Creating a Defense Contractor Stability Pool: Converting Termination Risk into Insurable Protection
Mobilizing Private Capital: Practitioner Recommendation 3 by Andrew Hersh
This is an excerpt from our Mobilizing Private Capital for National Security: BENS Practitioner Recommendation Series. Drawing on BENS members’ extensive experience across private equity, venture capital, investment banking, and defense contracting, we are introducing practitioner-authored novel concepts and approaches to make the national security ecosystem more investable.
This recommendation comes from Andrew Hersh, National Security Leader at Newfront Insurance, Chairman of Governance Risk Global, and Founder and former CEO of Sigma7 Risk. With nearly 30 years addressing complex risk challenges, Andrew is a thought leader on how private insurance capital can be best leveraged to achieve national resilience, in securing critical supply chains, and to facilitate private capital investments across these sectors. He believes that risk pooling mechanisms – proven in commercial and non-defense infrastructure – could lower the risk profile for defense contractors and unlock private investment.
Recommendation In Brief
Establish a Public-Private Partnership (P3) Defense Contractor Stability Pool (DCSP), an industry‑funded, privately managed risk pool that transfers the risk of termination‑for‑convenience (T4C) exposure that FAR Part 49 does not fully compensate. This would convert sovereign contract uncertainty into priced, transferable risk, mobilizing private capital to expand defense production capacity. While we acknowledge that ”insurance” is almost entirely constrained to accidental and fortuitous loss, we are using the term broadly to refer to transferable risk.
The mechanism advances only if validation confirms:
Termination uncertainty is a top constraint on lending;
Loss patterns support sustainable pooling; and
Government backstop can be structured to avoid Federal Credit Reform Act (FCRA) subsidy scoring.
The Opportunity
Mid‑tier contractors – roughly $50M–$500M in revenue – hold real Department of Defense (DoD) demand, but face high borrowing costs or outright denials because lenders cannot price sovereign contract uncertainty. Collective risk mechanisms in other sectors, Federal Housing Administration mortgage insurance, terrorism insurance in the United Kingdom known as Pool Re, and Owner‑Controlled Insurance Programs (OCIPs) in construction demonstrate that risks viewed as “uninsurable” can become investable when losses are defined, pooled, and backstopped.
How the Pool Would Work
Coverage structure: The DCSP would cover specific, uncompensated losses from T4C, the residual risk exposure that FAR Part 49 either explicitly excludes or leaves to subjective determination.
Coverage would use clear, objective triggers and exclusions to limit moral hazard through either:
Traditional indemnity insurance covering documented extra-expenses directly related to the canceled project and its business impact, such as unrecovered capital investments, contract-specific tooling, and working capital stress during settlement. This approach makes contractors whole for actual incurred losses.
Parametric trigger structure (an insurance-linked security) where contract cancellation triggers a predetermined fixed payment to the contractor regardless of actual documented losses. The parametric approach expedites payment without requiring extensive loss documentation, making tooling and facility investments effectively “cash-equivalent” collateral for lenders. Unlike indemnity insurance, this capital markets instrument could include compensation for lost expected profits on unexecuted work.
Financing and backstop: Premiums would be priced actuarially based on historical dollars-canceled rather than count of terminations; the pool is funded by contractor premiums. Government provides a catastrophic backstop structured as senior secured debt with super-priority repayment rights, subject to clear repayment terms with potential interest, making the backstop cost-neutral or revenue-positive over time. Private reinsurers and capital markets should participate to reduce the government backstop burden, which will also be reduced as capital reserves grow over time. As with any insurance company, the DCSP will be able to invest its float capital subject to government and regulatory rules, generating investment income that contributes to long-term sustainability.
Why This Matters
If T4C exposure can be priced and pooled, lenders can underwrite on conventional credit fundamentals – execution, collateral, cash flows – instead of worst‑case sovereign shocks. The expected effect is lower cost of capital and greater availability of growth debt for facility build‑outs, tooling, and workforce, precisely where DoD needs surge capacity.
Economic benefits extend beyond contractors: Contract cancellations trigger economic losses that reduce corporate and payroll tax revenue back to government. While insurance premiums may represent 1-2% of covered contract values, the government gains investment income from capital reserves, tax revenue protection from economic stabilization, and avoidance of emergency appropriations for distressed defense suppliers. Over time, a well-managed pool could become revenue-neutral or positive for government while materially expanding defense industrial capacity.
