Understanding the Business Risk Limitations John H. Podesta Murchison & Cumming, LLP San Francisco, CA I. INTRODUCTION Some of the most commonly cited, yet least understood coverage limitations for contractors are those limiting the carrier s exposure to claims that the insured s work is nonconforming and in need of repair or replacement. In the industry standard general liability policy form, Exclusions J, K, L, M and N collectively form the business risk Exclusions that address non-conforming work claims. While often referred to collectively, each must be understood in its own place: Exclusion J is the broadest, excluding damage to property owned by the insured(j1), to real property sold by the insured to others(j2), and to property being worked on by the insured that must be replaced(j5 and J6); Exclusion K excludes coverage for damage to the Named Insured s own product; 1
Exclusion L excludes coverage for damage to the Named Insured s own work, while not excluding coverage for damage to completed subcontracted work; Exclusion M excludes coverage for loss of use of a structure that incorporates the Named Insured's defective work, where the insured s work can be corrected or replaced and the host (the building or structure that the insured s work is incorporated into) restored to use; Exclusion N precludes economic losses where a host cannot be used because of a known or suspected defect in another similar structure 1. This article will provide background of the business risk exclusions and recent cases interpreting them, in the context of contractors. RISK MANAGEMENT AND ISSUE SPOTTING One of the most important steps in determining if a Business Risk Exclusion applies to a given situation is view the claim in the context of the risks insured and the purpose of General Liability Insurance. 1. Who has the right to seek coverage from the carrier? In a liability insurance context, the insured is entitled to protection from a claim presented against it. Regarding insurance coverage for contractors, the distinction recognizing who the Named Insured is carries additional importance. By definition, the Named Insured is referred to throughout the policy as you. Many exclusions and other provisions draw a distinction between "you" or "your" and simply "an insured" or "the insured". An exclusion that applies to you, your, or similar language by definition only to the named insured, rather than the party seeking coverage or making the claim. 2. Errors and Omissions versus General Liability coverage. While there are many differences between professional liability coverage and general liability coverage, for purposes of risk management, there is one major difference. A professional liability policy or errors and omissions coverage covers all damages that result from a wrongful act committed by the insured in the course of performing covered services. Therefore, so long as the "insured" is engaged in a covered 1 It is sometimes called a sister ship exclusion, where one ship must be taken out of use because a defect was discovered in a sister ship. 2
activity, there is broad coverage for the economic damages awarded against it. The "Business Risk" exclusions are not present in Errors and Omissions policies. Unlike Errors and Omissions coverage, General Liability coverage is triggered, or provides coverage, only for certain types of damages ( bodily injury or property damage ) but covers a broad range of the insured s activities. 2 3. Does the claim involve property damage or a mere defect in the insured s work? General liability policies provide generally that the carrier will pay on behalf of the insured those sums that the insured is obligated to pay because of property damage caused by occurrence. Therefore, it begs the question what is property damage? Critical to understanding whether property damage has occurred are two elements: physical injury to and tangible property. If there is no physical injury, has there been a "loss of use of tangible property"? If these elements are not present, then there is no property damage and no CGL coverage, before addressing any of the exclusions. 