Risk Management

Insurers should not try to be lawyers

Be on the lookout for insurers meddling in the contracts between contractors & subs

By Donald S. Malecki, CPCU

Frequently, many individuals and entities turn to insurance as the first course of action when implementing risk management alternatives in handling risks. In actuality, insurance should be the last recourse and not a substitute for implementing measures to reduce, control or otherwise deal with risks.

The reason insurance is often the initial (and sometimes sole) source of handling risks is that risk managers or agents/brokers can eliminate the time-consuming, but all-important, process of identifying risks, analyzing the loss-producing capabilities of risks and then pondering how to best deal with the loss exposures. Purchasing insurance, therefore, usually is a lot easier than having to spend time and money figuring out how to handle risks through the use of other measures, such as avoidance, retention and transfer.

Insurers are not patsies

Insurance companies, of course, are in the business of accepting risks of loss from others for sum certain, but they are not particularly interested in being viewed as the dumping ground for risks. So what many insurers do when underwriting the applicants is to implement measures that the applicants, themselves, probably should have done before seeking insurance.

An example is when a general contractor hires the services of one or more subcontractors. What the general contractor should do, in addition to determining the subcontractors’ competence in performing the work, is to impose certain insurance requirements with solvent insurers and request proof by way of a certificate.

Sometimes general contractors do not have the option of imposing certain insurance requirements on others; they sometimes are forced to do so by insurers. For example, one insurer of a CGL policy automatically adds an endorsement titled “Independent Contractor(s) Insurance Agreement.” This states that when the named insured uses any independent contractor(s) or subcontractor(s), the policies of the latter are to maintain certain coverages and for limits of not less than those shown and confirmed by an insurance certificate.

This endorsement also requires that the insurance (1) obtained by these contractors be issued by an insurer with an A.M. Best rating of not less than “A minus” and “Class VII,” (2) include the named insured as an additional insured under ISO form CG 20 10 (07/04) or broader and (3) apply on a primary basis.

Failure of the named insured to obtain a certificate reflecting the requirements imposed is said not to invalidate the insurance. What the insurer says it will do instead is to increase the premium the general contractor has to pay for its failure to obtain insurance from subcontractors.

In fact, the endorsement in question states that in determining the earned premium due the insurer at audit, the insurer will apply the rate shown for uninsured subcontractor costs against the amount of subcontracted work for which the named insured did not obtain an insurance certificate.

Case in point

Failure to meet the requirements of this kind of an endorsement can be a costly proposition. A case in point—which is still subject to further proceedings but appropriate for comment here—is Steadfast Insurance Company v. SMX 98, Inc. and SPAWMAXWELL COMPANY, L.P., No. H-06-2736 (U.S. Dist. Ct. S.D. TX 2009).

This case involves a contract dispute which arose from an endorsement requiring the named insureds, a construction company, to have their subcontractors obtain commercial general liability policies that meet certain conditions. The requirements, as a matter of fact, are quite similar to the preceding endorsement, except with respect to the result for failing to meet the endorsement’s requirement.

Here, the endorsement stated that failure to comply would not change the named insured’s coverage but would result in the subcontractors being considered “to be [the insured’s] employees for the purpose of computing rate and premium and that such premium would be charge[d] at a rate of: $20 per $1,000 of uninsured/uninsured subcost.”

After the policy ended, the insurer audited the subcontractors’ insurance. It concluded that the named insured had failed to comply with the subcontractors’ warranty endorsement by hiring subcontractors with either no insurance or with insurance issued by insurers with Best ratings lower than “A.”

The named insureds paid their insurer $41,196 for those subcontractors retained that did not maintain any insurance. The named insureds paid this amount based on an invoice issued by the insurer that calculated the premium for contracts with no insurance using the formula of $20 per $1,000 of subcost.

The insurer, however, was not satisfied with this payment. It instead notified its named insureds that an additional amount of $518,212.22 was owed for those subcontracts in which the subcontractors had insurance, but the insurers were rated below “A” or “A+.”

While the court agreed with the insurer that the endorsement applies to both subcontractors without any insurance and subcontractors with insurance that did not meet the endorsement’s conditions, the court concluded that the damages provision was an unenforceable penalty.

It will be interesting to see how this matter is concluded, if it is tried. It is important to note, however, that this kind of endorsement is not unusual, particularly among surplus lines insurers that write a lot of contractors today.

