Narrow margins and tight schedules make construction contracting a cut-throat, volume-driven business. Contractors spend virtually all of their resources on delivering their existing work on time and securing their next round of projects. Consequently, when significant defects and damage are discovered post-completion, a contractor is almost certain to turn the matter over to its insurance carrier to resolve, rather than self-perform the repairs. This is not because contractors don’t care about the quality of their work; it is because most contractors are not financed or structured to repair completed projects.
This business model can leave property owners in a difficult position. Rather than working with the contractor, property owners have to turn to insurance carriers who have no financial incentive to provide assistance. Specifically, a contractor’s insurance carrier owes no legal duty to the property owner unless and until a final judgment is obtained against the contractor; the carrier is immune from bad faith actions filed by a property owner for wrongful delay or denial of its claims; the carrier has deep pockets to pay for prolonged investigations and preferred legal rates to pay for litigation; and the carrier makes money by holding onto premiums as long as possible. In most cases, insurance carriers have a financial incentive not to repair damage without prolonged investigations, and often, litigation.
Some carriers are more aggressive in their approach to claims than others. Consequently, it is important for any business engaging in the improvement of real property to become familiar with the different carriers in the marketplace. It is also important for an owner to understand the limitations of its contractor’s insurance coverage and the options available for obtaining additional or alternative sources of coverage.
General liability coverage
The majority of construction projects are insured through general liability policies, obtained and maintained by contractors. To exercise some control over the coverage, sophisticated owners often include contract provisions setting forth minimum aggregate limit requirements, minimum financial ratings for the carriers, and requiring the contractor to maintain the same level of coverage for a set period of time after completion.
While general liability policies account for a substantial portion of the construction insurance market, they have lost market-share over the last several years for a few reasons.
1. Coverage depletion
Each general liability policy obtained by a contractor covers every project the contractor works on during the period of the policy. Absent a specialty endorsement to the contrary, none of the limits are dedicated to any given project, and the entirety of the limits can be depleted with just one or two large claims.
Assume a high-risk trade contractor maintains a general liability policy with a $2 million general aggregate limit and a $1 million per occurrence limit. Further assume that the contractor works on ten projects during the policy period. Here, the contractor’s limits can be significantly impaired, if not depleted, by claims against two of its projects, leaving the remaining eight projects underinsured or uninsured.
Because many contractors have a tendency to repeat mistakes on multiple projects, it is not uncommon for high-risk contractors to be sued for several projects in the same policy period, making insurance depletion among high-risk trades frequent over the last decade.
2. Montrose-based exclusions
General liability policies do not guarantee the work of the insured contractor. They insure against personal injury and property damage arising from the contractor’s work. Further, only personal injuries and property damage that “occur” during the policy period are covered under standard ISO policies. This requires a simple analysis when a contractor drops a hammer and hits a bystander in the head, becoming more complicated with construction defects.
Assume a contractor improperly installs roof tiles on a project. No ill effects are encountered until the first rain after the project is completed. During this, small droplets of water bypass the roof tiles and get to the plywood roof sheathing. After a few years of exposure, the roof sheathing begins to rot and water gets down to framing members in the attic space. Several years later, the framing members have developed dryrot and water begins to leak into the unit interior. The owner discovers the leak and resulting damage to its floor and furniture.
Here, the damage “occurs” over several years. In 1995, the California Supreme Court held, in the seminal case of Montrose Chemical Corp. v. Admiral Insurance, that in this situation, where damage progresses over multiple policy years (a “progressive or continuing loss”), the standard ISO policy provides coverage under each affected policy. For property owners and developers, this decision resulted in protection from insurance depletion. If one policy period was depleted, there was potential coverage under other policies.
However, insurance carriers quickly began crafting new policy exclusions to circumvent the Montrose holding. These have evolved significantly over the last decade, becoming increasingly more onerous. One in particular, the “Prior Works” exclusion, precludes coverage for all work completed prior to the inception date of the policy.
While this exclusion may seem harmless on its face, it actually wreaks havoc on progressive loss claims by creating an earlier triggering event for the exclusion (completion of work) than for the coverage (occurrence of damage). Consider the roof leak example, above, and add the following facts:
Assume the roofer’s policy runs from July 1, 2005, to June 30, 2006. Further assume that the project is completed on June 1, 2006, and that the first rain event following completion does not occur until Sept. 1, 2006. When damage is discovered several years later in 2010, the owner notifies the contractor, and the contractor notifies its carriers.
Under Montrose, every policy issued from 2005 to 2010 would be on the risk for the damage caused during its policy period.
If, however, all of the contractor’s policies had “Prior Works” exclusions, the only policy with potential for coverage is the 2005-2006 policy, as the work was completed prior to the inception of all subsequent policies. More alarmingly, the carrier that issued the 2005-2006 policy could (and almost certainly would) contest liability on the grounds that most, if not all, of the property damage occurred after its policy expired. Specifically, the carrier would argue that, without any rain between the date of completion and the expiration of the policy, the odds that any damage occurred during its policy period are slim. Second, the carrier would argue that, at most, it is only liable for the cost of repairing the roof sheathing, as framing damage and ceiling leak damage undeniably occurred years after the policy expired.
An earlier triggering event for the exclusion (completion of work) than for the coverage (occurrence of damage) creates a loophole that allows all of the carriers to “walk between the raindrops” on liability for progressive loss claims – rendering the majority of the damage uncovered.
To be sure, not all insurance policies contain “Prior Works” exclusions, and those that do are often negotiable. However, it has become increasingly rare for policies to be free from any form of Montrose-based exclusions, each of which has a unique negative impact on coverage, and all of which should be understood by owners before commencing construction insured by a contractor’s general liability coverage.
Insuring a construction project is a complicated undertaking, and the proliferation of Montrose-based exclusions has only complicated the effort. However, it is imperative that owners understand the reach and long-term impact of the endorsements contained in their contractor’s insurance policies, so that they can evaluate the risks they are assuming and the benefits and drawbacks of negotiating specialty endorsements, removal of Montrose-based exclusions, and/or alternative methods of insuring their projects altogether.