Additional insured status: It's not what it used to be

Recently, the scope of coverage provided to additional insureds has become a heated issue among construction risk and insurance professionals. Traditionally, contractors have routinely agreed to give 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 rather than the indemnity agreement, and because the policy language for years did not restrict coverage based on any negligence of the additional insured, indemnitees have been successful in obtaining coverage that exceeds what they legally can transfer in the indemnity agreement. The irony of this is that while contractors may negotiate tirelessly for limitations in the indemnity agreement, many do not think twice about making the indemnitee an additional insured. Unfortunately, that one act can effectively strip out any limitation in the indemnity agreement.

The perceived inequity in allowing insurance coverage for an additional insured's sole negligence, when indemnification for that negligence is against the law, has been most intense in the general contractor-subcontractor relationship. The primary objection of subcontractors is that their policies end up getting pulled into claims where their connection to a loss is minimal, if any. For example, suppose a pedestrian is injured when a scaffold that was to be used by a painting subcontractor collapses. The scaffold was rented and erected by the general contractor and the painting subcontractor had not yet even begun its work. Nevertheless, when the general contractor is sued by the pedestrian, it tenders the claim to the subcontractor's insurer based on its status as an additional insured. Although the subcontractor did nothing to contribute to this loss, its insurer may end up paying to defend the general contractor against this claim and paying damages awarded to the pedestrian. (Actual outcomes vary based on court interpretations of policy language, but this hypothetical scenario could easily result in a covered claim.)

Subcontractors have begun to band together to resist contract requirements for additional insured coverage that exceeds the allowable level of indemnity on the grounds that these requirements circumvent state anti-indemnity laws. Currently, 41 states have anti-indemnity statutes that place some restrictions on allowable risk transfers in specified construction and/or design contracts. Some states forbid only the transfer of liability for one's negligence when it is the sole cause of a loss. Others prohibit any transfer of liability for one's negligence. These limitations are well known and accepted, and the drafters of the construction contracts go to great lengths to ensure that risk transfers do not exceed permissible levels. (Alabama, Arkansas, Iowa, Kansas, Maine, Nevada, Vermont, Wisconsin and Wyoming have no anti-indemnity statutes. Therefore, indemnification even for another's sole negligence is allowed, as long as it meets certain fair-bargaining requirements.)

However, in many states, even though statutes prevent one party from shifting some or all of its liability to another by means of an indemnification agreement, they do not prevent one party from requiring another to provide insurance that will respond to these liabilities. In other words, while it may be illegal to require a contracting party to indemnify another's contributory or sole negligence, it is not illegal to require the party to insure such liabilities. (Missouri, for instance, specifically exempts additional insured requirements from its anti-indemnification statute.)

Over the past few years, the rationale for allowing an indemnitee to require insurance coverage that exceeds the allowable scope of indemnity has been challenged. Some argue that this practice not only circumvents anti-indemnity statutes, leaving upstream parties unaccountable for their own actions, but also forces lower-tier subcontractors to assume a disproportionate share of the project risks.

Legislatures and courts weigh in

Recently, there has been a push to prevent indemnitees from requiring indemnitors to provide them with liability insurance coverage that exceeds the scope of allowable indemnity. Montana, New Mexico and Oregon already have enacted such prohibitions, and additional states are considering them. (New Mexico's statute specifically authorizes the use of owners and contractors protective liability insurance to respond to indemnitees' concerns about a need for direct coverage. However, OCP coverage always has been much more restrictive than additional insured coverage, and would not respond to most claims alleging direct negligence on the part of the indemnitee--even where indemnity for contributory negligence is permitted.)

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

Additional insured coverage is trimmed

Prior to 1993, the standard ISO additional insured endorsements provided broad coverage, similar to that enjoyed by the named insured. The only significant restriction on the additional insured's coverage (beyond restrictions that also applied to the named insured contractor) was that the injury or damage must arise out of the contractor's operations for the additional insured.

Over the past 12 years, as general contractors sought coverage under their subcontractors' policies for an unprecedented number of construction-defect claims, insurers have slowly chipped away at the coverage provided to additional insureds. In 1993, ISO revised its standard endorsements to apply only to injury or damage arising out of the contractor's ongoing operations for the additional insured. That is, an additional insured's coverage was limited to claims alleging injury or damage that occurred during the course of construction, which effectively removed coverage for many construction-defect claims.

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

As construction-defect litigation soared, and the insurance market in general began to tighten, many insurers began using more restrictive nonstandard additional insured endorsements that not only eliminated completed-operations coverage but also imposed restrictions on coverage for claims alleging direct negligence on the part of the additional insured (i.e., general contractor). In 2004, ISO followed suit by revising its standard additional insured endorsements to require contributory negligence on the part of the named insured (i.e., subcontractor) for the additional insured's coverage to apply. The net impact of the ISO endorsement changes is a loss of coverage for injury or damage caused solely by the additional insured's negligence. An optional endorsement similarly modifies the definition of "insured contract" to require contributory negligence on the part of the insured contractor for the policy's contractual liability coverage to apply. With this endorsement attached, coverage for broad-form indemnity (indemnifying a party for its sole negligence) is eliminated, even where allowed by statute.

Conclusion

As previously mentioned, the most intense controversy over the scope of additional insured coverage is between general contractors and subcontractors. To be sure, the existence of broad additional insured coverage causes subcontractors to get pulled into claims when their connection to a loss is negligible. Still, strong arguments can be made for allowing this practice. Construction-defect claims aside, general contractors argue that because they have deep pockets, they are going to be brought into almost any claim involving a subcontractor's injured employee. And because of restrictions on an injured worker's ability to sue one's own subcontractor employer (where workers compensation applies), the claim against the general contractor is always going to allege some form of direct negligence. General contractors say that granting them additional insured status is the best way to ensure they receive a direct defense for such claims.

Many construction risk professionals expect these new restrictions to increase insurers' overall costs, mainly due to increased litigation. Addition-al insureds (and their CGL insurers) will fight long and hard to establish contributory negligence on the part of the named insured contractor (i.e., the subcontractor). Many general contractors say that they will continue to require broad additional insured coverage, forcing subcontractors to either pressure their insurers to provide it, self-insure it or face breach-of-contract claims. For many subcontractors, the first alternative is not an option, as they lack the muscle to persuade their insurers to provide the broader coverage--and many subcontractors don't want them to do so, anyway.

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