Expert Commentary

Contractual Risk Transfer for Contamination Risks

The introduction of exclusions for losses related to fungus/mold/bacteria/Category 3 water in virtually all forms of commercial property and liability insurance has changed the game for contractual liability risk transfer in construction operations. Based on loss frequency, these exclusions have increased the need for contractors environmental liability (CEL) insurance at least 1,000-fold since the origins of the CEL product line in 1986.

January 2014

Despite the plethora of CEL insurance products available, the majority of contractors that need CEL do not have this important coverage in place today. To further exacerbate the insurance coverage gap created by expanding exclusions for contaminants, the environmental liability policies being sold today have unacceptably high fundamental coverage defect rates for indoor environmental loss exposures. This is because very few environmental insurance policies were designed to be used for indoor environmental risks.

Illustration of Need for Environmental Insurance

The need for insurance for indoor environmental risks can be demonstrated utilizing the example of an actual sequence of events arising from the construction of a hospital lobby. The loss involves wrongful death claims resulting from the exposure to bacteria living in a decorative water feature in a hospital lobby. This situation illustrates why traditional contractual liability risk management practices using insurance transfer in construction projects will turn into a house of cards unless the effects of pollution/contamination exclusions in insurance policies are addressed.

A commercial interior design firm was contracted by the owner of a hospital to design and build an attractive space for the hospital lobby. The design/build work performed under this contract included furnishing the seating area, installing the wall and floor coverings, and installing the decorative water feature—a small waterfall.

A general contractor (GC) with 20 years of experience was hired by the interior design firm to build out the plan. The GC then hired a plumber subcontractor to install the water feature.

Industry standard procurement contracts between the hospital and the interior design firm were completed, whereby the design firm agreed to indemnify and hold harmless the hospital owner for potential liabilities arising from the lobby project. The indemnity obligation of the design firm was backed by general liability insurance, which was specified to include contractual liability coverage making the hospital owner an additional insured on a primary and noncontributory basis and to waive all rights of subrogation against the owner.

Following custom and practice in the construction industry, the design firm passed on its contractual indemnity obligations and insurance requirements to the GC, and the GC, in turn, required the plumber subcontractor to indemnify the GC and back up that obligation with equivalent insurance to that required of the GC.

The construction of the lobby was completed to the hospital owner's satisfaction.

Two years after the completion of the project, there was an outbreak of deadly Legionnaires' disease in the county where the hospital was located. Within days, public health officials determined that all of the infected people had recently walked past the decorative waterfall feature in the hospital lobby.

Eight people became very ill from the pneumonia-like symptoms caused by the Legionella bacteria living in the lobby water feature. The deadly bacteria had been released into the air by the aerosolized falling water in the hospital lobby. The airborne bacteria were inhaled into the lungs of the passing visitors, causing infections and the untimely deaths of two exposed victims.

Within months, the hospital and the vendors it had hired to design and build the lobby were sued by the eight injured parties, including the families of the deceased.

Per the terms of its contract, the hospital owner demanded indemnity from the design firm that had arranged for the construction of the water feature. Part of the indemnity demand was for the design firm's general liability insurer to defend the owner as an additional insured under the policy.

The design firm mirrored the demand for indemnification by the GC under the indemnity provisions in its contract with the GC and, of course, the GC demanded indemnification from the plumber subcontractor who built the waterfall.

The hospital was located in a state where bacteria "contamination" has been determined to fall within the definition of a "pollutant" in the Insurance Services Office, Inc. (ISO), standard pollution exclusions. California, Wisconsin, and Indiana all have insurance coverage case law designating bacteria as a "contaminant." Therefore, claims in which the proximate cause of the loss was exposure to bacteria fall within the ISO standard definition of a "pollutant" in insurance policies. Additional states could follow this precedent in coverage litigation, as the logic is very simple to exclude bacteria as a contaminant. (See "Revealing the Dark Secrets of Category 3 Water Exclusions.")

In addition to the "standard" pollution exclusions, the general liability policies sold to all of the stakeholders further excluded losses related to fungus/mold/bacteria by endorsement. The exclusions for fungus/mold/bacteria also contained anti-concurrent causation (ACC) language, which can take precedence over any other provisions in the insurance policy if even a speck of the excluded materials is involved in an otherwise covered loss. In this situation, the loss was caused by direct exposure to Legionella bacteria, so there was little dispute over which part of the loss may or may not have been caused by bacteria.

The insurance vendor for at least one of the defendants in this toxic tort case had not informed its client about the effects of the new exclusionary endorsements for fungus/mold/bacteria in its liability insurance policies. Nor had the insurance vendor offered its client CEL coverage to fill the liability coverage gaps created by universal pollution/contamination exclusions. The insurance vendor would not be alone in these omissions. The vast majority of insurance vendors and underwriters have no understanding of the effects of pollution/contamination exclusions in indoor environments or of the use of environmental insurance to fill the resulting coverage gaps.

It's All a House of Cards

In the face of wrongful death and toxic tort claims for millions of dollars against the stakeholders in the lobby project, how did the sophisticated indemnity agreements and general liability insurance coverage specifications respond for the design firm and the other stakeholders?

A claim for defense costs was submitted to the design firm's general liability insurer both for the design firm and for the hospital owner as an additional insured. The claim for both parties was promptly denied by the insurance company under the fungus/mold/bacteria exclusion.

Litigation over the fungus/mold/bacteria exclusion in the design firm's general liability policy ensued, with the design firm losing its case on appeal. The courts determined that the proximate cause of the loss was bacteria contamination and that the fungus/mold/bacteria exclusion clearly and unambiguously applied to the claim on the general liability insurance policy. The national trend in coverage litigation over the meaning and effect of this exclusion follows the same findings.