4. Did the damage occur during operations or after operations were complete? A general liability policy is divided into two basic coverages for purposes of contractors. The first is the products-completed operations hazard. The other is the general aggregate, or "ongoing operations" coverage. The general aggregate or operations coverage applies to damage that occurs while the Named Insured s work is being performed. The products-completed operations hazard applies once the work is turned over by the contractor to the owner or the general contractor (if the Named Insured is a subcontractor). Whether the loss falls within the General Aggregate or the Product-Completed Operations Hazard is critical, especially to general contractors. III. CASE LAW INTERPRETING BUSINESS RISK EXCLUSIONS 1. Exclusion J For purposes of contractors claims, Exclusion J, especially J(1) ("Owned Property") and J(2) ("Alienated Premises") will apply in the context of conversion projects where, for example, an apartment building is converted to condominiums. In that case, an insured purchases the existing apartment building, hire contractors and other inspectors to refurbish and prepare the building for sale; oftentimes, the original 2 General liability policies also provide personal injury and advertising injury coverage, which applies somewhat differently, but the business risk exclusions have little or no effect on that portion of the policy. 3
purchaser of the building is the one that sells the individual units to unit owners. Should the converter be sued later for damages, the owner will likely have no coverage for damage occurring while he owns the property, prior to creation of the HOA and transfer to purchasers. Similarly, in Exclusion J(2), the socalled alienated premises exclusion, in a conversion context, the property was not constructed for sale and thus the exclusion for damage to property the insured sells would apply. Care should be taken however, where the converter is an LLC or Corporation, where the liability for damages at the project may not be the Named Insured, but a member or employee who may not be subject to the exclusion. Where the Named Insured performs contracting work on a real estate project, Exclusion J(5) and J(6) are very significant. A General Liability policy is not a performance bond-- it does not guarantee the performance of the insured s work. To apply the exclusion, therefore, the initial focus is on the scope of work being performed by the Named Insured at the time of the incident causing damage, and that particular part of the property being worked on. For example, where the Named Insured s work encompasses several trades or subp-parts, such as fire alarms and plumbing, the actual trade that is responsible for the damage is the relevant inquiry for whether the damage is to that particular part of real property on which the insured is performing operations. Your next inquiry is whether the work is only performed on a portion of the host, if the host is divisible into subparts. Regardless of the jurisdiction, the basic analysis is as follows: where the insured is working on an area that is logically detached and separable from the damaged areas, coverage is only excluded from the discrete area where the insured is working. This is especially true in jurisdictions where Courts have held that the exclusions are ambiguous. 3 The key policy language is that damage to that particular part of real property being worked on is excluded. The following cases had an expansive view of that particular part, finding that it extends to the entire property affected by the insured s work: 1) Copple Constr., L.L.C. v. Columbia Nat'l Ins. Co., 279 Neb.60 (Neb. 2009).2) Visant Elec. Contr. v. Aetna Cas. & Sur., 530 S.W.2d 76 (Tenn. 1975). 3)Jet Line Services, Inc. v. American Employers Insurance Co., 404 Mass. 706, 537 N.E.2d 107 (1989) 4) Am. Equity Ins. Co. v. Van Ginhoven, 788 So.2d 388 (Fla. Dist. Ct. App. 5th Dist. 2001) 5) Southwest Tank & Treater Mfg. Co. v. Mid-Continent Cas. Co., 243 F. Supp. 2d 597 (E.D. Tex. 2003). 6) Goldsberry Operating Co. v. Cassity, Inc., 367 So. 2d 133 (La.App. 2 Cir. 1979). 7) Shelby Insurance Company v. Northeast Structures, Inc.; 767 A.2d 75. 3 See, Pekin Ins. Co. v. Miller, 367 Ill. App.3d 263, for a discussion on the ambiguity in the exclusions language. 4
