Construction Defects
Does Your Insurance Cover Construction Defects?
Harold E. Johnson, W. Alexander Burnett and Katie T. Temple
State courts are split on whether commercial general liability (CGL) insurance covers property damage from defective workmanship. Here’s a primer on the split and how you can protect yourself.
Consider the following real-life scenario. An individual contracts with a general contractor to build a new house. The contractor, the named insured on a CGL policy, hires a subcontractor to install stucco onto the exterior of the house. Several years after completion of the project, extensive water damage results from defective installation of the stucco, requiring the homeowners to spend more than $500,000 to correct the defective construction and the resultant property damage to other parts of the house. The homeowners sue the contractor, which then tenders the claim to its CGL insurer. Arguing that the defective stucco installation does not constitute a covered “occurrence” under the policy, the insurer denies coverage and the contractor is left unprotected. The contractor files bankruptcy, leaving the owner to bear the burden of the defective construction. Each of the parties in this example has a stake in the contractor’s right to insurance coverage for defective work under its CGL policy. However, ther is no national consensus as to whether such coverage exists. Rather, the answer varies on a state-by-state basis.1 The jurisdictional split in authority raises certain liability concerns for owners and contractors–especially those who conduct business on a multistate or national level or frequently use subcontractors who operate across state lines. A court’s interpretation of whether defective construction constitutes an accidental “occurrence” depends on the view adopted by the jurisdiction in which the policy was delivered; and the jurisdictions vary in those views.
THE GENERAL FRAMEWORK OF STANDARD CGL INSURANCE
CGL insurance provides liability coverage designed to protect the policyholder against third-party claims for bodily injury or property damage arising out of the policy holder's business operations. The standard CGL policy contains three basic components: (1) a general grant of coverage, called the “insuring agreement”; (2) exclusions from the grant of coverage, which bar coverage for certain types of claims or osses; and (3) policy conditions and miscellaneous provisions. While CGL insurance is not a construction-specific product, most contractors, recognizing the risks inherent in the construction business, obtain this liability coverage to guard against third-party claims. Most CGL insurance policies are written on standardized forms developed by the Insurance Services Office (ISO).2
BROAD COVERAGE UNDER THE INSURING AGREEMENT.
In a CGL policy, the insuring agreement establishes the scope of coverage without regard to limitations imposed by exclusions or conditions contained elsewhere in the policy. The standard language states that the insurer “will pay those sums that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damage’” caused by an “occurrence” that takes place in the “coverage territory.” Almost all CGL policies use extremely similar if not identical language to define the terms “bodily injury,” “property damage,” and “occurrence.” The term “bodily injury” typically means “bodily injury, sickness or disease sustained by a person, including death resulting from any of these at any time.” “Property damage” is defined typically as “[p]hysical injury to tangible property, including all resulting loss of use of that property” or “[l]oss of use of tangible property that is not physically injured.” The term “occurrence” is commonly defined as an “accident, including continuous or repeated exposure to substantially the same general harmful conditions” and this definition essentially limits coverage to “fortuitous” events, or those that happen by accident or chance. It is not uncommon that CGL policies lack a definition for “accident,” requiring courts to look to the ordinary meaning and usage of the word when determining what constitutes an accident within the definition of an “occurrence.”3
EXCLUSIONS FROM COVERAGE: THE BUSINESS RISK EXCLUSIONS.
CGL insurance limits the broad scope of coverage provided under the insuring agreement by including various exclusions and conditions that shift certain risks back to the insured. Coverage disputes resulting from defective construction most often implicate the “Your Work” and “Expected or Intended Injury” exclusions. These exclusions are often referred to as the “business risk” exclusions because they purport to eliminate coverage for certain risks inherent in a contractor’s business.
Under the “Your Work” exclusion, coverage does not apply to “‘property damage’ to ‘your work’ arising out of your work or any part of it and included in the ‘products-completed operations hazard.’” The standard CGL policy defines “your work” as “[w]ork or operations performed by you or on your behalf” and “[m]aterials, parts or equipment furnished in connection with such work or operations.” Some courts have relied upon this exclusion to deny coverage for defective work, explaining that the exclusion reflects a key principle of the “business-risk doctrine”–a contractor should be held responsible for the quality of its own work.4
The “Your Work” exclusion however, includes a subcontractor exception that may place any damaged work that is performed by a subcontractor on the insured’s behalf outside the scope of the exclusion. Nonetheless, as explained below, courts are split as to whether the subcontractor exception establishes a right to coverage for construction defect claims that would otherwise be excluded.
