Jeffrey J. Vita and Michael V. Pepe | Saxe Doernberger & Vita
First-party, third-party, builder’s risk, professional liability, commercial general liability, wrap-ups, and additional insured status are all potential sources of insurance coverage for a large construction loss. Therefore, it is critical for construction industry participants, from owners and developers to general contractors and their subcontractors, to have a functional knowledge of the different types of insurance coverage available to them and how those coverages intersect to respond to a loss. This paper presents a brief overview of the various types of coverage available to contractors, construction managers, and owners in a large construction loss and the risks each coverage is designed to insure.
In general, there are two forms of coverage: (1) First-party liability coverage, which protects an insured’s own losses on a project during construction; and (2) Third-party liability coverage, which insures the project participants for losses that become the subject of claims or suits brought against the project participants by third parties. When a loss occurs, such as property damage, both types of coverage can be implicated. For example, if a fire burns down a building under construction, the contractor likely would incur first-party losses such as cleanup costs. The contractor may also have third-party exposure if the owner alleges that the contractor was responsible for the fire. On the other hand, when a bodily injury occurs, all losses to the contractor will be third-party losses. A broad overview of each of these policies is provided below.
II. First-Party Insurance Coverage for Construction Projects
First-party coverage protects the insured or its property against a covered loss.
A. Builder’s Risk Builder’s risk is a form of commercial property policy that provides coverage for direct physical loss to the construction project while it is being built. Unlike liability policies, builder’s risk coverage does not require a claim or suit to be brought against the insured to trigger coverage. Rather, builder’s risk policies provide first-party coverage, i.e., coverage for the insured’s own property (the building that is being constructed), typically along with any materials and fixtures to be incorporated into the finished project.
Generally, builder’s risk policies are written on either an “all-risk” (often referred to as “special form” policies) or “named peril” basis. All-risk policies provide the broadest coverage. All-risk policies typically insure against all risks of loss except those specifically excluded. Most jurisdictions that have analyzed all-risk policies have held that all-risk policies cover all fortuitous losses, which cause some form of physical alteration to covered property.1 Some courts have gone a step further by not requiring any actual physical damage or alteration of property to trigger coverage.2 Courts agree that the initial burden of showing that coverage is triggered is on the insured. This is generally satisfied by proving that there was a fortuitous loss to covered property. Then the burden shifts to the insurer to prove that an exclusion unambiguously applies.3
In contrast, “named peril” policies insure against only those losses caused by a specifically listed peril or cause of loss. Named peril policies typically include coverage for fire, windstorms and hail, flood, earthquake, and other specific risks. The insured has the burden of proving that one of the listed perils caused its loss to obtain coverage.4 Generally speaking, policyholders prefer broad all-risk coverage for construction projects; however, all-risk coverage is more costly than named peril coverage and may not be feasible for every project.
Builder’s risk insurance policies vary widely. Insurance Services Office (“ISO”) has developed a standardized builder’s risk form (CP 00 20), but most carriers nonetheless choose to write builder’s risk policies on their own forms. Also, many policyholders look to the London markets for coverage. Because of the variation in terms, policyholders must carefully review their policies to ensure that they receive the coverage they expect.5
One area to pay particular attention to is who is insured under a builder’s risk policy. An owner may choose not to insure any contractors or only the prime contractor, when the owner purchases a builder’s risk policy. When an owner negotiates with the prime contractor for the prime contractor to purchase a builder’s risk policy, the prime contractor will often require that the owner, as well as upstream parties and lenders, be added as additional insureds. It is possible that a builder’s risk policy may insure only the party that purchased the policy or every party in the contractual chain from the landowner to the lowest tier subcontractor. In addition, most policies limit an insured’s status to the scope of their insurable interest in the project. Thus, a subcontractor may only have coverage for its own work or materials.
Perhaps one of the biggest impacts of who is an insured under a builder’s risk policy is related to subrogation. Parties must be very careful in drafting waivers of claims and waivers of subrogation with respect to first-party losses covered under a builder’s risk policy. Suppose a party that is an insured under a builder’s risk policy has not waived claims against a downstream party, and the downstream party is not an insured under the builder’s risk policy. In that case, the builder’s risk insurer may bring a subrogation claim against the downstream party if the downstream party caused the property damage for which a claim was paid.6 In this situation, the downstream party may be surprised to find out it has liability even though a builder’s risk policy was in place. This example illustrates the importance of carefully drafting risk transfer provisions and reviewing them in conjunction with the insurance that is purchased to ensure the risk transfer mechanisms work as intended.
