How Does an Extrinsic Contract Impact Additional Insured Coverage?

In most cases, the reason that a commercial general liability (CGL) insurer issues an additional insured endorsement is that its policyholder has entered into a contract with a customer of the policyholder, and that contract requires the policyholder to name the customer as an additional insured. (Such contracts will be called "extrinsic contracts" in this article.) The endorsement is then issued to satisfy that obligation.

The same extrinsic contract invariably also requires the policyholder to indemnify its customer for bodily injury and property damage arising out of whatever work the policyholder is doing (construction, property management, commercial leasing, product distribution, as the case may be). The contractual liability coverage of the CGL policy insures the policyholder's obligations under an indemnity clause in an extrinsic contract.

Although the insurer may issue the additional insured endorsement to satisfy its policyholder's obligation to provide insurance to the policyholder's customer, the insurer is not a party to the extrinsic contract between the policyholder and its customer. Accordingly, that contract neither broadens nor narrows the coverage the additional insured endorsement provides, right? Generally, that is correct. An example of this general rule can be seen in pairs of cases decided by the Illinois Appellate Court and the California Court of Appeal.

Illinois and California Appellate Cases

In the Illinois cases, the court rejected attempts by the insurer to limit its additional insured coverage to what the extrinsic contract required, when the additional insured endorsement provided more coverage. In J.A. Jones Constr. Co. v Hartford Fire Ins. Co., 645 NE2d 980 (Ill App 1995), the court held that the additional insured was entitled to coverage for his own negligence, even though his contract with the policyholder entitled him only to coverage arising out of the policyholder's negligence, because the additional insured endorsement provided coverage for the additional insured's own negligence. In Mobil Oil Co. v Maryland Cas. Co., 681 NE2d 552 (Ill App 1997), the court held that the additional insured was entitled to the full limits of the policy, even though its contract with the policyholder required much lower limits.

On the other hand, in the California cases, the court held that the insurer's obligations would not be broadened by the indemnity agreement in its policyholder's extrinsic contract. In Travelers Cas. & Surety Co. v American Equity Ins. Co., 93 Cal App 4th 1142 (2001), the court held that a building owner's insurer, on whose policy an apartment manager was an additional insured, owed only pro rata coverage in accordance with its other insurance clause, and not sole primary coverage. The apartment manager argued that the indemnity clause in its contract with the building owner evidenced a clear intent to shift the entire loss to the building owner's insurer, but the court held that the indemnity agreement was irrelevant to the insurer's obligations, absent a judgment against the building owner on that agreement.

In Reliance Natl. Indem. Co. v General Star Indem. Co., 72 Cal App 4th 1063 (1999), the court held that an excess insurer that provided additional insured coverage to its policyholder's customer did not have to pay reimbursement to the additional insured's own primary insurer, despite the indemnity agreement requiring the excess insurer's named insured to indemnify the additional insured for the entire loss.

An exception to this general rule applies when the additional insured has a judgment for indemnity against the named insured. In such a case, the policy's contractual liability coverage will apply to the named insured's obligation to indemnify the additional insured. Since the contractual liability coverage belongs to the named insured, but the additional insured coverage belongs to the additional insured, the policy's other insurance clause does not apply. This is because an "other insurance" clause apportions coverage between policies covering the same insured. Cases applying this exception include Rossmoor Sanitation, Inc. v Pylon, Inc., 13 Cal 2d 622 (1975), and J. Walters Constr. Co., Gilman Paper Co., 620 S2d 219 (Fla App 1993).

Most reported cases in this area involved endorsements that did not specifically or generically refer to the policyholder's obligations under an extrinsic contract, other than a blanket endorsement's identification of the additional insured as one entitled by an extrinsic contract to such status. Some cases, however, have involved endorsements that specifically or generically conditioned coverage on the requirements of an extrinsic contract, such as where the additional insured endorsement provided for excess coverage unless an extrinsic contract required primary coverage. See, e.g., Bieda v Carson, Pirie Scott & Co., 663 NE2d 102 (Ill App 1996). That case involved a generic reference to an extrinsic contract. An example of a specific reference to an extrinsic contract is Truck Ins. Exch. v Liberty Mutual Ins. Co., 428 NE2d 1183 (Ill App 1981).

