Thus far, the discussion in this book has covered both prime construction contracts and three examples of closely related contracts: the labor agreement, purchase order agreements, and subcontract agreements. This chapter continues with insurance contracts, a fourth category of contract closely related to prime construction contracts.

Individual companies engaged in the practice of construction contracting are exposed to many risks and liabilities besides the monetary risk of performance of the construction work itself. For example, they are responsible for the health and safety of their employees while on the job, injury or property loss to third parties, loss or damage to construction work in place but not yet accepted by the owner, and loss or damage to their construction equipment. Additionally, they bear liability stemming from indemnification clauses in prime contracts, purchase orders, and subcontracts (see Chapters 5 and 7). These risks and liabilities are so large that contractors must purchase insurance policies to protect, or partially protect, themselves. Some of these policies are required by the terms of prime contracts and subcontracts or by statute. In many respects, construction industry insurance contracts are similar to those used throughout the business world. However, these contracts also contain provisions unique to the construction industry.

The primary parties to construction-related insurance policies consist of the construction contractor (the insured) and an insurance company who provides the required insurance coverage (the carrier, sometimes referred to as “the company”). Additional parties are sometimes named as additional named insureds.

The following are the important individual policies for the construction industry:

• Worker’s compensation and employer’s liability policies
• Public (or third-party) liability policies
• Builder’s risk policies
• Equipment floater policies
• Miscellaneous policies for special situations and needs

Each of these policies insures against loss from a different kind of risk or liability.

Worker’s Compensation and Employer’s Liability Policies

Virtually every state in the nation imposes a statutory liability on employers, including construction employers, in the event that their employees are injured or killed in the course of performing their employment duties. The liability is absolute and does not depend on the circumstances of an occurrence or who is at fault. The dollar amount of the liability to the employer for any specific occurrence is normally established by statute for the particular state involved.

The essence of the worker’s compensation and employer’s liability insurance contract is that the insurer agrees, for a price (the “premium”), to

Public Liability Policies

By the very nature of their work, contractors are exposed to significant potential liability for damages suffered by noncontractually-involved third parties (the general public). Depending on the nature of the project involved, these potential liabilities can be modest or of enormous magnitude. For example, building a one-story school building on the outskirts of a small country town would involve relatively little potential liability. On the other hand, performing underground utility work involving gas mains in a downtown urban location would entail great potential liability. Construction mishaps on projects of this type have resulted in explosions destroying several blocks of street, causing loss of life and millions of dollars of property damage. Construction contractors cannot afford to risk liabilities of this magnitude, so they purchase public, or third-party, liability insurance policies to protect themselves.

The essence of the public liability insurance contract is that the insurance company, in exchange for the premium, agrees to assume the liabilities of the insured contractor subject to a stated deductible amount, up to stated monetary limits of the policy. In addition to paying any judgment awarded in the event of third-party lawsuits against the contractor, the insurance company will furnish and pay for the legal defense in court of such suits.

It is important to understand that public liability insurance (often called comprehensive liability insurance or comprehensive general liability insurance) protects the insured contractor from the claims of third parties only, as distinct from claims of the owner who is one of the parties to the construction contract. Contractors have occasionally attempted to use comprehensive general liability insurance policies to cover the costs for making good any defective contract work performed by them or by their subcontractors. The following two court decisions demonstrate the futility of such attempts.

In the first case, a general contractor for a condominium project in Florida subcontracted the furnishing and erection of prestressed concrete. The subcontract provided that the subcontractor would be covered by a comprehensive general liability policy obtained by the general contractor. Two years after completion of the project, the owner sued the general contractor for breach of contract due to several construction defects. The general contractor settled the suit with the owner and then sued the subcontractor whose prestressed concrete work was part of the defective work. The subcontractor argued that they were protected by the comprehensive general liability policy. The District Court of Florida rejected this argument stating:

If insurance proceeds could be used to pay for repairing and/or replacing of poorly constructed products, a contractor or subcontractor could receive initial payment for its work and then receive subsequent payment from the insurance company to repair and replace it. Equally repugnant on policy grounds is the notion that the presence of insurance obviates the obligation to perform the job initially in a workman like manner.^[1]

In the second case, a Minnesota court ruled similarly but even more forcefully. The owner of a newly constructed high-rise apartment building sued the general contractor because masonry walls on the completed project were cracking and spalling. As procured by the general contractor, the comprehensive general liability policy included an endorsement that explicitly excluded coverage for property damage to work constructed by the general contractor, but a similar exclusion for work constructed by others “on behalf of” the general contractor had been deleted from the policy. The masonry work was constructed “on behalf of” the general contractor by a masonry subcontractor. Even so, the Minnesota Supreme Court ruled that the coverage of the policy did not apply to defects in the constructed work of the project, no matter by whom it was constructed.

