Construction Defect Insurance Coverage Remains Difficult To Predict

Usually, one of the concerns for many contractors is the variation among state laws as to whether construction defects constitute an "occurrence," "property damage," or are excluded under a contractor's commercial general liability (CGL) insurance policy. For example, under Florida law, property damage arising out of a construction defect constitutes an occurrence as long as it is unexpected and unintended,¹ but under Pennsylvania law, property damage arising out of a construction defect is viewed as foreseeable and is not an "occurrence."²

The recent case of Gilbert Tex. Constr., LP v. Underwriters at Lloyd's, London, No. 08–0246 (Tex. June 4, 2010), illustrates another difficult challenge presented to the construction industry in its quest for predictability in managing and transferring the risks associated with construction defects. In Gilbert, the Supreme Court of Texas departed from well-established case law to the contrary and applied Exclusion b, the contractual liability exclusion, to a claim involving a direct breach of contract, as opposed to an indemnity or hold harmless agreement. Suffice it to say, no one could have predicted such a result.

The Coverage Dispute

In Gilbert, the insured entered into a contract with Dallas Area Rapid Transit Authority (DART), as general contractor, to construct a commuter railway system. During the course of the project, heavy rains damaged neighboring buildings owned by RT Realty (RTR). RTR sued DART, Gilbert, and other entities for statutory violations, nuisance, and trespass. RTR claimed third-party beneficiary status as to the contract between Gilbert and DART, asserting that Gilbert was liable to RTR for breach of contract. This claim was based on a contractual provision with DART that obligated Gilbert to protect all existing improvements and utilities at or near the work site or on adjacent property of a third party, and to repair any damage to them. In the event Gilbert failed to perform the repairs, the contract further provided that DART could undertake the repairs and charge the costs back to Gilbert.

Since DART was a public entity, the doctrine of sovereign immunity barred all negligence claims, and the case instead proceeded as a breach of contract claim by RTR against Gilbert. Gilbert's primary insurer contributed its limits to settle the suit, but Underwriters at Lloyd's, the excess insurer, refused to contribute to the settlement, so Gilbert funded the large shortfall and filed a coverage suit against Underwriters.

Under governing Texas case law, the claim against Gilbert involved an "occurrence" of unexpected and unintended "property damage" to a third party's property, and, as such, it had all the earmarks of a covered claim under Gilbert's excess policy.³ Despite the fact that the excess policy followed the form of the primary, Underwriters took an approach that was 180 degrees from the coverage position of the primary insurer, arguing that Exclusion b, the contractual liability exclusion, nevertheless applied to deny coverage for Gilbert. That exclusion states that the insurance does not apply to:

"Bodily injury" or "property damage" for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement. This exclusion does not apply to liability for damages:

(1) Assumed in a contract or agreement that is an "insured contract"; or

(2) That the insured would have in the absence of the contract or agreement.

The policy goes on to define the term "insured contract" to include various types of indemnity agreements commonly encountered, including a real property lease, a railroad sidetrack agreement, an elevator maintenance agreement, and the commonplace indemnity clause contained in most construction contracts in which the insured indemnitor assumes the tort liability of another party to pay for bodily injury or property damage to a third person.

The Court's Reasoning

Both this definition and the terms of Exclusion b itself make it clear that the scope of the contractual liability exclusion extends only to indemnification or hold harmless agreements in which the insured assumes the liability of a third party. Even the Texas Supreme Court in Gilbert acknowledged the nearly universal case law dating back to Olympic, Inc. v. Providence Washington Ins. Co., 648 P.2d 1008 (Alaska 1982), that held that the predecessor exclusion from the 1973 edition Insurance Services Office, Inc. (ISO), policy form applied only to the "assumption of liability" of a third party in the indemnification context. The Texas Supreme Court had additional guidance from the Fifth Circuit Court of Appeals in Federated Mut. Ins. Co. v. Grapevine Excavation, Inc., 197 F.3d 720 (5th Cir. 1999), in which the court, applying Texas law, held that an assumption of liability for purposes of the contractual liability exclusion did not apply where the insured is being sued for its own conduct in breaching a contract, but only as the contractual indemnitor of a third party's conduct.

