1 Risk-Shifting Agreements In Construction Contracts: Why Insurance May Not Work The Way It Used To David S. White The newer additional-insured clause might leave the owner and subcontractor without the protection they expect. David S. White is Senior Counsel with Thompson & Knight, LLP, in Dallas. He has written extensively on insurance topics, and can be reached at For years, parties to construction contracts allocated their anticipated risks through indemnification and additional-insured agreements. However, a recent change in standard liability insurance policies may leave additional insureds without coverage for risks that the parties intend to cover. Suppose a subcontractor agrees in the contract to indemnify the owner for worksite injuries and to add the owner as an additional insured to the subcontractor s liability insurance. Further suppose that the subcontractor s employee is injured on the job owing to the sole fault of the subcontractor. If the employee sues the owner, both the subcontractor and the owner would reasonably expect the subcontractor s insurance company to defend and indemnify the owner when the contract requires the subcontractor to add the owner as an additional insured to the subcontractor s policy. However, many standard additional-insured endorsements issued after 2004 exclude coverage for the owner under the facts stated above, not only leaving the owner without insurance coverage but also possibly subjecting the subcontractor to a lawsuit from the owner for which the subcontractor may have no coverage. This article explains why and suggests remedies. The Practical Real Estate Lawyer 43
2 44 The Practical Real Estate Lawyer January 2007 THE WAY IT USED TO WORK The construction industry has for years relied on indemnification ( hold harmless ) agreements to shift legal liability for worksite injuries to the party in the best position to keep the construction site safe. Owners and general contractors typically expect their subcontractors to indemnify and hold them harmless for liabilities arising from the worksite. Commercial property owners likewise often require tenants to do the same for accidents on the leased premises. In both cases, the party indemnifying the other, that is, the indemnitor that indemnifies the indemnitee, is usually in actual control of the worksite conditions and usually in the best position to prevent accidents. Consequently, construction contracts usually require subcontractors to indemnify owners. Owners, however, rarely have to, or want to, invoke the indemnification in the contract to protect them. They usually agree that the indemnitor will purchase liability insurance for the construction project and will add the indemnitee owner as an additional insured to the subcontractor s insurance policy. The subcontractor s insurer is then expected to defend and indemnify both the named insured subcontractor and the additional-insured owner against injury and property damage claims arising from the subcontractor s worksite. Although the subcontractor has to bear the cost of procuring the policy, this arrangement benefits the subcontractor as well by avoiding confusion and unnecessary legal costs when a workplace lawsuit is filed. The parties do not have to waste time and money sorting out which party is responsible for defending the lawsuit. The subcontractor s insurer has its marching orders to defend all parties to the contract. Also, because the subcontractor s insurer is arguably covering additional insureds only because the liability arises out of the subcontractor s work, most underwriters do not require the subcontractor to pay an extra premium for additional-insured coverage. At least, this is the way it used to work. Before 2004, when the subcontractor s employee sued the owner for injuries, such as a fall from a scaffold, the subcontractor s insurer defended and indemnified the additional-insured owner even when the employee alleged that the owner caused the injury. Because the owner had direct rights as an insured under the subcontractor s policy, the owner could communicate directly with the insurer and receive a defense immediately, without waiting for later indemnification from the subcontractor under the contract. THE ADDITIONAL-INSURED ENDORSE- MENT The additional-insured endorsement used to cover suits against owners. But insurers never liked covering additional insureds, for which they usually received no extra premium. They particularly didn t like covering additional insureds when the additional insured caused or contributed to the accident. Accordingly, insurance companies have consistently taken the position that their liability policies cover additional insureds only when the named insured is legally responsible for the accident, at least in part. Courts, however, have typically required insurers to cover additional insureds even if the named insured is not the culpable party, as long as the accident occurs within the course of the named insured s contract work or on the named insured s premises. The named insured may not even be a party in the suit. The typical additional-insured endorsement in effect before 2004 resembled the 1984 ISO form CG as follows: ADDITIONAL INSURED OWNERS, LESSEES OR CONTRACTORS (FORM B) This endorsement modifies insurance provided under the following: WHO IS AN INSURED (Section II) is amended to include as an insured the person or organization shown in the