In defense of the owner’s lawsuit for breach of contract due to the defective masonry walls, the general contractor argued that although the insurance policy did not cover the defective walls if they had constructed the walls with their own forces, the deletion of the phrase “on behalf of” meant that the policy did cover defects in work constructed by their subcontractor. The court rejected the argument that the cost of making good any defects in the subcontractor’s work was covered by the policy, concluding instead that general liability insurance policies do not protect contractors or subcontractors against contractually assumed business risks such as failure to complete a project properly.^[2]

Clearly then, comprehensive general liability insurance policies only protect the insured against the claims of third parties who have been injured or whose property has been damaged in some way by construction activities related to the referenced project.

Normal Liabilities That Are Covered

The liabilities assumed by the insurer are limited to the risk of loss or injury to third parties only, usually caused by any or all of the following:

• Construction operations at the project site
• Ownership, operation, or use of the site itself
• Operations of the insured’s subcontractors
• Automotive operations related to the work at the site

By endorsement, a special provision expanding coverage, the policy can be made to cover additional liabilities such as those resulting from injuries to others occurring after the project has been completed (“completed operations” coverage) and liabilities flowing to the insured because of some separate contract that is related to the prime contract.

Most contractors prefer the second method since, if the estimated labor for the project should overrun, the contractor at least avoids being doubly penalized by paying more for third-party liability insurance.

Contractors can often obtain lower premium charges for public liability insurance by arranging a “retro” insurance policy with their insurance carrier. Under this arrangement, more favorable premium rates are offered for a low claim/loss record for previous years, whereas an unfavorable claims/loss record will cause future premiums to rise. This system is similar to the premium modifier system used on worker’s compensation insurance, previously discussed.

Definition of Occurrence

The term occurrence has special meaning in the insurance industry. An occurrence is an event that gives rise to a claim that the insurance company must pay. Ordinarily, the occurrence is an accident from the point of view of the insured. There are some limits on the type of event that can constitute an occurrence under the terms of the policy. To constitute an occurrence, the event must be something that was neither “intended” nor “expected” by the insured. For example, a contractor who failed to take precautions against gravel spilling from trucks in a haul operation over public roads, knowing that the gravel would spill but counting on insurance to cover the cost of any broken windshields that would result, may find the insurance company refusing to pay claims for broken windshields on the grounds that the contractor “expected” the gravel to spill and, by doing nothing to prevent it, “intended” that the gravel would spill.

Along these same lines, once a particular occurrence has taken place, the insured has a duty to do everything reasonably possible to ensure that the same occurrence does not happen again. If it does reoccur and the insured cannot show that everything reasonably possible was done to prevent the reoccurrence, the insurance company is not likely to pay.

P & I Policies

Public liability policies covering marine operations are called protection and indemnity policies (P & I policies). They operate in essentially the same way as third-party policies covering land-based operations.

Builder’s Risk Policies

A third major type of construction insurance policy is builder’s risk insurance, sometimes called “installation floater” insurance. According to the terms of most prime contracts, the risk of physical loss to construction work put in place by a contractor rests with the contractor until the work is completed and accepted by the owner. This risk can be enormous in dollar terms. Builder’s risk insurance can be obtained to cover all or part of this risk.

The essence of a builder’s risk policy is that the insurer, for a price (the premium), agrees to assume the risk of physical damage to or loss of work in place and will pay the insured contractor the value of the work that was lost or damaged, subject to any agreed deductible, up to the monetary limits of the policy.

Reasons for Carrying Builder’s Risk Insurance

Many prime contracts require the contractor to carry builder’s risk insurance with stated minimum monetary limits. In this case, the contractor has no choice and must obtain the insurance. A contractor who has the option usually evaluates the risk, compares the costs and probability of occurrence of possible losses against the certain cost of the policy premiums, and makes the decision on that basis. Obviously, the nature of the project is a major influence on the decision. A contractor whose contract consisted solely of constructing a large pedestal-type concrete foundation for a steam turbine at an open rural site would be exposed to virtually no risk of loss, but if the project consisted of a multi-story, wood, low-cost housing complex in a congested urban setting, the exposure to risk would be relatively high.

The more costly that builder’s risk coverage becomes, the more it becomes a factor in competing for construction work. Wealthy companies possess the ability to “self-insure,” and in cases in which the contract documents do not require the contractor to carry builder’s risk insurance, these companies have a cost advantage over smaller companies who must purchase the insurance to avoid catastrophe in case of a loss.

