Construction Insurance

image: Are you Covered?Insurance recovery partner Tyler Gerking and I have co-authored an article examining two recent cases from separate California state courts that we feel correctly interpret the phrase “that particular part” as it applies to certain CGL policy exclusions, and apply it in its intended narrow sense. The rulings in Pulte Home Corp. v. American Safety Indemn. Co. and Global Modular, Inc. v. Kadena Pacific, Inc. are good news for contractors and are in contrast to some recent decisions by federal courts.

It is encouraging to see California appellate courts studying the meaning of the actual policy language, and not simply accepting insurers’ broad brush straw-man arguments about what CGL policies are, or are not, intended to cover. By comparing the actual language of exclusions against each other and comprehending what each one was intended to exclude, the Pulte Home and Global Modular courts realized that each exclusion had a specific intent, and the terms of one exclusion could not be imparted to another exclusion, nor could they all be “mushed together” to make one large, catch-all type exclusion.

Read the full article discussing the two cases.

In May, California’s Second Appellate District affirmed a summary ruling that a Commercial General Liability insurer did not have a duty to defend a subcontractor who supplied faulty “seismic tie hooks” that were encased in concrete shear walls.  The case is Regional Steel Corporation v. Liberty Surplus Insurance Corporation, Cal. Ct. App. 2d Dist. B245961, and the court has just granted Liberty’s request to certify the case for publication. 

The Second Appellate District declined to follow the “incorporation doctrine,” adopted by the First Appellate District in cases such as Armstrong World Industries, Inc. v. Aetna Casualty & Surety Co., 45 Cal.App.4th 1 (1st Dist. 1996), Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc., 78 Cal.App.4th 847 (2000).  At issue in Armstrong was the cost of removing asbestos-containing building materials, which had been installed in larger structures.  At issue in Shade Foods was a supply of ground almonds that was contaminated with wood chips, but had been incorporated into “nut clusters” for breakfast cereal.  In both cases, the First Appellate District held that the mere incorporation of these faulty products or material into third-party property constituted covered “property damage.” 

Continue Reading Newly-Published Regional Steel Case Raises More Questions Than It Answers

A new case from Oregon deals with a recurring problem in construction defect litigation—the absence of clear dates in the complaint regarding when damage is alleged to have occurred. Frequently, a plaintiff will allege that defects in a construction project have caused property damage to other elements of the project, but the complaint is often silent as to when the damage allegedly began. We have long argued that, since the duty to defend exists if there is any “potential” of covered liability, there is a potential that damage happened before that project was completed, or at any time after completion, triggering all policies in that time frame. This implicates the policies in effect both during the course of operations and after operations are completed. This point is particularly important if some or all of the policies exclude liability falling within the completed operations hazard. This was the situation in Breese Homes, Inc. v. Farmers Insurance Exchange, 353 Or. 112 (2012). There, the court rejected Farmers argument that a claim was excluded by a “products/completed operations hazard” exclusion unless the insured could produce facts showing that damage in fact occurred prior to the completion of the project. The Oregon Supreme Court ruled that the duty to defend was governed by the complaint, which clearly encompassed the possibility that damage occurred prior to completion, and that the insured had no burden to establish any additional facts to support that potential.

While Breese involves a simple and straightforward application of established duty to defend law, the case provides helpful authority in countering the specious positions taken by many carriers on this issue.

Even when carriers agree to defend an insured, policyholders and carriers can still get locked into disputes about who will provide such a defense.  Policyholders often want to choose their own counsel while a carrier has its own idea about who should defend the case.  The dispute in Travelers Property v. Centex Homes, C10-02757 (N.D. Cal. April 1, 2011) illustrates this problem and shows how a dispute over defense counsel can potentially lead the carrier to argue that the policyholder has breached its duty to cooperate and that such a breach relieves the carrier of both its duty to defend and indemnify under the policy.    