In addition to this precedent, the court considered numerous other cases and legal commentaries that reached the same conclusion, i.e., that the contractual liability exclusion does not apply to claims in which recovery is sought against the insured for its direct liability in contract, rather than the assumed liability of a third party in a hold harmless agreement.

Inexplicably, despite acknowledging this overwhelming precedent as to the limited application of Exclusion b, the Texas Supreme Court applied a much broader reading of the term "assumption of liability." Relying primarily on the dictionary definition of "assume," defined to include "undertake," the court further stated that had the exclusion been intended to be so narrow as to apply only to an agreement which the insured assumes liability of another party under an indemnification or hold harmless agreement, the CGL policy could easily say so. The court's reasoning amounts to a highly simplified—but strict—application of the "plain and ordinary meaning" rule, in that it not only ignores, but forsakes prior case law.

That departure from prior precedent causes particular distress for Texas insureds in light of the same court's coverage-friendly stance taken barely 3 years earlier in Lamar Homes v. Mid-Continent Cas. That case, regarded as a landmark opinion in Texas and throughout the United States, clearly rejected any demarcation between tort and contract liability in the context of CGL coverage for construction defect claims that involve breach of contract. The court held that regardless of the label of the cause of action, there was a covered "occurrence" when property damage that was unexpected and unintended from the standpoint of the insured is alleged.⁴ Obviously, the application of Exclusion b to claims that, like the one in Gilbert, involve only breach of contract because the application of the sovereign immunity doctrine eliminates any negligence claim, radically alters Texas law as to coverage for construction defect claims.

It should be noted that, in response to arguments made by Gilbert, the insured, the court also addressed whether the "insured contract" and the "liability in the absence of contract" exceptions to the exclusion applied. The court determined they did not, but there was no reason to reach those issues since there was no need to apply any exception at all. This was because the main body of the exclusion itself ruled out coverage, applying only to the assumption of liability, and had no application to the factual scenario before the court involving a claim for direct breach of contract against the insured. As such, that resort to the exception simply clouded what should have been a relatively routine determination that the exclusion did not apply.

Potentially Far-Reaching Uncertainty

The recitation of the contractual liability exclusion is standard fare in many reservation of rights letters received from insurers regarding tendered construction defect claims. As to most of those claims, it historically amounted to little more than a tongue-in-cheek recitation since insureds and insurers alike acknowledged the restriction of the exclusion to the assumption of a third party's liability in an indemnification agreement. But, particularly in light of the influential nature of the Texas Supreme Court's prior opinion in Lamar Homes, it is possible that in addition to potentially standing CGL coverage on its head in Texas, it may also affect these types of arguments nationwide. Again, the result is the creation of disturbing uncertainty, and in this instance, uncertainty that simply should not be generated by Exclusion b.

Admittedly, a complicating factor may have been the rather novel terms of the contract that obligated Gilbert to repair third-party property damage and conferred third-party beneficiary status on the neighboring property owners, paving the way for RTR's direct claim against Gilbert for breach of contract. Nevertheless, even though those claims were pursued as third-party beneficiaries to Gilbert's contract with DART, they were direct claims and not the type of indemnification claimed under a hold harmless agreement. Most construction contracts obligate the insured contractor to repair damage to property, and applying the contractual liability exclusion in that context impermissibly denies coverage.

Because of its radical departure from prior Texas case law, Gilbert filed a motion for rehearing with the Texas Supreme Court which garnered amicus curiae support from various parties, including national construction organizations. If the court grants rehearing, it is hoped that a misapplication of the contractual liability exclusion can be reversed, or at least that application can be limited to the peculiar facts of the claim. As it stands, Texas insureds are already seeing significant denials and reductions of coverage in light of Gilbert, fueling uncertainty and adding to the difficulty of pursuing coverage for otherwise covered claims.

¹U.S. Fire Ins. Co. v. J.S.U.B., 979 So. 2d 871 (Fla. 2007).

²Kvaerner Metals v. Commercial Union Ins. Co., 908 A.2d 888 (Pa. 2006).

³Lamar Homes, Inc. v. Mid-Continent Cas. Co., 242 S.W.3d 1 (Tex. 2007).

⁴For a prior column on this website analyzing Lamar Homes v. Mid-Continent Casualty, see Worth the Weight (in Gold): The Texas Supreme Court Weighs in on Defective Construction as Occurrence, September 2007.