Construction contractors are finding it increasingly difficult to obtain
the insurance that they have traditionally maintained to insure the risks associated
with their business. This state of affairs makes it nearly impossible for contractors
to meet the contractual requirements specified by owners or other higher-tier
contractors for insurance coverage to be provided in connection with specific
projects. The situation is particularly distressing in light of the growing
inability to obtain certain coverages that have heretofore been regarded as
customary components of the standard form commercial general liability (CGL)
insurance policy. That policy forms the cornerstone of most contractors' insurance
program. Unfortunately, many contractors—particularly those in certain niches,
like residential construction—have encountered a lengthening "endangered list"
of unavailable coverages for many of their operations.
One of the coverages that appears destined for that endangered list is the
coverage for general contractors for property damage arising out of the work
of their subcontractors, often referred to as the "subcontractor exception"
to Exclusion l, the "your work exclusion." That exclusion states that the insurance
does not apply to:
"Property Damage" to "your work" arising out of it or any part of it
and included in the "products-completed operations hazard."
This exclusion does not apply if the
damage to work or the work out of which the damage arises was performed
on your behalf by a subcontractor.
The construction industry, the insurance industry, and the courts have regarded
the subcontractor exception (emphasized above) as an enhancement to the CGL
coverage provided to a general contractor or any other entity that uses subcontractors
in its operations. As a result, general contractors have been able to tap a
considerable amount of completed-operations coverage under appropriate circumstances
in reliance on that exception. In response to the growing problem of construction
defect litigation, particularly in the residential arena, Insurance Services
Office, Inc. (ISO), promulgated a standard endorsement that eliminated the subcontractor
exception from the "your work exclusion." [See Full Circle Regression: The New ISO "Your Work" Endorsements (January 2002).] While some insurers have been adding
this endorsement to policies on a manuscript basis, the promulgation of a standard
endorsement by ISO would most likely foster its widespread use for construction
risks.
The attachment of this endorsement leaves general contractors in a curious
position in that one of their major sources of coverage for construction defects,
and a major source of a defense and indemnity for completed-operations claims
such as subdivision-wide residential or condominium defect litigation, is being
eliminated. This result is particularly unpalatable in light of recent court
cases that have upheld the enhanced coverage provided through the subcontractor
exception.
American Family Mutual v American Girl
One of these cases is American Family Mut. Ins. v
American Girl, Inc., 673 NW2d 65 (Wis 2004). In that case, the insured
general contractor, Renschler, contracted with Pleasant (now known as American
Girl) to design and construct a distribution warehouse. The soils engineering
subcontractor, Lawson, gave Renschler faulty site preparation advice. As a result,
there was excessive settlement of the soil under the building, causing it to
sink by as much as 8 inches on one end. The structure buckled and cracked. Ultimately,
the warehouse was found unsafe due to structural steel over-stress and had to
be torn down.
American Family, the CGL insurer of Renschler, denied the claim, but the
Wisconsin Supreme Court upheld coverage for Renschler for the property damage
attributable to the actions of Lawson, its subcontractor. The court noted that
the "your work exclusion" would operate to exclude coverage under the circumstances
of the case before it, but for the subcontractor exception that specifically
restored coverage for the property damage that arose out of the work performed
by the subcontractor. In that connection, the court stated as follows:
This subcontractor exception dates to the 1986 revision of the standard
CGL policy form. Prior to 1986, the CGL business risk exclusions operated
collectively to preclude coverage for damage to construction projects caused
by subcontractors. Many contractors were unhappy with this state of affairs,
since more and more projects were being completed with the help of subcontractors.
In response to this changing reality, insurers began to offer coverage for
damage caused by subcontractors through an endorsement to the CGL known
as the Broad Form Property Damage Endorsement, or BFPD. Introduced in 1976,
the BFPD deleted several portions from the business risk exclusions and
replaced them with more specific exclusions that effectively broadened coverage.
Among other changes, the BFPD extended coverage to property damage caused
by the work of subcontractors. In 1986 the insurance industry incorporated
this aspect of the BFPD directly into the CGL itself by inserting the subcontractor
exception to the "your work" exclusion.