Equipment Floater Policies

The fact that builder’s risk policies exclude construction equipment leads to the fourth major kind of construction insurance called equipment floater insurance. This type of policy protects the contractor against physical damage or loss to tools and construction equipment (including theft). On many kinds of construction projects, the contractor’s tools and equipment can be exposed to considerable risk of loss or damage. In this type of insurance contract, the insurance company agrees to make good any loss or damage to the contractor’s equipment subject to any agreed deductible up to the policy limits. Equipment floater policies, like builder’s risk policies, can be all risk policies or may insure only against certain named perils. All risk policies are more common.

Method of Determining Loss

The policy stipulates the method of determining the value of a total loss to the contractor’s equipment. Commonly used methods include the following:

• Under the replacement value method, the insurer will pay the cost of replacing the lost unit with an equivalent new unit.
• Under the book value method, the insurer will pay only the depreciated value of the unit on the contractor’s books at the time of the loss.
• Under the pre-agreed value method, the insurer will pay a value pre-agreed by the parties and stated in the policy for each unit of equipment insured.

The book value method is more common.

Premium Structure

Equipment floater insurance premiums are usually reckoned as a percentage of the value of the covered equipment per year (usually the book value). As the equipment depreciates, the book value is less, and the premiums decline.

Equipment Floater Insurance for Marine Equipment Operations

Equipment floater insurance is called hull insurance when it covers permanently floating marine equipment, such as barges, tugs, and dredges. When land-based equipment is working from barges on water—for example, a crawler crane working from crane mats on a barge deck—the equipment on the barge is normally insured under the equipment floater policy, but at a higher premium for the time that the equipment is on the water. The barge would be covered by a separate hull insurance policy.

Evaluating the Need for Equipment Floater Insurance

A final point on equipment floater insurance concerns the need for the insurance. The chances of damage or loss for certain kinds of equipment may be relatively high, whereas, for others, it is virtually nil. For example, contrast the previously mentioned example of the crawler crane operating on crane mats on a flat-decked work barge on a river bridge crossing with a service crane in the contractor’s home-base shop or yard complex. The former certainly would be insured, whereas the latter probably would not. The need for insurance is highly project-specific and use-specific. When the purchase of new equipment is financed by pledging the equipment as collateral for the loan, the lending institution will insist that the equipment be insured to its full value.

Miscellaneous Policies for Special Situations

A final construction insurance category consists of the miscellaneous construction insurance policies that are sometimes obtained by construction contractors. Chief among these are:

• Railroad protective insurance (usually required when working over or near a railroad right-of-way), in which the railroad is insured against loss caused by contractor’s operations.
• Transit insurance, which covers loss or damage when items are being transported (refer, for instance, to the TBM incident related in Chapter 7).
• Business interruption insurance, which is intended to cover the costs incurred by a contractor when normal business is interrupted by some event beyond the contractor’s control. This type of insurance is seldom purchased because it is so expensive.
• Fidelity and forgery insurance, which is intended to replace losses due to malfeasance in the office place by a contractor’s own employees, such as theft or forgery—that is, so-called “white collar” crime.

Owner-Provided Insurance Programs

Owner-provided insurance programs sometimes provide all or part of the insurance policies required for a project free of charge to the contractor. The project bidding documents will include the scope of the insurance coverage provided. For instance, the AIA form of contract provides that the owner will provide builder’s risk insurance for the full value of the contract work. It is not uncommon for large public owners to provide a complete package consisting of worker’s compensation insurance, major public liability insurance, and builder’s risk insurance. This latter arrangement is often called a “wrap-up” insurance program.

Under this arrangement, the contractor excludes from the bid all premium costs for the insurance designated to be provided by the owner, including premium monies only for insurance policies required by law or by the terms of the contract that the owner is not providing. The bid may also include the premium costs for any additional insurance that the contractor considers necessary on and above that provided by the wrap-up program.

Contractors generally do not favor owner-provided wrap-up insurance. They prefer to control the insurance procurement process so they can benefit from the bargaining power derived from a favorable claims/loss history and their past relationships with a particular insurance company. Under owner-provided wrap-up insurance arrangements, contractors with low claims or loss experience lose the benefit of their superior past performance.

“Red Flag” Insurance Provisions

As with all contracts, insurance policies contain certain provisions that are particularly important to both construction contractors and their insurance carriers. An adequate comprehension of the protection actually provided by the policy is impossible unless these provisions are completely understood; hence, the following discussion of the principal “red flag” clauses.

