Habitational limits on construction activity
Endorsements may exclude or severely limit liability coverage when building's purpose becomes habitational
By Donald S. Malecki, CPCU
Over the past two decades, liability coverage written for contractors of all tiers has undergone substantial revision in a number of ways. One such way is with a limitation on coverage for construction work involving habitational risks.
Increasing litigation involving these types of habitational projects has caused many, if not most, insurers to take a number of steps including, but not limited to:
• Declining to write coverage for the liability exposure
• Completely excluding coverage for those exposures by endorsement
• Limiting coverage for those exposures
As a result, construction projects used for habitational purposes are very likely to be excluded from liability coverage or severely restricted through the use of special nonstandard endorsements, the latter of which is the subject of this article.
It also is well-understood (or should be) that the rationale for this change lies in the fact that habitational-use projects are much more likely to generate litigation, in the event of construction defects, than, say, commercial construction.
What complicates matters, too, is that even contractors who do not build residential properties can be at risk because office buildings, hotels, and old hospitals and schools have occasionally been converted to residential condos, timeshares, or live/work condos for artists and craft people. Thus, almost any building contractor and its agent is vulnerable to this problem.
General rationale behind endorsements
Typically, those special endorsements that are used to exclude any kind of residential construction activity often result in disputes over what is considered residential for purposes of applying these endorsements.
For example, some endorsements define what they view as residential by stating that the term residential includes, but is not limited to, single-family dwellings, homes, apartments, townhomes, condominiums, multi-tract housing developments, and cooperatives.
One area where there has been a dispute is whether these endorsements encompass timeshares, when not specifically listed in one of these special endorsements.
One of these endorsements titled Exclusion—Residential Conversion, which is to be attached to a CGL coverage part, excludes any bodily injury, property damage and personal and advertising injury arising from "the construction of any building, in whole or in part, which has been converted to a non-commercial dwelling or residence, at any time after the inception date of the policy at issue."
Parenthetically, reference to "any time after the inception date of the policy at issue" in the above endorsement is necessary because the underwriter knows or should know about the risks confronting the named insured prior to policy inception, but does not know what jobs are taken during the policy period.
This endorsement also states that, as used in this exclusion, non-commercial dwellings or residences include, but are not limited to, homes, cooperatives, townhomes, lofts and condominiums.
This exclusion, however, is stated not to apply to the construction, management, or ownership of apartment buildings, hotels or motels by the named insured.
One problem with the wording of the preceding endorsement is that the scope of coverage that the insurer seeks to exclude is unclear. In other words, based on the above language in quotes, it is obvious, at a minimum, that the exclusion is intended to apply to construction activities associated with the renovation or conversion of an existing commercial structure for use as residential units.
The language used, however, is not exactly clear, making it difficult to apply this exclusion in the context of constructing a building that has been converted to residential use. What is unclear is how one constructs a building that has been converted, given the fact that, to be converted, the construction process has to have been completed at some earlier time.
Also, what begs a question here is what is encompassed by the phrase "converted to a non-commercial dwelling or residence." If a developer and/or contractor constructs apartments, but before using them for that purpose decides to call them condominiums, does that constitute construction of a building that has been converted to a non-commercial dwelling or residence, as opposed to a mere name change?
While the above exclusionary endorsement makes an exception for apartments, the policy will likely include some kind of exclusion and/or deductibles. One exclusion that underwriters have as a tool is the elimination of coverage for completed operations in relation to construction of buildings that will involve habitational use.
Thus, while at first blush there is an exception for apartments, absent an appropriate premium, it is likely there will be other exclusions and deductibles to address the exposure.
Another concern is that there is nothing to prevent an owner of a project from converting an apartment project to a condominium project at some point after construction is completed. Certainly the contractor could seek a guarantee that there will be no conversion for a number of years.
The question, however, is enforceability. Courts might not enforce agreements that constitute what is referred to as a restraint on alienation, meaning taking away the right of the property owner to sell its property as it sees fit. This is likely to be more of a problem if the original owner sells the property. Legally binding the new owner to such a commitment may prove challenging.
One solution might be to contractually eliminate any legal obligation on the part of the developer, general contractor, or subcontractors to pay damages in any way attributable to construction defects, in the event the property is converted from the use intended at the time of construction.
