DEFECT EXCLUSIONS IN CONTRACT WORK POLICIES

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1 WHITEPAPER May DEFECT EXCLUSIONS IN CONTRACT WORK POLICIES The need for risk balance and transfer of risk in highly invested construction projects has resulted in the fast growth of construction insurance industry, particularly in the developed markets. This growth can be a boon or turn out to be a false hope, either of which depends on the care taken while the insurance contract is signed by the client. The reimbursements for insurance claims are solely dependent on their exact written inclusion in the insurance contracts, especially in mature markets such as the U.S. and Australia. Defect exclusions often prevent the construction procurement team, from seeking proper claim for damages. This White paper highlights the possible loopholes and the most common mistakes made by US insurance procurement team, after effects of the mistakes and the ways to overcome them.

2 Construction Insurance allows for the pre identification of charge and responsibility in the event of harm, injury or damage as a result of employment within the construction project. Construction Insurance allows the employees to collect compensation, but may also protect employers from prosecution. Each Construction Insurance policy will vary with regard to the nature of the project and the inherent risk of employment within a construction site determining factor of individual Construction Insurance policies. Construction Insurance market in the USA: Insurance market conditions for US construction firms are expected to decline in Significant losses and reduced investment returns prompted many U.S. insurers to seek rate s in As a result, rates in many specific construction product lines began to. The insurance market is in a state of changeover, but a toughening of market conditions is not evident for contractors. Contractors have the potential to reduce their cost of risk through calculated planning and decision making based on analysis. Attentive evaluation of capital to the predetermined risks in their business can lead to more efficient allocations that will drive marginal growth. Several important trends have been identified in the US construction insurance industry: Coverage Segment Rate Change Q Rate Change Q General Liability Excess Casualty Large/midsize organizations 5% to 9% Project specific 4% to 12% Large/midsize organizations 4% to 9% 5% to 9% 4% to 12% 4% to 9% Builders Risk All other perils Flat Flat Cat-exposed Flat to 10% Flat to 10%

3 A/E Professional All Flat to 10% Flat to 5% Contractors Professional All Flat to 5% Flat to 5% Project Professional Contractors Pollution Liability Contractors Pollution and Professional Liability Project professional liability Owners protective Professional indemnity Contractors protective Professional indemnity 5% Flat to 5% Flat to 5% Flat to 5% All 5% decrease to 10% All 5% decrease to 10% Flat to 5% Flat Flat to 10% Flat to 5% Construction works insurance scope The main purpose of any construction insurance is to encompass the construction work in progress and for any loss or damage that occurs during construction. Insurance can be agreed explicitly for each project or as an annual policy covering all projects undertaken with the insurance premium paid on works turnover. There is no standard policy for any type of construction. Builders should take particular care when taking out construction works insurance as there is significant variations in the extent and quality of policies issued by various insurance companies. Every builder should ensure whether their construction works policy covers the following:

4 Although these conditions are quite familiar to the builders there are certain aspects of coverage that insured s often overlook or underappreciate, which can make a significant difference in a claim situation. The different levels of coverage available, under contract work policy in respect of defects and how the differing levels of coverage will respond in a claim scenario are stated below. Defect Exclusions Introduction: Contract work insurance policies provide varying coverage responses for defects and the drafting of these clauses may be understated and their response to a claim might have a dramatic impact. Damage as a result of defect is significant in any construction site potentially running into millions of dollars. A number of claims and interesting court decisions have occurred over the years particularly in US. Every court s approach will generally be to rely on the language used in the policy. It is for this reason it is very critical for the insured party to clearly understand and appreciate the differences in coverage available under the contract work policies. It is advisable to get the help of an insurance broker to draft a tailored policy that clearly mentions and deals with the specific risks that are predicted to occur in the construction project under cover. The hired insurance broker should be clearly informed about the specifications and the particularities of the venture to be insured to use the benefits of insurance completely. All the defect exclusions which are to be covered are incorporated in every policy wordings that has no limitation in the scope of cover granted in respect of defective design material and workmanship following physical damage Detailed defect exclusions: The general practice among the clients and contractors is to include defect exclusions in all policy wordings, with no scope constraints. They then exactly restrict the cover to the desired level by discounting the aspects that are not to be covered. This is a more particular method and works to the

