Design-builders, general contractors and “at risk” construction managers are all vulnerable to the risk of a subcontractor default. Aside from contract-related safeguards, such as increased retention, joint checks and letters of credit, subcontractor surety bonds have been the traditional mechanism for third-party risk transfer.

First introduced in the mid-1990s, subcontractor default insurance (SDI) provides a viable “first-party” insurance alternative to traditional surety bonds. To compete with surety bonds, SDI policies are heavily marketed as having a more efficient claim processes. In practice, the SDI claim process is not without its challenges. Effective techniques can be employed to streamline the process and keep the project funded and on track.

What Is SDI?
In its broadest sense, SDI is a first-party insurance policy that indemnifies the insured for costs incurred as a result of a default by one of its subcontractors. The product was designed to directly address many of the disadvantages associated with traditional surety bonds. Unlike surety bonds, which typically lack transparency as to the types of covered losses, SDI policies typically cover all paid project losses, including costs to complete a defaulted subcontractor’s scope of work and the costs to correct defective or nonconforming work. SDI policies also typically cover indirect costs, such as costs to investigate the default, legal and consultant fees, as well as costs associated with project delays and acceleration.

Typical policies can be purchased with limits up to $50 million per claim/$150 million aggregate for direct claims and $5 million for indirect costs. SDI will not advance payments to the insured for project losses. Rather, the losses must be paid by the insured before they can be recouped through SDI. Moreover, project owners can be added to an SDI policy through a financial interest endorsement, and dedicated limits can be provided.

Another key advantage of SDI is the element of control given to the named insured over which subcontractors are enrolled in the program. The prequalification process usually includes a comprehensive financial analysis of the subcontractor. This control carries over to subcontractor defaults.

Unlike surety bonds, which require the contractor to wait for a surety to conclude its investigation into the merits of a subcontractor default, most SDI policies give the insured the sole right to declare a default, which would trigger policy coverage. Moreover, unlike surety bonds, where the surety decides the post-default course of action, SDI permits the insured to decide whether to finance the defaulted subcontractor or hire a replacement to complete the work.

Advanced Negotiation
SDI insurance is not without its drawbacks. Certain key SDI policy provisions can have significant impacts on both the timing and scope of post-default claim recovery. Depending on a firm’s buying power, effectively negotiating SDI policy language during the procurement process can have a dramatic and positive impact on the claim process.

Most SDI policies give the carrier subrogation rights against a defaulted subcontractor. In other words, the carrier paying the claim proceeds to the insured may bring a lawsuit in the name of the insured against the defaulted subcontractor to recover the payment. If the suit is unsuccessful, the carrier can seek recovery of the claim payment from the insured. Before purchasing an SDI policy, the insured, through its broker or counsel, should seek to negotiate modifications to this policy language to avoid disgorgement of the policy proceeds or allow the insured to control the subrogation lawsuit.

Another common SDI term that must be considered is the “other insurance” clause. These clauses typically require the insured to pursue and exhaust any other project insurance triggered by the subcontractor’s default before pursuing the SDI policy. The insured that pays significant premiums for an SDI policy should not be forced to first pursue other project insurance implicated by the default.

SDI policies typically require claim payments within 30 days of the submission of a “satisfactory” proof of loss. In reality, because “satisfactory” is typically undefined in most SDI policy forms, insurers may focus on this undefined policy language to delay the 30-day payment clock. Although the insurer must apply the term in a commercially reasonable manner, the insurer’s judgment may lead to delayed payments. Insureds should seek SDI policy modifications to define the term “satisfactory.”

Moreover, common SDI policy language concerning coverage for project contracts acquired from other entities or those transferred from the insured to another entity should be modified to help maintain coverage in the event that a project requires modifications to project scope completion responsibilities.

Finally, SDI policy language that prohibits enrollment of subcontractors with contractors valued above certain benchmarks (e.g., $40 million) must be addressed. Upfront clarification should be sought from the carrier to determine whether project change orders that bring the value of an otherwise covered subcontract above the benchmark will result in an exclusion of the entire subcontract from coverage.

Post-Default
Once a subcontractor default occurs, the process of streamlining a claim should begin before a claim is even submitted to the carrier. Almost immediately, the insured should takes steps to minimize the impacts of the default by identifying pitfalls affecting the project owner and the overall completion of the project. Properly documenting the entitlement and facts of the default also will prove useful if the SGI insurer challenges the propriety of the default. A claim strategy should be developed that is proactive and aligns the project controls with the real-time claim preparation.

In preparing a proof of loss, the actual calculations are rather simple: Reconcile the remaining available subcontract value against the work scope completion costs. The overrun is the base claim. The difficulty tends to be more about establishing a reasonable level of documentation, which should be arranged in a way that clearly marks the project status and contract values both pre- and post-default. Investing time to prepare a well-documented claim will pay off by setting the pace of the post-claim process. Claim processing delays can be avoided by giving in on small or undocumented items.

Claims for delays, extended project overhead or increased general conditions will be viewed skeptically by the insurer and lead to claim processing delays unless documentation can clearly link these costs to the defaulted subcontractor.

Although most SDI polices require payment within 30 days after the proof of loss is submitted, the process is, in practice, usually quite longer. The insured should expect a reservation of rights letter from the SDI carrier accompanied by a rather extensive request for information. In many cases, the claim process will involve multiple rounds of RFIs with responses. The RFI process is designed to rectify defects in the proof of loss submission.

Depending on the complexity of the claim, the RFI process can be rather lengthy. The insured should anticipate preparing detailed responses accompanied by backup claim documentation. Practically speaking, the insured RFI responses should take time to build strong narratives, as they will follow the company throughout the claim process. Moreover, the responses should create positive positions by highlighting consistent positions taken by the insurer in other cases. Importantly, the insured should be prepared to keep the project independently funded during this process.

Lastly, most SDI policy forms provide for mandatory, binding arbitration of coverage disputes. This can be problematic particularly given the latent ambiguities many SDI policy forms contain compared to more common insurance policies. These ambiguities are likely to trigger coverage disputes. In that event, insureds will want to take steps to avoid arbitration and have the benefit of a judicial forum, with an appellate process.

SDI policies are viable risk transfer options that offer many benefits. Many of the drawbacks related to the claim process can be eliminated through advanced policy language negotiation, especially for larger policy purchasers, which will be perceived by the carrier as repeat customers. Drawbacks that cannot be negotiated can be minimized by employing preparation, organization and diligence, as well as competent legal counsel.


Christopher A. Barbarisi is a partner at the Newark, N.J., office of K&L Gates LLP and is a member of the firm’s construction and engineering group. For more information, visit klgates.com.