Named Exclusions

Probably the most important of all of the “red flag” provisions is the named exclusion section of the contract. This section includes a clear statement of the particular risks and hazards that are excluded from the coverage of the policy; however, insureds sometimes overlook important exclusions simply because they do not read the policy carefully.

Subrogation

Another “red flag” clause concerns subrogation. An insurer who has been granted subrogation rights literally “stands in the insured’s shoes” with regard to any right or remedy that the insured may have against the party who was at fault causing claims to be made. This means that once the insurance company has paid a claim or judgment entered against the insured, they are free to attempt to recover the money paid by suing (in the name of the insured) the original party at fault. They have this right whether the insured wants its name to appear in such a lawsuit or not. Contractors may not want to be named as plaintiffs in lawsuits in which they no longer have a direct interest. If this is the case, it is important when they consider a potential insurance contract to note whether or not the insurance company has been granted subrogation rights.

Policy Cancellations

Finally, insurance policies normally contain provisions establishing the right of the insurance company to unilaterally cancel the policy prior to the expiration of the normal term. The contractor must be sure this clause also requires the insurance company to give adequate notice before canceling so the contractor will have a reasonable opportunity to canvas the market and replace the insurance at a reasonable premium.

Recent Trends in the Construction Insurance Industry

The insurance industry has changed significantly in recent years. Two examples occurring in the mid-1980s were the emergence of the claims-made policy and a dramatic increase in premium levels coupled with reduced coverage. Fortunately, from the construction contractor’s point of view, both trends were decreasing by the mid-1990s.

Claims-Made v. Occurrence Policies

The traditional form of insurance policy is the occurrence policy. The insured is covered if the occurrence giving rise to the loss takes place within the term of the policy, even though the claim with respect to the loss is made after the expiration of the policy. Claims or lawsuits commonly are initiated several years after the event causing the loss occurred, often after the project has been completed and the policy has expired. Occurrence policies cover this situation, as long as the event giving rise to the loss and to the claim occurred during the policy period.

In the mid-1980s, the insurance industry aggressively promoted a different type of policy called a claims-made policy. In this form of coverage, the insurer is liable only when both the event giving rise to the claim and the claim itself occur during the policy term. If the actual claim is not made during the policy period, the policy will not cover it, even though the event giving rise to the claim occurred during the policy period. Contractors have no way to control when third parties may decide to file claims and are thus at considerable risk under this type of policy. Under a claims-made policy, contractors cannot meet prime contract indemnification requirements without putting their entire companies on the line. Although the trend toward claims-made policies is currently on the wane, contractors should be alert to their existence and note this aspect of policy coverage provisions carefully.

Premium Escalation and Diminished Coverage

The mid-1980s also saw a marked escalation in insurance premiums. The increases far exceeded price increases generally, and many smaller contractors were driven out of business. Even some larger companies experienced severe difficulties. For example, prior to 1985, one large contractor bought public liability insurance in a combined policy covering all of its projects for a premium of about 0.6% of the company’s total annual labor exposure (the total yearly labor cost expenditure for all of the company’s projects). The total annual labor exposure was about $15,000,000, so the annual premium was $90,000 ($15,000,000 times 0.006). The limit of the third-party liability coverage was an aggregate amount of $30,000,000.

By 1987, the same company paid 5% of its total labor exposure for only one-third the coverage. This meant that the annual premium increased to $750,000 ($15,000,000 times 0.05), and coverage decreased to an aggregate amount of $10,000,000. Builder’s risk insurance premiums increased about the same. Fortunately, insurance premiums have since abated.

Conclusion

This chapter discussed the general need for construction contractors to protect themselves from various kinds of losses by purchasing insurance policies. The common insurance policies in use in the construction industry today were listed, followed by a discussion of the kinds of protection provided by each policy and details of how the policy generally operates. The principal “red flag” clauses pertaining to insurance policies in general were briefly discussed, followed by a brief examination of some recent trends in the construction insurance field.

Chapter 9, on the subject of surety bonds, will round out this book’s discussion of closely related contracts that arise or result from the existence of prime construction contracts.