Finally, it is important to be mindful of the temporary nature of builder’s risk insurance. Builder’s risk coverage ceases once construction is completed. Thereafter, the owner must procure appropriate property insurance to cover operations at its new premises. Some policies call for a specific expiration date of coverage, while others automatically terminate upon occupancy of the project, whether in whole or in part. This may cause a coverage issue if the project contemplates a phased roll-out or if the owner otherwise decides to start its business operations in one area of the project before the entire project is complete. Therefore, builder’s risk policyholders must work with their insurers to ensure that there is no gap in coverage in these scenarios. If there is an overlap, there are appropriate “other insurance” provisions to establish priority clearly.
B. Subcontractor Default Insurance Subcontractor Default Insurance (“SDI”) is a first-party coverage that indemnifies an insured contractor for losses resulting from a subcontractor’s default. SDI insures the cost of completing the work, the cost of correcting defective/non-conforming work, legal and other professional expenses, costs incurred in the investigation, adjustment, litigation, and defense of disputes related to the default and other expenses as set forth in the policy. SDI is often considered an alternative product to performance bonds and differs from such bonds in several respects:
SDI is a two-party insurance agreement between Contractor and Insured as opposed to a three-party guarantee arrangement between bonding company, subcontractor, and contractor. The Contractor prequalifies the subcontractors as opposed to the bonding company. Coverage extends to the policy limit, unlike a bond which is limited to the value of the contract. The insurer responds quickly to the claim as opposed to the bonding company, which can take considerable time to investigate the claim.
III. Third-Party Liability Insurance for Construction Projects
Third-party coverage protects the insured against claims made against it. The person or entity making the claim is the third party that suffered some loss for which it seeks to hold the insured liable.
A. Commercial General Liability Insurance Commercial General Liability (“CGL”) insurance is the most common form of third-party liability insurance purchased by businesses, including those operating in the construction industry. CGL policies are meant to provide the policyholder “with the broadest possible spectrum of protection and to transfer to the insurer the risk of all liabilities for unintentional and unexpected personal injury or property damage arising out of the conduct of the insured’s business.”7
CGL policies are primarily a standardized product, written on a form drafted (and periodically revised) by the ISO (form number CG 00 01). The standard policy form provides coverage for “those sums that the insured becomes legally obligated to pay as damages” because of “bodily injury” or “property damage” caused by an “occurrence,” or because of “personal and advertising injury,” which takes place within the coverage territory during the policy period.8 Standard CGL coverage applies to the insured’s operations nationwide. It is common, however, for construction project participants to purchase a specific CGL policy to cover a single project, such as wrap-up insurance policies which are discussed in more detail below.
CGL insurers have two key duties to their insureds in the event of a covered loss. The first key duty is the insurer’s duty to defend. In practice, the insurer’s duty to defend means that it will retain an attorney on the insured’s behalf when the insured is made party to a lawsuit or claim. This duty to defend may convert to a duty to reimburse,9 or the insured may have the right to select their own counsel, which the insurer pays in cases of a conflict of interest.10 The duty to defend, which essentially functions as “litigation insurance,”11 is typically provided outside of the policy’s limits of liability, meaning that all costs the insurer expends in defense of its insured will not count towards reducing or exhausting the per-occurrence or aggregate limits of liability. Whether an insurer has a duty to defend a given claim is dependent on the policy terms and state law. Most jurisdictions recognize that the duty is broad and is triggered whenever a claim is alleged against the insured that has the potential to invoke coverage under the policy, including those claims which may appear groundless, fraudulent, or false.12
The second key duty is the insurer’s duty to indemnify their insureds from any covered legal liability. Whereas the duty to defend depends on filing a suit against the insured,13 the duty to indemnify is typically triggered by entry of a final judgment, settlement, or other means of final resolution.14 “In short, whereas the duty to defend is measured by the allegations of the underlying complaint, the duty to indemnify is measured by the facts as they unfold at trial or are inherent in the settlement agreement.”15
Parties to construction contracts also may shift their risk by requiring “additional insured” status on another party’s CGL insurance. More specifically, an “upstream” party (e.g., an owner or general contractor) will require in its subcontracts that all “downstream” parties (e.g., subcontractors and suppliers) provide the upstream party with additional insured status on the downstream parties’ CGL insurance. Parties may specify terms such as limits of liability, coverage triggers, and scope of additional insured status. There are several benefits to additional insured status. First, the additional insured is typically entitled to the same coverages under the CGL policy as the named insured, subject to the “triggering” language of the additional insured endorsement, which usually requires some causal connection between the named insured’s work and the additional insured’s liability.16 Second, the upstream party protects its own insurance program by shifting risk from the upstream party’s insurance to the downstream party’s insurance. The upstream party’s limits are not exhausted, and the loss does not count against its loss/claim history. This benefits the upstream party because it avoids the possible negative impact on insurability or increased premiums on future policies.