Knowing such a limitation exists would likely serve to dampen any incentive on the part of the owner to convert a project, but without eliminating the owner's right to do so, knowing it assumes all risk of future damages. Whatever the case may be, legal counsel would have to review the approach to see if it can withstand judicial scrutiny.
Finally, there have been situations where apartment projects have been converted to condominiums following construction. Whether that was part of a grand scheme and plan all along or simply decided upon in response to an upswing in property values is unknown.
Certainly no property owner or developer would be willing to admit to having such an intent while failing to disclose it. However, it has happened, and an endorsement like the one mentioned earlier is part of the insurers' response.
When it comes to residential conversion endorsements, there is no shortage of disputes that lead to litigation. One of the problem areas, alluded to earlier, is that these nonstandard endorsements can be ambiguous, and that is a good thing for the insureds being confronted with a possibility of no coverage.
One such case is American Empire Surplus Lines Insurance Company v. National Fire Insurance Company, et al., 2013 WL 1194866 (U.S. Dist. Ct. S.D. TX). Space limitations prevent a full discussion of this dispute. As explained by the court, however, it was a dispute between two insurers over the interpretation of "a poorly drafted exclusion" dealing with a residential property exclusion.
Another interesting but very involved case where the insureds were found to be without coverage is RSUI Indemnity Co. v. RCG Group (USA), et al., 890 F.Supp.2d 315 (U.S. Dist. Ct. S.D. N.Y.2012).
This case arose following the collapse of a tower crane during the construction of a residential high-rise that killed seven people, injuring dozens more, and causing millions of dollars in property damage. The central issue of this case was whether the primary building at issue was solely residential or contained commercial space as well, such that it was fairly described as "mixed use." In either case, however, the residential exclusion applied.
In other words, even if the building included commercial and community space, in addition to residential space, the building was considered to be a "mixed use" one in the endorsement and, therefore, coverage was barred for the resulting damages.
Exclusion not limited to contractors
The insureds affected by these residential work exclusions are not limited solely to construction contractors. These exclusions affect anyone who has any work related to residential construction, including, for example, architects, engineers and professionals.
One recent case, which affected an architect under a claims-made liability policy, is James River Insurance Company v. Oscar I. Garcia, Architect, P.A., et al., 856 F.Supp. 2d 1284 (U.S. Dist. Ct. S.D. FL. 2012). After one year of coverage beginning in 2009, the insurer notified its surplus lines broker, who in turn notified the architect's producer, that a condominium exclusion would be placed on the policy at renewal.
The architect accepted the renewal premium with the residential condominium/townhome exclusion, which cost 30% less than the preceding year's coverage. The price reduction was said to be the result of the new exclusion.
During the new policy period, a claim was filed against the architect for deficiencies and delay in work on the condo project. The following month, the claim was forwarded to the insurer. The lawsuit was filed five months later.
Much of this dispute was over the extended reporting period and whether it applied to the claim/suit involving this matter. In the final analysis, the court ruled that, since the claim was not made during the 2009 policy period, that policy was not activated.
Also, no extended reporting period endorsement applied because the applicable state's statute holds that a change in policy terms, conditions or premiums is not considered to be a nonrenewal for purposes of triggering an extended reporting period. The later policy, on the other hand, also did not apply because of the residential condominium/townhome exclusion. It was a double whammy.
The mechanics of claims-made policies can be tricky. Simply dealing with claims-made policies can be a problem in and of itself. When these kinds of policies deal with residential conversion endorsements, situations can get very complicated.
Given the fact that residential conversion endorsements are nonstandard in nature, they must be read very carefully, since there is no benchmark against which to compare with other endorsements.
About the only advantage for insureds, dealing with these exclusionary endorsements, is the defense of ambiguity. This means that if insurers want to avoid these kinds of responses by insureds in disputes, they need to exercise caution in how to draft policy language that laypeople can understand.
Donald S. Malecki, CPCU, has spent more than 50 years in the insurance and risk management consulting business. During his career he was a supervising casualty underwriter for a large Eastern insurer, as well as a broker. He currently is a principal of Malecki Deimling Nielander & Associates LLC, an insurance, risk, and management consulting business headquartered in Erlanger, Kentucky.