3 Risk-Shifting Agreements 45 Schedule, but only with respect to liability arising out of your work for that insured by or for you. Under this form, as long as the injury arises in the course of the subcontractor s work, the claim against the additional-insured owner is covered. Thus, lawsuits brought against the owner, but not against the subcontractor, were usually covered by the subcontractor s insurance as long as the accident occurred on the worksite. Because the subcontractor s employee is usually barred from suing the subcontractor owing to workers compensation laws, the construction industry is especially prone to this kind of lawsuit. If the subcontractor s employee sues, he or she frequently sues the owner alleging that the owner failed in some way to keep the construction site safe, even though the subcontractor/employer may be at fault. THE WAY IT WORKS TODAY In 2004, the insurance industry reacted to the judiciary s expansive interpretation of additional-insured endorsements by attempting to limit the coverage for additional insureds. An insurance industry trade group, the Insurance Service Office ( ISO ), which provides a variety of services to the property/casualty insurance industry, including promulgation of standard policy forms, amended most of its additional-insured endorsements to exclude the sole negligence of additional insureds. The 2004 edition of ISO Form CG provides: This endorsement modifies insurance provided under the following: COMMERCIAL GENERAL LIABILITY COVER- AGE PART A. Section II Who Is An Insured is amended to include as an additional insured any person(s) or organization(s) shown in the Schedule, but only with respect to liability for bodily injury, property damage or personal and advertising injury caused, in whole or in part, by: 1. Your acts or omissions; or 2. The acts or omissions of those acting on your behalf; in the performance of your ongoing operations for the additional insured(s) at the locations designated above. B. With respect to the insurance afforded to these additional insureds, the following additional exclusions apply: This insurance does not apply to bodily injury or property damage occurring after: 1. All work, including materials, parts or equipment furnished in connection with such work, on the project (other than service, maintenance or repairs) to be performed by or on behalf of the additional insured(s) at the location of the covered operations has been completed; or 2. That Portion of your work out of which the injury or damage arises has been put to its intended use by any person or organization other than another contractor or subcontractor engaged in performing operations for a principal as a part of the same project. This 2004 endorsement restricts coverage in two ways not found in the earlier endorsement: Part A of the 2004 form provides that the additional insured is covered only if the liability is caused in whole or in part by your acts or omissions, meaning the acts of the named insured, or the acts or omissions of the named insured s employees or contractors. Thus, suits alleging fault only against the additional insured are not covered; Part B excludes coverage for injuries or damage occurring after the work is completed or put to its intended use. This restriction is not discussed in this article, but may be as signifi-
4 46 The Practical Real Estate Lawyer January 2007 cant in limiting coverage in ways not anticipated by the parties to the contract. Considering just Part A, however, as discussed below, employee lawsuits that the subcontractor and the owner probably intend to be covered by the subcontractor s insurance might not be. Owner May Not Be Covered For Subcontractor s Employee s Claims Assume that the subcontractor ( S ) agrees to provide painting services at a construction project. Under the parties contract, S agrees to indemnify and hold the owner ( O ) harmless for injuries occurring at the project and also to add O as additional insured on S s liability insurance. S orders its employee ( E ) to work on a scaffold that S has failed to properly maintain. One of the scaffold legs buckles, and the scaffold collapses, resulting in injuries to E. Despite receiving workers compensation benefits, E sues O for failing to properly supervise S s work, provide safe equipment, and maintain a safe worksite. Workers compensation laws prevent E from suing S. O submits the claim to S s insurer under the insurance policy and to S under the contract, asking for defense and indemnification from both. S s insurance policy contains the 2004 edition of ISO Form CG To O s surprise, S s insurer refuses to defend or indemnify, and S, after consulting its lawyer, likewise rejects O s claim. This result may seem surprising given that S, not O, was responsible for the accident, at least in part, and both S and S s insurer agreed to cover O in that