Construction Defect Crisis Produces Coverage-Restricting Endorsements

August 2003

Insurance prices for contractors are rising, and coverage availability is shrinking. When available, insurers are making significant changes to their policies in response to rising construction defect claims. Coverage restrictions affecting known loss, EIFS, mold, earth movement, residential construction, and additional insureds are becoming common. Agents and brokers serving the construction market must closly examine CGL policy forms and endorsements for irregularities in the language that could impact coverage.

by Ann Rudd Hickman, CPCU, ARM
IRMI

An onslaught of construction defect litigation over the past 2 decades has pummeled the construction insurance industry. Contractors must rely primarily on their liability insurance programs for protection against construction defect claims. Unfortunately, in some states the impact of construction defect claims on coverage availability and affordability has reached crisis status. Subcontractors, in particular, have experienced a drying up of insurance markets, because much of the risk from construction defects falls in their laps. California, Nevada, Arizona, Texas, Florida, and Colorado have the most significant construction defect problems, but many other states are experiencing increased litigation in this area as well.

Insurers have undertaken a number of strategies for dealing with the growing cost of construction defect claims. General and umbrella liability insurers alike have adopted an underwriting philosophy of avoiding altogether certain classes of contractors, types of construction, or problematic regions. For example, some insurers have stopped writing coverage for residential developers, general contractors performing residential construction, and any contractor directly or indirectly involved in the installation of synthetic stucco (commonly known in construction and insurance circles as exterior insulation and finish systems, or EIFS).

Alternatively, insurers may decline to write contractors with more than a certain percentage of their work in problematic areas, such as residential construction or EIFS installation. Some insurers have completely withdrawn from construction insurance markets in problematic regions, primarily California.

In addition to the underwriting restrictions described above, insurers will likely attach a combination of coverage restricting endorsements. Many insurers attach exclusions to contractors' and subcontractors' policies that target common types of construction defects claims, such as mold and damages attributable to the use of EIFS on the building. The precise combination of endorsements will vary by class of contractor, type of construction, and by state.

Many insurers have also begun using restrictive additional insured endorsements, which may leave a contractor in noncompliance with respect to their additional insureds, and with less coverage than expected with respect to coverage they receive as additional insureds on subcontractors' policies. This article discusses some of the more common exclusionary endorsements currently being used on contractors' liability policies and highlights key variations in these endorsements that can have a significant impact on coverage. The changing scope of additional insured coverage is also examined.


COMMON EXCLUSIONARY ENDORSEMENTS
Known or Continuous Injury or Damage Prevents policies from being triggered with regard to losses of which the insured is aware prior to the policy inception date.
EIFS Exclusion Removes coverage for injury or damage connected in any way to the presence of an EIFS on the building.
Mold Exclusion Removes virtually all coverage for claims arising out of exposure to or inhalation of fungi, which includes all varieties of mold and bacteria.
Earth Movement Exclusion Removes coverage for injury or damage that is wholly or partially caused by virtually all types of earth or land movement.
Residential Construction Exclusion Removes coverage with respect to any operations in connection with property intended for habitation. Some of these endorsements apply only to multifamily housing, such as apartments, town homes, and condominiums.
Damage to Work Performed by Subcontractors on Your Behalf (CG 22 94 and CG 22 95)

Eliminates coverage for damage to "your work" arising out of subcontractors' work, and damage to the named insured's work that is caused by a subcontractor's work.

Contractors Limitation Endorsement Adds a combination of the above exclusions, as well as others not related to construction defects, to the umbrella policy.

Known Loss Provisions

Construction defects often produce property damage that takes place over a period of time. For example, moisture caused by faulty installation of windows or seals may cause ongoing deterioration of wood and other materials. It is possible, therefore, for a contractor to be aware of defects that are likely to give rise to claims well before the claims actually surface.

Most insurance professionals would agree that losses, or potential losses, of which the insured is already aware when an insurance policy is purchased are not covered by the policy. However, the California Supreme Court ruled otherwise. In Montrose Chemical Corp. v Admiral Insurance Co., 913 P2d 878 (1995), the court ruled that prior to the determination of an insured's actual liability for the injury or damage, the loss is neither certain nor fully "known." Consequently, knowledge of a potential claim at the time the policy becomes effective does not negate coverage (at least in that jurisdiction) as long as there is uncertainty regarding the insured's actual degree of liability.

To counter the impact of the Montrose decision, many insurers developed "known injury or damage" endorsements that specifically exclude coverage for losses or potential losses of which the insured was aware prior to the policy period. In 2001, Insurance Services Office, Inc. (ISO), incorporated a known loss provision into its standard commercial general liability (CGL) insurance policy insuring agreement which states that the policy does not apply to injury or damage that is a continuation of damage known to the insured at the inception of the policy period.

The effect of the ISO known loss provision is to make the policy in effect when the insured becomes aware of the damage the last policy that will be triggered by the claim. It does not, however, prevent multiple policies in effect during the progression of damage from being triggered as long as the insured was not aware of the damages prior to the inception of each of these policies.

