Graham Company: Contractor Default Insurance: A Nuanced Alternative to Performance Bonds

For some construction management firms, a subcontractor default insurance policy offers a viable alternative to performance bonds. These policies are designed for "at risk" construction managers, general building contractors, and design-build firms with an annual subcontract volume of $75 million or more. Often, subcontractor default insurance policies are procured in connection with a single "mega" project, and as a component of an owner-controlled insurance program. In addition to offering CM's better options in the event of a default, subcontractor default insurance coverage is generally significantly less expensive than a bond of equivalent liability limits.

What Does it Cover?

Subcontractor default insurance (SDI) is structured to allow a CM to avoid some of the difficulties that plague claims against sureties – at least in theory. These programs expressly cover five broad categories of losses: (1) the actual cost of completing a defaulted sub's scope of work; (2) the cost of correcting defective or nonconforming work/materials; (3) certain legal and professional fees incurred in connection with a sub's default; (4) costs incurred in the investigation or adjustment of the default; and (5) 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, frequently engendering litigation, especially over the recoverability of delay damages and attorneys' fees.

Additionally, CM's 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. On the back end, if the sub is not found to be in default, the proceeds paid to the policy holder must be returned.

Subrogation Issue

The standard subcontractor default insurance 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, then bringing suit in the name of the CM against the subcontractor, and if the carrier is defeated on the merits, seeking reimbursement from the CM. CM's, along with their coverage counsel and insurance broker, should seek changes to the policy to avoid this situation. The CM may seek the removal of the subrogation terms, or it can seek terms allowing it to control any action against the defaulted sub. But the careful 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 with a third party that will effectively determine whether the CM is entitled to policy proceeds.

Size Limitations on Subcontractors Work

SDI policy's standard terms contain other important limitations. First, subcontracts over $40 million cannot be enrolled without the carriers express consent. If a change order brings the value of a contract above this threshold, it must be reported to the carrier who will determine whether to accept the contract for coverage under the policy. To the extent that SDI is aimed at construction managers involved in mega projects, this can be a problematic limitation. The major subcontracts to be let for such a project – e.g., structural steel, electrical – can easily exceed $40 million in value. At a minimum, SDI policyholders should seek clarification that a change order that brings the value of a covered contract above the specified threshold will not result in the exclusion of the entire contract from coverage under the policy.

Risk Transfer is Excluded

The program's standard terms exclude coverage for any contract that is acquired by the CM from any other person or entity, or 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. For projects that go smoothly, these terms are a non-issue, but of course, mega projects rarely run completely smoothly. Accordingly, prospective policyholders – and other interested parties like project owners – should seek modifications to these terms to ensure that the coverage will continue to be effective in the event a project runs into difficulties that require a "shuffling" of responsibility for a project's completion, like the insolvency or termination of the construction manager. In addition, CMs and their constituencies should insist that every entity that stands to potentially take over the running of a project should the CM become insolvent or be terminated be identified as a named insured.

What Policy Pays and When?

Another potentially problematic term is the "other insurance" clause. A typical "other insurance" clause states that the SDI policy "shall be excess only and non-contributing over any other valid and collectible insurance available to you." Large projects, and especially projects insured through Controlled Insurance Programs (CIPs), invariably involve numerous types of insurance coverage such as Builder's Risk, Commercial General Liability, Workers' Compensation and Contractors Pollution Liability that may have at least some overlap. One or more of these policies may be potentially triggered by a subcontractors' default. For example, if a subcontractor performs faulty or defective work, and that work results in damage to work performed by another subcontractor, the General Liability component of the CIP program may provide coverage. 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 indeed 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 in the event of a subcontractor's default. Accordingly, prospective policyholders and their insurance professionals should seek the removal or appropriate alterations of the "other insurance" clause.

High Deductibles

In the event of a claim, the carrier requires the policyholder to satisfy significant retention/deductible and co-insurance obligations. For example, a $1 million deductible and 20% co-insurance, at a minimum, is not unusual. Thus, policyholders will have significant amount of "skin in the game," and will be motivated to avoid declaring a default in those situations in which some accommodation can be reached with a non-performing sub.

Claim Investigation and Lag Time Between Payments

Before the carrier will make any payment, the CM must submit a detailed proof of loss that includes "a written description and any other supporting evidence, including the applicable Covered subcontract or purchase order agreement(s) and notice of Default of Performance, that document a claim as a covered Loss and quantify the amount of the Loss." The carrier is required to respond to the proof of loss within 30 days. They may respond by paying, but the more likely scenario is that the carrier will 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-organized and well-documented. Payments to the defaulted subcontractor should be clearly associated with well-documented work progress and a specific payment application. Payments made to a replacement subcontractor should also be well-documented and clearly relate to items within the scope of work of the defaulted sub. 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. Again, CMs are well-advised to maintain a careful and thorough record for the project.

Mandatory Arbitration and Other Standard Requirements

Finally, prospective policyholders should be aware that most SDI policy forms provide for mandatory, binding arbitration of coverage disputes. In addition, its form typically contains a choice of law provision designating New York law as governing the policy. The choice of law provision should be eliminated where 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 or policy.

Mandatory arbitration is also problematic for policyholders. In the event of a dispute in an arbitral setting, the policyholder may not receive the benefit of favorable canons of policy interpretation that have been adopted by nearly all jurisdictions in the United States. Because SDI is comparatively new and is not in wide use, it is more likely to contain latent ambiguities and contradictions than a more "ordinary" insurance policy, and coverage disputes are more likely to arise. When and if they do, CMs will want to be sure that they have the benefit of a judicial forum that recognizes the uneven bargaining power between CMs and the SDI carrier.

Conclusion

Subcontractor default insurance may be a viable alternative to traditional performance bonds because of the potential upfront cost savings and the ability to gain greater control over the claims process, but it is not for everyone. Making effective use of the SDI requires a CM to be large, very well-organized, involved in a substantial annual dollar volume in subcontracts, involved with a roster of trusted trade subcontractors, and prepared to self-insure before "real" coverage is available for a loss. It is also essential that the prospective policyholder's coverage counsel and insurance broker closely scrutinize all proposed policy terms to ensure that the protection expected is actually procured.

Source: Graham Company