event. Nevertheless, a recent Texas case illustrates why courts might reject an additional insured s insurance coverage claim under these facts. Courts May Not Consider Facts Not Alleged By The Plaintiff In Transport International Pool, Inc. v. Continental Insurance Co., 166 S.W. 3d 781 (Tex. App. 2005), Transport leased a construction trailer to a contractor. The equipment contract required the contractor both to indemnify Transport and to add Transport as an additional insured to the contractor s insurance. After being injured when the trailer blew over in a high wind, an employee of the contractor sued Transport for negligent installation of the trailer. The contractor s insurer refused to defend or indemnify Transport because the policy s additionalinsured endorsement excluded injury caused by the sole negligence of the additional insured. Because the employee s lawsuit alleged only Transport s negligence, and was silent as to the contractor s conduct, the insurer denied coverage. Transport brought a coverage suit against the insurer, asserting that the insurer had an obligation to defend the lawsuit because the contractor was at least partly responsible for the accident. Transport brought forth evidence showing that the contractor at least contributed to causing the accident. Because insurers must defend insureds, including additional insureds, Transport argued that, when there is a potential for coverage, the mere factual possibility that the contractor was partly at fault should be enough to avoid the sole-negligence exclusion in the additional-insured endorsement. Despite Transport s evidence, the court denied coverage and followed established law that an insurer s duty to defend must be determined under the complaint allegation or eight-corners rule. According to this rule, the only relevant evidence of an insurer s duty to defend must be found exclusively within the four corners of the pleading and the four corners of the policy. The plaintiff s petition must allege facts within the scope of coverage; otherwise, the insurer will not be legally bound to provide a defense for the insured. Id. at The court further held that an insurer would have no duty to indemnify if it had no duty to defend. Therefore, actual proof of the employer s fault is irrelevant to determine the insurer s duty to defend
5 Risk-Shifting Agreements 47 and indemnify the additional insured. The insurer was not required to cover the additional insured. Transport s problem went far beyond this one case. The company had hundreds of equipment contracts across the country, all of which had the same additional-insured requirement. Builders are in a similar pickle. A recent Texas Supreme Court case suggests that O may have a limited opportunity to establish that others were at least partly responsible for E s accident. In Evanston Insurance Company v. Atofina Petrochemicals, Inc., 2006 Tex. LEXIS 439 (Tex. May 5, 2006), motion for rehearing granted, an employee of a named insured contractor was killed, and his family brought a wrongful death suit initially against both the additional insured refinery and the named insured contractor. The plaintiffs later dismissed the contractor. The refinery counterclaimed, alleging that the employee was at least partly at fault. The case settled, and the refinery, which had sought coverage as an additional insured from the contractor s insurer, brought an action to recover defense costs and the settlement payment from the insurer. The policy contained a sole-negligence exclusion in the additional-insured endorsement. The lower court dismissed the suit in favor of the insurer because the plaintiffs alleged fault only against the refinery, having dismissed the contractor. The Texas Supreme Court reversed and instructed the lower court to make a factual determination of liability in light of both the earlier allegation against the contractor and the contributory negligence allegation against the deceased employee. Therefore, additional insureds may look to earlier pleadings or allege fault against the injured employee to show that they were not in fact solely at fault. But these exceptions may not be available in all cases. The insurance policies that subcontractors have been purchasing since 2004 probably contain solenegligence exclusions. Moreover, as stated above, it is not uncommon for employees of named insured subcontractors to sue others on the project, even if the basis for liability is questionable. Workplace accidents on construction sites occur with unfortunate frequency. So when the insurance fails, what can O do to shift risk as the parties intended? Also, how does the exclusion affect S? The Indemnification Clause May Also Fail To Cover Owners The parties contractual indemnification probably offers no greater relief to O. In most states, S would probably not be required to indemnify and hold O harmless under most indemnification clauses typically inserted into construction contracts. Assume that the parties drafted an indemnification clause in which S agreed to indemnify O for all injuries occurring on the construction site. This clause might provide: Subcontractor ( S ) agrees to indemnify and hold harmless Owner ( O ) for from and against all liabilities, claims, penalties, fines, forfeitures, suits, and the costs and expenses incident thereto (including costs of defense and attorney s fees), which O hereafter may incur or pay as a result of death or bodily injury to any person, destruction or damage to any property, arising out of the Construction Site or S s operations under this Contract. S probably has no obligation to defend O for the employee lawsuit described above because the indemnity clause does not state clearly and unequivocally that S will indemnify O when the plaintiff alleges that O is the negligent party. This is the clear and unequivocal rule adopted in most states. Under this rule, simply stating that S will defend and hold harmless against all liabilities and claims does not clearly and unequivocally provide that S will cover claims allegedly caused by O s negligence. Fair Notice Test Texas has adopted an even more stringent test, the fair notice test, that requires the intent to indemnify against the indemnitee s own negligence
6 48 The Practical Real Estate Lawyer January 2007 to be stated both expressly and conspicuously. Under the fair notice test, O should be covered if the clause included at the end of the last sentence the phrase, EVEN IF O IS NEGLIGENT IN WHOLE OR IN PART. This language meets the express negligence component and the boldface, all-caps format is sufficiently conspicuous. Without this express statement, a court applying Texas law will refuse to require S to defend O under the scenario described above. One might reasonably ask why a court would refuse to enforce the indemnity and require S to defend O when the actual facts show that S, not O, was the party whose negligence caused the injury. The court s decision would be based on the same legal principles that were followed in the Transport case. E, the plaintiff in the underlying lawsuit, alleged that O was negligent. E presumably alleged no facts placing any blame on S. A court will determine S s duty to defend O under the indemnification clause based on the pleadings, not the actual facts, at least until O can judicially establish S s negligence, either by prevailing in E s lawsuit or pursuing indemnification against S in a separate proceeding. Therefore, at best O loses the benefit of a defense and must incur the costs both of defending itself in E s lawsuit and of pursuing a separate action against S. That, however, is not the worst thing that happens to O. If O prevails in E s lawsuit and proves that O was not at fault, O may believe that it should at least be allowed to go back to S and recover the defense costs that O should have been receiving all along. O s expectation may seem reasonable, but that is not the law, at least in Texas. The Texas Supreme Court held in Fisk Electric Co. v. Constructors & Associates, 888 S.W. 2d 813 (Tex. 1994), that an indemnity agreement that did not meet the express negligence test was unenforceable to recover defense costs even after the indemnitee had established in the underlying lawsuit that it was not negligent. The Fisk court held that the indemnitor had no obligation to reimburse the indemnitee for defense costs incurred in establishing the indemnitee s innocence. In Fisk, the parties entered a construction contract with an indemnity clause providing: to the fullest extent permitted by law, [indemnitor] shall indemnify, hold harmless and defend [indemnitee]...from and against all claims, damages, losses, and expenses, including but not limited to attorney s fees... arising out of or resulting from the performance of the indemnitor s work. The indemnitors employee was injured on the job and brought a negligence action against the indemnitee. The Texas Supreme Court concluded that the parties did not intend that the indemnitor should pay the defense costs of a suit alleging negligence of the indemnitee. Had that been the intent, the parties would have expressed that intent in language satisfying the express-negligence test. The rule proposed by [indemnitee] regarding defense expenses would leave indemnitors liable for cost resulting from a claim of negligence which they did not agree to bear... Without an express reference in the indemnification provision to claims based upon negligence, there is no indemnity for defense costs incurred in connection with the negligence claim irrespective of whether the claim is ultimately proved. Subcontractors May Face Increased Litigation The new additional-insured endorsements will not likely benefit S either. The worst thing that could happen to S is that the parties indemnification clause is enforceable, and, after S s insurer refuses to defend O, O sues S under the indemnification clause. For reasons explained below, O s indemnification claim against S is probably not covered by S s insurer because after 2004, the insured contract coverage probably also contains a sole-negligence exclusion. In other words, S s insurer will not cover S s contractually assumed liability unless S is alleged to be at fault. Therefore, S should assume that it has no coverage for O s liability.