Four recent cases add to the body of case law on the important question of how additional insured coverage is impacted by requirements in an extrinsic contract:

• An Eighth Circuit case held that the indemnity agreement between a product manufacturer and the retailer required the manufacturer's primary and excess policies to pay the entire loss on behalf of the retailer (an additional insured on those policies), even though the manufacturer's excess policy provided that its coverage did not incept until exhaustion of all applicable primary policies.
• A Fifth Circuit case held that the indemnity agreement between a general contractor and a subcontractor required that the subcontractor's CGL policy pay the entire loss on behalf of the general contractor (an additional insured on the subcontractor's policy), even though the other insurance clauses of the two policies both provided for sharing with other primary policies.
• A California appellate case held that the scope of coverage for the additional insured would be commensurate with the scope of the indemnity agreement, and not as broad as the additional insured endorsement provided.
• A New York high court case held that the additional insured would be entitled to primary coverage under an endorsement providing that coverage for the additional insured is excess unless a contract requires primary coverage. The high court held that additional insured coverage, by its very nature, is primary, that contracts requiring additional insured coverage necessarily require primary coverage, and that no special words are needed for this purpose.

The Eighth Circuit Case

In Wal-Mart Stores, Inc. v RLI Ins. Co., 292 F3d 583 (8th Cir 2002), Jasmine, a minor, was severely burned in a fire allegedly caused by a halogen lamp purchased at Wal-Mart and manufactured by Cheyenne. Jasmine's parents, on her behalf, filed suit against Wal-Mart and Cheyenne. Her suit was eventually settled for $11 million.

Wal-Mart and Cheyenne had entered into a vendor agreement under which Wal-Mart agreed to sell halogen lamps manufactured by Cheyenne. The agreement contained an indemnity clause, which obligated Cheyenne to indemnify Wal-Mart for any liability resulting from its sale of Cheyenne's lamps. The agreement also required Cheyenne to obtain CGL insurance with limits of $2 million.

Cheyenne had a primary CGL policy with St. Paul, with limits of $1 million. Cheyenne also had a $10 million excess policy with RLI. RLI's policy contained an excess "other insurance" clause. Wal-Mart was an additional insured on both of these policies. Wal-Mart had its own primary CGL policy with National Union, with limits of $10 million. The National Union policy also contained an excess "other insurance" clause.

All parties agreed that St. Paul owed the first $1 million of the settlement paid on Wal-Mart's behalf. They disagreed, however, as to who owed the next $10 million—Cheyenne's excess insurer, RLI, or Wal-Mart's insurer, National Union. RLI paid the remaining $10 million, and sought reimbursement from National Union in a declaratory judgment action. The district court, applying Arkansas law, found that a comparison of the other insurance clauses required the conclusion that RLI's policy was excess over National Union's. The court therefore entered judgment for RLI. National Union and Wal-Mart appealed.

On appeal, the court found it unnecessary to resolve the competing other insurance clauses. The court held that the indemnity clause of the vendor's agreement controlled. The court said that the indemnity agreement reflected a clear intent that Wal-Mart be fully indemnified by Cheyenne for any losses caused by its products, and that to allow RLI to obtain reimbursement from Wal-Mart or its insurer would frustrate that intent. The court rejected RLI's contention that its true excess policy should not be triggered before exhaustion of National Union's primary policy with an excess other insurance clause. The court also rejected RLI's contention that because Cheyenne had not been found liable to indemnify Wal-Mart, the indemnity agreement should not control.

Lastly, the court opined that to allow RLI to obtain recovery from National Union would result in a "circuity of litigation," resulting in RLI ultimately owing the debt anyway. This is so, said the court, because if National Union had to reimburse RLI, then National Union, as Wal-Mart's subrogee, would assert Wal-Mart's right to be indemnified by Cheyenne. Cheyenne's obligation to indemnify Wal-Mart, in turn, would be covered by RLI, thus leaving the loss where it began.

The court reversed the judgment in favor of RLI. The court opined that Travelers Cas. & Surety Co. v American Equity. Ins. Co., 93 Cal App 4th 1142 (2001), and Reliance Natl. Indem. Co. v General Star Indem. Co., 72 Cal App 4th 1063 (1999), were inconsistent with Rossmoor Sanitation, Inc. v Pylon, Inc., 13 Cal 2d 622, 532 P2d 97 (Cal 1975), and so declined to follow those more recent appellate cases.