Continue Reading Harsh Result In Dispute Over Appointed Counsel

The California Supreme Court recently issued a decision in Century-National Ins. Co. v. Jesus Garcia, No. S179252, holding that California Insurance Code section 533, which bars coverage for intentional conduct, does not apply to coverage for innocent co-insureds.  The Court examined this issue in the context of a fire insurance policy.  The insureds, Jesus and Theodora Garcia, suffered substantial property damage to their home when their adult son – who was also an insured under the policy – set fire to his bedroom.  Century-National denied coverage for the Garcias’ claim citing the policy’s exclusion for claims based on the intentional acts or criminal conduct of “any insured.”  The trial court agreed and granted Century-National’s demurrer on the grounds that 1) the Century-National policy defined the term “any insured,” to include relatives of the insured who lived at the insured property; 2) courts generally interpret policy exclusions for intentional or criminal acts to exclude coverage for innocent co-insureds; and 3) Insurance Code section 533 expressly sets forth California’s public policy of denying coverage for willful wrongs. Continue Reading Section 533 Does Not Bar Coverage for Innocent Co-Insureds

In Clarendon America Insurance Company v. North American Capacity Insurance Company, E048176, 4th Dist. Ct. App. (Super. Ct. No. CIVRS701868), a new California Court of Appeal decision, the Fourth Appellate District has rejected an insurer’s attempt to apply multiple self-insured retentions to a single lawsuit.

Clarendon America Insurance Company (“Clarendon”) and North American Capacity Insurance Company (“NAC”) issued general liability insurance policies to a home builder (“Tanamera”) for two successive one-year policy periods.  Tanamera was sued by a group of individual homeowners for various alleged construction defects in one of its housing developments.  Of the 43 homes involved in the action, eight were completed during the NAC policy period (and therefore were covered by the NAC policy).

Clarendon agreed to defend the action, and ultimately settled it by paying a single lump sum to the homeowner group.  NAC, however, refused to defend or contribute to the settlement.  NAC’s policy imposed a self-insured retention (“SIR”) of $25,000 “per claim,” and NAC took the position that Tanamera had to pay a separate $25,000 SIR for each of the eight homes covered under its policy ($200,000 total).  Unless and until Tanamera did so, NAC argued, it had no duty to defend the litigation or contribute to settlement.  Clarendon sued NAC for equitable indemnity and contribution, and NAC moved for summary judgment on the basis of it SIR policy language.

The SIR provision stated, in pertinent part:

The Self-Insured Retention, shown above, applies to each and every claim made against any insured, to which this insurance applies, regardless of how many claims arise from a single ‘occurrence’ or are combined in a single ‘suit’.

The court acknowledged that on its face, this language appeared to draw a distinction between “claims” and “suits,” with a “suit” being capable of alleging multiple “claims.”  Based on this distinction, NAC argued that the term “claim” could only refer to each of the 43 homes involved in the construction defect litigation, while the term “suit” referred to the entire action.  Thus, NAC reasoned, Tanamera was required to satisfy a separate SIR for each of eight separate “claims” (the eight homes completed during the NAC policy period).

The Clarendon court, however, was not willing to take this leap.  The court observed that the term “claim” was undefined, and noted that in other places in the policy, the words “claim” and “suit” were used interchangeably.  Thus, the court could not accept the interpretation advanced by NAC as being the only reasonable interpretation of the SIR provision.  In the context of the policy as a whole and under the specific circumstances of this case, the term “claim” was subject to more than one reasonable interpretation, and therefore was ambiguous.  See E.M.M.I. Inc. v. Zurich Am. Ins. Co., 32 Cal. 4th 465, 470-71 (2004) (a case relied upon heavily by the Clarendon court).

The court went on to consider whether NAC had met its burden to show that the ambiguity should be resolved in NAC’s favor.  To do so, NAC had to establish that it would not have been objectively reasonable for Tanamera to expect that only one SIR would apply to a construction defect lawsuit involving multiple homes and multiple claimants.  See E.M.M.I. Inc., 32 Cal. 4th at 471.  The court concluded that NAC had presented no evidence below to support such a conclusion.  (Indeed, the court found support for the opposite conclusion by extrapolating NAC’s argument:  In a lawsuit involving all 450 homes covered under the policy, NAC’s interpretation would require Tanamera to pay $11.25 million in SIRs before it could access $2 million in liability limits.)

Although the Clarendon case involved a dispute among two insurers, the decision has positive implications for policyholders, who often confront this issue in coverage disputes with their insurers.  Insurers frequently attempt to leverage their policies’ SIR provisions in order to defer or entirely avoid their coverage obligations, attempting to apply multiple SIRs to a single lawsuit.  Clarendon makes clear that California courts will not permit this result unless the policy language clearly and unambiguously dictates it.

Adequate preparation is essential for any mediation, and mediations involving insurance coverage issues are no exception.  Whether the focus of the mediation is the insurance coverage dispute itself, or whether the insurer is attending a mediation of the underlying action (with an expectation that it will fund any settlement), the insured can and should take certain steps to ensure a more productive session.