Why insurance pooling over alternatives? Expanded Defense Production Act (DPA) Title III direct loans require program-by-program appropriations and do not address systemic risk perception across the lending community. Cost-plus contracting reduces contractor risk but doesn’t unlock private capital for facility investment. Pooling, where actuarially viable, creates a self-sustaining mechanism that transfers risk and scales across programs without repeated appropriations battles.
The Challenge: What FAR 49 Leaves Uncertain
FAR Part 49 provides substantial protection to contractors through allowable cost reimbursement through FAR Part 31, reasonable profit on work performed and preparations made through FAR 49.202, and partial payments during settlement through FAR 49.112-1 – up to 100% for completed items and approved subcontract settlements, and up to 90% for termination inventory and other allowable costs.
However, FAR 49 explicitly excludes certain categories and leaves others to subjective determination, creating a residual risk exposure that lenders cannot price. This residual risk, though smaller than total contract value, is what makes defense contracts difficult collateral for private lenders.
The DCSP targets only this gap:
Consequential damages and certain cost recoveries face subjective determinations. FAR 49.201 calls for “fair compensation” determined by the Termination Contracting Officer (TCO) using “business judgment, as distinguished from strict accounting principles.” What constitutes fair compensation for unamortized capital and specialized tooling made post-award for multi-year production may not be fully recovered when termination occurs early in contract performance.
Subcontractor penalties may or may not be allowable depending on FAR Part 31 cost principles and how subcontracts were structured.
Working capital gaps persist despite partial payments. The 10% not advanced on certain costs, plus settlement expenses, which do not receive partial payments, plus 6-12 month settlement timelines create cash flow stress – particularly for smaller firms without deep credit lines.
Subjective determinations of what costs are “reasonable” and what profit is “fair” under FAR 49.202’s nine-factor test create uncertainty that lenders cannot price. FAR 49.202 also explicitly excludes anticipatory profits, while traditional indemnity insurance cannot cover speculative profits, parametric insurance-linked security structures could address expected returns on capital.
The inability to insure or price this residual sovereign termination uncertainty degrades collateral value and drives lenders to demand prohibitive rates or decline the exposure entirely.
NOTE: DCSP does not replace FAR 49. It insures the residual risks that FAR 49 either explicitly excludes or leaves to subjective determination. The goal is to convert sovereign uncertainty into priced, insurable risk, making defense contracts viable collateral for private lending.
Actuarial Uncertainty
Pooling requires dollar‑weighted loss data by fiscal year, agency, appropriation, contract type, and phase. If cancellations are infrequent but highly correlated during fiscal stress such as sequestration‑like periods, capital reserves may be depleted in a black-swan event and the government backstop may be triggered. To stand up a P3 insurance pool, it must acknowledge and be prepared for a black-swan event. Today, the necessary data to determine the spread and magnitude of risk exists across DoD/DCMA/Comptroller systems but are not analyzed for this purpose.
Critical risk: Termination decisions are policy choices, not random events. In a year like 2025, where the government engineered widespread spending reductions through its DOGE program, risk that previously appeared distributed could breach the capital reserves in the pool.
Moral Hazard and Governance
Because government decisions trigger claims, design must avoid dulling program discipline. Coverage must exclude terminations for cause such as contractor non-performance, use narrow and objective triggers, and structure premium differentials to internalize cancellation costs. Governance must be independent of program offices while remaining accountable to Congress, the U.S. Department of the Treasury, and participating firms.
Budget Optics and Scoring
Contractors will pass premiums into bids, with DoD effectively paying 1-2% more on covered programs. That surcharge is justifiable only if the mechanism unlocks materially more private investment and accelerates capacity than alternative tools, and if the government realizes offsetting benefits through investment income, tax revenue stabilization, and reduced emergency appropriations.
Critical barrier: Under the Federal Credit Reform Act (FCRA), if the government backstop has expected net cost (premium revenue < expected claims + admin costs), the Congressional Budget Office (CBO) will score subsidy cost upfront as budget authority. Phase 1 must pre-clear a backstop structure with the CBO and Office of Management and Budget that qualifies it as revolving credit; not a credit subsidy. A proposed approach for addressing this barrier is for government to collect risk-based premiums for the backstop itself – making it actuarially neutral. Or structures the backstop as senior secured debt with super-priority repayment rights above all other pool obligations. Without favorable CBO scoring, political viability is zero.
The Path Forward
A staged approach with hard decision gates ensures we only scale if the economics, insurability, and market behavior check out.
Dive into Andrew’s three-phased approach to create a Defense Contractor Stability Pool.
Explore even more practitioner recommendations to Mobilize Private Capital for National Security.