7 Risk-Shifting Agreements 49 What about coverage for S s liability that O alleges in the indemnification lawsuit? One would think that S should be covered for its own liability and that S s insurer would have to defend S in the indemnification lawsuit. However, many liability policies contain exclusions for lawsuits brought by one insured against another insured, often called insured v. insured exclusions. Because O is an additional insured under the policy, and therefore an insured, S may not have coverage for O s indemnification action. Thus, the worst-case scenario for S is that O succeeds in shifting liability for E s lawsuit to S for which S has no insurance coverage. Even if O cannot shift liability to S, or if S is covered for O s lawsuit, S still faces increased litigation, and all parties lose the efficiency and predictability of knowing which insurance company has the initial responsibility to step in and defend E s lawsuit. Accordingly, the new endorsements probably will not benefit subcontractors. What Should The Parties Do? Owners, general contractors, and other contractual indemnitees should first find out if their subcontractors liability insurance policies contain additional-insured endorsements purporting to exclude the additional insured s sole negligence. Most ISO additional-insured endorsement forms whose last four digits are contain a sole-negligence exclusion. However, the indemnitee should ask to examine the policy itself to verify the specific form used. Contracts rarely require subcontractors to provide actual copies of their insurance policies. Typically, the contract requires indemnitors to provide no more than a certificate of insurance, which usually is not prepared by the insurance company and does not state the specific form or language in the policy. Parties expecting to be covered as additional insureds should review the indemnitor s actual insurance policy. If the insurance policy contains a sole-negligence exclusion, additional insureds should anticipate that the insurer will refuse to defend any lawsuit that does not include the named insured as a co-defendant. For parties with only a few contracts, the remedy may be simply renegotiating the contract, if that is feasible, and requiring the other party to purchase insurance without a sole-negligence exclusion. The named insured should make inquiries through its broker or agent to determine if the insurer will agree to provide an additional-insured endorsement that does not exclude the sole negligence of the additional insured. Insurers appear to be serious about holding the line on the new endorsements and may refuse to provide a pre-2004 type endorsement even for an additional premium. If that is the case, or if the additional insured has hundreds of contracts, then renegotiation of the contracts and insurance policies may not be practical. Owner Probably Cannot Get Insured- Contract Coverage There is a third avenue for O to recover defense costs from S s insurer. Most policies also cover the named insured s insured contracts, referring to agreements in which the named insured assumes the tort liability of another party. Of course, insured contract means simply an indemnification agreement. Accordingly, S s insurer may cover O in two ways. First, O may be covered directly as an additional insured. Second, the insurer may be obligated to cover S s indemnification of O through the insured-contract provision. If S s indemnification agreement is enforceable, that is, if it meets the fair-notice test in Texas, or the clear-and-unequivocal test in most other states, then S s insurer should cover O indirectly by covering S s obligation to defend and indemnify O. If, however, S s indemnification is not enforceable, then neither S nor S s insurer have any duty to pay O s liability. But under the hypothetical posed above, in which O is in fact not negligent, would S s insurer have an obligation to reimburse O s defense costs if O proved in E s trial that O was not negligent? The
8 50 The Practical Real Estate Lawyer January 2007 Fisk decision, discussed above, holds that S has no such obligation, but S s insurer might be held to a higher standard. After all, courts are instructed to construe narrowly against enforcing indemnification agreements but to construe liberally in favor of insurance coverage. The answer, however, may be academic. After 2004, insurers are limiting standard insured-contract coverage to exclude the sole negligence of the indemnitee. In other words, insurers are modifying both their additional-insured endorsements and their insured-contract provisions to exclude coverage for the additional insured/indemnitee unless the named insured/indemnitor is also a party defendant in the lawsuit. This restriction may create a dilemma for indemnitors with enforceable indemnifications. As stated above, subcontractors may find their indemnification obligations exceed their insurance coverage. S may thus have a legal obligation to cover O in a lawsuit brought by E without having insurance to pay for it. Therefore, the parties should consider whether the indemnification is both enforceable and backed by the indemnitor s insurance. If the indemnification agreement is unenforceable under the applicable state s law, or if an indemnification not backed by insurance is not satisfactory to either party, then the indemnitee owner will have to look to its own insurance to cover the liabilities that it formerly could shift to the indemnitor. Subcontractors should anticipate these potential difficulties and inquire if pre-2004 additionalinsured endorsements are available. If not, then subcontractors should by all means determine both whether the parties indemnification clause is enforceable under applicable law and whether the subcontractor s contractual liability is covered in the event the owner brings an indemnification action. All parties should assume that indemnification agreements will receive greater attention than before. Indemnitees will probably seek to revise the indemnification