Subcontractor Default Insurance (“SDI”): Can a Contractor’s SDI Insurer Claw Back Payments Made After a Claim Has Been Adjusted?
Category | Briefing Papers
By Robert L. Smith and Dean B. Thomson
Rob and Dean are members of the firm’s Construction Law Department. Rob can be reached at 612.359.7648 or rsmith@fwhtlaw.com. Dean can be reached at 612.359.7624 or dthomson@fwhtlaw.com.
A recent case out of New York challenges basic assumptions about Subcontractor Default Insurance (“SDI”) and raises questions about the circumstances under which an SDI insurer can claw back payments it made to the contractor it insured. SDI was developed to address a common risk on construction projects: the failure of a subcontractor to perform its contractual obligations. When a subcontractor defaults, the general contractor must act immediately to contain the consequences of that failure, including project delays, incomplete work, defective performance, and the resulting financial impacts. SDI policies are intended to provide a mechanism through which contractors can quickly obtain insurance recovery for those losses caused by a defaulting subcontractor, allowing work to continue without waiting for lengthy litigation.
The SDI claims process generally operates in three stages. First, the insured contractor determines that a subcontractor has defaulted, thereby triggering potential coverage, and submits the resulting costs to its insurer. Second, the insurer evaluates those claimed costs through the policy’s proof-of-loss and adjustment procedures to determine whether they qualify as covered “Loss” under the policy. Third, after paying the insured for covered Loss, the insurer obtains the exclusive right to pursue recovery from the defaulting subcontractor through subrogation. In doing so, the insurer assumes the possibility that it may not recover the full amount it paid, particularly because the insurer’s recovery rights are governed by the subcontract and may differ from the policy’s coverage obligations.
A recent New York case raises significant questions regarding this allocation of risk. In Lecesse Constr. Servs., LLC v. Hudson Excess, Ins., a New York trial court concluded that an SDI insurer could require its insured general contractor to repay a substantial portion of insurance proceeds it had paid to the contractor because the contractor was unable to recover an equivalent amount from the defaulting subcontractor. The insurer had actively participated in the policy’s adjustment process, issuing more than one hundred information requests, reviewing twelve separate proof-of-loss submissions over approximately a year, and ultimately determining that more than $8 million constituted covered Loss under the policy. After paying those benefits, however, the insurer sought reimbursement of more than $5.5 million based on the outcome of a subsequent arbitration proceeding against the defaulting subcontractor.
In that arbitration, the panel confirmed that the subcontractor had, in fact, defaulted. Nevertheless, the panel awarded less than the general contractor’s total claimed damages, expressing concerns regarding the scope of the claimed amount and instead awarding what it considered a fair and reasonable measure of damages under the subcontract. The arbitrators were not asked to interpret the SDI policy, apply the policy’s definition of “Loss,” or decide any coverage issue. Despite this, the insurer treated the arbitration award as establishing the proper measure of covered Loss and it demanded repayment of all policy proceeds exceeding the amount awarded against the subcontractor.
The trial court accepted that argument based on the policy’s so-called “claw back” provision, which required reimbursement where there has been a “legally binding determination that the Loss [did] not arise out of a Default of Performance.” That interpretation, however, is flawed for several reasons.
First, the court’s interpretation conflicts with the policy’s text and overall structure. Under the policy, the insurer is solely responsible for determining what constitutes covered Loss and the amount of the Loss through the contractual claim-adjustment process. The arbitration panel did not construe the SDI policy, apply its coverage standards, or evaluate whether specific costs qualified as covered Loss. Instead, it addressed damages recoverable under the subcontract. As a result, the arbitration award should have had no bearing on the insurer’s own prior determination that the claimed amounts were covered under the policy. Read in context, the claw back provision should apply only when a legally binding decision establishes that no Default of Performance occurred, meaning coverage was never triggered. Here, the arbitration panel reached the opposite conclusion, expressly finding that the subcontractor was in default.
Second, the insurer’s interpretation effectively eliminates the significance of the policy’s carefully defined claims process, disregards the contractual procedures for resolving coverage disputes, and alters the parties’ agreed allocation of rights and responsibilities. Under the insurer’s theory, the extensive adjustment process, during which the insurer gathered information, analyzed documentation, and determined the amount of covered Loss, would ultimately have no meaningful effect if a later decision-maker in a separate proceeding reached a different damages figure under a different legal standard. Such a reading not only renders the adjustment process largely meaningless, it also undermines the policy’s designated framework for resolving disagreements concerning covered Loss. Taken to its logical conclusion, the insurer’s position would permit coverage determinations made under the policy to be superseded by outcomes reached in later subrogation proceedings, even though those proceedings involve different issues and standards. Nothing in the policy authorizes such a result. To the contrary, the policy expressly contemplates circumstances in which the insurer may pay covered Loss that exceeds the amount ultimately recovered from the subcontractor.
Third, the insurer’s position, and the trial court’s adoption of it, is incompatible with the basic purpose of insurance and with the expectations of contractors who purchase SDI coverage. SDI exists to transfer the financial risk associated with subcontractor default from the contractor to the insurer in exchange for the payment of premiums. By accepting that premium, the insurer assumes the possibility that it may not recoup every dollar paid on a covered claim. That risk is fundamental to the insurance relationship. The insurer’s interpretation, however, effectively removes that risk entirely. Under its approach, any shortfall in subrogation recovery can be shifted back to the insured contractor, resulting in the insurer being made whole either through recovery from the subcontractor or repayment by its own policyholder. Such an arrangement does not meaningfully transfer risk; rather, it transforms the policy into a financing mechanism that deprives the insured of the protection and certainty for which it purchased coverage.
These issues strike at the heart of the parties’ agreement. The policy does not authorize the insurer to revisit and revise coverage determinations based on a later proceeding that applies different standards and addresses different questions. Nor does it permit the insurer to return to the insured and reallocate to it the very risk the insurer agreed to assume when it issued the policy. For those reasons, the general contractor has appealed the trial court’s ruling.
While the appeal is pending, the case provides key takeaways for SDI policyholders: First, in this case, the contractor started a recovery action against the subcontractor even though it likely did not need to do so. It should have left any such action to the SDI insurer because, under the policy, the SDI insurer is at risk for any difference between what it has paid its insurer and what it recovers from the defaulting subcontractor. Second, and more importantly, contractors should make sure coverage under their SDI policy is determined through the policy’s adjustment process with their SDI insurer and not some subsequent lawsuit between the SDI insurer or the contractor and the defaulting subcontractor. The policy should make clear either through an endorsement or the standard terms that the SDI insurer remains at risk for any difference between what the SDI insurer pays after reviewing all necessary proof-of-loss documentation and what might be recovered from the defaulting subcontractor.
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