Builder's Risk Insurance: Part Five

AUTHOR: JIM LOBB, BEST LAWYERS© 2017 REAL ESTATE “LAWYER OF THE YEAR” FOR LOUISVILLE.

Do not assume your builder’s risk policy covers defective workmanship – check your state’s case law!

A Builder’s Risk Insurance policy may contain language in the insuring agreement that it “insures against all risks of physical loss or damage to the subject matter here insured.”[1] However, a commercial general liability policy often uses a much narrower insuring agreement, such as: “We will pay those sums that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damage’ to which this insurance applies.“[2]

As discussed earlier, Builder’s Risk Insurance policies are often referred to as “all risks” policies,[3] which differ from the much narrower insuring agreements commonly found in commercial general liability policies.[4] As a consequence, a Builder’s Risk Insurance policy generally covers a much narrower policy period for a specific project, and generally coverage ends when the project is complete. In contrast, a commercial general liability policy will continually provide narrow coverage for every renewed policy period, and may provide coverage for events that happened in earlier periods that do not cause damage until many years later.[5] The two insurance forms work together much like an accordion, with concentrated coverage for the property provided for a project through a Builder’s Risk Insurance policy and narrower coverage provided to the named insured upon a project’s completion, in the event the named insured is found to be liable to a third party as a result of actions relating to the project. Thus, a wise real estate attorney advising an owner on a new transaction will recommend acquiring both policies before a single shovel hits the ground

The wise real estate attorney in this instance should also strongly consider obtaining an Owner’s and Contractors Protective policy.  This standalone policy is designed to give the owner protection against losses resulting from the contractor’s activities or resulting from the owner’s actions related to the supervision of the contractor’s activities.

However, these policies have a universal theory that guides their underwriters: the doctrine of fortuity.

As the Kentucky Supreme Court explained in Cincinnati Ins. Co. v. Motorists Mut. Ins. Co.,[6] when interpreting the provisions of a commercial general liability policy, a Court must keep in mind that an insurance policy provides coverage for a “fortuitous event”[7]:

Indeed, ‘the fortuity principle’ is central to the notion of what constitutes insurance … ‘ Although we have used the term ‘fortuity’ in the past, we have not fully explored its breadth and scope. In short, fortuity consists of two central aspects: intent, which we have discussed in earlier opinions, and control, which we have not previously discussed. We recently recognized that the concept of fortuity is ‘inherent in all liability policies,’ and explained that a loss was fortuitous if it was ‘not intended. ... ‘ …. For an event to be truly fortuitous, it must, of course, be accidental because the policy only covers occurrences that are accidents. … Or, in other words, a court must bear in mind that a fortuitous event is one that is ‘beyond the power of any human being to bring … to pass, [or is] … within the control of third persons … ‘ It is abundantly clear, therefore, that the issue of control is encompassed in the fortuity doctrine.[8]

Keep in mind that while this decision discussed a liability policy as opposed to a property policy, the reasoning may still be applicable as this doctrine flows with the general theory of insurance. Some courts have also held that this doctrine of fortuity underlies “all risks” policies as well.[9]

In the aforementioned Cincinnati Ins. Co. case, the insured was a homebuilder who sought coverage under a commercial general liability policy for a claim of defective workmanship.[10] The Court held that the policy only provided coverage for fortuitous events:

Cleary, Elite had control over the construction of the Mintmans’ home, either directly or through the subcontractors it chose. One cannot logically say, therefore, that the allegedly substandard construction of the Mintmans’ home by Elite was fortuitous, truly accidental event. This leads to the inevitable conclusion that the faulty workmanship claim at issue is not covered by the CGL policy Elite purchased from Motorists because the faulty workmanship was not an accidental occurrence.[11]

Ultimately, the faulty workmanship was held to not be an “accident,” which was required to trigger coverage under the commercial general liability policy.[12]

By extension, an insured who purchased a Builder’s Risk Insurance policy that is an “all risks policy” that applies to property may expect to have broader coverage for faulty workmanship – but courts have sometimes applied similar reasoning when interpreting these types of policies.

