CGL Policies Only Cover Resultant Damages
Commercial general liability (CGL) policies are purchased for various reasons, including protecting a general contractor or tradesman from construction defect claims. CGL policies, however, are not performance bonds. Performance bonds are issued to one party of a contract as a guarantee against the failure of the other party to meet the obligations of the contract, including construction defects. Unlike performance bonds, CGL policies do not guarantee that a contractor will perform its work correctly. Instead, CGL policies cover instances where the insured’s defective work causes bodily harm or damages other portions of the property—typically referred to as resultant damages.
A California appellate court has succinctly explained the law and its rationale:
General liability policies . . . are not designed to provide contractors and developers with coverage against claims their work is inferior or defective. The risk of replacing and repairing defective materials or poor workmanship has generally been considered a commercial risk which is not passed on to the liability insurer. Rather liability coverage comes into play when the insured’s defective materials or work cause injury to property other than the insured’s own work or products. As one commentator explained: “This distinction is significant. Replacement and repair costs are to some degree within the control of the insured. They can be minimized by careful purchasing, inspection of material, quality control and hiring policies. If replacement and repair costs were covered, the incentive to exercise care or to make repairs at the least possible cost would be lessened since the insurance company would be footing the bill for all scrap. Replacement and repair losses tend to be more frequent than losses through injury to other property, but replacement and repair losses are limited in amount since the greatest loss cannot exceed the cost of total replacement. If the insured will stand these losses, insurance can be provided more cheaply since the company will be freed from administering many small claims for repairs, and it can set a rate for the more unusual risk of injury to property other than the contractor’s work or product.”
“Occurrence” Requirement
CGL policies are only triggered by an “occurrence” that causes bodily injury or property damage. An “occurrence” is defined as an accident, including damage caused by continuous and repeated exposure. Construction defect litigation claims often seek compensation to repair or replace the insured’s faulty workmanship. CGL policies undoubtedly contemplate coverage of claims where the insured caused resultant damage to other property. In cases where the damage is limited to the insured’s work, however, courts take different approaches on whether faulty workmanship is inside or outside the insuring grant.
Most jurisdictions hold that faulty workmanship that only damages the insured’s work product is not an occurrence and therefore outside policy coverage. The common rationale is that faulty workmanship is not an accident but a foreseeable business risk. These jurisdictions stress that performance bonds, not CGL policies, are the products in the marketplace that insure against faulty workmanship.
A few jurisdictions hold that even though the faulty work is an “occurrence,” it does not constitute “property damage” within the meaning of the policy. Same result, different word focus. For example, a roofer installs a roof on a home. Despite their efforts, the roof leaks and causes water damage to the home’s interior (ceiling, drywall, and carpets). Liability insurance does not cover the cost of tearing off and replacing the roof with a properly constructed roof. Instead, liability insurance pays for the resultant damage to the home—repairing the ceiling, drywall, and carpets.
Things are seldom simple in life and law. A few jurisdictions offer a third approach to whether faulty workmanship is an occurrence. Some jurisdictions hold that faulty workmanship is an occurrence as long as the defective work had been unintended, as viewed from the insured’s perspective. Those jurisdictions reason that faulty work to one’s own product and faulty work that damages other property are both caused by negligence—which is accidental—and therefore within the insuring grant (even if later excluded by business risk exclusions). Knowledge of the jurisdictional interpretation of this issue is essential to making proper coverage decisions and preventing claims of waiver.
When analyzing the occurrence requirement, it is also important to note that in most standard-form CGL policies, performance on the work (i.e., the occurrence) can occur within a different policy period. These policies contemplate that latent defects, like water intrusion or mold, may manifest in a separate policy period than the occurrence (i.e., the faulty work). This is often referred to as long-tail coverage or long-tail claims, such as asbestos, environmental contamination, or even latent construction defects.
Some carriers or risk retention groups may require in their policy language that the occurrence transpire in the same policy period as the property damage manifests. As a result, coverage under these forms is significantly more restricted.
Business Risk Exclusions Bar Repairing the Insured’s Work
Even if the claimant seeks damages resulting from the insured’s work, coverage may be limited by five exclusions commonly referred to collectively as the “business risk exclusions.” They include the exclusions for (1) damage to property, (2) damage to your product, (3) damage to your work, (4) damage to impaired property or property not physically injured, and (5) recall of products, work, or impaired property. These exclusions preclude coverage for repair or replacement of the insured’s work due to poor workmanship. In enforcing these exclusions, many courts reason that repair and replacement of the insured’s work is foreseeable and can be minimized through careful work and using quality products. Nevertheless, these exclusions have minor but distinct differences.