8) Century Indem. Co. v. Golden Hills Builders, Inc., 348 S.C. 559 (S.C. 2002). 9) Amerisure Mut. Ins. Co. v. Am. Cutting & Drilling Co., 2009 U.S. Dist. LEXIS 21077 (S.D. Fla. Mar. 17, 2009); 10) William Crawford, Inc. v. Travelers Ins. Co., 838 F. Supp. 157 (S.D.N.Y. 1993). In the above cases, the insured was performing its operations on property which could not be divided into individual parts or components, thus, the entire project was excluded property, for example a swimming pool or a fuel tank. However, there is a second line of cases which holds a more restrictive view of that particular part. Closer examination of the cases reveals not so much a difference in the law, but distinguishable facts. The following cases show a restrictive view of that particular part, that limits the exclusion to the limited area area where the insured is actually working on at the time of loss that occurs during operations. 1) Liberty Mut. Fire Ins. Co. v. Mark Yacht Club on Brickell Bay, Inc., 2009 U.S. Dist. LEXIS 75225 (S.D. Fla. Aug. 25, 2009); 2) Columbia Mut. Ins. Co. v. Schauf, 967 S.W.2d 74 (Mo. 1998); 3) ACUITY v. Burd & Smith Constr., Inc., 2006 ND 187, P27 (N.D. 2006); 4) EOTT Energy Pipeline Limited Partnership v. Hattiesburg Speedway, Inc., 303 F. Supp. 2d 819 (S.D. Miss. 2004); 5) Mid-Continent Cas. Co. v. JHP Dev., Inc., 557 F.3d 207 (5th Cir. Tex. 2009). 4 6) Gore Design Completions, Ltd. v. Hartford Fire Ins. Co., 538 F.3d 365; 7) Minergy Neenah, LLC v. Rotary Dryer Parts, Inc., 2008 U.S. Dist. LEXIS 33814 (E.D. Wis. Apr. 24, 2008); 8) Basic Energy Servs. v. Liberty Mut. Ins. Co., 655 F. Supp. 2d 666, 668 (W.D. Tex. 2009); 9) General Cas. Ins. Cos. v. Exterior Sheet Metal, Inc., 2002 U.S. Dist. LEXIS 25423; 10) Beaverdam Contr. v. Erie Ins. Co., 2008 Ohio 4953; 11) Transp. Ins. Co. v. Piedmont Constr. Group, LLC, 301 Ga. App. 17 (Ga. Ct. App. 2009) 12) Travelers Cas. & Sur. Co. v. Dormitory N.Y., 2010 U.S. Dist. LEXIS 79024 2. Exclusion K While significant, in the context of contractors, the your product exclusion has limited application. The exclusion has been specifically held not to apply to a real property construction risk, by definition, since your product does not include real property. Md. Casualty Co. v. Reeder, (Cal.App. 1990) 221 Cal.App.3d 961.. 4 No relation to the author 5
3. Exclusion L Exclusion L excludes coverage for damage to "your work", meaning the work of the Named Insured. For a General Contractor, this would nearly eliminate coverage entirely for construction defect claims. However, in the ISO General Liability coverage form (e.g. form number CG 0001), damage to subcontracted work is not excluded in completed work, which functionally fills the gap left by the absence of builders risk coverage once the project is complete (Maryland Casualty vs. Reeder). Thus, where there is damage to a completed structure that is caused by a subcontractor, or is caused by the general contractor's own work that damages a subcontractor s work, the exclusion for damage to "your work" does not apply. There are three relevant inquiries to determine whether the "damage to subcontracted work" coverage applies: 1) is the loss within the products-completed operations hazard; 2) is there a claim for property damage; and, 3) is the damaged property work that was performed by a subcontractor, or did a subcontractor's work cause the damage? The first question, whether the loss is within the products-completed operations hazard, is determined by the language of the policy itself as to the Named Insured. California has recently ruled that a contractor that is terminated does not enjoy the benefits of coverage for damage to subcontracted work. Therefore, the more restrictive exclusions applicable to damage occurring during operations (Exclusion J, above) applies. Functionally, for a terminated general contractor, this means that since the entire project is being built by or on behalf of the insured, the entire project is likely excluded property. Clarendon America Ins. Co. v. General Security Indemnity Co. of Arizona, (Cal.App. 2011) 193 Cal.App.4th 1311. Assuming that the work of the Named Insured is completed, and thus the Products-Completed Operations Hazard is triggered, the next question is whether the damaged work (or the work that caused the damage) was performed by a subcontractor. In this context, the definition of subcontractor is broad, and generally is understood to include an entity that undertakes a portion of the general contract, including the supply of specifically manufactured components. National Union Fire Ins. v. Structural Sys. Tech. (E.D. Mo. 1991) 756 F. Supp. 1232. If the damaged work was performed by a subcontractor, that damage is covered, or, stated more precisely, it is not excluded by the "your work" exclusion. Limbach Co., LLC v. Zurich Am. Ins. Co. (4th Cir. Va. 2005), 396 F.3d 358, 365: 6
