Allocating Risk In Today’s Marketplace: Tracking Trends in The Insurance Arena Affecting Contractors
By K&L Gates attorneys Joseph L. Luciana, III and Thomas C. Ryan
Proper risk allocation is critical to the ultimate success of a construction project. And, the cornerstone of proper risk allocation for any construction project is a well-conceived and appropriately tailored insurance program. Too often, the concept of insurance remains an afterthought because contracting parties blindly rely on standard language in form agreements prepared earlier without fully investigating and understanding the current insurance market conditions. Moreover, most contractors do not want to consider the possibility of a disaster or another party’s failure to perform that may have project-wide implications.
I. INTRODUCTION
In this article, we will highlight three trends that should be on every checklist when it comes to placing or obtaining insurance for a construction project. First, every party should have a sense of the trends in the insurance industry with respect to issues such as capacity, premium growth, and underwriting risk appetite – just to name a few. Second, contractors should keep abreast of new or alternative insurance products that may either supplant, supplement or replace traditional types of policies. Finally, all involved parties – especially contractors – will be well-served to contact legal counsel before negotiating the final insurance provisions of a construction contract to gain at least a general understanding of legal trends developing with respect to insurance coverage in the construction context.
II. TRENDS IN THE INSURANCE MARKET
Concepts such as market capacity, underwriting appetite, loss history and policy form revisions play a crucial role in placing an insurance program for any construction project, regardless of the size and location of the project. The real issue, however, is the ability to gauge an accurate assessment of the market because these concepts are constantly in flux as global and regional markets fluctuate. A catastrophe such as a hurricane or an unforeseen insurer liquidation can turn the softest market hard overnight.
Nonetheless, observations of the recent market trends indicate, generally speaking, a continued decline in premiums for property and casualty insurance, while the general scope of coverage remains the same. The domestic casualty insurance market has experienced recent stability, which has allowed insurers to achieve solid returns. That increased profitability should lead to softer markets and increased competition and result in pressure on insurers to lower premiums.
Indeed, one insurance broker noted that, for commercial general liability (“CGL”) insurance in 2007, “[r]ates on risks with good loss experience are decreasing in the range of 5 percent to 15 percent.” Further, another leading broker commented that “[c]ommercial market capacity [is] at its highest levels since 9/11.” This trend, if it continues, bodes well for the contractor (and owner) looking to place CGL insurance for construction projects on the near horizon.
On the other hand, the market for more specific types of construction-related insurance products may be hardening. After enjoying relatively stable premiums during 2005 and 2006, the underwriters’ appetite for professional liability insurance may be curbing and rates may increase. In such cases, it becomes critical for contractors, owners and design professionals to assess the cost and benefit of such insurance and to evaluate alternatives.
In sum, the current insurance market seems generally favorable to contractors and owners looking to place insurance coverage for construction projects. However, a current, detailed assessment of the particular market and type of coverage is necessary for either the contractor or owner (or both) to make an informed assessment of the most appropriate program.
III. TRENDS IN EMERGING (OR REEMERGING) INSURANCE PRODUCTS
As construction projects continue to become more sophisticated, the contracting parties have looked for more and more inventive ways to transfer and manage risk. This desire has caused the insurers and the insurance market generally to respond with a number of alternatives to the traditional CGL, builder’s risk, property and professional liability policies that are placed for most construction projects. Default insurance, efficacy insurance, force majeure insurance and professional protective insurance are a few of the insurance products that may provide viable (and less expensive) options to contractors when pricing risk and/or placing coverage.
A. Default Insurance
One of the largest and unquantifiable risks borne by an EPC contractor involves subcontractor performance. Large construction projects can take years to complete and, during that time, the financial or operational viability of a significant subcontractor may deteriorate. A product sometimes called “default insurance” or “subguard” is available to address situations of subcontractor default. An alternative to the traditional surety bond, default insurance may provide the general contractor with more comprehensive coverage as well as more latitude to act quickly in maintaining the project schedule. Also, importantly, default insurance may provide broader payment benefits as only the policy limits control rather than the specific subcontract amount, as with a surety bond.