There was another level of general liability exclusions that could have been triggered in this case. The total pollution exclusions in the stakeholders' general liability policies would also apply if their general liability policies were purchased in the state where the hospital was located. In that state, bacteria is a "pollutant" in ISO-based insurance policies, as determined by prior insurance coverage case law. However, with the ACC fungus/mold/bacteria exclusion endorsement in place on all of the stakeholders, there was no reason for their general liability insurers to be denying the loss under either the traditional pollution exclusion f. or the total pollution exclusion endorsements. Although that was an option.

The exclusionary endorsements for fungus/mold/bacteria are much broader than standard "'pollution' exclusions" in the basic policy forms. One important differentiator is that, under the exclusionary endorsement for fungus/mold/bacteria, the insurance company can eliminate the obligation to defend a claim arising from fungus/mold/bacteria. This was the actual situation for some of the defendants in this example—no coverage and no defense costs, either.

A similar claim for defense costs was denied for the GC, although that denied claim was not litigated.

Without liability insurance, the GC and its subcontractors are forced by their indemnity obligations to indemnify the upstream parties without insurance to reimburse them for these costs.

The hospital's general liability insurance policy had the same exclusions as its vendors for pollution/contamination/fungus/mold/bacteria-related losses.

Traditional Contractual Risk Transfer Is a House of Cards for Environmental Risks

It turned out that none of the general liability policies purchased by the stakeholders responded to this loss. Not even defense costs were covered by the general liability policies in the above scenario because of the operation of the ACC-based fungus/mold/bacteria exclusions.

There is one common denominator for all of the stakeholders defending themselves without the benefit of insurance. Everyone involved ignored the existence and effects of pollution/contamination exclusions in their risk management strategies. It turned out that all of the contractual risk transfers were a house of cards because there was no environmental insurance in place backing up the indemnity obligations.

A proactive approach to serving the environmental risk management needs of the stakeholders would have been a better solution for all the parties, including their insurance vendors.

Where Are the Insurance Brokers in This Mess?

The sky is not falling on insurance brokers for selling policies with major coverage gaps for fungus/mold/bacteria-related losses. The reasons for this vary from state to state based on the required standard of care for insurance intermediaries in each state. Most states set low standards of care for the quality of insurance products sold. Insurance buyers are primarily responsible for the insurance they choose to buy—so buyer, beware!

Another saving grace for insurance producers is that insurance coverage litigation is very expensive. It's normally pursued only by firms that have the resources to defend themselves from a denied liability insurance claim while paying another set of lawyers to sue their insurance company hoping for a judge to decide there is coverage under the insurance policies they purchased. In most denied pollution loss scenarios, insurance buyers do not have enough money to pay two teams of lawyers for years, not to mention a third team of lawyers alleging malpractice by the insurance vendor for failing to cover such an obvious loss exposure and providing no advice to insure it.

When a substantial liability claim is denied, as it was in this case, even firms with tens of millions of dollars in sales can simply go out of business due to unfunded liabilities. The good news in all of this for the insurance vendors servicing the stakeholders is that, if there is not enough money to pursue insurance coverage litigation, the insurance buyer probably doesn't have enough money to pay lawyers to sue the insurance broker for professional malpractice, either. But there is still a downside for the insurance vendors. If the client does have the money to hire multiple sets of lawyers to pursue not only coverage litigation for a denied claim but also professional malpractice allegations against its insurance vendors, one thing will be certain: The claim being made against the insurance vendor will be for big dollars.

There is no reason for insurance vendors to be betting the farm on uninsured environmental risks in their customer base. There is a glut of environmental insurance availability. Specially modified environmental coverage for indoor loss exposures, including coverage for fungus and mold, was introduced by Zurich Insurance Company in September 2003. By October, this coverage could have been found on the first page of an Internet search by typing "mold insurance" into Google. Coverage for bacteria as a pollutant appeared in 2008, when coverage for microbial matter as a pollutant was introduced.

The fundamental flaw in contractual liability risk transfer for contamination risks is not a dearth of environmental insurance product availability. The house of cards is created by fundamentally defective insurance specifications commonly used by property owners, contractors, and their lenders. An insurance specification supposedly backing up an indemnity agreement is fundamentally flawed if it ignores the existence of environmental/contamination loss exclusions in the requested coverage.

Correcting Contractual Environmental Liability Risk Transfer Design Flaws

It is simple to correct for the universal exclusions of claims associated with pollutants/contaminants in property and liability insurance policies if stakeholders understand and correct for the effects of various pollution/contamination exclusions in insurance policies.

In this case:

  1. The hospital, design firm, and GC should have specified modified CEL insurance in their procurement contracts. A more complete set of sample CEL insurance specifications for indoor environmental risks can be found on American Risk Management Resources Network's website at; search "insurance specifications." A summary of stakeholders' environmental insurance needs can be found in the December issue of The Risk Report titled "Environmental Risks, Insurance, and Pitfalls."

  2. The hospital owner needed a specially modified environmental impairment liability insurance policy to address the gaps in the property and liability insurance policies caused by exclusions for pollution/contamination/fungus/mold/bacteria in virtually all of the insurance policies a hospital would purchase.


The continuously expanding scope of exclusions related to various contaminants can convert traditional contractual liability risk transfer strategies into a house of cards. Fixing the problem is as simple as correcting for the environmental exclusions in property and liability policies through enlightened insurance specifications and procurements made by informed insurance vendors.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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