agreement to meet the legal requirements for enforceability. If so, subcontractors will likely bear the brunt of the liability and should at least make sure that their insurers will cover the contractual liability. CONCLUSION It is too early to tell how the 2004 additional-insured endorsements will affect risk-shifting agreements in construction contracts. Owners, general contractors, and other indemnitees may find it difficult and costly, perhaps impossible, to shift workplace risks to the indemnitor, at least when the indemnitor is not also joined in the lawsuit. The modifications in standard liability policies are likely to increase litigation, at least at first, as indemnitees are forced to seek recovery under the indemnification clause. However, risk may be managed in a number of ways. As long as the parties are aware of the changes in their insurance policies, they can manage the risk one way or another. The worst thing is not knowing that the subcontractor s insurance does not cover a type of risk until after an accident happens. If the subcontractor s policy does not cover the owner s sole negligence, and the subcontractor cannot or will not procure insurance that provides coverage, then the owner may have to rely on its own insurance and pass the extra costs to the subcontractor. For its part, the subcontractor could end up the big loser from this change and should make sure that its policy does not exclude coverage for indemnity lawsuits brought by the owner. The subcontractor should anticipate that the owner will ask to see the additional-insured endorsement, so the subcontractor should inquire from its broker or agent if the pre-2004 type of endorsement is available for a reasonable premium. For most subcontractors, particularly small businesses, commercial insurance remains the only practical way to manage workplace risks. Self-insurance is usually not a practical solution. Accordingly, subcontractors should seek the best coverage available and communicate clearly with other parties to the contract
9 Risk-Shifting Agreements 51 exactly what insurance coverage is available. Only if the parties discuss insurance shortfalls ahead of time, can they reach a rational plan for managing workplace risks. PRACTICE CHECKLIST FOR Risk-Shifting Agreements In Construction Contracts: Why Insurance May Not Work The Way It Used To In a common arrangement, a subcontractor would agree to indemnify an owner for worksite injuries and to add the owner as an additional insured to the subcontractor s liability insurance. However, many standard additional-insured endorsements issued after 2004 exclude coverage for the owner. This leaves the owner without insurance coverage, and can subject the subcontractor to a lawsuit from the owner. First, check the subcontractor s additional-insured endorsement. The earlier version which will provide coverage for the owner reads as follows: ADDITIONAL INSURED OWNERS, LESSEES OR CONTRACTORS (FORM B) This endorsement modifies insurance provided under the following: WHO IS AN INSURED (Section II) is amended to include as an insured the person or organization shown in the Schedule, but only with respect to liability arising out of your work for that insured by or for you. The later version which will not provide coverage states: This endorsement modifies insurance provided under the following: COMMERCIAL GENERAL LIABILITY COVERAGE PART A. Section II Who Is An Insured is amended to include as an additional insured any person(s) or organization(s) shown in the Schedule, but only with respect to liability for bodily injury, property damage, or personal and advertising injury caused, in whole or in part, by: 1. Your acts or omissions; or 2. The acts or omissions of those acting on your behalf; in the performance of your ongoing operations for the additional insured(s) at the locations designated above. B. With respect to the insurance afforded to these additional insureds, the following additional exclusions apply: This insurance does not apply to bodily injury or property damage occurring after:
10 52 The Practical Real Estate Lawyer January All work, including materials, parts or equipment furnished in connection with such work, on the project (other than service, maintenance or repairs) to be performed by or on behalf of the additional insured(s) at the location of the covered operations has been completed; or 2. That Portion of your work out of which the injury or damage arises has been put to its intended use by any person or organization other than another contractor or subcontractor engaged in performing operations for a principal as a part of the same project. The effect of the newer provision is that the additional insured is covered only if the liability is caused in whole or in part by your acts or omissions. Your means the named insured (the subcontractor), or the acts or omissions of the named insured s employees or contractors. Thus, suits alleging fault only against the additional insured (the owner) are not covered. If this clause is present, the remedy may be simply purchasing insurance without a sole-negligence exclusion. The named insured should make inquiries through its broker or agent to determine if the insurer will agree to provide such additional-insured endorsement that does not exclude the sole negligence of the additional insured. With respect to the indemnification agreement, the following language should suffice: Subcontractor ( S ) agrees to indemnify and hold harmless Owner ( O ) for from and against all liabilities, claims, penalties, fines, forfeitures, suits, and the costs and expenses incident thereto (including costs of defense and attorney s fees), which O hereafter may incur or pay as a result of death or bodily injury to any person, destruction or damage to any property, arising out of the Construction Site or S s operations under this Contract EVEN IF O IS NEGLIGENT IN WHOLE OR IN PART. To purchase the online version of this article or any other article in this publication go to and click on online.