B. Excess Liability and Umbrella Coverage For many construction projects, the project participants’ risk of potential liability exceeds the amount of coverage available on a primary basis. Accordingly, policyholders often purchase excess and umbrella insurance policies, which provide coverage over and above the insured’s primary insurance. Excess and umbrella coverage responds only once the primary policy or policies have paid their limits of insurance.17 Excess and umbrella insurance, though both purchased to meet this need, differ in function.18
Excess insurance applies only after a set amount of primary insurance exhausts. There are many types of excess forms. Some excess policies strictly “follow form” to the designated underlying policy, except for items specific to the excess policy (e.g., limits and policy period). The policyholder enjoys the same or substantially similar coverage from the first dollar of primary coverage to the last dollar of excess coverage. Other excess policies may only follow form for specific items but not for others. For example, excess policies may contain their own terms that apply to the excess coverage, which may not match all terms of the primary policy.19 As a general rule, excess coverage will not be broader than the underlying primary coverage.
Umbrella insurance is a subset of excess insurance that provides potentially broader coverage than what is provided by the underlying policy. An umbrella policy performs two key functions: (1) it provides an additional layer of insurance for losses that are generally covered by primary insurance; and (2) it provides additional coverage for those less common liabilities that are not usually covered by primary CGL insurance (e.g., malpractice coverage). Thus, umbrella coverage is often considered a hybrid contract, which combines “aspects of both a primary contract and a following form excess insurance contract.”20
C. Wrap-Up Insurance Policies It has become increasingly common for contractors and owners to purchase some form of consolidated or “wrap-up” insurance policy covering the project and all or some of the project participants. Wrap-ups consolidate what would otherwise be multiple policies held by the owner, general contractor/construction managers, and subcontractors into a single, unified insurance program.21 Most often, a wrap-up includes CGL and excess/umbrella insurance; although, a wrap-up may also include workers’ compensation insurance. A wrap-up is usually procured by either the owner (an “Owner Controlled Insurance Program” or “OCIP”) or the general contractor (a “Contractor Controlled Insurance Program” or “CCIP”). All project participants performing on-site work, with a few notable exceptions,22 are typically included as insureds on the wrap-up policies and have equal rights to coverage thereunder. Wrap-up policies provide many advantages to both the entity procuring the coverage and the other project participants. Given the economies of scale involved, the procuring party typically has greater bargaining power with potential insurers. As a result, it can often secure better coverage terms than any one party could obtain on its own. This is particularly important in jurisdictions where subcontractors struggle to procure quality coverage (whether due to poor insurance markets or lack of sophistication). In a “traditional” (i.e., non-wrap) project, the upstream parties must rely on downstream parties to secure appropriate coverage that will protect them as an additional insured. Procuring a wrap-up alleviates this concern. The party sponsoring the wrap-up controls the coverage it procures.
