For some reason, construction defect claims have always seemed to confound
the insurance industry when it comes to commercial general liability (CGL) insurance
coverage. Undoubtedly, they upset the carefully cultivated compartmentalization
of construction property damage claims between fortuitous accidents and uninsurable
"business risks." Unfortunately, such a tidy dichotomy breaks down where an
insured, such as a general contractor, uses subcontractors to perform work at
a job site.
While the work of subcontractors is regarded as a general contractor's own
work under the CGL policy, the contractor still cannot exert complete control
over that subcontractor's operations. From the standpoint of the insured general
contractor, property damage caused by defective workmanship on the part of the
subcontractor may not be a controllable business risk. Rather it borders on
a fortuitous occurrence.
This uneasy compromise (at least from the standpoint of the insurance industry)
between the uninsurable business risk of the insured's own defective work and
the occurrence of defective work performed by the named insured's subcontractors
resulted in the creation of an exception to the general exclusion for defective
work under a CGL policy. Under the exception, the named insured is provided
coverage for property damage arising out of the defective work of its subcontractors.
This exception has been accomplished in a number of ways. It was first introduced
in 1969 as part of Broad Form Property Damage (BFPD) endorsement, edition 3006
(including completed operations), and, later by incorporation into Exclusion
(l) as part of the 1986 revisions of the CGL forms.
As of December 1, 2001, Insurance Services Office, Inc. (ISO), has come full
circle back to pre-BFPD endorsement days by offering two new endorsements for
attachment to an insured contractor's CGL policy. Endorsements CG 22 94 and
CG 22 95 eliminate the subcontractor exception to Exclusion (l), one on a blanket
basis and one on a project-specific basis.
By issuing standard endorsements, ISO has, in effect, stamped its imprimatur
on a significant reduction in coverage for many construction insureds. At the
same time, these new endorsements are sure to alter the way in which construction-related
"business risks" have been previously treated by the courts.
Endorsements CG 22 94 and CG 22 95
The new endorsements have been submitted for approval and were released for
use in December of 2001. Endorsement CG 22 94 provides as follows:
ISO Endorsement CG 22 94 EXCLUSION—DAMAGE TO WORK PERFORMED BY SUBCONTRACTORS ON YOUR BEHALF Exclusion 1. of Section 1—Coverage A—Bodily Injury and Property Damage
Liability is replaced by the following. 2. Exclusions This insurance does not apply to: 1. Damage To Your Work "Property damage" to "your work" arising
out of it or any part of it and included in the "products-completed
operations hazard." Source: ISO Properties, Inc.,
Copyright 2000 |
In turn, Endorsement CG 22 95 Exclusion—Damage to Work Performed by Subcontractors
on Your Behalf—Designated Sites or Operations," is identical to CG 22 94, except
it states that it applies only to those sites or operations designated in the
schedule of the endorsement.
Historical Perspective
The development, application, and court interpretation of the subcontractor
exception to the exclusion of coverage for the insured's work has not only provided
significant coverage for insured contractors, but it has also provided a framework
for the development of much of the law surrounding coverage for construction
defects.1 Naturally, much of the importance
of the exception is due to its extension of coverage for subcontractor's defective
work since subcontractors are extensively used throughout the construction industry.
However, the significance of the subcontractor exception also derives from
the fact that it constitutes a major inroad into the "business risk" doctrine,
a major defense relied on by insurers to deny coverage for defective construction
claims. In other words, by focusing on the subcontractor exception and the precise
language of the CGL policy (whether under the BFPD endorsement or the 1986 Exclusion
(l)), construction insureds have often been able to rein in a court from going
off on a pure "business risk" tangent by focusing on the fact that a certain
amount of coverage is actually provided under a CGL policy for business risks,
including defective workmanship of subcontractors. In this way, an insurer's
denial of a claim based on the blanket assertion that "business risks are not
covered under a CGL policy" can be demonstrated to be overly broad and contrary
to the language of the policy itself.
Prior to introduction of the 1986 CGL insurance program, CGL policies not
endorsed with BFPD endorsement 3006 had been interpreted to exclude coverage
for the insured contractor's faulty workmanship. A classic statement of that
notion is found in Weedo v Stone-E-Brick, Inc.,
405 A2d 7 (88 NJ 1979). There, the court applied Exclusion (n), the products
exclusion, and Exclusion (o), the "work performed" exclusion, in the 1973 standard
CGL policy form to deny coverage for defective masonry work performed by the
insured.
In doing so, the court placed heavy reliance on a law review article published
in 1970, which analyzed the effect of the 1966 revisions to the CGL policy forms.
That revision split products liability coverage for manufacturers from completed
operations coverage for contractors and other providers of services by separating
the products hazard and the completed operations hazard. In one of the more
classic statements of the "business risk" doctrine contained in that law review
article, Insurance Protection Products Liability
and Complete Operations—What Every Lawyer Should Know, 15 Nebraska Law
Review 415 (1970), by Professor Roger Henderson stated:
The risk intended to be insured is the possibility that the goods, products
or work of the insured, once relinquished or completed, will cause bodily
injury or damage to property other than to the product or completed work
itself, and for which the insured may be found liable. The insured, as a
source of goods or services, may be liable as a matter of contract law to
make good on products or work which is defective or otherwise unsuitable
because it is lacking in some capacity. This may even extend to an obligation
to completely replace or rebuild the deficient product or work. This liability,
however, is not what the coverages in question are designed to protect against.
The coverage is for tort liability for physical damages to others and not
for contractual liability of the insured for economic loss because the product
or completed work is not that for which the damaged person bargained.