Default insurance, however, has its own drawbacks. Contractors and owners may be less likely to employ default insurance because of significant deductibles as well as more detailed due diligence on the insured’s part, as compared to the obligee of a surety bond. Nonetheless, default insurance may present a contractor with more risk control as well as cost savings.
B. Efficacy Insurance
Large industrial EPC construction projects often (if not always) contain performance or operational guarantees. Whether it is satisfying specific processing levels of discrete chemicals or meeting target refining requirements, most EPC contractors are required to meet threshold performance standards to achieve substantial completion. Failing to meet those performance or operational guarantees can have devastating consequences to a contractor’s bottom line and even its ongoing viability. Efficacy insurance, which is a form of financial guaranty insurance that insures the efficient performance of the is a good way for the contractor to protect itself from a performance failure. Owners also may require efficacy insurance to cover the loans used to finance the project, the repayment of which may be contingent upon the project meeting production requirements.
C. Force Majeure Insurance
Building plants and facilities in Third World countries with unstable political climates undoubtedly increases the likelihood that an event of force majeure may impact the project schedule. A repeal of an export regulation or the enactment of sweeping environmental legislation may drastically change the feasibility of project execution. Or, perhaps nationwide civil insurrection renders key ports or roadways inaccessible. Whatever the case may be, contractors have begun to give some thought to finding ways to insure the costs for force majeure events because those events may not be compensable under the construction contract.
Although not widely used, force majeure insurance policies are available to cover the lending facilities in the event of force majeure. A force majeure policy may also provide coverage for overhead and administrative expenses attributable to the delay. For example, a force majeure policy may provide an extension of coverage for a change in law, as follows:
The adoption, promulgation, or modification, after the inception date of this Policy of:
(a) any federal statute, ordinance, code, directive, rule, regulation or order, and/or
(b) any state or municipal statute, ordinance, code, directive, rule, regulation, or order
which establishes any requirement causing the design, construction, testing, acceptance or operation of the project to be more burdensome than the most stringent requirements contained in Existing Law (as defined herein) or order of any Court of competent jurisdiction enforcing a Change of Law as defined [herein].
Currently, force majeure insurance is cost-prohibitive and its application is usually reserved for mega-construction projects. Nonetheless, this tool may present a mechanism for an owner and contractor to at least quantify and allocate the risk that force majeure events present to the cost and schedule of any construction project.
D. Professional Protective Policies
Because the market for professional liability policies was relatively volatile prior to 2005, the insurance industry developed alternative insurance products that handle similar risks (and the policies have gained in popularity). “Professional Protective” policies have been issued to cover owners, design-builders and contractors to insure against losses arising out of work by design professionals. The critical distinction between a protective policy and a traditional professional liability policy is that the protector policy indemnifies the insured (i.e., the contractor) for claims arising out of the liability of the design professional. That is, the contractor has direct access to insurance proceeds for liabilities arising out of the acts or omissions of the design professional.
Generally, this type of coverage sits in excess of the design professional liability policy and only attaches if the claim exceeds the underlying coverage. However, these policies also provide difference-in-condition coverage that will typically provide coverage when the underlying professional coverage is deficient. As such, the professional protective policy may be a good way for a contractor or owner to protect itself from the risks arising from the errors and omissions of design professional on a construction project.
IV. TRENDS IN INSURANCE CASE LAW
Procuring an insurance policy simply to satisfy generic form requirements without an understanding of how critical issues of coverage may be interpreted in the relevant jurisdiction(s) may render the policy (and the attendant premiums) of little value. The gamut of coverage issues that may arise under an insurance policy will vary greatly, but it is important to at least have a general understanding of how relevant jurisdictions – particularly the jurisdiction whose law may apply to a coverage dispute – interpret key coverage issues. This preventive exercise undoubtedly will assist in assessing the risk profile for a particular construction project.
The hottest insurance coverage issue in the construction arena is coverage for a contractor for alleged construction defect claims under a standard CGL policy. Although the specific facts of each case and the specific policy language at issue (along with effective advocacy) play a critical role in determining coverage, the most intriguing aspect of the ongoing construction-defect litigation is the vastly different approaches taken by the respective state supreme courts in resolving substantially the same issue: that is, whether a construction defect claim constitutes an “occurrence” (i.e., an accident) under the standard CGL policy, thereby triggering an insurer’s duty to defend. Indeed, the vastly different approaches taken to an otherwise relatively straightforward question leave a fair amount of uncertainty in this area of insurance coverage under a CGL policy on a construction project.
