Background







Indemnity versus insurance

Recently, the scope of coverage provided to additional insuredshas become a heated issue among construction risk and insuranceprofessionals. Traditionally, contractors have routinely agreed togive indemnitees (project owners or other upstream parties)additional insured status on their liability insurance policies.Because this coverage is governed by a policy's language ratherthan the indemnity agreement, and because the policy language foryears did not restrict coverage based on any negligence of theadditional insured, indemnitees have been successful in obtainingcoverage that exceeds what they legally can transfer in theindemnity agreement. The irony of this is that while contractorsmay negotiate tirelessly for limitations in the indemnityagreement, many do not think twice about making the indemnitee anadditional insured. Unfortunately, that one act can effectivelystrip out any limitation in the indemnity agreement.

The perceived inequity in allowing insurance coverage for anadditional insured's sole negligence, when indemnification for thatnegligence is against the law, has been most intense in the generalcontractor-subcontractor relationship. The primary objection ofsubcontractors is that their policies end up getting pulled intoclaims where their connection to a loss is minimal, if any. Forexample, suppose a pedestrian is injured when a scaffold that wasto be used by a painting subcontractor collapses. The scaffold wasrented and erected by the general contractor and the paintingsubcontractor had not yet even begun its work. Nevertheless, whenthe general contractor is sued by the pedestrian, it tenders theclaim to the subcontractor's insurer based on its status as anadditional insured. Although the subcontractor did nothing tocontribute to this loss, its insurer may end up paying to defendthe general contractor against this claim and paying damagesawarded to the pedestrian. (Actual outcomes vary based on courtinterpretations of policy language, but this hypothetical scenariocould easily result in a covered claim.)

Subcontractors have begun to band together to resist contractrequirements for additional insured coverage that exceeds theallowable level of indemnity on the grounds that these requirementscircumvent state anti-indemnity laws. Currently, 41 states haveanti-indemnity statutes that place some restrictions on allowablerisk transfers in specified construction and/or design contracts.Some states forbid only the transfer of liability for one'snegligence when it is the sole cause of a loss. Others prohibit anytransfer of liability for one's negligence. These limitations arewell known and accepted, and the drafters of the constructioncontracts go to great lengths to ensure that risk transfers do notexceed permissible levels. (Alabama, Arkansas, Iowa, Kansas, Maine,Nevada, Vermont, Wisconsin and Wyoming have no anti-indemnitystatutes. Therefore, indemnification even for another's solenegligence is allowed, as long as it meets certain fair-bargainingrequirements.)

However, in many states, even though statutes prevent one partyfrom shifting some or all of its liability to another by means ofan indemnification agreement, they do not prevent one party fromrequiring another to provide insurance that will respond to theseliabilities. In other words, while it may be illegal to require acontracting party to indemnify another's contributory or solenegligence, it is not illegal to require the party to insure suchliabilities. (Missouri, for instance, specifically exemptsadditional insured requirements from its anti-indemnificationstatute.)

Over the past few years, the rationale for allowing an indemniteeto require insurance coverage that exceeds the allowable scope ofindemnity has been challenged. Some argue that this practice notonly circumvents anti-indemnity statutes, leaving upstream partiesunaccountable for their own actions, but also forces lower-tiersubcontractors to assume a disproportionate share of the projectrisks.

Legislatures and courts weigh in

Recently, there has been a push to prevent indemnitees fromrequiring indemnitors to provide them with liability insurancecoverage that exceeds the scope of allowable indemnity. Montana,New Mexico and Oregon already have enacted such prohibitions, andadditional states are considering them. (New Mexico's statutespecifically authorizes the use of owners and contractorsprotective liability insurance to respond to indemnitees' concernsabout a need for direct coverage. However, OCP coverage always hasbeen much more restrictive than additional insured coverage, andwould not respond to most claims alleging direct negligence on thepart of the indemnitee--even where indemnity for contributorynegligence is permitted.)