In contrast to the scenario addressed by Professor Henderson, under the BFPD
endorsement, in the completed operations context, the damage to work exclusion
(o) of the pre-1986 CGL policy is modified so that it no longer applies to property
damage to work performed "by or on behalf of" the named insured, but only to
work performed "by the named insured." By virtue of the deletion of the "or
on behalf of" language, an insured general contractor is covered for property
damage arising out of work performed on its behalf by subcontractors. Only property
damage to work performed by the named insured itself is excluded.
Despite the careful drafting, some courts, relying on the "uninsurable business
risk" rationale, and quoting the Henderson Nebraska Law Review article and cases
such as Weedo, refused to acknowledge the underwriting
intent.2 For example, the court in Knutson Constr. Co. v St. Paul Fire & Marine Insurance
Co., 396 NW2d 229 (Mich 1986), denied coverage to the insured general
contractor for property damage arising out of its subcontractor's work. It found
support from the Henderson business risk analysis, referring to the deletion
of the "or on behalf of" language from Exclusion (o) at a "slight difference
in wording" which did not affect the exclusion for damage to a general contractor's
product.
In another case, Tucker Construction Co. v Michigan
Mutual Insurance Co., 423 S2d 525 (Fla App 1982), the court also discounted
the effect of the deletion of the "or on behalf of" language from Exclusion
(o) by simply reiterating that in the completed operations context, the insured
general contractor has accepted its subcontractor's work, so that any defects
in it should be regarded as defects in the contractor's own work.
Of course, numerous other cases have given effect to the subcontractor exception
and upheld coverage for an insured general contractor under the circumstances.
Many of those cases openly criticize the business risk rationale of cases such
as Knutson, including cases such as:
- Fireguard Sprinkler Systems v Scottsdale Insurance
Co., 864 F2d 648 (9th Cir 1998)
- Maryland Casualty Co. v Reeder, 221 Cal
App 3d 961, 270 Cal Rptr 719 (1990)
- Green Construction Co. v National Union Fire
Insurance Co. of Pittsburgh, Pa., 771 F Supp 1000 (WD Mo 1991)
The manner in which BFPD endorsement 3006 (including completed operations)
accomplished the exception for property damage arising out of a subcontractor's
work, through the deletion of the "or on behalf of" language from Exclusion
(o) from the 1973 policy form, was rather cumbersome. So, in 1986 ISO expressly
stated the subcontractor exception within the "your work" exclusion, Exclusion
(l), which provides that "this exclusion does not apply if the damaged work
or the work out of which the damage arises was performed on your [the named
insured's] behalf by a subcontractor."
This exclusion seems to have fared a bit better in terms of court interpretation
according to the underwriting intent. Even in Minnesota, where the Knutson case continues to apply to a 1973 policy
endorsed with a BFPD endorsement, in O'Shaughnessy v
Smuckler Corp., 543 NW2d 99 (Minn App 1996, petition for review denied)
(Minn 1996), the court distinguished Knutson on that basis and upheld coverage
for the insured general contractor for property damage arising out of its subcontractor's
work under the 1986 policy form.
Due to the new language in the exclusion, the court stated that it would
be "willful and perverse for this court simply to ignore the exception that
has now been added to the exclusion." On the other hand, other courts have had
no difficulty doing just that. For a court case citing to the Henderson Law
Review article analysis in support of a denial of coverage to a contractor for
property damage arising out of the work of its subcontractors and involving
a 1986 policy form, see Oak Crest Construction Co. v
Austin Mutual Insurance Co., 998 P2d 54 (Or 2000).
The Fallout for Construction Insureds
Obviously, insurers have previously been able to eliminate the subcontractor
exception in individual policies via the use of manuscript endorsements. Now,
however, the availability of standard form ISO endorsements will undoubtedly
make it simpler to accomplish the elimination of that coverage. Coupled with
a hardening insurance market and the tightening of coverage for other related
risks, such as mold, an increasing number of construction insureds may be forced
to accept this reduction in coverage upon renewal or, at least, to pay an increased
premium to retain coverage for subcontractors' defective work.
This will resemble the situation under the earlier BFPD endorsement arrangement,
where ISO advised an extra premium of 20 percent of the policy's property damage
liability premium to add a BFPD endorsement including completed operations to
a contractor's CGL policy and 10 percent for a BFPD endorsement excluding completed
operations. Although ISO has made no recommendations as to pricing of the new
endorsements, it is reasonable to expect that an increased premium may be charged
to avoid the attachment of the endorsements reducing coverage.
Admittedly, the extra coverage to an insured general contractor provided
through the subcontractor exception should be worth a higher premium, which
construction insureds are already paying. Moreover, from a purely legal standpoint,
the danger in eliminating the subcontractor exception amounts to a significant
expansion of the "business risk" rationale in that it also eliminates the concession
from the insurance industry that a general contractor may not have the ability
to control all risks associated with a subcontractor's work. It may have the
unintended result of making it more difficult for insureds to argue that such
defective work constitutes an occurrence, or even property damage since, due
to the subcontractor exception, a thorough analysis of a construction defect
claim requires consideration of the exclusions.
Absent that exception, insurers may argue even more strenuously that such
claims should be eliminated on the basis of the lack of occurrence, or even
property damage. This will eliminate coverage for claims that should be otherwise
be covered, resulting in an overall reduction of coverage for construction insureds.
Unfortunately, with the hardening insurance market, it may be difficult for
insureds to obtain alternative types of coverage for the defective work exposure,
such as gap policies or rip and tear coverage.
Conclusion
It remains to be seen how widespread the use of the new ISO endorsements
will become, but all signs seem to indicate that construction insureds will
be faced with hard choices upon renewal due to their potential use. The insurance
industry appears to have come full circle back to pre-BFPD endorsement days
as to property damage due to subcontractors' work. Unfortunately, full circle
does not amount to advancement for construction insureds—it amounts to regression.