5 benefit of the insured on the basis that the threat is covered, unless excluded. The alternative method is to start with an outright exclusion and then extend the wordings to the cover, with the danger that some events can be overlooked. When we take defect exclusions into consideration the operative clause should typically read The Insurers will protect the Insured in respect of physical loss or damage to any of the property Insured arising during the period of Insurance from any cause not excluded How to avoid insurance coverage issues in construction defect claims? It is not possible to summarize all the exclusions and how it has been treated in state and federal case law. This is due to the factors like number, scope and nature of the exclusions in liability policies which would answer to construction defect claims. However the commonly found exclusions must be reviewed in appropriate situations. One of the predominantly used exclusions is called as business risk exclusions, which covers three exclusions, namely damage to property ; damage to your property, and damage to your work exclusions. In addition, there are exclusions that concern prior work; contractual liability; mold; owned property; earth movement, and known injury/damage. Losses relating to pollution from construction activities are also a commonly addressed. This white paper will act as a guide to help every client in their independent analysis and research before taking an insurance policy. For this purpose, a number of defect exclusion claims within the United States have been identified, which forms the basis for this study. For a better analysis, these cases have been grouped by abbreviated factual summary, and the court s finding. However, this only forms a basis for the current study, and a One of the predominantly used exclusions is called as business risk exclusions, which covers three exclusions, namely damage to property ; damage to your property, and damage to your work exclusions. In addition, there are exclusions that concern prior work; contractual liability; mold; owned property; earth movement, and known injury/damage.

6 detailed analysis of each of these cases needs to be undertaken separately. Case Examples Case 1: Location: Colorado Defect exclusions and claims raised under each: Is there an occurrence? The first step in any coverage analysis is to determine whether the underlying claim or suit comes within the scope of insurance. Occurrence is generally defined as an accident, including continuous or repeated exposure to the same or similar general harmful conditions. Despite the similarities the policy language and fact patterns is what constitutes an occurrence in the context of a construction defect claims, which often varies widely from one jurisdiction to the next. What should be done to avoid an occurrence claim? Situation under Claim: General contractor sued the framing/siding subcontractor claiming that the work was defective and damaged and it affected other works in the construction site Findings: Occurrence found Comments: Contention that insured s defective work caused damage to a third party might constitute an occurrence. Contract signed stated damage caused to a third party constitute an occurrence hence there was a possible occurrence. Case 2: Location: Arkansas Situation under Claim: Company subcontracted fabrication of six silos, one of which collapsed due to subcontractor s faulty welds. Damage to adjacent silos and equipment. Define the term occurrence including all the expected and unexpected misfortunes pertaining to the particular type of construction site. Once the term occurrence in defined the contract for this exclusion can be worded by the insurer s way. Care should be taken to ensure there is no mismatch between the policy language and fact patterns. Every jurisdiction has its own policy definitions for every defect occurring. It s better for both the insurer and Findings: Occurrence found but claim not valid as the contract do not include subcontractors faulty work as an occurrence. Comments: Defective workmanship alone and damage only to work product is not an occurrence in the contract; however, coverage should exists for any damage.

7 insured to use the policy language followed in that particular jurisdiction. Is There Property Damage? Most courts have held that claims limited to fixing or replacing all or part of defective construction or claims of diminution in value, because of defective construction work or materials with no physical injury, are not claims for property damage. In order to trigger coverage under a commercial general liability policy, the insured s liability must be based on actual physical injury to tangible property or an actual loss of use of such property. What should be done to avoid an occurrence claim? Definition of property damage in the concerned court should be taken into consideration. Damage caused and the expenses made on/for the damage should be properly documented before the claim. Reason for the damage caused if sited as an occurrence can get the claim for the insured. Coverage Trigger: When injury of damage is believed to have taken place within the policy period, trigger of coverage comes into existence. Construction defect claims more frequently cover a disastrous event, latent Case 3: Case 6: Location: Louisiana Location: Arizona Situation under Claim: Plant owner sued insured hired to Situation install improvements under Claim: at Insured its oriented developer strand sought board plant, defense alleging for claims breach asserted of contract, against invalidity it by homeowners of contract, for negligent negligence, construction. and resulting damages. Findings: Findings: Property Continuous damage found Comments: Comments: Evidence Insurers presented must provide by plant coverage owner for established ongoing property damage that in the occurs form during of physical the injury policy to property period, even and if loss other of use. similar damages preceded that damage. Case 4: Case 7: Location: Florida Location: California Situation under Claim: Building contractor sought coverage Situation for under costs Claim: incurred One in demolishing insurer sued another and rebuilding seeking foundation equitable contribution installed by for a subcontractor. a portion of costs paid to defend and settle an underlying construction defect lawsuit. Findings: Not property damage Findings: Injury-in-fact Comments: Florida law clearly instructs that property damage under a CGL policy does not include costs associated Comments: with The removing policy is and reasonably replacing susceptible defective to work. the interpretation that the trigger of coverage was damage to the property, not the causal conduct, and certain included endorsements were designed to Case 5: obviate the application of the continuous trigger. Location: Louisiana Case 8: Situation under Claim: Plant owner sued insured hired Location: California to install improvements at its oriented strand board plant, alleging breach of contract, invalidity of contract, Situation negligence, under Claim: and Insured resulting sought damages. contribution from other insurers for the cost of defending insured roofing contractor against construction defect claims. Findings: Property damage found Findings: Manifestation Comments: Evidence presented by plant owner established property damage in the form of physical injury Comments: to property The and relevant loss of inquiry use. to determining coverage potential is whether there was a possibility that any property damage first manifested itself during the policy period.