The “Expected or Intended Injury” exclusion reinforces the fortuity requirement inherent in the definition of “occurrence” by excluding coverage for “bodily injury” or “property damage” that is “expected or intended from the standpoint of the insured.”5 Courts have interpreted this language to mean that coverage does not apply to any property damage or bodily injury that is foreseeable to the policyholder.6
Insurers frequently invoke this exclusion for claims of property damage resulting from defective construction, arguing that the damage is a foreseeable or expected result of faulty workmanship. The contractor often responds by asserting that it did not expect or intend faulty workmanship (a reasonable argument in and of itself) and thus, the resultant property damage or bodily injury does not constitute a foreseeable result. If the property damage were the result of a subcontractor’s defective work, this may bolster the policyholder’s argument against application of the exclusion because the contractor is further removed from the work.
THE JURISDICTIONAL SPLIT OVER WHETHER CONSTRUCTION DEFECTS ARE “OCCURRENCES”
CGL coverage disputes involving claims of property damage resulting from defective workmanship are commonplace in courtrooms across America. Surprisingly, although the policies at issue in these cases often contain almost identical language by way of the standardized ISO forms, courts’ interpretations of the policies lack any such uniformity. Two primary views have emerged from the split between authorities. One line of cases, representing the majority position, generally holds that construction defects may be accidental and thus may trigger coverage for “property damage” caused by an “occurrence.” Under this view, the decisions generally fall into two schools of thought: (1) Construction defects constitute “occurrences” as long as the property damage was not expected or intended by the insured; or (2) construction defects constitute “occurrences” to the extent that property other than the work performed by the insured was damaged.
The other line of cases, representing the minority view, has reached the opposite conclusion—defective workmanship does not constitute an accident; thus, coverage does not apply to property damage arising from defective construction. Within the minority position, three secondary schools of thought have emerged: (1) Construction defects do not constitute “occurrences” because they are not “accidents”; (2) construction defects do not constitute “occurrences” because to apply coverage would impermissibly transform CGL insurance into surety or performance bonds; or (3) construction defects do not constitute “occurrences” because they arise out of intentional acts and any resultant damage is therefore a foreseeable consequence.
Jurisdictions are split on whether the definition of occurrences includes construction defects, with many courts increasingly overturning precedent and finding in favor of contractors who see their CGL insurance as a backstop for any unforeseen damages.
See a survey of cases from various jurisdictions following the majority or minority rule in the footnotes following this article.
COURTS HOLDING CONSTRUCTION DEFECTS CONSTITUTE “OCCURRENCES.”
Recent decisions reflect the growing trend among states to adopt the position favoring broader coverage. The Supreme Court of West Virginia’s recent decision in Cherrington v. Erie Ins. Prop. & Cas. Co. illustrates the reasoning generally applicable to the majority view. In Cherrington, the plaintiff hired a general contractor to build a new home. The contractor, who was the named insured on a CGL policy, used a subcontractor to perform a substantial amount of the construction. After completion of the project, the homeowner discovered defects in the house. These included an uneven concrete floor, water seeping through the roof and chimney, a sagging support beam, and cracks in the drywalls throughout the house. The homeowner sued the contractor and the contractor tendered the claim to its insurer; however, the insurer denied coverage.
The Supreme Court of West Virginia reversed longstanding precedent and held that the CGL policy did cover the property damage. Discussing the occurrence requirement, the court emphasized that its earlier case law was “incongruous with the policy’s express language providing coverage for the acts of subcontractors.”8 In a complete reversal from its previous holdings, the court held that construction defects can constitute an occurrence unless the claimed damages or injuries are “deliberate, intentional, expected, desired, or foreseen.”