An unorthodox approach

What is undoubtedly an unusual risk management approach by an insurer to avoid having to pay a loss, short of denying a claim, is to mandate that its producers whose insureds are general contractors add wording to their contracts when dealing with subcontractors.

In effect, what the insurer is requiring here is a waiver of the subcontractors’ workers compensation immunity, to the extent such a waiver is otherwise permitted. One problem is that contract wording is for lawyers to handle and not producers. Another problem is that the insurer that makes such a mandate without further explaining the rationale behind it frustrates everyone. What makes matters even worse is that if the producers do not follow through, the insurer warns it will not renew the general contractor’s liability insurance.

The following is the wording that was suggested to be added to the named insured’s (general contractor’s) indemnification agreement:

In claims against any person or entity indemnified under this Section by any employee of the Subcon­tractor, the Subcontractor’s subcontractor, or anyone directly or indirectly employed by them or anyone for whose acts they may be liable, the indemnification obligation under this Section shall not be limited by a limitation on amount or type of damages, compensation or benefits payable by or for the Subcontractor or the Subcontractor’s subcon­tractor under workers’ or workmen’s compen­sation acts, disability benefits acts or other employee benefits acts.

Strictly from a non-legal standpoint, the above provision appears to be saying that the subcontractor must fully indemnify the general contractor for the full amount of any liability the general contractor incurs. The subcontractor cannot hide behind limitation of liability clauses.

Because this provision states there will be no recognition of any limitations, such as the subcontractor not having to pay any more in damages than workers compensation benefits, this provision also could serve as a waiver of statutory immunity under workers compensation.

What begs the question is what a waiver of immunity is and why it is commonly imposed. One would think that an insurer imposing such a requirement would educate its producers, considering it is relying on its producers to be the deliverer of the contractual provision.

Perhaps the best way to explain the situation is with a common scenario. An employee of a subcontractor is injured and collects statutory workers compensation benefits. The employee then files a suit against the general contractor maintaining that the primary cause for his or her injury was the general contractor’s failure to supervise.

The general contractor in turn files suit against the subcontractor for protection (despite the fact that subcontractor had to pay benefits under the policy it had purchased), because the subcontractor agreed to hold harmless and indemnify the general contractor.

With some workers compensation statutes holding that the payment of benefits is the exclusive remedy against the employer, the subcontractor, in some cases, could justifiably refuse to defend the general contractor despite the promise to provide defense and indemnity. The reason again is that the subcontractor’s assumption of the general contractor’s liability may not constitute a waiver of the subcontractor’s immunity.

What the insurer hopes to accomplish here is to require the subcontractor’s insurer to protect the general contractor, rather than the insurer having to pay for its named insured’s (general contractor’s) defense and indemnity.

A number of cases have arisen over the years on this issue. Some have required subcontractors to fulfill their promises, whereas the courts in other cases have upheld statutory immunity as a bar to preclude additional protection.

There are ways to “tweak” the wording so that when a waiver of immunity is permitted by law, such a waiver may be upheld. Judging from the cases involving this matter, it would appear that the above wording of one insurer requires some work.

The key to a better waiver will not be suggested here for two reasons. One is that it is a legal matter. Another is that the best way for an insurer to find out why its wording may not work is to engage in expensive and timely litigation where the adverse decision can be spelled out by the court.

Conclusion

Typically, the provisions of contracts are decided upon by parties to the contract. If a general contractor contracts with a subcontractor, it is these two parties who need to be satisfied with the contract wording. It is unheard of for an insurer to mandate additions to a contract of indemnity.

What is unfortunate is that once the door is opened by an insurer, this idea may spread to other insurers. Whatever the case may be, producers may have no other choice but to be the messenger. What they should do, however, is to recommend to the insured that the matter be taken up with the insured’s attorney, since what the insurer is doing is a legal matter.

It may be worthwhile for the producer to document such requests in the event of suit. Producers should also start looking for another market for their insureds, since some may not agree to such waivers even if it means being the recipient of a nonrenewal notice.

Certainly, there is a place for insurers to practice good risk management. But the insurer that is an officious meddler into the contracts of others may be making matters worse. For one thing, they may be raising the standard of care in the event of some argument over this matter. If insurers want to reduce their payouts, they should shape coverage by way of policy modifications which is their proper role.

The author
Donald S. Malecki, CPCU, has spent 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 L.L.C., an insurance, risk, and management consulting business headquartered in Erlanger, Kentucky.