1)  Select the right mediator

Only the attorneys handling the case can judge which mediator has the right style and temperament to handle their specific matter.  An additional consideration, however, should be whether the mediator has some experience with insurance coverage issues.  Like many litigators, some mediators view insurance coverage as a somewhat rarefied and obscure area of law.  A mediator with little or no insurance coverage experience may hesitate to roll up his or her sleeves, focus on the insurance policy language and the legal rules which govern its interpretation, and work out whatever coverage issues exist between your client and the insurer.

On a more practical level, a mediator with insurance coverage experience will be familiar with the carrier thought process and have a better understanding of how decisions are made within an insurance company.  Therefore, a mediator with such experience can better motivate and persuade the carrier, working through any internal hurdles to decision-making and ultimate resolution.

2)  Ensure decision-makers are in attendance

When attorneys agree to mediate, it is frequently assumed that their respective clients will attend.  Insurance companies frequently make precisely the opposite assumption, and will only send their attorneys to a mediation.  While an insurer’s unwillingness to send a representative may appear obstructionist, in part it simply reflects the reality that in-house insurance claims handlers frequently manage hundreds of files at a time, and simply can’t be in two places at once.  At the same time, anyone who has participated in a mediation attended by attorneys only knows that such sessions typically are not productive.

The best way to ensure that a fully-authorized carrier representative attend the mediation is for the insured to expressly insist upon it, and to do so early, often, and forcefully.  If you’re considering mediation, bring the carrier into the loop as soon as possible regarding scheduling.  Even if the insurer does not ultimately agree to send a representative, you will have a record of your attempts to accommodate the carrier’s schedule.

3)  Prepare the way the insurer prepares

Before a mediation, review all reservation of rights letters and other significant correspondence.  Know the history of the file and remind yourself of all the various bases for the insurer’s reservation of rights and when they were first raised.  Issues which have been lying dormant for months, and which the policyholder may have assumed the insurer has abandoned, often resurface at mediation.  If you are mediating an underlying liability case, be sure defense counsel is prepared to appropriately explain the insured’s potential exposure.  Indeed, it is usually advisable for defense counsel to deliver a pre-mediation report to the insurer, detailing the case status and the insured’s potential exposure.  (Where the insurer either is not defending or is defending subject to a reservation of rights, privilege concerns can be addressed by delivering the report orally, rather than in writing.)

Keep in mind that a primary goal of the insurer will be to emerge from the mediation having terminated any defense obligation, and having paid less than the full limits of its policy.  If the insurer has been funding the defense, know where the defense costs stand – how much has been paid to date, and how much defense costs will be in the future if the matter is not resolved.  Future defense costs can be a significant factor in motivating the insurer to settle the case.  Getting a good handle on defense costs is particularly important if the policy is a “wasting limits” policy.  You’ll want to know exactly how much of the policy limits are left, and how much is already “spoken for” (i.e., outstanding defense billings that the insurer has not yet paid).

Make sure your client and defense counsel are prepared with your position on tough questions or issues that may arise during the mediation, such as: (1) the insurer insisting that the insured contribute to funding the settlement; (2) the insurer announcing its intention to seek recoupment of amounts expended, pursuant to Buss v. Superior Court and Johansen; or (3) the insurer requesting either a full policy release, or a release of all potential future claims related to the issue being mediated (e.g., in environmental exposures, the possibility that a regulatory agency will re-open an enforcement action).

4)  Brief the coverage issues promptly and thoroughly

Without the pressure of a court-imposed deadline, attorneys often ignore the mediator’s deadlines for mediation briefs, submitting them just a day or two before the mediation.  Attorneys representing policyholders should resist this temptation.  Insurance companies are large bureaucracies, charged with monitoring thousands of claims at any given time.  As noted above, the representative responsible for your client’s file is typically handling hundreds of other claims at the same time.  To ensure that the representative has time to fully review and absorb your mediation brief, and to procure appropriate settlement authority based on the arguments made therein, submit your brief on time.  (Indeed, you should confirm well in advance of the mediation that the parties will be exchanging briefs.  Otherwise, the first time the insurer representative will be hearing your best articulation of your client’s coverage position will be at the mediation itself.)