D. Professional Liability Insurance Professional liability insurance is another type of third-party liability coverage that is particularly important to construction project participants performing some form of design or engineering services. Most CGL policies specifically exclude, by endorsement, coverage for bodily injury or property damage “arising out of the rendering of or failure to render professional services.”23 Professional liability insurance is intended to dovetail with this exclusion, providing broad coverage for any kind of act or service that arises out of specialized knowledge, skill, or labor that is predominantly intellectual.24 Although design professionals are not generally required by law to purchase and maintain professional liability insurance; most project owners require that they do to ensure there is an adequate means to respond to a loss caused by a breach of their professional services contract.25
Typically, professional liability insurance is supplied on a “claims-made” basis. This means that the policy will respond to claims first made against the insured during the period when the policy is in effect.26 When a claim is “made” for purposes of triggering coverage, it is often defined as when the insured receives a demand for money or services or is made party to a lawsuit.27 Professional liability policies frequently include a “retroactive date,” a date in the past that cuts off coverage for claims that result from wrongful acts or omissions which took place prior to that date, regardless of whether the claim is made during the policy period. It is critical that construction industry policyholders ensure the retroactive date pre-dates the start of their services or work on the project to avoid incurring a gap in coverage.
Finally, additional insured status is not available on professional liability insurance, so upstream parties should not expect that project consultants can supply the upstream parties with that coverage. There are, however, specialized products available for those project participants who may be concerned about incurring liability on a vicarious basis for the errors and omissions of their consultants. Those products are known as owner’s or contractor’s protective indemnity policies. These protective indemnity policies are a source of recovery for losses incurred by a contractor or owner because of a consultant’s professional negligence.
E. Other types of Coverage Other lines of insurance coverage that may be implicated in a large construction project include, but are not limited to:
Pollution Liability Protects against injury or damage caused by pollution, which is generally excluded under CGL policies. Pollution liability policies can provide coverage for both first-party and third-party losses. Pollution liability policies are often “claims-made” policies, meaning that coverage expires when the project is completed. However, insureds can often purchase a “tail” to provide continued coverage after project completion.
Workers Compensation Worker’s compensation is a type of first-party insurance that protects an insured’s injured workers and limits the insured’s liability for claims.
Business Auto Policy The Business Auto Policy (“BAP”) is an ISO commercial auto policy that provides coverage for both auto liability and physical damage. Auto liability insurance covers third-party loss resulting from accidents caused by vehicles used in the policyholder’s business. Auto physical damage insurance covers first-party loss resulting from loss events, which include, but are not limited to, collisions, hail, theft, and vandalism.
Policyholders may expand coverage available under a BAP by endorsement.
Cyber Cyber risk insurance provides both first-party loss and third-party liability coverage for data breach events, privacy violations, and cyber-attacks. There are variations in the types of cyber insurance policies available; however, cyber insurance generally provides risk shifting for costs associated with having to respond, investigate, defend, and mitigate loss arising from a cyber-attack.
Inland Marine Originally covering ocean materials and vessels, inland marine insurance has expanded to cover various types of property, including tools and mobile equipment at or in transit to a project site.
“Rip and Tear” Third-party coverage insuring contractors from costs to remove and replace defective work.
Crisis Management First-party coverage that protects the contractor for professional responsibility and response costs in a publicized event.
IV. Conclusion In any given construction project, policyholders are faced with a multitude of potential risks. It is critical that policyholders carefully consider and evaluate potential risks in determining which types and amounts of insurance coverage will provide the best protection from those risks. Parties to a construction contract should first obtain some form of first-party insurance: generally, a builder’s risk policy, to protect the property of the insured during the project, and some form of third-party insurance, generally in the form of a CGL policy, to protect parties in the case of third-party claims In addition to those policies, policyholders should consider the advantages of obtaining additional insurance, such as (1) excess coverage to cover losses that exceed the limits of the primary policy; (2) professional liability coverage, to cover risks relating to the performance of a specialized or design-related nature; (3) pollution liability coverage, to cover any risks associated with the release of contaminants and/or mold; (4) a performance bond, to ensure completion of the project; and/or (5) SDI insurance to cover risks associated with subcontractor default.
Once policyholders have obtained coverage for their construction project, they should carefully maintain records evidencing that coverage. Because most third-party coverage is “occurrence” based, policies may still hold value years after the construction project is completed. If policyholders do not carefully maintain records, they may find themselves in a position, years after project completion, where they are forced to pay out-of-pocket because there is no record of the policy in place for that year. Thus, policyholders should carefully evaluate what coverage is necessary and maintain records of that coverage in case of future claims.