RISK PROBLEMS/SOLUTIONS
By LeRoy H. Utschig, CPCU, ARM
The thrust of this article is the possibility of an errors and omissions claim that rises out of work done at a construction site. Most of the scenarios will focus on the exposures created by the subrogation clauses that appear in every insurance contract that I have ever seen.
For many years, "subrogation" was the name for the clause. Today, it is rare to see the word "subrogation" in an insurance contract. In the interest of clarification and making the contract simpler and easier to read, today's insurance contracts tend to use words such as "transfer of rights of recovery against others to us."
There is one purpose for the use of the subrogation clause. An insurance company(ies) wants someone else to pay for the loss it covered. A common example of this is automobile accidents. The insurance company pays its insured for the loss. Then, the insurer tries to recover from someone else the amount of money it paid to its insured.
Construction contract provisions
Sometimes, the main construction contract for a building site will prohibit the use of subrogation clauses. My experience has been that most construction contracts do not say anything about them. From an insurance agent's perspective, there is potential for E&O problems in either case. Several insurance contracts allow their subrogation clause to be nullified. However, the vast majority of insurance contracts prohibit the waiving of that insurer's subrogation rights. If the insured has waived the insurer's subrogation rights in violation of the insurer's terms, an insurer can deny payment of anything to its policyholder.
Here is a fictitious example to illustrate some of the potential problems:
Electrician, Inc., was working on a construction site. One of Electrician's workers caused an electrical control panel to explode. The explosion destroyed the control panel, causing about $20,000 in damage to the unit. Because Electrician had not been paid for the panel, it presented a claim to Project Owner, LLC, for the value of the panel and labor for installing it.
Besides damaging the panel, the explosion caused $600,000 damage to an air treatment unit that was being installed. In fact, the electrical panel that exploded was to be used as the control for that air treatment unit. Air, Ltd., the firm installing the air treatment equipment, did have an installation floater to cover the equipment while it was being installed.
The explosion and ensuing fire damaged some of the structure. Project Owner presented a claim for the damage to its insurer, Builder's Insurance, Inc.
Electrician did not have an installation floater. The owner expected to have the loss covered by Builder's Insurance, Project Owner's insurer. Builder's Insurance reviewed the construction contracts used by the various contractors. A provision in all of the contracts dealt with paying the contractors for the work that they had done. Payments were to be made on a monthly basis. Once a month, the construction manager would review each contractor's work to determine whether or not the contractor had done what it was supposed to have done. In addition, she verified that the work had been done correctly. If the quality and quantity checked out okay, payment for that month's work was made to the respective contractor(s). Nothing was owed to any of the contractors for work they had done between the time the construction manager had last approved some of their work and the present date.
Because of this approval provision in the lease, Builder's Insurance denied Electrician's claim for the damaged electrical panel.
Air sustained a loss of approximately $600,000 to the equipment that it was in the process of installing. It first submitted a claim to Project Owner. Project Owner passed Air's claim on to its insurer, Builder's Insurance. Builder's Insurance denied the claim. The denial was based on the same premise that had been used to deny Electrician's claim. Project Owner did not owe any contractor any money for work done between the last time the construction manager had approved their work and today's date. Air had moved the $600,000 unit onto the premises after the last approval by the construction manager. Thus, Project Owner did not owe Air any money for the damaged $600,000 unit. Air then presented its claim to Marine, Inc., which had written its installation floater. Marine denied Air's claim. The adjuster stated that the unit had been attached to the structure. Their installation floater ceased to provide coverage on any item that was attached to any structure. This clause is found in many insurers' installation floater forms.
The owners of Air argued that there was coverage for this kind of loss. The adjuster read the policy, including the endorsements. One said, "This form will provide coverage until the insured's work is accepted by the entity for which the work is being done." In this case, Air's installation floater would cover the work being done at this site until the construction manager accepted it. The claim person approved payment to Air.
At the time of signing the proof of loss, Marine had Air sign a subrogation form. The purpose of any subrogation form is to authorize the insurer to seek recovery from the firm that negligently caused the damage. In this case, Electrical negligently caused the damage to Air's unit. Marine paid Air for its loss. Air actually had the legal right to seek recovery from Electrician. In the subrogation form, Air assigned its recovery rights to Marine. Marine then made a claim against Electrician for the amount of money that it had paid Air.
