Coverage for general contractors for property damage arising out of the work of their subcontractors is becoming increasingly difficult to find. Two recent court rulings underscore the value of this coverage and the drastic effect on contractors of limited availability of subcontractor coverage in the market. This could create a coverage gap that will be extremely difficult to fill, particularly for large contractors.
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.
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.
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.
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.
Perhaps one of the most fascinating aspects of the Wanzek case was not briefed and argued before the Minnesota Supreme Court. However, it was discussed by the lower Court of Appeals in its opinion, Wanzek Construction, Inc. v Employers Insurance of Wausau, 667 NW2d 473 (2003). There, the court addressed Wausau's argument that since no lawsuit had been filed against Wanzek, it could not be "legally obligated" to pay damages within the meaning of the insuring agreement of the standard CGL policy. The court rejected that argument stating that the insuring agreement was broad and general enough to pertain to Wanzek's claim which involved property damage and an apparent contractual obligation on Wanzek's part to repair or pay for the property damage. Nothing in the provision suggested a lawsuit was necessary to trigger coverage. Finally, the court concluded that to construe the language of the provision to require a lawsuit to trigger coverage would not serve the public policy goal of encouraging the resolution of disputes without litigation.
In addition to the subcontractor exception endorsement, exclusion of residential construction risks is frequently accomplished by an exclusionary endorsement that applies to all broadly defined residential construction operations on a blanket basis.
3 Examples of cases that ignore the subcontractor exception in favor of the truncated occurrence analysis include Hartrick v Great American Lloyds Ins., 62 SW2d 270 (Tex App—Houston [1st Dist] 2000, no pet.), and William C. Vick Constr. v Pennsylvania Natl. Mut. Cas. Ins., 52 F Supp 2d 569 (ED NC 1999), affirmed, 213 F3d 634 (4th Cir 2000). The questionable rationale of these and other similar cases have been the subject of prior columns. See Defective Work as an Occurrence (July 2000); More on Defective Work as an Occurrence (November 2000); Even More on Defective Work as an "Occurrence" (October 2002).
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