Several courts have addressed the issue of whether a contract'sinsurance provisions violate construction anti-indemnity statutes.Most have found that requiring an indemnitor to furnish insurancethat will respond to claims against an indemnitee do not violatethe anti-indemnity statutes, even if the insurance coverage exceedsthe allowable scope of indemnity. However, an Oregon court recentlyheld that whether an indemnitee shifts the risk of its ownnegligence by requiring an indemnitor to sign an indemnificationagreement or furnish insurance covering the indemnitee'snegligence, the result is the same [Walsh Construction Co. vs.Mutual of Enumclaw, SC S51104 (Jan. 27, 2005)]. Thus, the courtsaid, a requirement for insurance coverage that exceeds theallowable scope of indemnity violates Oregon's anti-indemnitystatute. It re- mains to be seen if other courts will adopt theOregon court's reasoning.

Additional insured coverage is trimmed

Prior to 1993, the standard ISO additional insured endorsementsprovided broad coverage, similar to that enjoyed by the namedinsured. The only significant restriction on the additionalinsured's coverage (beyond restrictions that also applied to thenamed insured contractor) was that the injury or damage must ariseout of the contractor's operations for the additionalinsured.

Over the past 12 years, as general contractors sought coverageunder their subcontractors' policies for an unprecedented number ofconstruction-defect claims, insurers have slowly chipped away atthe coverage provided to additional insureds. In 1993, ISO revisedits standard endorsements to apply only to injury or damage arisingout of the contractor's ongoing operations for the additionalinsured. That is, an additional insured's coverage was limited toclaims alleging injury or damage that occurred during the course ofconstruction, which effectively removed coverage for manyconstruction-defect claims.

Many owners and contractors got around the completed-operationslimitation by stipulating in their contracts and subcontracts thatadditional insured status would be provided on the 1985 edition ofthe standard endorsement. In the soft market of the 1990s, insurerswere largely willing to comply with this request.

As construction-defect litigation soared, and the insurance marketin general began to tighten, many insurers began using morerestrictive nonstandard additional insured endorsements that notonly eliminated completed-operations coverage but also imposedrestrictions on coverage for claims alleging direct negligence onthe part of the additional insured (i.e., general contractor). In2004, ISO followed suit by revising its standard additional insuredendorsements to require contributory negligence on the part of thenamed insured (i.e., subcontractor) for the additional insured'scoverage to apply. The net impact of the ISO endorsement changes isa loss of coverage for injury or damage caused solely by theadditional insured's negligence. An optional endorsement similarlymodifies the definition of "insured contract" to requirecontributory negligence on the part of the insured contractor forthe policy's contractual liability coverage to apply. With thisendorsement attached, coverage for broad-form indemnity(indemnifying a party for its sole negligence) is eliminated, evenwhere allowed by statute.

Conclusion

As previously mentioned, the most intense controversy over thescope of additional insured coverage is between general contractorsand subcontractors. To be sure, the existence of broad additionalinsured coverage causes subcontractors to get pulled into claimswhen their connection to a loss is negligible. Still, strongarguments can be made for allowing this practice.Construction-defect claims aside, general contractors argue thatbecause they have deep pockets, they are going to be brought intoalmost any claim involving a subcontractor's injured employee. Andbecause of restrictions on an injured worker's ability to sue one'sown subcontractor employer (where workers compensation applies),the claim against the general contractor is always going to allegesome form of direct negligence. General contractors say thatgranting them additional insured status is the best way to ensurethey receive a direct defense for such claims.

Many construction risk professionals expect these new restrictionsto increase insurers' overall costs, mainly due to increasedlitigation. Addition-al insureds (and their CGL insurers) willfight long and hard to establish contributory negligence on thepart of the named insured contractor (i.e., the subcontractor).Many general contractors say that they will continue to requirebroad additional insured coverage, forcing subcontractors to eitherpressure their insurers to provide it, self-insure it or facebreach-of-contract claims. For many subcontractors, the firstalternative is not an option, as they lack the muscle to persuadetheir insurers to provide the broader coverage--and manysubcontractors don't want them to do so, anyway.

Ann Hickman is the principal research analyst for the InternationalRisk Management Institute's Construction Risk Management reference,the curriculum director for IRMI's Construction Risk Conference andauthor of the contractual risk transfer course for the ConstructionRisk and Insurance Specialist (CRIS) program. For more informationabout IRMI and its programs, visit www.IRMI.com.