Damage to property. Subsection (5) of the damage to property exclusion bars coverage where the insured damages its own work while its work is ongoing. It does not apply to completed operations cases or any resultant damages.
Subsection (6) of the damage to property exclusion prohibits coverage for property damage to the particular part of property that must be repaired, restored, or replaced because the insured’s work was incorrectly performed on it. It does not apply to property damage occurring after the insured’s work is completed. This exclusion, too, does not apply to property damaged by the insured’s work.
Damage to your product and your work. The damage to your product and your work exclusions preclude coverage for damage to the insured’s own product and work. Like the other business risk exclusions, these exclusions do not apply where the defective work causes damage to others’ work or property. Additionally, the damage to your work exclusion does not apply where the damaged work or the work out of which the damage arose was performed on the insured’s behalf by a subcontractor.
Damage to impaired property or property not physically injured. The damage to impaired property or property not physically injured exclusion prohibits coverage for property that has not been physically damaged or “impaired property” (property that cannot be used because it incorporates the insured’s defective work or product, if it can be remedied by removing the insured’s defective work or product), arising from a defect, delinquency, or inadequacy in the insured’s work. It also excludes damages for a delay or failure of the insured in performing a contract. As such, this exclusion knocks out coverage for claims where the insured delayed in completing the project or failed to perform its work in accordance with the project specifications. This exclusion will not apply to the loss of use of property arising from sudden and accidental physical injury to the insured’s work or product after it has been put to its intended use (i.e., a completed operations claim).
Recall of products, work, or impaired property. The recall of products, work, or impaired property exclusion bars coverage for damages associated with withdrawal, repair, removal, or adjustment to the insured’s work, product, or impaired property. It also does not apply to resultant damages.
Contractual Liability Exclusion Bars Warranty Claims and May Preclude Indemnification Claims
Construction defect suits commonly include claims for breach of contract, breach of warranties, and express indemnity. The contractual liability exclusion may limit coverage based on the version written into the policy.
The first version broadly excludes coverage for liability assumed in a contract or agreement but contains an “insured contract” exception. “Insured contract” is a defined term in the policy. These are contracts the insurance company is comfortable insuring and typically include leases and the indemnification provision in construction contracts for property damage or bodily harm. Where the policy has the insured contract exception, analysis of the enforceability of the indemnification provision itself should be considered, as some states restrict the enforceability of indemnity agreements in construction contracts by statute or case law.
The second version, the most restrictive, excludes contractual liability claims without exception, meaning there is simply no coverage for contract-based claims—regardless of the theory of liability.
Whatever the version presented, breach of contract claims such as breach of warranty and breach of contract, without resultant damages, are excluded. In addition, losses arising from delays in work commonly fall under the contractual liability and damage to impaired property exclusions.
On a related note, breach of warranty claims are commonly excluded by the damage to your product and your work exclusions, which are defined to include “[w]arranties or representations made at any time with respect to the fitness, quality, durability, performance or use of” the named insured’s product or work.
Contractual liability exclusions do not apply to liability the insured would have in the absence of the contract or agreement, such as negligence or strict liability.
Earth Movement and Subsidence of Land Exclusions Preclude Coverage for Soil Movement
Some CGL policies contain exclusions for earth movement or subsidence of land. These exclusions bar coverage for damage caused, in whole or in part, by earth shifting, earthquake, erosion, settling, cracking, and other similar situations. They commonly apply to cases with foundation or excavation work. If soil is moving, these exclusions apply.
Mold Damage Is Typically Excluded
Construction defect claimants commonly allege water intrusion. Many CGL policies include an exclusion barring coverage for mold damages. The name of the exclusion may vary from fungi or bacteria exclusion to deleterious substances exclusion to mold exclusion. All apply to bar coverage for mold.
Work Performed by Subcontractors May Be Limited or Excluded
Early CGL forms excluded property damage to work performed by the insured or subcontractors working on the insured’s behalf. The Insurance Services Office (ISO) drafts commonly used standard-form insurance forms. In 1986, ISO modified its policy forms to include a subcontractor exception to the damage to your work exclusion. With this change, the damage to your work exclusion does not apply if the damaged work or the work out of which the damage arises was performed by the insured’s subcontractors.