Finally, insurance coverage issues are often best addressed in separate and/or private submissions to the mediator.  In a mediation of the underlying case, a separate submission on the coverage issues is usually appropriate, with the submission going only to the mediator and the insurance carrier.  Separate or private submissions may also be appropriate in cases where multiple insurance carriers are involved.  The carriers will undoubtedly have differing views regarding which among them has the greatest obligation to fund settlement.  In such cases, carve out an agreement in advance that will allow each carrier to do a private submission that is shared only with the insured and the mediator (but not the other carriers).  The insured may also provide a private submission with its views on allocation, or with leverage points that can be used separately with each carrier. 

Like any other step in litigation, success in mediation depends on advance planning and preparation, as well as giving careful consideration to the viewpoint of your ultimate decision-makers.  Taking the above steps will help ensure that you are thoroughly prepared to address any issues that may arise at the mediation itself.

A recent California Supreme Court decision, 21st Century Insurance Co. v. Superior Court (Quintana), S154790 (Aug. 24, 2009), clarifies the rules governing an insurer’s right to reimbursement for payments to its insured, after the insured obtains a recovery from the responsible third party.  The Court held that while the insured has right to be “made whole” before the insurer can assert its reimbursement rights, the made whole rule only applies to the insured’s non-covered damages, not his attorney’s fees.  While the decision is favorable to insurers, it only applies to auto insurers seeking to recover small payments made pursuant to the standard “med-pay” coverage in their policies.  See id. at n. 1.  By circumscribing its holding so narrowly the Court may be signaling that, in other contexts, it would reach a different result.

“When an insurance company pays out a claim on a first-party insurance policy to its insured, the insurance company is subrogated to the rights of its insured against any tortfeasor who is liable to the insured for the insured’s damages.”  Progressive West Ins. Co. v. Sup. Ct., 135 Cal. App. 4th 263, 272 (2005).  Virtually all first-party (and most third-party) insurance policies contain a subrogation or reimbursement provision.  When the insurer pays a claim, these provisions entitle the insurer carrier to recoup its payments from a responsible third party.

In cases involving property damage claims, the insurer may pay the insured’s claim and proceed directly against the third party tortfeasor.  Alternatively, if the insured has brought an action against the responsible third party (for example, to recover uninsured losses), the insurer may intervene in that lawsuit.  See Hodge v. Kirkpatrick, 130 Cal. App. 4th 540, 551 (2005).  However, personal injury claims are non-assignable in California.  Therefore, an insurer may not recover a bodily injury or medical insurance payment directly from the tortfeasor.  Rather, the insurer must wait for the insured to obtain a recovery from the responsible third party, then request reimbursement out of that recovery.  See Progressive West, 135 Cal. App. 4th at 272.

In either context, California recognizes the common law “made whole” rule:

The general rule is that an insurer that pays a portion of the debt owed to the insured is not entitled to subrogation for that portion of the debt until the debt is fully discharged.  In other words, the entire debt must be paid.  Until the creditor has been made whole for its loss, the subrogee may not enforce its claim based on its rights of subrogation.

Sapiano v. Williamsburg, 28 Cal. App. 4th 533, 536 (1994), quoting2 Cal. Ins. Law & Prac. (1988 rev.) § 35.11[4][b].  Under this rule, an insurer may not obtain a subrogation recovery before its insured is fully compensated for both insured and uninsured losses.  Id.; see also Progressive West, 135 Cal. App. 4th at 274.

In 21st Century, the insured (Quintana) was injured in a car accident.  Pursuant to the no-fault “med-pay” coverage provision in Quintana’s auto insurance policy, 21st Century paid her the full $1,000 policy benefit.  Quintana then instituted a personal injury action against the responsible third party.  In that action, she incurred attorney’s fees and costs of $2,106.50 and settled her claim for $6,000.  Quintana acknowledged that the $6,000 payment fully compensated her for her total damages (both insured and uninsured).

21st Century then sought reimbursement of its $1,000 med-pay payment out of Quintana’s recovery.  Quintana contended that 21st Century was not entitled to any such reimbursement, because she had not been made whole – after deducting the $2,106.50 in legal expenses, her $7,000 total recovery ($6,000 from the third party tortfeasor, $1,000 from 21st Century) did not fully compensate Quintana for the $6,000 in damages that she sustained.

21st Century conceded that its reimbursement claim should be reduced, in consideration of the legal expenses incurred by the insured.  However, 21st Century contended that any such off-set was governed the “common fund doctrine”: “One who expends attorneys’ fees in winning a suit that creates a fund from which others derive benefits, may require those passive beneficiaries to bear a far share of litigation costs.”  Quinn v. State of Cal., 15 Cal. 3d 162, 167 (1975).  Under the common fund rule, a party who benefits from another party’s efforts to obtain a recovery must bear a pro rata share of the litigation costs.  Thus, under 21st Century’s view, it was entitled to reimbursement in the amount of $600 – the $1,000 med-pay benefit, less its pro rata share of Quintana’s litigation costs ($400).