In addition, American Family argued that it was impermissible for the court
to "create coverage" through an exception to an exclusion. Again, the court
rejected this argument stating as follows:
This interpretation of the subcontractor exception to the business risk
exclusion does not "create coverage" where none existed before, as American
Family contends. There is coverage under the insuring agreement's initial
coverage grant. Coverage would be excluded by the business risk exclusionary
language, except that the subcontractor exception to the business risk exclusion
applies, which operates to restore the otherwise excluded coverage.
The Wisconsin Supreme Court also relied on the subcontractor exception in
rejecting American Family's argument that the installation of defective work
by Renschler did not constitute an occurrence under the CGL policy because the
damage amounted to mere economic loss barred by the "economic loss rule." [For
a discussion of the economic loss rule as relating to CGL coverage, see The New Business Risk Rationale (Part 1) and Part 2 (December 2003).]
The Wisconsin Supreme Court stated that even though the economic loss doctrine
restricted the owner's recovery to specific warranties in the construction contract,
there was no basis for the insurer's argument that a loss giving rise to a breach
of contract or warranty claim could never categorically constitute "property
damage" within the meaning of the CGL policy's coverage grant. The court determined
that, under the circumstances of an occurrence of physical injury to tangible
property, the CGL insuring agreement provided coverage for the claim, a claim
for "property damage" within the meaning of the policy. The court stated:
If, as American Family contends, losses actionable in contract are never
CGL "occurrences" for purposes of the initial coverage grant, then the business
risk exclusions are entirely unnecessary. The business risk exclusions eliminate
coverage for liability for property damage to the insured's own work or
product—liability that is typically actionable between the parties pursuant
to the terms of their contract, not in tort. If the insuring agreement never
confers coverage for this type of liability as an original definitional
matter, then there is no need to specifically exclude it. Why would the
insurance industry exclude damage to the insured's own work or product if
the damage could never be considered to have arisen from a covered "occurrence"
in the first place?
Thus, the coverage provided by virtue of the subcontractor exception to the
"your work exclusion" preserves coverage not only for a subcontractor's defective
work, but also serves as the cornerstone for the argument that in light of the
presence of such restrictions on the property damage exclusions in the CGL policy,
it does in fact preserve coverage for certain elements of an insured's defective
work.
Wanzek Construction v Employers Insurance of Wausau
The subcontractor exception has also received broad treatment as to the type
of entity that constitutes a "subcontractor" for purposes of application of
the exception. [See Back to the Exclusions—The "Subcontractor" Exception (May 2001).] One of the very recent cases to engage
in such an interpretation is Wanzek Construction v Employers
Insurance of Wausau, 679 NW2d 322 (Minn 2004). In that case, Wanzek,
the general contractor, entered into a contract to construct a city aquatic
center, including a pool. The contract called for Wanzek to install custom fabricated
coping stone at the perimeter of the pool. That coping stone was provided by
Aquatic. As part of its obligation to supply the coping stone, Aquatic also
provided training to Wanzek personnel as to installation of the stone. After
completion, occupancy and use of the pool, the stones failed. Wanzek replaced
the stones pursuant to its obligations under the contract, seeking coverage
for the cost of repair from Wausau, its CGL insurer.
Wausau raised several defenses to the claim, first arguing that the coping
stone constituted Wanzek's product, so that the "your product" exclusion applied,
in that the entire construction project constitutes a general contractor's product.
The court rejected this argument based on the definition of "your product" contained
in the standard CGL policy form that contains an exception for "real property."
Wausau's main argument was that the subcontractor exception to the "your
work exclusion" did not apply to the supplier of materials so that the exclusion
denied coverage for property damage arising out of Wanzek's work. In support
of that argument, Wausau relied on state sales tax cases, while, on the other
hand, Wanzek relied on surety payment bond cases for its position that a supplier
should be treated the same as a subcontractor. The court found neither of these
lines of cases controlling because that precedent did not deal with the language
of the "your work exclusion" in Wausau's policy. The court stated as follows:
The policy language governs. If the policy language is ambiguous, it
must be interpreted in favor of finding coverage…. Because there is no statutory
or regulatory definition of subcontractor that is incorporated into the
"your work" exclusion, and the policy does not define the term, we hold
that the term "subcontractor" in the exception to the "your work" exclusion
of the CGL insurance policy is ambiguous and we will construe it liberally
in favor of coverage.
