Risk Management

Now you see it; now you don't

Insurers provide coverage, only to have the courts litigate it away

By Donald S. Malecki, CPCU

Given today’s business constraints, it is encouraging to see so many producers inquiring about insurance coverage issues, many of which are quite thought- provoking. While some of these inquiries are motivated by claims presented and the ever-present threat of an errors and omissions claim, there is evidence that many producers are also seeking to better understand the insurance products they are selling.

Whatever the motive, what complicates matters and puzzles some producers is when a long-standing, standard coverage is challenged by an insurer or where a court rules in such a way as to distort the very understanding of how coverage is to apply. An example is broad form property damage coverage.

Available since 1954, broad form property damage coverage is difficult to understand. Part of the problem in gaining a better understanding of this coverage—which has largely disappeared—is that it is created by an exception to the so-called “damage to property” and “damage to your work” exclusions of standard ISO commercial general liability forms.

Despite this coverage’s longevity, ISO finally had to issue an explanatory memorandum in 1979 so that everyone—including insurance buyers—could grasp its application and significance.

Broad form property damage coverage applies to both ongoing operations and completed operations. This coverage is especially significant for completed operations. When work is performed incorrectly by a subcontractor, and a claim is made against the general contractor for property damage, an exception to the “damage to your work exclusion” leaves coverage unaffected for the general contractor for the work performed on its behalf.

In the wake of so many construction defect claims, ISO made available two exclusions that are intended to close the door: Exclusion-Damage to Work Performed by Subcontractors on Your Behalf-CG 22 94, used as a blanket exclusion, and CG 22 95-Exclusion-Damage to Work Performed by Subcontractors on Your Behalf-Designated Sites or Operations, used for designated work sites or operations.

The big issue

It was probably an enterprising attorney and an insurance company claims person who ultimately decided that neither of the foregoing exclusions is necessary in excluding coverage for construction defect claims. When a claim is large enough, the chief task of some insurers is to deny or dispute claims rather than to seek and find coverage.

All that is necessary for an insurer to accomplish this objective is to find some judge who can be convinced that liability coverage should not apply to anyone because construction defects are not considered property damage and there can be no occurrence, despite the separation of insureds condition of the CGL policy. There is evidence that a number of courts have been so convinced.

A case in point is Westfield Insurance Company v. Sheehan Construction Company, et al., 1:05-cv-0617-RLY-TAB (U.S. Dist. Ct. So. Dist. Indiana 2008), where home owners in a class action sued a general contractor for defective construction performed on its behalf by subcontractors.

The court held that for there to be coverage, there must be (1) property damage, as defined in the policy, (2) property damage caused by an occurrence, and (3) no applicable exclusions. In this regard, the court ruled for the insurer, holding that defective workmanship is neither property damage nor considered to be caused by an occurrence, no matter who performed such deficient work.

The Indiana courts have been consistent with these types of holdings. Interestingly, one insurer currently offers an endorsement in Indiana, for an additional premium charge, holding that damage to the named insured’s work (a general contactor, for example) will be considered an occurrence.

This kind of endorsement is troubling. The issue of whether a construction defect is an occurrence, although to be determined by the court, is created by the insurer. If the insurer does not raise this issue, then it is the exclusions that must be referred to in order to determine whether or not coverage applies.

Some people therefore could view this endorsement as a way of saying that if the insured pays a premium for it, the insurer promises not to raise the occurrence issue. There is a term for this kind of practice. Also, what may beg the question here is why a state insurance department permits such coverage filings, unless its review results in a simple rubber stamp.

The point here is that even though a contractor is able to purchase broad form property damage coverage, there is no guarantee that coverage will apply. Much will depend on the size of the loss, the subrogation possibilities and the jurisdictional precedents. As long as there is a court case holding against coverage, insurers will likely rely on it so as to not pay claims.

This means that contractors in Indiana should not expect coverage even where insurers are using ISO provisions clarifying that claims for construction defects created by subcontractors on behalf of general contractors are covered, in the absence of any endorsement to the contrary. Indiana, by the way, is not the only state. The other states that—based on court cases—also view construction defects as not being an occurrence are: Delaware, the District of Columbia, Hawaii, Illinois, Iowa, Massachusetts, Michigan, Mississippi, New Jersey, New York, North Carolina, Pennsylvania, Virginia and West Virginia.