But the court overlooked what distinguishes Rossmoor from the appellate cases: the presence or absence of a judgment for indemnity, or some other determination that indemnity was owed. This key distinction was explained very well by the court in Travelers Cas. & Surety Co. v American Equity. Ins. Co.

The Fifth Circuit Case

In American Indemnity Lloyds v Travelers Property Casualty Ins. Co., 2003 WL 21437012 (5th Cir 2003), Alas was injured on a prison construction project while employed by Elite Masonry, a subcontractor. Alas sued Caddell Construction, the general contractor, for his injuries. The subcontract between Caddell and Elite contained separate clauses for indemnification and insurance. The indemnification clause required Elite to indemnify Caddell for any bodily injury claims or suits arising out of Elite's work, including those caused by Caddell's negligence, except for those losses caused by Caddell's sole negligence. The insurance clause required Elite to make Caddell an additional insured on its CGL policy.

American Indemnity Lloyds (AIL) issued a CGL policy to Elite, containing a blanket additional insured endorsement. Caddell was the named insured on a CGL policy issued by Travelers. Both the Travelers and AIL policies contained the ISO CG 00 01 coverage form, pre-1998 version, which provided for sharing with other primary policies. Travelers initially defended Caddell in the Alas lawsuit, but AIL subsequently assumed Caddell's defense under the blanket additional insured endorsement to the AIL policy.

AIL advised Travelers, however, that it deemed the two policies' coverage to be concurrent, and that AIL would seek contribution from Travelers for any sums AIL paid to defend and indemnify Caddell. AIL then settled the Alas suit for $625,000, after having incurred $230,000 in defense costs. AIL demanded half these sums from Travelers, and when Travelers refused, AIL filed a declaratory judgment action in federal court in Texas.

AIL's position was that its right to contribution was based on the other insurance clauses of the two policies, which, when compared, provided for concurrent coverage. Travelers' position was that the indemnity agreement controlled, not the other insurance clauses.

The insurers stipulated to all relevant facts, and that Travelers was subrogated to whatever indemnity rights Caddell had under its subcontract with Elite. They also stipulated that AIL's policy covered Elite's indemnity obligations, if any, to Caddell, and that there was no judicial determination of fault or negligence in the Alas suit. Travelers contended that because the court in the Alas suit had not determined that Caddell was solely negligent, the lone exception to Elite's obligation to indemnify Caddell therefore did not apply, and thus, that Elite owed indemnity to Caddell for Alas's suit. Since the insurers had stipulated that Travelers was subrogated to Caddell's indemnity rights, and that AIL insured Elite's obligation to pay indemnity to Caddell, AIL was therefore barred from suing Travelers for contribution, Travelers contended.

The district court agreed with Travelers' contentions, and entered summary judgment in Travelers' favor. AIL appealed.

On appeal, the court acknowledged that, as AIL contended, the general rule is that where two liability policies issued by different insurers provide coverage to the same insured, and both contain an other insurance clause that provides for sharing with other primary policies, the two insurers share the loss, and if one paid it and the other did not, the paying insurer may recover contribution from the non-paying insurer. However, said the court, there is an exception to this general rule where the insurer seeking contribution insures the obligation of its named insured to indemnify the additional insured for the loss in question. In this case, then, since AIL's policy insured Elite's indemnity obligation under its subcontract with Caddell, AIL was not allowed to seek contribution form Travelers. As an example of this exception, the court cited the Wal-Mart case.

To support the court's reliance on this "indemnity exception," the court discussed with approval the "circuity of litigation" rationale of the Wal-Mart case. The court reasoned that to allow AIL to obtain contribution from Travelers would only result in Travelers, as Caddell's subrogee, asserting Caddell's right to be indemnified by Elite, and AIL, which insured Elite's obligation to indemnify Caddell, paying the ultimate loss.

Finally, the court addressed AIL's contention, supported by Travelers Cas. & Surety Co. v American Equity Ins. Co., 93 Cal App 4th 1142 (2001), that the indemnity agreement did not control because there had been no determination of liability in the Alas suit, and thus no determination that Elite owed indemnity to Caddell. The court said that AIL could have sought such a determination in the federal declaratory litigation. The court also noted that Texas law, unlike California law, does not require a finding that the indemnity obligation was actually owed for the indemnity agreement to control allocation of coverage.