And now, having come full circle, some insurers are restricting coverage for property damage or bodily injury caused by the insured’s subcontractors. These provisions should be carefully reviewed. Limiting coverage for damages caused by subcontractors can be addressed at one or several provisions, usually found in manuscript policies or endorsements. First, a policy may apply a higher deductible or a higher self-insured retention (the amount that must be paid by the insured before the policy will respond to a loss) when damage is alleged to be caused by a subcontractor.
Second, the policy may have a blanket exclusion for work performed by a contractor or subcontractor. Some policies bar coverage for supervision of subcontractors whether or not hired by the insured.
Third, the insurer may impose several conditions before triggering coverage for damage from a subcontractor. These typically require the insured to have a written indemnity agreement in the insured’s favor, the subcontractor to name the insured as an additional insured, and the subcontractor to carry liability insurance with specified minimum limits. If any of these requirements are not met, the condition is breached and liability for damage caused by subcontractors will not be covered.
Fourth, the insurer may impose a sublimit on any work performed by a subcontractor, such as $25,000 or $50,000, to cap exposure for such claims.
Trigger of Coverage for Latent Defects
In latent defect cases, it is essential to determine which policies are triggered. A CGL policy with ISO forms is triggered when the bodily injury or property damage occurs. This is simple in most claims because a slip and fall or property collapse will have a definitive date. However, the issue becomes more complicated with latent or progressive damage cases. For example, construction defect claims commonly involve latent water intrusion or foundation issues developing over months or years.
Four approaches have been developed nationally to determine which policies apply: (1) manifestation theory, (2) exposure theory, (3) continuous theory, and (4) injury-in-fact theory. Under the manifestation theory, courts will analyze coverage under policies that were in effect when the harm was first discovered. Under the exposure theory, all policies in effect when the person or property was exposed to the element that created the damage are triggered. Courts analyzing under a continuous trigger theory—the broadest theory—will define coverage under policies in effect from the date of the first exposure of the harm through the discovery. Under the injury-in-fact theory, the policy that is in effect when the real, but undiscovered, injury is shown to have taken place is triggered.
It is important to note that courts may follow different theories depending on the type of damage alleged. For example, the U.S. District Court for the Northern District of Ohio has stated that it will not apply the continuous trigger theory unless there is evidence that the damage is continuing in nature instead of one-time or episodic. Absent such showing, it will apply the injury-in-fact theory. For latent defect claims, a thorough review of the jurisdiction’s case law specific to the coverage trigger is a vital first step.
On a national scale, jurisdictions tend to be moving toward adopting the continuous trigger theory. This is a development that will broaden liability for insurers, especially in latent defect cases. Some insurers have responded to this changing legal landscape by incorporating continuous and progressive exclusions. The standard ISO CGL policy incorporates known loss or “Montrose language” in the insuring agreement. Others include exclusions for prior completed work, meaning that there is no coverage for property damage where the work took place before the policy was purchased.
Some insurers have limited their exposure with anti-stacking provisions. Anti-stacking provisions prevent the stacking of coverage where multiple policies are in effect during the same loss.
Finally, if another insurer’s policy is triggered, risk transfer protocols could be beneficial in mitigating or sharing costs.
Practice Pointers
We offer the following practice pointers.
Determine which state’s law applies. Many construction contractors use American Institute of Architects (AIA) standard-form contracts. AIA contracts specify that the law of the state where the project is located is the controlling law.
Other contractors draft their own construction contracts. Parties are free to contract and impose whatever state law they desire to their disputes. Where the construction contract does not contain a choice-of-law provision, it is necessary to undertake a choice-of-law analysis. For the tort and contractual claims between the owner or general contractor and subcontractors, the governing law is typically the state where the project is located.
Review the trade contract to see if the parties agreed to a different state’s laws to govern their disputes, in particular, claims between property owners and their general contractor, or a general contractor and its subcontractors. For example, it is common for New Jersey contractors to perform construction services in New York City and include a New Jersey choice-of-law provision. New Jersey allows for greater risk transfer via contractual indemnification than New York. New Jersey allows an indemnitee to be contractually indemnified for their own negligence, while New York invalidates such contracts.
