subcontractor default insurance involves subrogation against a subcontractor. The standard SDI program provides the carrier with subrogation rights against a subcontractor declared to be in default. This raises the prospect of the carrier paying policy proceeds to the CM and bringing suit in the name of the CM against the subcontractor. If the carrier loses the case, that company would seek reimbursement from the CM.

The CM, its coverage counsel and its insurance broker should seek changes to the SDI policy to avoid this situation. The coverage counsel or broker should ensure that the policyholder cannot be put into the position of sitting on the sidelines while the carrier litigates an action that will determine whether the CM is entitled to policy proceeds.

SDI policies’ standard terms contain other important limitations. First, subcontracts over $40 million cannot be enrolled without the carrier’s express consent. If a change order brings the value of a contract above this threshold, it must be reported to the carrier, which will determine whether to accept the contract for coverage under the policy. Because SDI is aimed at CMs involved in mega projects, this can be problematic. At a minimum, SDI policyholders should seek clarification that a change order that brings the value of a covered contract above the threshold will not result in the exclusion of the entire contract from coverage.
Standard SDI terms exclude coverage for any contract that is acquired by the CM from any other person or entity or that is transferred from the policyholder to any other person or entity. The SDI policy also requires that the carrier be notified of any change in the ownership or composition of the policyholder and prohibits assignment of the policy without the carrier’s consent.

Prospective policyholders and other involved parties should seek modifications to these terms to ensure the coverage will continue to be effective in the event that a project requires a shuffling of responsibility for completion. CMs and their constituencies should identify every entity that may take over a project and identify each as a named insured.  

Making Claims
Another occasionally problematic term is the “other insurance” clause. Such clauses typically state that the SDI policy “shall be excess only and non-contributing over any other valid and collectible insurance available to you.” Large projects invariably involve numerous overlapping insurance policies. One or more of these policies may be triggered by a subcontractor’s default. A CM who makes the substantial premium investment required to procure an SDI policy should not be forced to pursue another insurer for losses arising from a subcontractor’s default. If another insurer’s policy is implicated by a loss covered by the policy, the carrier can pursue equitable contribution claims from that insurer, but the CM should not be forced to look to other coverage first. Prospective policyholders should seek the removal or alteration of the “other insurance” clause.  

Contractors should also be aware that the carrier requires the policyholder to satisfy significant retention/deductible and co-insurance obligations. A minimum of a $1 million deductible and co-insurance of 20 percent is not unusual. These obligations are implemented so that policyholders will be motivated to avoid declaring a default in those situations in which some accommodation can be reached with a non-performing sub.

Before the carrier will make payment, the CM often must submit a detailed proof of loss that includes default notices, subcontracts and purchase order agreements. The carrier may respond by paying but will more likely respond with additional information requests.  

The best way for CMs to avoid problems during the claim process is to ensure that the project is well documented. Claims for delay, extended overhead or increase in general conditions costs will be viewed skeptically unless the CM can tie the loss specifically to the defaulted subcontractor.

Standard Requirements
Prospective policyholders should be aware that most SDI policy forms provide for mandatory, binding arbitration of coverage disputes. In addition, the forms typically contain a “choice of law” provision designating New York law as governing the policy. This choice of law provision should be eliminated when New York has no meaningful connection to the project or policyholder. If elimination of the clause is not feasible, amend the choice of law provisions to designate either a neutral jurisdiction or one that has a logical connection to the project.  

The arbitration itself can also be problematic. Because SDI is comparatively new and is not in wide use, it is more likely to contain latent ambiguities and contradictions than more common insurance policies, and coverage disputes are more likely to arise. In the case that such a dispute does arise, CMs will want to have the benefit of a judicial forum that recognizes the uneven bargaining power between CMs and SDI carriers.