The court reasoned that because the indemnity agreement applied unless the exception was established, i.e., that Caddell was solely negligent, the lack of a judicial determination that Caddell was or was not solely negligent failed to establish the exception. Therefore, indemnity was owed, and the indemnity agreement determined the allocation between the two insurers, not their other insurance clauses. The court affirmed the judgment in favor of Travelers.

The California Appellate Case

In St. Paul Fire & Marine Ins. Co. v American Dynasty Surplus Lines Ins. Co., 101 Cal App 4th 1038 (2002), Casados was injured while doing electrical work for his employer, Sasco Electric, at a rail yard in California. ARB was the general contractor, and Sasco was ARB's subcontractor. Although Casados was doing Sasco's work under the subcontract, his injury was not caused in any way by that work. Rather, ARB was pressure testing a pipe connected to a fuel tank in a completely different area when the pipe exploded, causing metal fragments to strike Casados and injure him. Casados filed suit for his injuries against ARB and the railroad, ATSF.

The subcontract required Sasco to name ARB an additional insured on its CGL policy, and to indemnify ARB from any bodily injury claims or suits arising out of Sasco's work, provided that such claims or suits arose from Sasco's acts or omissions. American Dynasty issued a CGL policy to Sasco. The policy included an additional insured endorsement on a CG 20 10-type form that provided coverage to ARB for "liability arising out of [Sasco's] ongoing operations performed for [ARB]." ARB had its own CGL policy with St. Paul.

St. Paul provided a defense to ATSF and to ARB, and tendered their defense to American Dynasty. American Dynasty declined the tender, and St. Paul paid a total of $113,000 in defending and settling the Casados suit. St. Paul then filed an action for declaratory relief, seeking reimbursement from American Dynasty. It was undisputed that no act or omission of Sasco caused the injury to Casados. The trial court entered judgment for St. Paul for the amounts it paid to defend and settle the Casados suit. American Dynasty appealed.

On appeal, the court found that the language in the additional insured endorsement ("arising out of [Sasco's] ongoing operations") was ambiguous, because it could reasonably be construed as "embracing either (1) any liability arising while Sasco was on [the construction site] doing work under the subcontract or (2) liability restricted to that arising, at least in part, from Sasco's actual performance of such work." Instead of resolving that ambiguity against the insurer and in favor of additional insured coverage, however, the court found that it was necessary to construe the endorsement along with the subcontract. Since the subcontract required indemnity only for liability arising from the subcontractor's acts or omissions, concluded the court, the additional insured endorsement could not be read to provide broader coverage.

This decision is difficult to justify. First, the court construed what it found to be an ambiguous policy term in favor of the insurer that drafted it. Second, the court, in looking to the subcontract, ignored the additional insured requirement, which required coverage for the subcontractor's ongoing operations, and instead focused on the indemnity clause, with its more restrictive obligation. But if it was proper to look to the subcontract at all to determine the scope of coverage, surely, the portion of the subcontract that prescribed the scope of additional insured coverage is more specific, and more relevant, than the indemnity clause. Additionally—all other things being equal—when confronted with two clauses providing different types of coverage, a court is supposed to choose the clause that results in broader coverage. Third, the court overlooked the fundamental differences between private-contract indemnity and commercial liability insurance. To import the narrow construction against indemnification for one's own negligence that applies to an indemnity clause into a discussion of additional insured coverage is unprecedented and unwarranted.

I am not the only commentator to criticize this decision. See also John K. DiMungo and Paul E.B. Glad, California Insurance Law Handbook, § 106 (2003 ed.). Those authors said the following.

The analysis of the St. Paul court does a disservice to principals seeking protection from the risks associated with hiring an independent contractor. Principals can never be sure that their indemnity clauses will be found enforceable. * * * [I]nsurance is most needed when the indemnity obligation fails; yet the effect of the St. Paul decision is to limit insurance to indemnifiable claims. This despite the fact the general contractor in St. Paul presumably paid in the subcontract price the premium for the additional insured endorsement.

The New York High Court Case

In Pecker Iron Works of New York, Inc. v Travelers Ins. Co., 786 NE2d 863 (NY 2003), an employee of Upfront Enterprises was injured at a construction site. Upfront was a second-tier subcontractor of Pecker Iron Works, which in turn was a subcontractor of the general contractor. The Upfront employee brought suit for his injuries against the owner and general contractor, who then impleaded Pecker.