The court found that the “Your Work” exclusion, by its plain language, excludes coverage for any work done by the insured, but this does not apply to work performed by subcontractors, as clearly expressed in the subcontractor exception. The court reasoned that when a general contractor becomes liable for property damage resulting from a subcontractor’s defective workmanship, the primary purpose of the subcontractor exception is to preserve coverage otherwise negated by the “Your Work” exclusion. The court also determined that the lower court improperly applied two other “business risk” exclusions to exclude coverage—the “Impaired Property” and “Product Recall” exclusions.
The Cherrington decision demonstrates the fundamental points that courts use to support a finding of broader coverage: (1) Contractors do not intend their work product to be faulty or defective, nor do they expect their work to result in property damage; so defective workmanship constitutes an “accident” within the meaning of the term “occurrence.” (2) To hold that the “Your Work” exclusion applies to eliminate coverage for a subcontractor’s defective workmanship would directly contradict the express language of the “subcontractor exception,” rendering the exception superfluous. (3) Contractors have a reasonable expectation that CGL coverage applies to third-party claims for property damage resulting from construction defects because a contractor’s liabilities commonly will involve or relate to their construction work.
COURTS HOLDING CONSTRUCTION DEFECTS DO NOT CONSTITUTE “OCCURRENCES.”
The states that have maintained the minority position generally hold that coverage does not apply to defective construction claims on the ground that faulty workmanship does not constitute an “accident” within the definition of “occurrence.” Courts in these states typically do not distinguish between construction defects that are a product of the policyholder’s own faulty workmanship and defective construction that was performed by the insured’s subcontractors.9
Although the common law definitions of “accident” reflect some variations from state to state, they generally incorporate the concept of fortuity–an accident is something that is unexpected, unintentional, or happens by chance.
The Supreme Court of Kentucky, for example, heavily relied on the fortuity doctrine to guide its application of the ordinary meaning of “accident” to the facts of the case.10 Noting that control and intent are both fundamental aspects of the concept of fortuity, the court recognized that it would be a rare case indeed where a contractor subjectively intended to build a defective work product. The court emphasized, however, that because a contractor maintains control over a construction project, any argument that defective workmanship that occurred during construction is a “fortuitous, truly accidental, event” and thus a covered “occurrence” must fail. Similarly, the court rejected the argument that “any claim of poor workmanship would fall within the policy’s definition of an accident occurrence so long as there was not proof that the policyholder intentionally engaged in faulty workmanship.” The court explained that such a conclusion would turn CGL policies into performance bonds or guarantees.
Other courts have reached similar conclusions, emphasizing that CGL insurance “is not intended to substitute for a contractor’s performance bond, the purpose of which is to ensure the contractor against claims for the cost of repair or replacement of faulty work.”11 Further, a subcontractor’s faulty or defective workmanship constitutes a business risk for which CGL insurance is not intended to provide coverage.12
SUGGESTED PRACTICES FOR HANDLING COVERAGE FOR DEFECTIVE WORK
The split in how different states interpret CGL coverage for construction defects creates substantial uncertainty for contractors and exposes them to potential liabilities for which they may not be prepared. While there is no foolproof way to navigate the murky waters related to these issues, careful attention to the evolving insurance trends and the terms of insurance contracts can help reduce the risk of uninsured exposure for construction defects.
First, both project owners and contractors should become familiar with the laws regarding CGL coverage for construction defects in the various states where they operate. Additionally, contractors should contact their attorneys and insurance brokers regularly to make sure they learn about changes in insurance laws that might affect them. Contractors should also discuss their CGL policy with their insurance brokers to try to eliminate any gaps in insurance coverage in the event of a loss or defective work claim. Contractors located in states that hold the minority view (that CGL policies do not cover construction defect claims) may be well served to supplement
their CGL insurance with builder’s risk insurance, professional liability insurance, or other types of coverage, either through endorsements to a CGL policy or via independent policies. Owners and developers should take similar steps prior to commencing any new projects to ensure there will be insurance coverage in the event of a construction defect.