Some insurers still use their own "known loss" exclusions, many of which are broader than the ISO provision. For example, some known loss endorsements limit recovery to a single policy by requiring that the insured first become aware of the injury or damage during the policy period to be covered. This will be restrictive in states that allow a continuous coverage trigger on progressive damage claims.

Alternatively, some insurers attach endorsements in which all property damage is "deemed" to have occurred at a specific moment in time. For example, the endorsement may provide that all covered property damage is deemed to have occurred at the moment damage first began, regardless of when it was discovered. Under these types of endorsements, informally referred to by some as "deemers," the insured's knowledge of a claim is not relevant to which policy is triggered. As with the "first knowledge" endorsement described above, only one policy can be triggered by a given loss (assuming all the affected policies have this type of provision), but the actual policy that is triggered could be different under these two approaches.

EIFS Exclusions

Exterior insulation and finish systems (EIFS) are multilayered exterior wall systems that are designed to provide high energy efficiency. (Synthetic stucco, a popular building material in many regions, falls into this category.) EIFS have been at the core of a significant amount of construction defect litigation, particularly in warm climates such as Southern California, Florida, Texas, and Nevada. Typically, these claims alleged faulty installation or some other product defect that allowed water to penetrate the walls, where it became trapped. Wood rot and mold were some of the problems commonly encountered by the owners of the properties.

In light of the tremendous losses suffered by the insurance industry related to these insulation systems, EIFS exclusions began to appear on the liability policies of EIFS installation subcontractors, as well as virtually any other contractor whose work could conceivably be tied to the infiltration of moisture (e.g., roofers, HVAC, window and garage door installation contractors, and plumbing contractors). Although residential construction has been harder hit by EIFS claims than commercial buildings (probably because damages are greatest on wood frame construction), EIFS exclusions are in widespread use for both residential and commercial construction contractors.

As of yet, there are no standard EIFS exclusions, but most insurers writing contractors have developed their own endorsements that exclude this exposure. While many contractors will not be able to avoid an EIFS exclusion, they should examine the scope of the exclusion carefully. In their attempts to draft sweeping exclusions for all EIFS-related losses, some of these endorsements, perhaps unintentionally, go far beyond the actual EIFS exposure.

For example, one insurer's EIFS exclusion removes coverage for virtually all claims associated with a contractor's work on an exterior fixture of the building if an EIFS is included on any portion of the structure. That is, the exclusion does not just apply to damages caused by the presence of an EIFS or by the contractor's installation or other involvement with an EIFS system, but to all losses related to the contractor's work on any exterior fixture of any project that contains an EIFS. This exclusion may be appropriate if the insured is an EIFS manufacturer or EIFS installation contractor, since virtually all of their work involves the use of EIFS, but attached to other types of construction contractors' policies it goes well beyond most contractors' and insurance professionals' expectations for an EIFS exclusion.

Mold Exclusions

In recent years, the construction and insurance industries have seen a dramatic increase in the number of claims alleging bodily injury and property damage caused by mold. Experts disagree on the prevalence of toxic molds and their long term impact on people who are exposed to them, but clearly mold can produce serious property damage. Molds tend to form where there is a combination of moisture and poor ventilation, therefore any construction activity that has the propensity to lead to water infiltration or restricted ventilation presents a mold risk. Unfortunately, this includes a wide spectrum of contractors, such as roofers, plumbers, window, sheetrock or siding installers, HVAC contractors, and anyone performing grading, landscaping, or foundation work on the property.

Most insurers have attached mold exclusions to a broad cross section of contractors' liability policies. Some insurers attach mold exclusions to all contractors' policies, regardless of the risk assessment. The standard ISO "fungi or bacteria exclusion" endorsement is very broad, removing coverage for all injury or damage that would not have occurred "but for" exposure to any fungi (e.g., mold) or bacteria, as well as any costs incurred in cleaning up the fungi or bacteria.

Mold exclusions are currently in wide use on contractors' general liability policies, and most insurers are not open to negotiating on this issue. For a while, contractors who carried pollution liability insurance could find protection for mold claims under those policies. Today, most contractors pollution liability insurers routinely exclude coverage for claims alleging damage caused by mold, but will add the coverage back for an additional premium. The "buy back" may be limited in terms of covered damages or a separate sublimit.

Earth Movement Exclusion

Contractors whose work involves the foundation of a building, or any form of moving, grading, or compaction of land or dirt on the construction site may see an "earth movement" or "subsidence" exclusion on their general and umbrella liability policies. (Where the term "subsidence" is used, it is typically defined to include virtually any form of earth movement, including landslide, mudflow, collapse, or movement of fill, earthquake, and virtually any form of earth rising, sinking, setting, eroding, tilting, or settling.) Some insurers attach these exclusions only with respect to residential construction, or construction in certain areas prone to earth movement, most notably California.