Thermacor custom manufactured the steam pipe in accordance with the shop drawings and project specifications[for the General Contractor Limbach], and the company provided on-site installation instructions. Since we conclude that the steam pipe was manufactured by a subcontractor, and since the parties stipulated that the pipe was damaged by the leak, the "your work" exclusion does not preclude coverage for the cost of replacing the pipe. The damaged pipe clearly falls within the exclusion's exception for work performed by a subcontractor. 4. Exclusion M the Impaired Property Exclusion The impaired property exclusion addresses only one situation: where a defect in construction, or a malfunction in material supplied, creates a loss of use. An example of impaired property is a building that cannot be used or is less useful because the wrong material was used, therefore, it cannot be used for its intended purpose. If the only damage is a loss of use of the host structure, and the structure can be restored to use by removing and replacing the insured s work or product, the exclusion is intended to apply. Note, however, that if there is any physical injury to the host structure, the impaired property exclusion does not apply. A second significant feature of the "Impaired Property" exclusion is historical. Arguments were made under the 1973 ISO General Liaibility forms that although the defective work or product may not have caused any resulting physical injury, to remove it from the host and repair the condition would involve damaging the host; therefore, the method of repair of the defective work or product creates property damage. The addition of the defined term Impaired Property in the 1985 form eliminates that possibility, because the definition of excluded property now specifically includes not just the condition, but the repair of the condition, even if the repair would involve physically injuring the host. The Massachusetts Court of Appeal applied the Exclusion in Dorchester Mut. Fire Ins. Co. v. First Kostas Corp. (Mass. App. Ct. 2000) 49 Mass. App. Ct. 651, 653-654 thusly: The damage claimed by the owners came from the alleged dispersal of lead-based paint chips and dust. The painters are said to have failed to contain the toxins they set free through their scraping and sanding operations, certainly an inadequacy and a dangerous condition in their work. That faulty workmanship denied the owners the use of their house until it could be restored to use by the removal of the faulty element of the 7
contractor's work, the errant chips and dust. There was no other damage to the property other than the contractor's work. IV. CONCLUSION From a risk management perspective, the insurance professional should recognize that the business risk exclusions, collectively, will limit or eliminate coverage under a general liability policy for work and damage that is under the control of the contractor, and many losses that are occasioned by a contractor's normal operations. Things that are not installed properly, or components that do not work, are supposed to be the responsibility of the contractor, according to the insurance policy. The risk manager or broker should decide whether additional types of coverage may be available that might not have these same limitations, for example errors and omissions coverage in addition to the general liability coverage. Once the damage has occurred, however, and looking to the General Liability policy, the lawyer or claims professional should look first to the injury for which compensation is being sought: is there a claim for property damage, either a physical injury to some property or loss of use of property, occasioned by an accidental event? Second, one should determine whose policy is potentially triggered for this event: the subcontractor, a general contractor or the owner? Determine whose work is the cause of the injury: the named insured s, an additional insured s, or some third party s? Third, identify whether the damage caused by the responsible subcontractor occurred during its operations or once operations were complete, to determine if the Products-Completed Operations Hazard is triggered or not. The completed operations hazard requires completion of the work by the Named Insured, not the project as a whole, and different exclusions apply. If the work was complete, the General Contractor's own coverage may afford him or her more protection than the subcontractor's policy. Fourth, look to the terms of the exclusions themselves as to whether the particular loss is barred. Following these steps makes it much more likely that the exclusions will be applied as intended. The carrier and the policyholder will get the benefit of the policy as drafted. 8