Insurance coverage disputes arising out of construction projects may be subject to a different governing law. CGL policies typically do not have choice-of-law provisions. Where it is possible that different states’ laws may apply, it is first necessary to determine whether there is an actual conflict of laws between the jurisdictions. If an actual conflict of laws exists, it is necessary to apply a choice-of-law analysis. Many jurisdictions follow the Restatement’s “most significant relationship” test. Other jurisdictions follow lex loci contractus, under which an insurance policy is “governed by the law of the place where made.” Where the policy had been negotiated and issued, the state where the insured is headquartered, and the domicile of the parties all become relevant to determining which state’s laws should govern.
Read the policy. Insurance policies can vary widely. It should not be assumed that an insurance company uses standard forms or what forms are included. Understanding the nuances of each policy is critical to effectively pursuing or defending a claim. Reading the policy is required to understand the insurance company’s rights and obligations. Be sure to pay special attention to the named insured and policy period on the declarations page, the insuring grant, the exclusions, and any endorsements that may modify coverage.
Timely notify the insurer and co-insurer. Liability insurance requires timely notice of the claim and the suit and for suit papers to be forwarded to the insurer. Policyholders should immediately place their insurer on notice when they learn about a claim or potential claim. Some policyholders are concerned with premium increases and delay in giving notice to their detriment. Very little, if anything, is gained by waiting. Placing the insurer on notice allows a defense to be assigned and the claims to be investigated. This is valuable to both policyholders and insurers. Failure to do so may result in the claim being denied.
Insurers should determine early if other insurers or policies may respond to a loss and immediately place those insurers on notice. Where the insurer’s identity is unknown, determine how to find this information. Certificates of insurance are helpful. Where a certificate of insurance does not identify the liability insurer, sometimes a call to the insurance broker listed on the certificate of insurance will aid in identifying the liability insurer or subsequent insurer. Tender early; tender often.
Allocate covered vs. noncovered damages. As explained above, CGL insurance applies to casualty claims; it does not guarantee that a contractor will perform its work correctly. In evaluating coverage for construction defects, whether from the claimant, policyholder, or insurance company perspective, the starting point is the defect list. Review the defect list and determine which of the items are faulty workmanship and which items are resultant damages (i.e., damage to other portions of the home or project). Resultant damage means either damage to the existing building or damage to work performed by a different contractor. Determine which party’s work caused the damage and which party’s work or property was damaged in connection with the allocation analysis. Damage to the contractor’s work is not resultant damage.
In most cases, the damages can be readily ascertained and sorted into covered and noncovered damages. Where it is unclear which camp the damages fall under, annotate the defect list. A color-coded system will help you identify which portion falls within coverage or is excluded. We suggest using green (covered resultant damage), yellow (potentially covered damage), and red (not covered). During settlement discussions, we routinely share these marked-up defect lists with claimant attorneys and other insurers. While we represent insurers, we would gladly receive a marked-up defect list from a policyholder as part of settlement discussions. Candid settlement discussions ensure both parties know the other’s position and facilitate settlement on the merits.
For latent defect claims, determine the trigger of coverage. Sometimes construction defects are continuous and progressive in nature. In such instances, it is essential to determine the trigger of coverage for latent defects in your jurisdiction. For example, what is the first policy that is potentially triggered? What is the last policy that is potentially triggered? Where does this insurer fit within that timeline? Knowing the coverage trigger is helpful when pursuing risk transfer against other insurers. This applies to both policyholders and insurers.
Invite subcontractors to the party. In cases where subcontractors were used, property owners, general contractors, and subcontractors should implead their subcontractors early on. Waiting until extensive discovery takes place will only hinder early alternative dispute resolution (ADR) efforts. We often attend mediations where the case has been pending for years, yet several or all subcontractors still need to be impleaded. Invite subcontractors to the party early if you want them to participate in a settlement package. Waiting can result in unfruitful mediation, where the lack of subcontractor participation is a significant hurdle to settlement.
Examine the enforceability of indemnity agreements. At the end of the case, someone is going to pay—literally or figuratively. So rather than adopting a “wait and see” approach, get the contracts, tender to indemnitors, and determine which party or parties will ultimately bear responsibility for the loss. If additional information is needed to determine this, request it.