Generally, the more reasonable interpretation of a standard CGL policy favors finding coverage in what could be described as the “typical” construction defect case. The “typical” construction defect case involves a situation where the contractor completes and turns over the project to the owner, the owner subsequently discovers that there was an error in some portion of the project (i.e., the roof leaks, the foundation is cracked, the electrical system malfunctions, etc.), physical damage occurs to the work and the owner files a lawsuit against the contractor (often limited to a breach of contract claim because of the application of the economic loss rule).
Prior to 1986, standard-form CGL policies generally did not provide coverage for damage to a contractor’s work arising from defective construction. However, in 1986, the Insurance Services Office (“ISO”) made changes to the “business risk” exclusions within the standard CGL form policy that were intended to provide coverage for damage to a contractor’s completed work in certain circumstances.
ISO incorporated these changes in Exclusion (l) or the “Your Work” Exclusion (“Exclusion L”), which disclaims coverage for “property damage” to “[the insured’s] work” arising out of it or any part of it and included in the “products-completed operations hazard.” However, Exclusion L further provides that “[t]his exclusion does not apply if the damage to work or the work out of which the damage arises was performed on your behalf by a subcontractor.” Considering that a vast majority of work performed on complex construction projects is performed by subcontractors, the so-called “subcontractor exception” has effectively restored CGL coverage to a contractor for claims arising from property damage to completed construction work that would have been otherwise excluded.
Recognizing that “business risk” exclusions do not bar construction defect claims, insurers have systematically shifted the focus of construction defect litigation to challenging whether such claims fall within the CGL policy’s initial grant of coverage. That is, insurers have denied contractors’ coverage, taking the position that a construction defect claim does not constitute an “occurrence” that causes “property damage.” As a result, according to the insurers’ position, whether the subcontractor exception in Exclusion L restores coverage becomes irrelevant because their duty to defend was never triggered under the insuring agreement of the CGL policy.
A. The “Occurrence” Threshold
Discerning what may seem as simple an undertaking as deciding whether a construction defect is an “occurrence” has proven to be the battle ground in construction defect litigation – with no clear winner. Under the 1986 CGL policy, an insurer’s duty to defend is triggered by a claim for “property damage” or “bodily injury” caused by an “occurrence.” Although it has taken on variations over the years, “occurrence” is generally defined as “an accident, including continuous or repeated exposure to substantially the same general harmful conditions.” The standard-form CGL policy does not define “accident.” As such, the interpretation of the singular word “occurrence” has spurned diametrically opposing viewpoints. State supreme courts have split on this issue, with no clear sign of a consensus building. Indeed, the Texas and Pennsylvania Supreme Courts have reached polar opposite conclusions on the “occurrence” issue despite interpreting virtually the same policy language and operative facts.
1. The Straightforward Texas Approach
The Texas Supreme Court is the most recent state supreme court to weigh in on whether a construction defect may constitute an “occurrence” under a CGL policy. On August 31, 2007, the court issued its opinion in Lamar Homes, Inc. v. Mid-Continent Cas. Co., answering a number of certified questions from the Fifth Circuit Court of Appeals and, more importantly, resolving substantial confusion in the Texas appellate courts. In that case, the Texas Supreme Court affirmatively concluded that “claims for damage caused by an insured’s defective performance or faulty workmanship may constitute an occurrence, when property damage results from the unexpected, unforeseen or undesigned happening or consequence of the insured’s negligent behavior.” As a result, the rule of law in Texas now requires a CGL carrier to defend a contractor when a faulty workmanship claim is brought against it.
Lamar Homes involved the “typical” construction defect case. In particular, Vincent and Janice DiMare bought a new home from Lamar Homes, Inc. only to discover problems with the foundation several years later. The DiMares eventually sued Lamar and its subcontractors based on the foundation defects. Lamar tendered the suit to its CGL carrier, Mid-Continent, seeking a defense and indemnity for the DiMares’ claim. Mid-Continent denied coverage, and Lamar’s declaratory judgment action in the Western District of Texas followed.