Wausau also argued that even if the supplier met the definition of a "subcontractor,"
the "your work exclusion" nevertheless applied because the supplier did not
perform its work on behalf of Wanzek, but had supplied materials manufactured
to the specification of the owner. The court was not persuaded by this argument,
observing that Aquatic had no agreement with the city for providing the coping
stone. Instead, it contracted directly with Wanzek and that contract obligated
Aquatic to furnish and pay for supervision, labor, materials, tools, equipment,
services, and all other items necessary to design and fabricate the stones.
The court held that since Aquatic's performance of its obligations to Wanzek
contributed to the performance by Wanzek of its obligation to the city to furnish
and install the coping stones, Aquatic had performed its work as a subcontractor
on behalf of Wanzek.1
Lessons To Be Learned
This discussion raises an obvious question, and that is, whether cases such
as American Girl and Wanzek are of merely historical value in light of the trend toward endorsing
CGL policies to eliminate the subcontractor exception. Not necessarily, since
some markets will continue to write the coverage, though issues may remain as
to pricing in order to avoid the attachment of the endorsement. However, it
is likely that certain types of contractors, such as residential homebuilders
and condominium developers, will be unable to purchase the coverage at an affordable
premium.
It is readily apparent that completed operations claims involving residential
construction defects have seriously impacted CGL insurers that may have underestimated
the risk in the underwriting of these risks, particularly in prior policy years
before residential construction defect litigation exploded. In that sense, the
insurance industry's reaction to the defective work exposure mirrors its handling
of other risks that emerged as significant, unanticipated losses. These risks
include asbestos, EIFS, silica, and mold. Now residential defective workmanship
completed operations claims will be added to that list of excluded risks.2
It is somewhat difficult to find the silver lining in what appears to be
extremely bad news for contractors, particularly residential builders. But even
in the face of this drastic reduction in coverage, there are several positives.
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One major problem with completed-operations defective work claims is
that in many states they may trigger multiple policies. The attachment of
the subcontractor exception limiting endorsement to a contractor's current
CGL policy implicitly admits that there is coverage for property damage
arising out of a subcontractor's defective work under unendorsed policies
in effect in prior years. Those policies may also be triggered by the claim.
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Despite the clarity of language of the subcontractor exception and the
intent behind it, courts in various states have ignored the coverage available
to an insured general contractor through the subcontractor exception, cutting
the analysis short by holding that property damage arising out of a subcontractor's
defective work is not caused by an "occurrence" under the policy. While
the dubious reasoning behind this approach is immediately obvious, it nevertheless
introduces a degree of uncertainty into the litigation of even those claims
that appear to fall squarely within the subcontractor exception.3 Unfortunately, litigation over even straightforward defective work claims
appears to have become the rule for many insurers. If nothing else, the
elimination of the subcontractor exception by endorsement to a contractor's
policy creates some certainty. Certainty that the contractor has no completed
operations coverage under its policy for subcontractors' defective work
allows the contractor to manage that risk through other risk transfer mechanisms—indemnity,
investigation of the quality of subcontractors, limitations of liability
with the owner, alternative insurance products, etc.
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The tightening of construction coverage is as much a reaction to market
conditions in the insurance industry as anything. Softening of the market
in the next insurance cycle may affect the availability of coverage for
the subcontractor exposure. In the interim, the insurance industry will
most likely respond to this exposure with alternative products to address
it, much the way products such as the contractors pollution policy developed
in response to the excluded CGL risks of pollution and mold. Another example
is the contractors professional liability policy, a response to the need
to cover professional exposures of a contractor engaged in design-build.
Products directed at the defective work exposure already exist, including
rip-and-tear policies, rework policies, and Subguard policies. The exclusion
of subcontractor coverage may cause these products to be retooled to fill
the gap, particularly for smaller contractors.
Obviously, one has to stretch to find the silver lining in what is nothing
short of a catastrophic reduction in CGL coverage for many contractors. That
gap will be extremely difficult to fill. American Family
Mutual v American Girl, Wanzek v Employers of
Wausau, and other well-reasoned opinions only underscore the size of
the gap in coverage between a CGL policy that contains a subcontractor exception
and a CGL policy endorsed to eliminate it.