With the contracts in hand, research the enforceability of indemnity provisions in construction agreements in your jurisdiction. For example, does this jurisdiction allow a property owner, general contractor, or subcontractor to be indemnified for their own negligence from a lower-tier subcontractor? If so, push the lower-tier subcontractor to accept the loss. If not, property owners, general contractors, and subcontractors with independent negligence should consider putting money toward a settlement package.
Determine which insurer will ultimately own the loss. It is important to determine which insurer(s) will ultimately be responsible for the loss. Property owners and construction contractors often require their subcontractors to procure additional insured coverage for their benefit. Additional insured coverage can be better than contractual indemnification, especially where the general contractor or subcontractor has independent negligence.
Earlier versions of additional insured endorsements required the loss to “arise out of” the lower-tier subcontractor’s acts or omissions. Courts across the country construed the phrase “arising out of” quite broadly. Over the past decade, the insurance industry has tightened up additional insured coverage.
More recent versions are less broad and require the loss to be “caused, in whole or in part,” by the lower-tier subcontractor’s acts or omissions. Under the latter endorsements, the additional insured is entitled to full indemnification from the subcontractor’s insurer where the named insured (the lower-tier subcontractor) has at least 1% of the fault. Conversely, where the named insured is not negligent, additional insured coverage is not owed. For example, assume a general contractor requires its subcontractor to procure additional insured coverage, and the general contractor has 95% of the fault and its subcontractor has 5%. The general contractor is entitled to full indemnification as an additional insured. The general contractor’s substantial negligence is immaterial because the subcontractor contributed to the loss.
As such, additional insured coverage is particularly beneficial to a general contractor or subcontractor with substantial independent fault (which it otherwise might not have been able to pass onto its subcontractor due to restrictions on contractual indemnity agreements). Property owners, general contractors, and subcontractors with independent negligence, and their insurers, should push their subcontractor’s insurers to commit to full indemnification.
As with all policy provisions, additional insured endorsements need to be closely read. Some insurers have further restricted additional insured coverage by adding language that the additional insured coverage is no broader than that provided in the trade contract.
The mediator is your friend. Seasoned construction defect mediators have mediated enough cases to have an honorary doctorate in insurance coverage. There are certainly construction defect claims where there are no covered damages. Most typically have a mix of covered and noncovered damages, and further defense or coverage litigation is only sometimes beneficial. Where there are coverage issues, seasoned construction defect mediators can often account for their impact on strategy and value and push the parties toward an amicable resolution. Mediation is often the best use of funds, as opposed to further discovery, damages allocations, and expert reports. Whether you are the policyholder, defense counsel, coverage counsel, or an insurer, you should consider ADR early in the case.
Construction defect cases are ripe for mediation a lot sooner than most think. Consider an informal exchange of discovery, defect lists, and expert reports early on—even if under mediation privilege—to move the case into ADR. It is advantageous to the policyholder, their insurer, and their respective counsel to pursue ADR early on. This helps guard against either party becoming too entrenched based on their legal spend, where perhaps the merits are not as strong as they first believed or before they learned about significant coverage issues impacting recovery. Spite litigation is a game for the rich. Reasonable minds should evaluate their position, including strengths, weaknesses, and plan for collectibility.
Retain coverage counsel or local counsel. Know your limits. Recognize what you know and what you do not know. For claimants and policyholders, consider retaining coverage counsel to assist with the initial review of the claims and the policies and to provide guidance on pursuing insurance coverage. Insurers and claims professionals often oversee claims spanning a large region or nationally. Consider retaining coverage counsel (or local counsel) to assist you in determining your rights and obligations, overall strategy considerations, and cost-effective solutions to resolve claims.
Stay current. Stay current on developments in insurance law that may impact construction defect claims. Insurance law is constantly evolving, and staying current on recent cases and legislative changes is critical to effectively representing clients.
Conclusion
Insurance coverage for construction defect cases can, at times, feel complicated. To better understand coverage for construction defects, remember these precepts: Liability insurance covers resultant damages, not costs to repair or replace faulty work itself. The business risk exclusions are five different ways to say there is no coverage for faulty work. Understanding the contractual liability exclusion is quite easy once you know what an “insured contract” is. In recent years, the insurance industry has tightened up coverage for damages caused by subcontractors. Carefully read the policy to see whether work for subcontractors is covered and under which circumstances. For losses spanning multiple years, determine the trigger of coverage for latent defects or injury in your jurisdiction. By breaking the coverage issues into smaller components, insurance coverage for construction defects becomes simple.