The district court judge ruled in favor of Mid-Continent on cross motions for summary judgment and affirmed the denial of coverage to Lamar. In essence, the court concluded that Lamar was not entitled to coverage for construction errors that only damaged its own product (i.e., the foundation). On appeal, the Fifth Circuit recognized the conflict in the Texas appellate courts on this critical point and certified the question of coverage to the Texas Supreme Court. Of import, the Fifth Circuit posed the following question:
When a homebuyer sues his general contractor for construction defects and alleges only damage to or loss of use of the home itself, do such allegations allege an “accident” or “occurrence” sufficient to trigger the duty to defend or indemnify under a CGL policy?
Following a thorough analysis, the court arrived at the correct interpretation of coverage. From the outset, the court focused on the definition of “occurrence,” which was defined, in pertinent part, as an “accident.” In that regard, the court stated that, “[t]he determination of whether an insured’s faulty workmanship was intended or accidental is dependent on the facts and circumstances of the particular case.” Consistent with the general principles of insurance contract interpretation, the court held that “[f]or the purposes of the duty to defend, those facts and circumstances must generally be gleaned from the complaint.”
In that regard, the court noted that “[n]o one alleges that Lamar intended or expected its work or its subcontractors’ work to damage the DiMares’ home.” In other words, the critical issue in determining whether a contractor’s defect constitutes an occurrence is to analyze whether the attendant property damage could be characterized as either expected or intended from the standpoint of the insured. As a result, the DiMares’ claim – regardless of the specific cause of action alleged in the underlying complaint – fell within the carrier’s broad duty to defend.
In reaching this sound conclusion and providing appropriate meaning to the terms at issue in the CGL policy, the Texas Supreme Court fell in line with the holdings from six other state Supreme Courts that have reached a similar conclusion. This sound approach focuses on the broad definition of occurrence in light of the insurance contract as a whole. That way, the court can give meaning to all portions of the CGL policy – including terms, conditions and exclusions – and ensure that the insured contractor is receiving the coverage that the CGL policy was intended to provide.
2. Pennsylvania Takes The Long Road To Evade Coverage
Less than a year earlier than the decision in Lamar Homes, the Pennsylvania Supreme Court reached a diametrically opposite conclusion to the “occurrence” question. In Kvaerner Metals Div. of Kvaerner U.S., Inc. v. Commercial Union Ins. Co., the Pennsylvania Supreme Court ruled in favor of the CGL carrier and denied coverage to a contractor for claims arising out of its subcontractor’s alleged defective workmanship.
In that case, an EPC contractor was hired by an owner to design and construct a coke oven battery at its facility. In June 1997, the owner filed a complaint alleging claims of breach of contract and breach of warranty against the contractor. In essence, the owner claimed that the coke oven battery was damaged and that it did not meet the contract specifications and warranties because of the damage. Also, the owner incorporated into its complaint a “non-performance list,” which was an itemized accounting of damage to, and defects in, the coke oven battery. For example, this list included items such as cracked paver bricks, spalling oven walls and shifting brickwork. The contractor promptly tendered the claim to its CGL carrier, which summarily disclaimed coverage.
The contractor filed a declaratory judgment action alleging that the CGL carrier owed a duty to defend and indemnify the contractor for the owner’s claim. The parties filed cross motions for summary judgment, arguing, among other things, whether the owner’s claims constituted an “occurrence” under the CGL policy. The contractor argued that the coke oven battery suffered “property damage” because of “longitudinal movement of the roof,” which occurred because “the bricks in the Battery’s roof were ‘grouted’ too early and because of heavy rains that occurred on October 31, 1994.” In support of this argument, the contractor submitted two expert reports attached to its opposition to the CGL carrier’s motion for summary judgment on the same issue.