Second, whenever possible, owners and contractors should require all contractors downstream to obtain performance bonds and warranty bonds. A performance bond assures that a contractor will perform the terms of its contract and protects the owner and any upstream contractors from financial loss, up to the value of the bond's penal sum, should the contractor fail to perform the contract in accordance with its terms and conditions. A warranty bond (also known as a maintenance bond) assures that a contractor will uphold the terms of its warranty during the specified warranty period. The surety company issuing the bond will add another layer of protection from defects in a contractor’s work to help bridge gaps in insurance coverage–or in the event that a contractor files bankruptcy.
Finally, owners and contractors should always use written contracts, and they should ask their attorneys to update their contract forms regularly to stay current with trends in insurance law. Rather than simply requiring a subcontractor to carry CGL insurance, these provisions should be tailored to require downstream contractors to procure coverage for defective work. For example, it may be advisable to require the subcontractor to maintain specific types of insurance in addition to CGL coverage, such as performance bonds or builder’s risk policies that would cover the subcontractor’s defective work. This is especially true when the subcontractor is based in a jurisdiction that follows the minority rule excluding coverage for construction defects under CGL policies. All form contracts should also require contractors and subcontractors to name the owner and contractor as additional insureds under the subcontractor’s policies. And, form contracts should include language that requires subcontractors to indemnify and defend owners and contractors from the subcontractor’s negligence as well as from defects in the subcontractor’s work. Indemnification laws also vary from state to state, so attorneys must ensure that the indemnification provision does not exceed the scope of permissible indemnity in the states where the contractor operates.
By thinking through these issues at the inception of a project, owners and contractors can reduce (though perhaps not eliminate) the risk of exposure to uninsured liabilities for construction defects.
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(1) Facts similar to French v. Assurance Co. of Am., 448 F.3d 693 (4th Cir. 2006).
(2) In this article, references to policy language are taken from the standard CGL form CG 00 01 12 07, which is ISO’s most recently published form.
(3) (ISO Form CG 00 01 12 07 at Section I, 1.a.)
(4) (See, e.g., Auto-Owners Ins. Co. v. Home Pride Cos., Inc., 268 Neb. 528, 537, 684 N.W.2d 571, 579 (2004) (“The reasoning for the ‘your work’ exclusion is to discourage sloppy work by making contractors pay for the losses resulting from their own defective work and preclude transforming liability insurance into a performance bond.”)).
(5) (ISO Form CG 00 01 12 07 at Section I, 2.a.)
(6) (See French v. Assurance Co. of Am., 448 F.3d 693 (4th Cir. 2006)).
(7) (See Scottsdale Ins. Co. v. R.I. Pools Inc., 710 F.3d 488 (2d Cir. 2013) (applying Connecticut law); Cherrington v. Erie Ins. Prop. & Cas. Co., No. 12-0036, 2013 W. Va. LEXIS 724 (W. Va. June 18, 2013); Capstone Bldg. Corp. v. Am. Motorists Ins. Co., 308 Conn. 760, 67 A.3d 961 (2013)).
(8) (Cherrington v. Erie Ins. Prop. & Cas. Co., No. 12-0036, 2013 W. Va. LEXIS 724, at *35–39 (W. Va. June 18, 2013))
(9) (See Ark. Code Ann. § 23-79-155 (a)(2)(2011); Colo. Rev. Stat. § 13-20-808(3) (2010); S.C. Code Ann. § 38-61-70(B)(2) (2011)).
(10) (Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69 (Ky. 2010))
(11) (Nabholz Construction Corp. v. St. Paul Fire & Marine Ins. Co., 354 F. Supp. 2d 917, 922 (E.D. Ark. 2005); see also Kvaerner, 589 Pa. at 335, 908 A.2d at 899).