Residential Construction Exclusion

Much of the construction defect battle has been waged in the residential construction arena, particularly multifamily housing such as townhomes and condominiums. Some insurers have withdrawn from residential construction markets altogether, or in certain problem regions.

For contractors who perform primarily commercial construction but do some residential work, insurers may carve out the residential exposure by attaching a residential construction exclusion. (These endorsements are not standard, and may carry a variety of titles.)

The scope of the exclusions can vary significantly based the type of construction to which they apply—single versus multifamily housing and new construction versus renovation work, for example. The inclusion of a residential construction exclusion on a subcontractor's liability policy would also eliminate any coverage the contractor may have had as an additional insured on that policy.

Subcontractor Exclusion Endorsements

The CGL policy's "Damage to Your Work" exclusion, frequently referred to as the "workmanship" exclusion, eliminates coverage for damage to the insured contractor's completed work that arises out of the contractor's work. This prevents the CGL policy from acting as a warranty on the insured's work. Although the definition of "your work" includes work performed by subcontractors, by exception, the exclusion does not apply to damage to a subcontractors' work nor to damage caused by a subcontractor's work. In other words, the insured contractor's CGL will respond to all of the following.

  • Damage to the insured contractor's work that arises out of the work of a subcontractor
  • Damage to a subcontractor's work that arises from that subcontractor's work
  • Damage to a subcontractor's work arising out of the insured contractor's work
  • Damage to a subcontractor's work arising out of another contractor's or subcontractor's work

In 2001, ISO introduced two optional endorsements that remove the coverage that the subcontractor exception leaves intact. One of these endorsements eliminates all coverage for damage to "your work" that is, or is caused by, a subcontractors' work. The other eliminates this coverage only with respect to scheduled sites or operations.

Thus far, the subcontractor exclusion endorsements do not appear to be in widespread use, but contractors and their insurance representatives should be on the lookout for them. Contractors engaged in residential work are particularly likely to encounter these exclusions. For contractors who subcontract a significant portion of their work, the reduction in coverage is significant.

Contractors Limitation Endorsements

With respect to construction defect exposures, most umbrella insurers have chosen to combine various industry-specific exclusions into one endorsement commonly referred to as a contractors limitation endorsement. In recent years, many umbrella insurers have added a number of construction defect-related exclusions to their contractors limitation endorsements. For the most part, these exclusions mirror their CGL counterparts. Mold, EIFS, subsidence, and residential construction are all potential exclusions on the contractors limitation endorsement. Contractors should ensure that any such exclusions do not apply if the same damages would be covered by the underlying the CGL policy. That is, the umbrella should provide "following form" coverage with respect to these types of claims.

Additional Insured Endorsements

Construction contracts frequently require contractors to add other parties (i.e., the owner or other contractors) as additional insureds on their liability policies. Generally speaking, the additional insured wants broad protection for any claim it might face with respect to the construction activity. In reality, their coverage may be much more narrow than they expected.

The two key issues with regard to an additional insured's coverage are whether coverage applies to completed operations, and whether there is coverage with respect to losses caused by the additional insured's own negligence.

Prior to 1993, additional insureds enjoyed broad coverage for losses "arising out of" the named insured contractor's work. This language was broad enough to include ongoing and completed operations, and claims arising out of the additional insured's own negligence, including its sole negligence. (Compelling arguments have been made both for and against the "fairness" of providing coverage for an additional insured's sole negligence.)

In 1993, the standard additional insured endorsements were modified to extend coverage to additional insureds only with respect to the contractor's "ongoing" operations for the additional insured, thus eliminating completed operations coverage for the additional insured. For several years, insurers continued to offer the older versions of the endorsement in recognition of the fact that contractors needed this coverage to comply with their contractual requirements. As construction defect litigation snowballed, and the insurance market in general began to harden, more and more insurers stopped this practice. Most insurers now offer only the newer versions of the endorsement, which do not include coverage for completed projects.

Many insurers have drafted their own additional insured endorsements that not only remove completed operations coverage, but also narrow the scope of coverage for claims that can be tied to the additional insured's own negligence. Some additional insured endorsements eliminate coverage only with respect to the additional insured's sole negligence, while others eliminate all coverage with respect to the additional insured's own negligence. (Note that coverage for the insured contractor's contractual indemnification obligations are not affected by the language of the additional insured endorsement. Consequently, as long as the contractor's liability for such claims can be tied to a legally enforceable indemnity agreement, the policy would pay claims involving indemnification of an additional insured for its own, even sole, negligence, but perhaps on less favorable terms.)

Conclusion

Until the tide of construction defect claims is stemmed, insurers will continue to look for ways to limit their exposure in this area. Unfortunately, some insurers are not completely forthcoming about changes in their policies that reduce contractors' coverage, and, as a result, the restrictions may not be discovered until a claim is denied. Agents and brokers serving the construction market, particularly the residential construction market, must be diligent to examine CGL policy forms and endorsements for irregularities in the language that could impact coverage.


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