In Trinity Industries, Inc. v. Insurance Co. of North America,[13] the Fifth Circuit considered whether a Builder’s Risk Insurance risk policy provided coverage for repair/replacement costs due to the insured’s faulty workmanship.[14] The Court drew a distinction between cases where the defective workmanship caused a resulting accident, and cases where the insured sought to recover solely for the costs of fixing the faulty work:

We are mindful of the many cases that have found defective workmanship to be a risk covered by all risk policies. These cases, however, have dealt with an accident caused by defective workmanship, not with the cost of repairing or replacing defective workmanship. … In our case, the faulty workmanship, the twist, has not led to any such accident. In fact, in all of the cases cited by plaintiff, and that we have found, on this issue, faulty workmanship or design led to a discrete event that a reasonable person would call an accident.[15]

In essence, an attorney advising a property owner should never assume that a Builder’s Risk Insurance policy issued in a particular state will offer coverage for losses attributable solely to faulty workmanship. If necessary, seek counsel with an insurance attorney on how these insuring agreements have been interpreted in a particular state. If courts in your state have not considered defective workmanship to be covered, a wise property owner should not rely on a Builder’s Risk Insurance policy to cover costs of a contractor’s faulty work and may also consider requiring the contractor to provide a performance bond.

A performance bond works for the protection of the owner of the property, not the contractor.[16] Usually the contractor will be the principal of the bond and the owner will be the obligee, and the surety for the bond will issue it using a process very similar to making a loan.[17] The bond operates as a guaranty of the contractor’s financial ability to construct the project.[18] If the contractor’s faulty workmanship led to expensive repairs that a contractor could not cover financially, the surety may be obligated under the bond’s terms to pay for the losses. The bond thus provides an additional layer of protection to the owner of the property that the owner will hopefully not suffer a financial loss due to the contractor’s negligent construction.As an aside, the aforementioned cases all considered whether the insuring agreement for the policy provided coverage. However, even if the insuring agreement would otherwise provide coverage for losses due to faulty workmanship, there are various exclusions for faulty workmanship contained within some Builder’s Risk Insurance forms that Courts have held to be enforceable.[19] Therefore, even if you practice in a state where Courts have held a Builder’s Risk Insurance policy does provide coverage for faulty workmanship under the terms of the insuring agreement, an attorney should examine the insurance policy to ensure that no exclusions would otherwise deny this coverage.  In point of fact, AAIS Builder’s Risk forms include an explicit exclusion for “Defects. Errors, and Omissions.”

[1] See, e.g., Trinity Industries, Inc. v. Insurance Co. of North America, 916 F.2d 267, 269 (5th Cir. 1990)(emphasis added).

[2] See, e.g., Standard Fire Ins. Co. v. Chester-O’Donley & Assoc., 972 S.W.2d 1, 15-16 (Court of Appeals of Tennessee, 1998).

[3] See, e.g., Trinity Industries, Inc. v. Insurance Co. of North America, 916 F.2d 267, 269-70 (5th Cir. 1990)(emphasis added).

[4] See, e.g., Standard Fire Ins. Co. v. Chester-O’Donley & Assoc., 972 S.W.2d 1, 6 (Court of Appeals of Tennessee, 1998)(“General liability policies are not “all-risk policies.”)

[5] See Crossman Cmtys. Of N.C. v. Harleysville Mut. Ins. Co., 395 S.C. 40 (Supreme Court of South Carolina, 2011).

[6] Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69 (Ky. 2010).

[7] See the comments to the Restatement of Contracts § 291, which define a “fortuitous event” as one “dependent on chance.”

[8] Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69, 74-76 (Ky. 2010).

[9] See Morrison Grain Co. v. Utica Mut. Ins. Co., 632 F.2d 424, 430-31 (5th 1980).

[10] Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69, 71 (Ky. 2010).

[11] Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69, 76 (Ky. 2010).

[12] Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69, 79-80 (Ky. 2010).

[13] Trinity Industries, Inc. v. Insurance Co. of North America, 916 F.2d 267 (5th 1990).

[14] See Trinity Industries, Inc. v. Insurance Co. of North America, 916 F.2d 267, 268 (5th 1990).

[15] See Trinity Industries, Inc. v. Insurance Co. of North America, 916 F.2d 267, 270 (5th 1990).

[16] See Complex Construction Defect Claims Involving Performance Bonds and Insurance: Who Pays First? (Part 1), Patrick J. Wielinksi, June 2006, available at http://www.irmi.com/expert/articles/2006/wielinski06.aspx.

[17] See Complex Construction Defect Claims Involving Performance Bonds and Insurance: Who Pays First? (Part 1), Patrick J. Wielinksi, June 2006, available at http://www.irmi.com/expert/articles/2006/wielinski06.aspx.

[18] See Complex Construction Defect Claims Involving Performance Bonds and Insurance: Who Pays First? (Part 1), Patrick J. Wielinksi, June 2006, available at http://www.irmi.com/expert/articles/2006/wielinski06.aspx.

[19] See, e.g., Swire Pac. Holdings, Inc. v. Zurich Ins. Co., 845 So.2d 161 (Supreme Court of Florida 2003), holding that an exclusion to a builder’s risk policy for losses due to a design defect was enforceable.