Upfront's subcontract required it to furnish additional insured coverage to Pecker. Upfront's CGL policy with Travelers contained a blanket additional insured endorsement, which provided that its coverage was excess unless the contract requiring the coverage required primary insurance. Pecker tendered its defense to Travelers under the additional insured endorsement, and when Travelers declined the tender, Pecker commenced an action for declaratory relief.

The trial court entered judgment for Travelers, finding that the subcontract did not specify primary coverage, and concluding that the additional insured coverage was therefore excess of Pecker's own coverage. Pecker appealed, and the appellate court reversed. The appellate court held that the subcontract did not provide for excess coverage, and therefore had to be construed as requiring primary coverage. Travelers appealed to New York's highest court.

On appeal, the high court noted that it was undisputed that the Travelers policy provided Upfront (the named insured) with primary coverage. The court then observed that the term "additional insured" has a well-understood meaning, i.e., "an entity enjoying the same protection as the named insured." The court ended by noting that the obvious purpose of the additional insured requirement in the subcontract was to provide that Upfront's insurer—not Pecker's—would provide the primary insurance for a loss involving an Upfront employee.

The high court affirmed the appellate court judgment in favor of Pecker. This decision is clearly correct, although the reasoning is somewhat overwrought. It is not true that additional insureds enjoy the same protection as named insureds, although this overstatement did not taint the reasoning of the court. The court simply noted the obvious fact that the parties to the extrinsic contract could only have intended primary additional insured coverage, since coverage applying only in excess of the additional insured's own primary insurance is illogical.

These "elastic" excess clauses are in common use by some of the major property and casualty insurers, including Travelers, CNA, and St. Paul. Pecker Iron Works goes one step further than the decision of the Illinois Appellate Court in Bieda v Carson, Pirie Scott & Co., 663 NE2d 102 (Ill App 1996). The Bieda court held that the extrinsic contract's requirement that the insurance cover "any and all claims" against the additional insured necessarily meant primary coverage. But the extrinsic contract in Pecker Iron Works did not contain that "any and all claims" language. Armed with this new decision, additional insureds can now forcefully argue that no special language is needed in the extrinsic contract for their coverage to be primary, because it makes no sense to construe the contract any other way.

Conclusion

The wall of separation between extrinsic contracts and insurance policies is beginning to come down. In the two federal cases, the wall was breached so that the additional insured could insulate its own primary coverage from any obligation to share with, respectively, the named insured's primary policy, and the named insured's excess policy. It is interesting that these two federal cases, decided under Arkansas and Texas law, respectively, recognized that California law does not allow the wall to be breached absent a judicial determination of the indemnity obligation. This is probably the majority view.

Should it be necessary that the indemnity obligation be judicially determined before it controls the allocation between the insurers? These two federal cases say no, but California cases continue to say yes. Will the circuity of litigation rationale catch on? That rationale is very insightful and practical, but it assumes the enforceability of the indemnity obligation. Anti-indemnity statutes and the facts of the particular losses may leave the indemnity obligation unenforceable. What happens then?

These issues are going to have to be decided in a coherent way, because there isn't a construction contract signed these days that doesn't require both indemnification and the procurement of additional insured coverage. The interplay between the two does not always produce the desired result, as these decisions show. The vast majority of states continue to adhere to the simple rule that an insurance policy's coverage will not be determined by provisions of an extrinsic contract to which the insurer is not a party, unless the policy so provides.

But looking to the subcontract can be justified in general terms. It is black letter contract law that a contract should be construed with due regard for the context and purpose of the contract. In the case of additional insured coverage, the context and purpose can be discerned largely from the provisions of the extrinsic contract, which required the procurement of additional insured coverage to begin with.

The one conclusion that can be drawn from these recent cases is that drafting the extrinsic contract harmoniously is essential to good risk transfer planning. The indemnity and insurance obligations should be consistent with each other, because you never know when a court may look to the indemnity agreement to determine the scope or allocation of the additional insured coverage, whether the policy endorsement incorporates the indemnity clause or not. A court may even do this when the result is inconsistent with the insurance clause, as the California court did, although this decision was so patently wrong it's hard to imagine any courts outside California will follow it.

Additionally, the additional insured, to the extent he is able, should exert all efforts to see that the additional insured coverage conforms to the insurance clause of the extrinsic contract. Failure to take these steps can lead to costly and unsuccessful coverage litigation.