The trial court sided with the insurer on the basis that “damages resulting from a party’s breach of contract could never be classified as ‘accidental.’” Rather, the trial court concluded that the owner was solely seeking damages sounding in breach of contract and concluded that the owner’s complaint did not trigger the CGL carrier’s duty to defend. In other words, the trial court focused on the cause of action to define “occurrence” instead of the appropriate inquiry, which is whether that cause of action alleged property damage that was expected or intended by the insured. On appeal, the Pennsylvania Superior Court (an intermediate appellate court) reversed the trial court, found that the breach of contract claim constituted an “occurrence,” and remanded the case for further proceedings.
The CGL carrier pushed the case to the Pennsylvania Supreme Court, which reversed the Superior Court. Although not articulated, the underpinning of this holding appears to be that the owner’s claims only allege property damage from poor workmanship to the coke oven battery itself. As such, because “faulty workmanship does not constitute an ‘accident’ as required to set forth an occurrence under the CGL policies, [the Pennsylvania Supreme Court held] that [the CGL carrier] had no duty to defend or indemnify [the contractor] in the action brought by [the owner].” In effect, the Pennsylvania Supreme Court wrote into the policy the condition that an occurrence cause property damage to property other than the insured’s work.
In reaching its conclusion, the Pennsylvania Supreme Court asserted that it fell in line with the “majority rule” on this issue. Moreover, it can be inferred that the Pennsylvania Supreme Court decision provides that a contractor must show that the faulty workmanship caused damage to property other than the work itself. The Lamar Homes court tackled that issue head on, and its holding was essentially opposite the Pennsylvania Supreme Court:
The CGL policy, however, does not define an “occurrence” in terms of ownership or character of the property damaged by the act or event. Rather, the policy asks whether the injury was intended or fortuitous, that is, whether the injury was an accident. As one court has observed, no logical basis with the “occurrence” definition allows for distinguishing between damage to the insured’s work and damage to some third party’s property:
The logical basis for the distinction between damage to the work itself (not caused by an occurrence) and damage to collateral property (caused by an occurrence) is less than clear. Both types of property damage are caused by the same thing – negligent or defective work. One type of damage is no more accidental than the other. Rather, . . . the basis for the distinction is not found in the definition of an occurrence but by application of the standard “work performed” and “work product” exclusions found in a CGL policy.
Erie Ins. Exch. v. Colony Dev. Corp., 736 N.E.2d 950, 952 n.1 (Ohio App. 2000). We likewise see no basis in the definition of “occurrence” for the district court’s distinction.
The position of the Texas Supreme Court represents the more logical interpretation of the standard CGL policy. By reading into the “occurrence” definition a “damage to non-work property” component, courts are artificially creating conditions (barriers) to coverage that are adequately addressed by the insurance industry through the use of the “business risk” exclusions. Instead of allowing the parties to address the scope and nature of the insurability of construction defects in the context of policy exclusions (as intended by the 1986 revisions to the standard-form policy language), courts like the Pennsylvania Supreme Court have effectively eviscerated coverage that was otherwise promised to the contractor creating an initial roadblock in the construction of the word “occurrence.”
B. The Occurrence Issue Continues To Evolve
Before Lamar Homes, the insurance industry had some success in the arena of construction defect litigation. The L-J and Kvaerner courts showed a willingness to narrowly interpret insurance policies, without giving effect to the CGL policy as a whole, and to artificially insert constraints on the broad definition of “occurrence.” That type of truncated analysis renders other significant portions of the CGL policy, namely the subcontractor exception to Exclusion L of the business risk exclusions, effectively meaningless. Further, this abbreviated approach fails to abide by basic concepts of insurance contract interpretation or otherwise provide any credence to the policy drafter’s intent. However, on the heels of the thorough analysis set forth by the Texas Supreme Court in Lamar Homes, courts in other jurisdictions should recognize the significance of this issue and undertake the necessary thorough analysis.
V. CONCLUSION
The only certainty in construction insurance is that the concept is constantly evolving. Whether it is a change in market conditions, the development of new products, or varying interpretations of critical policy language, parties involved in the construction industry must stay abreast of the current topics to avoid legal and commercial pitfalls. In that regard, contractors should always consider issues related to the scope, amount, type and cost of insurance coverage from the outset of any construction project. Keeping current on trends in the area of construction insurance will assist in a successful and profitable completion of any construction project.