8 or progressive damage that may take place over an extended period of time. As a result, the determination of when property damage occurred and which policies must respond in the context of a construction defect claim often results in pointed disputes between insurers and policyholders. Types of Coverage Trigger claim Manifestation Trigger Exposure Trigger Actual Injury or Injury-In-Fact Trigger Continuous Trigger Allocation of loss: Every construction defect claim often connects consecutive policy periods, hence most of the time the amount of coverage available to respond to a claim may exceed the total amount of damages. In these circumstances, the damages must be allocated among the triggered policies or policy years. In general, courts have applied two key methods for determining how policies will respond: Case 9: Location: District of Columbia Situation under Claim: Insured sought coverage for property damage caused by collapsing wall. Findings: Manifestation and continuous Comments: General rule is that property damage occurs at the time the damage is discovered or when it manifests. A limited exception exists where the damage can be characterized as being continuous or progressive. Case 10: Location: Georgia Situation under Claim: Insured sought coverage for pollution damage resulting from the discharges of waste water into unlined surface impoundments. Findings: Exposure Comments: The exposure trigger of coverage is applicable. Case 11: Location: Minnesota Situation under Claim: Insured sought coverage for various construction defect claims filed against it. Findings: Pro rata Comments: Pro rata time-on-the-risk allocation applies, and the total period over which liability is allocated must include time periods which the insured was voluntarily self-insured. Adverse effects of defect exclusions:

9 Contractors end up paying for third party mistakes resulting in cost due to rework Subcontractor relationship becomes rigid in most cases Case filed may demand to stop work in the site resulting in project delays which lowers brand value of the contractor to a great extent Some cases may result in a huge fine payment to the insurance company A breach of insurance reduces the safety of the construction projects during all stages of construction Property damage exclusions often results in huge rework which is difficult to be compensated Increased number of insurance claims reduces the contractor s goodwill with their clients Checklists for Procurement Personals: The following points capture s all the important action items that are to be followed by procurement personals before drafting an insurance contract: Understand the type of construction to be done and choose the insurance company accordingly. As there are project specific insurance firms Once the short listed insurance firms are identified check on their existing financial claims and the situations which has resulted the claim Filter the list based on their past claims, matching those with the frequent incidents that occur in construction site After the insurance agent is finalized go through their method of contract writing and case filings to avoid mismatch in contract Make sure that all the possible exclusions are defined and covered as mentioned above in this whitepaper Check whether the definitions mentioned in the contract goes in line with the concerned court wordings Once the contract prepared, make sure that the insured and insurer agree to all the conditions mentioned throughout the agreement Procurement personals are expected to be updated with all the revisions and changes made to the insurance company s policies based on which the contract has to be updated. This is significant in case of long term contracts Conclusion: Construction industry facing number of unique challenges makes construction insurance a must buy. Construction insurance helps contractors to cover the risk of dealing with subcontractors,

10 who are financially stressed, better managing and improving employee management, understanding contractual risk transfer, identifying and predicting unexpected acts and directing health care reform and addressing the rising cost of benefits. For all these risks to be covered to the maximum degree the contact made with the insurance company must be made with utmost care. Most insurance brokerages are pleased to take money to hack away at the small problems, while overlooking those wicked problems that are driving climbing costs in the construction industry. This white paper covers most of the common defects made by the insurance clients while drafting the contract and the steps to be taken to avoid those. Case filings regarding construction insurance are recorded day in and day out in most of the nations with the United States being the topper in the list. Construction insurance cases filed in the same issue are treated differently in different courts at times in the same court too. Hence the insurance procurement team must be well informed about the inconsistencies that are expected to occur in the construction site during and after the completion of the project. All the prior cases and verdicts must be considered to avoid the defect exclusions to the greatest degree possible.