Electrician had combined general liability and commercial umbrella limits of $3,000,000. The subrogation claim was for $600,000. Builder's Insurance denied this claim based on the application of the care, custody and control exclusions in the policies. It again stated that Electrician was working on all parts of the unit when the explosion occurred.
This uncovered claim was enough to put Electrician out of business. Project Owner needed to find another electrical contractor to complete the work. Three events delayed the construction of the project:
1. The time needed to repair the loss caused by the explosion.
2. The time between the loss and the time Electrician actually filed bankruptcy.
3. The time needed to find another contractor to replace Electrician.
A firm that will provide money only during the time of construction typically finances new construction. Many of these interim financing agreements have an expiration date. Many times the expiration date is the date by which the construction is expected to be completed.
At the completion of construction and the end of the interim financing, the project will go to a different form of financing called long-term financing. Long-term financing is typically 15 to 20 years. Many projects are lining up tenants while the construction work is being done. Long-term financing may have a requirement that the project must have a certain percentage of occupancy by the end of construction. Should the project not have enough prospective tenants lined up, the firm that had agreed to provide long-term financing might not do so. In other words, the supplier of long-term mortgage money could back out of the deal.
Due to the loss that Project Owner suffered, the opening was delayed. As word spread, several of the firms that were to have been the lead stores for the project backed out. They said that they could not wait. The money interests for the interim financing would not extend the ending date of their financing. This meant that Project Owner would need to find another source of funds in order to finish the project.
The loss caused Project Owner to lose prospective tenants and incur increased funding costs. The owners of Project Owner asked their insurer whether or not their insurance program would cover these items. The insurer responded that there was no coverage for the time element part of the loss.
Coverage denied
Electrician did not have coverage due to the exercising of a care, custody and control exclusion. (I don't know of any insurance that that will take care of this situation.)
Air had an installation floater that covered the items already installed but not accepted by the customer. It is worth noting that a standard installation floater would not have covered its loss. A normal installation floater ceases coverage whenever an item is attached to someone else's real estate. Air's installation floater had been modified to provide coverage until the time that the customer accepted the work. The form to do this is probably not a published or filed endorsement. Installation floaters are an inland marine line of insurance, and the inland marine manual has a provision for writing manuscript endorsements. (This coverage is something that I routinely wrote starting during the early 1970s.) Most underwriters are willing to provide the coverage. If you encounter an underwriter who does not wish to provide the coverage, look for one who does.
E&O?
Project owner did not have insurance for the additional interest costs resulting from the delay in opening the project. It also did not have any coverage for the loss of future income resulting from the cancellation of leases by prospective tenants.
Insurance can be written to cover the kind of time element loss sustained by Project Owner. Insurance Services Office, Inc., promulgates a time element form that will cover the extra interest expense and the loss of future revenue due to leases being canceled. Some might say that the extra interest expense should be covered as part of the property claim. I recommend using time element forms for business interruption types of losses. I also recommend that the form not be limited to the period of construction only.
In this case, the lost leases were going to cause an interrupted income stream for some time after the project was completed. Endorsing on an extended period of indemnity would provide coverage for the loss of future income. The recommendation is to add on the extended period of indemnity for 12 months. This would provide coverage for a year after construction is completed. During the year, Project Owner would be able to replace the tenants who backed out of their leases.
Waiver of subrogation
Some construction jobs' contracts prohibit subrogation by anyone doing any work on the job. Should you have a contractor working at one of these job sites, you will need to attach endorsements to all of your clients' policies. While property policies automatically allow waiver of subrogation, other policies don't. Here is a partial list of contracts that you will need to endorse if you have a client working at a site where subrogation has been waived: auto, general liability, workers compensation, contractor's equipment, installation floaters and commercial umbrellas.
Summary
* Modify installation floaters to cover until the customer has accepted the work.
* Offer time element coverage to owners of new construction projects.
* Endorse waiver of subrogation clauses to all policies if your client is working at a site where subrogation is waived.
The author
LeRoy H. Utschig, CPCU, ARM, is a Wisconsin-based insurance educator, consultant and expert witness.