Questions and Problems

1. What are the five general categories of insurance contracts discussed in this chapter?
2. What is the essence of a worker’s compensation and employer’s liability insurance contract? Can a worker who has been injured on the job sue the employer for damages? Who can be sued? Explain the two separate kinds of liability involved. Which of these liabilities is statutory, and which is contractual?
3. What is the function of a state worker’s compensation commission?
4. What is the general import of the Longshoremen’s and Harbor Worker’s Act? The Jones Act? Are these state or federal laws? What is their relationship to state worker’s compensation laws? Which is more favorable to the worker? In what way? Can a worker receive benefits under the Longshoremen’s and Harbor Worker’s Act and state worker’s compensation laws simultaneously? Are the insurance premiums under the Longshoremen’s and Harbor Worker’s Act and the Jones Act higher or lower than those for coverage under most state worker’s compensation laws?
5. How are premium payments for worker’s compensation and employer’s liability policies usually reckoned? How is this done in the state of Washington? Which is better from the standpoint of a contractor employing union labor in a high wage rate area? Why? What two factors influence how high the basic premium (before application of a rate modifier) will be? Are the differences in premiums that could result from the first factor great or small? How great? How about the premium differences resulting from the second factor? What is a rate modifier? Can it have a significant effect on a contractor’s competitive position? How?
6. Hypothetical contractor A performs an annual construction volume of work containing a labor component of $15,000,000at the base pay level—that is, excluding union fringes and all forms of insurance premiums and taxes. Their average worker’s compensation insurance premium is $19.00 per $100 of payroll (calculated on base pay). Their experience modifier is 0.72. Hypothetical contractor B performs the same annual volume with the same labor component and same average worker’s compensation insurance premium rate, but their experience modifier is 1.45. What is the dollar difference in annual total worker’s compensation insurance premiums paid by contractors A and B?
7. What is the essence of a public liability or third-party liability insurance policy? Who are the beneficiaries under this kind of insurance? Do risks covered by this kind of insurance vary much from project to project? What were the two extreme examples discussed in this chapter? Can you think of other greatly contrasting risks that might be encountered? What about a contract for the disposal of toxic wastes from a construction site?
8. What is completed operations coverage? How may it be included in the policy? What are exclusions? What are the XCU hazards? Can they be excluded? Are they always excluded? If they are not excluded, what is the effect on the premium? What are deductibles? What relation do they have to the premium?
9. Are the monetary limits and inclusion or absence of exclusions in public liability insurance policies governed by law, or are they matters of agreement between the contractor and insurance company? What is a primary policy? An umbrella policy? What are the two different ways in which the premium for public liability insurance is reckoned? Which is the most favorable from the contractor’s standpoint? Why?
10. What is an occurrence? What is the significance of the phrase “neither intended or expected”? What duty does the contractor have with regard to the reoccurrence of an event that has resulted in a claim against the policy?
11. What is P & I insurance?
12. What is the essence of a builder’s risk policy? Does the need for builder’s risk insurance apply equally to all construction contracts? What two contrasting examples were discussed in this chapter?
13. What kind of losses are typically covered under a builder’s risk policy? What is the difference between consequential damages and proximate damages associated with a causal event? Does a builder’s risk policy respond to both? To either? If so, to which?
14. What is the difference between a named peril builder’s risk policy and an all risk policy? Can exclusions still apply to an all risk policy? If so, what are some of the common ones that might apply?
15. What is the distinction between how the errors, omissions, or deficiencies exclusion of a builder’s risk policy may be applied (depending on the wording of the exclusion language in the policy) to the insured contractor’s operations and to those of the designer when a project or portion of project is lost or destroyed during construction due to an error, omission, or deficiency? Explain the logic of this distinction.
16. What are the two ways of reckoning builder’s risk premiums discussed in this chapter? How is the premium usually stated in an insurance broker’s quotation to a contractor?
17. Is the need for builder’s risk insurance the same for different types of projects? What would be an example of a project that does not justify it? A project that does? Is builder’s risk insurance ever contractually required? Do some contractor’s “self-insure”? Which ones?
18. What is the essence of an equipment floater policy? What three methods are discussed in this chapter for determining what the policy will pay in the event of a loss? Can equipment floater insurance be a named peril or an all risk policy?
19. What is hull insurance? How is equipment floater insurance handled under one policy with respect to equipment such as crawler cranes operating from mats on floating barges as well as on dry land? Is the need for equipment floater insurance a variable, depending on the piece of construction equipment involved and the project involved? Cite some examples to illustrate your answer.
20. What are some of the types of miscellaneous insurance policies discussed in this chapter? What are the risks against which they insure?
21. What is an additional named insured? What is the relationship of additional named insureds on a public liability policy to the indemnification requirements in a prime construction contract?
22. What does right of subrogation mean with respect to an insurance contract? What is a common contractor attitude regarding an insurance company’s rights of subrogation?
23. What is an occurrence policy? A claims-made policy? Why is a claims-made policy not responsive to the needs of a construction contractor? What trends occurred in the 1980-1990 period in the insurance industry with regard to the level of premiums charged?