A property coverage issue

Although liability insurance appears to be a fertile ground for coverage disputes, the resolution of disputes over property insurance sometimes can be just as perplexing to producers and their insureds.

The crux of the problem is that the interpretation of an insurance policy is a question of law left to the courts to decide. This means that if one or both sides do not understand insurance and the court can be blindsided into buying an off-the-wall argument, the result can be likened to roulette: It is anyone’s guess what the ultimate conclusion will be.

Anyone who has been in the insurance business for a while, including someone who just concluded an insurance class preparatory to producer licensing, knows the difference between a policy written on an open perils basis vs. named perils.

When a property policy is issued for open perils, coverage applies for all risks of direct physical loss or damage, except for those perils specifically excluded. When a policy is issued on a named perils basis, coverage applies only if direct physical loss or damage is caused by or results from the peril named in the policy. This difference is Insurance 101, and it is a concept that has long been part of the insurance industry fabric.

Difficulties arise when parties to litigation do not understand insurance. The result can be a hopeless mess not only for the current litigants but for others in future cases. A perfect example of this kind of situation is the recent New York case of TAG 380, LLC v. Commet 380, Inc. 890 N.E.2d 195 (Ct App. N.Y. 2008).

The dispute in this case arose in the aftermath of the September 11, 2001, terrorist attacks, just prior to the enactment of the Terrorism Risk Insurance Act of 2002 (15. U.S.C. Section 6701 Note), where both the federal government and the insurance industry share the risk of loss.

In this case, the court was asked to determine whether or not the tenant breached its long-term ground lease (commencing in 1989) by obtaining insurance coverage expressly excluding terrorism, where the lease required the tenant to maintain insurance for loss or damage by fire and other perils included under the terms of the New York Standard Fire policy and the perils of the extended coverage endorsement. (The extended coverage endorsement, which was replaced in the mid-1980s, provided coverage for loss caused by windstorm, civil commotion, smoke, hail, aircraft, vehicles, explosion and riot.)

In June 2002, the tenant obtained insurance specifically excluding any damages caused by terrorism. In fact, the tenant’s policy stated that terrorism was excluded and defined a “terrorist’s purpose” as “the use or threatened use of any unlawful means, including the use of force or violence.”

The exclusions of the tenant’s policy also stated that it did not cover any peril caused by terrorists “whether such loss or damage is accidental or intentional, intended or unintended, direct or indirect, proximate or remote or in whole or in part caused by, contributed to or aggravated by any perils insured by the policy.”

The tenant argued that the insurance it procured provided coverage for any of the named perils and thus met its obligations under the lease even though its policy excluded terrorism.

The court disagreed and, in fact, rejected the tenant’s contention that because terrorism was not specifically mentioned as a named peril, it was outside the coverage. The court’s rationale was that terrorism is not limited to a specific cause of harm, such as fire, explosion or collision with an aircraft. Instead, terrorism can describe individuals, with a common purpose, who may potentially utilize any of the lease’s named perils to cause damage to the building.

Thus, by purchasing a policy that excludes from coverage all methods potentially used by terrorists, but includes the named perils in the lease, the tenant was said by the court to have breached its lease. (Using the court’s analogy, any tenant who obtains a policy excluding war or any other excluded peril that can cause fire or explosion, for example, should likewise stand in breach.)

Conclusion

One has to wonder what persuaded the courts to produce the absurd results in the above two cases. While some courts, unfortunately, have biases for a variety of reasons, many of these decisions (commonly referred to as bad law) have their genesis with insurers that do not want to pay legitimate claims or with attorneys who want to earn an insurer’s gold star.

Often, those courts that recognize their off-the-wall decisions usually state that the decision is not to be published or is not to be relied on as precedent. In this way, the court can resolve the matter, but without adversely affecting future cases.

The point here is that producers cannot be faulted when insurance products, particularly traditional ones, are found by the courts not to be payable in the event of loss, claim or suit for some absurd reason. Producers can no better anticipate a court’s ruling than anyone else. In addition, there is little in the way of risk management that can reduce the chances of E&O claims against producers in these situations—except for insurer brochures that describe their insurance products.

The author
Donald S. Malecki, CPCU, has spent 49 years in the insurance and risk management consulting business. He currently is a principal of Malecki Deimling Nielander & Associates L.L.C., an insurance, risk, and management consulting business headquartered in Erlanger, Kentucky.