(12) (Bennett & Bennett Constr., Inc. v. Auto Owners Ins. Co., No. 27284, 2013 S.C. LEXIS 170 (S.C. July 17, 2013))
*States that follow the Majority rule: See K & L Homes, Inc. v. Am. Family Mut. Ins. Co., 2013 ND 57, 829 N.W.2d 724, 736 (N.D. 2013); Am. Empire Surplus Lines Ins. Co. v. Hathaway Dev. Co., 288 Ga. 749, 752, 707 S.E.2d 369, 372 (2011); Sheehan Constr. Co. v. Cont’l Cas. Co., 935 N.E.2d 160, 171-72 (Ind. 2010), modified on other grounds, 938 N.E.2d 685 (Ind. 2010); Architex Ass'n, Inc. v. Scottsdale Ins. Co., 27 So. 3d 1148, 1162 (Miss. 2010); Revelation Indus. v. St. Paul Fire & Marine Ins. Co., 2009 MT 123, 350 Mont. 184, 199, 206 P.3d 919, 929 (2009);
United States Fire Ins. Co. v. J.S.U.B., Inc., 979 So. 2d 871, 888 (Fla. 2007); Columbia Mut. Ins. Co. v. Epstein, 239 S.W.3d 667, 672-73 (Mo. Ct. App. 2007); Travelers Indem. Co. of Am. v. Moore & Assocs., Inc., 216 S.W.3d 302, 308 (Tenn. 2007); Lamar Homes, Inc. v. Mid-Continent Cas. Co., 242 S.W.3d 1, 4 (Tex. 2007); Lee Builders, Inc. v. Farm Bureau Mut. Ins. Co., 281 Kan. 844, 859, 137 P.3d 486, 495 (2006); Wanzek Constr., Inc. v. Emp’rs. Ins. of Wausau, 679 N.W.2d 322, (Minn. 2004); Am. Family Mut. Ins. Co. v. Am. Girl, Inc., 2004 WI 2, 268 Wis. 2d 16, 43-44, 673 N.W.2d 65, 78 (2004); Corner Constr. Co. v. United States Fid. & Guar. Co., 2002 SD 5, 638 N.W.2d 887, 894-95 (S.D. 2002); Lennar Corp. v. Auto-Owners Ins. Co., 214 Ariz. 255, 262-64, 151 P.3d 538, 545-56 (Ariz. Ct. App. 2007); Century Indem. Co. v. Hearrean, 120 Cal. Rptr. 2d 66, 98 (Cal. Ct. App. 2002).
*States that follow the Minority rule: See Town & Country Prop., L.L.C. v. Amerisure Ins. Co., 111 So. 3d 699, 706 (Ala. 2011); Essex Ins. Co. v. Holder, 372 Ark. 535, 540, 261 S.W.3d 456, 460 (2008); General Sec. Indem. Co. of Ariz. v. Mountain States Mut. Cas. Co., 205 P.3d 529, 535 (Colo. Ct. App. 2009); Group Builders Inc. v. Admiral Ins. Co., 123 Hawaii 142, 148, 231 P.3d 67, 73 (Ct. App. 2010); State Farm Fire & Cas. Co. v. Tillerson, 334 Ill. App. 3d 404, 777 N.E.2d 986, 991, 268 Ill. Dec. 63, 68 (2002); W.C. Stewart Constr., Inc. v. Cincinnati Ins. Co., 770 N.W.2d 850 (Iowa Ct. App. 2009); Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69, 76 (Ky. 2010); Auto-Owners Ins. Co. v. Home Pride Cos., Inc., 268 Neb. 528, 535, 684 N.W.2d 571, 577 (2004); Concord Gen. Mut. Ins. Co. v. Green & Co. Bldg. & Dev. Corp., 160 N.H. 690, 693, 8 A.3d 24, 28 (2010); Firemen's Ins. Co. of Newark v. National Union Fire Ins. Co., 387 N.J. Super. 434, 447-49, 904 A.2d 754, 762-63 (N.J. Super. Ct. App. Div. 2006) Production Sys., Inc. v. Amerisure Ins. Co., 167 N.C. App. 601, 607, 605 S.E.2d 663, 666 (N.C. Ct. App.); Westfield Ins. Co. v. Custom Agri Sys., Inc., 133 Ohio St. 3d 476, 2012 Ohio 4712, 979 N.E.2d 269 (2012); Kvaerner Metals Div. of Kvaerner U.S., Inc. v. Comm. Union Ins. Co., 589 Pa. 317, 335, 908 A.2d 888, 899 (2006); L-J, Inc. v. Bituminous Fire & Marine Ins. Co., 366 S.C. 117, 123, 621 S.E.2d 33, 36 (2005); Hotel Roanoke Conference Center Comm’n v. Cincinnati Ins. Co., 303 F. Supp. 2d 784, 786-89 (W.D. Va., 2004).
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