The California Supreme Court agreed with 21st Century.  However, the rationale underlying its decision is tied to the unique nature of med-pay coverage in auto insurance policies.  First, as personal injury claims are non-assignable, a med-pay insurer cannot proceed on its own behalf against the third party tortfeasor, nor can it intervene in the insured’s personal injury lawsuit.  Therefore, the Court reasoned, the insurer cannot voluntarily elect to bear its own litigation costs in order to seek reimbursement.

Second, med-pay insurance is a no-fault coverage which “pays the insured’s reasonable and necessary medical expenses incurred due to an accident up to a relatively low dollar limit, in exchange for relatively low premiums.”  As such, the med-pay insurers “have no financial incentive to participate [in litigation against the third-party tortfeasor], given the likelihood that the attorney fees would exceed the amount of reimbursement sought.”  The Court further reasoned that, because the insurer’s maximum potential would rarely exceed a few thousand dollars, “plaintiffs’ attorneys may not want insurers to intervene in lawsuits, as the insurers’ litigation goals of reimbursement may conflict with the plaintiffs’ interest in recovery for losses beyond the low med-pay amount.”

The Supreme Court also rejected an argument which the Southern District of California, considering the same issue, had found persuasive: “If either the policyholder or the [insurer] must to some extent go unpaid because the policyholder has recovered less than her total loss, the loss should be borne by the insurer for that is the risk the insured has paid it to assume.”  Chong v. State Farm Mut. Auto. Ins. Co., 428 F.Supp.2d 1136, 1145 (S.D. Cal. 2006), internal quotes and citation omitted.  The Court again pointed to the unique nature of med-pay coverage – low premiums, in exchange for a small policy benefit – to avoid application of this principle:

Although this reasoning may hold true in certain insurance situations, in the context of med-pay insurance the insured has not contracted for the insurer to assume any risk beyond the insured’s medical payments.  Quintana’s lower premiums provide her only with medical payments in the event of an accident.  …Quintana has not paid 21st Century to assume the risk of paying attorney fees for uninsured losses on her behalf.

(Emphasis added.)

Clearly, the Supreme Court was not willing to extend its reasoning to any other type of insurer subrogation claim.  Indeed, a footnote in Justice Werdergar’s concurring opinion pointedly notes: “I address only the circumstances (as here) of an insurer that is, for public policy reasons, precluded from independently proceeding against the tortfeasor under subrogation, and not whether an insurer who could so proceed, but instead voluntarily elects to await reimbursement, should be placed in the same position under reimbursement as well as under subrogation.”  For most California policyholders, it therefore remains an open question whether the “made-whole” rule applies to their total out-of-pocket losses, including both uninsured damages and litigation costs.  By circumscribing its 21st Century decision so narrowly, the Court may be signaling that, in other contexts, the insured’s right to be “made whole” includes its right to recover litigation costs.

Construction defect coverage litigation has been declining over the years.  The building booms of the late 80s and 90s resulted in a boom of construction defect litigation too.  Coinciding nicely with the introduction of the 1986 ISO form policy with new wording, insurers found themselves paying for a lot of defective construction claims.  Since then, coverage for construction has gotten harder to get, and a lot narrower.  Insurers tightened down by introducing new – and more restrictive – versions of additional insured endorsements, by adding very restrictive versions of “Montrose” endorsements, and by ultimately by refusing to sell insurance to many contractors.

This decline in construction defect coverage litigation is probably due to both the end of the building boom, and also the fact that many of the issues have now been litigated all the way up to the top courts.  Therefore many of the once disputed issues are decided:  the scope of completed operations coverage; the meaning of “your work;” the alienated premises exclusions, and so on.  But it was somewhat surprising (to me at least) that some carriers are now disputing the meaning of “that particular part,” as that phrase is used in exclusions J(5) and J(6) of the current ISO CGL policy.  And interestingly, there are relatively few published court opinions across the nation that have interpreted these exclusions.
These exclusions are generally thought of as the “faulty workmanship” or “business risk exclusions,” and in the current version of the standard ISO CLG policy read:

Property damage to:

J(5)  That particular part of real property on which you or any contractors or subcontractors working directly or indirectly on your behalf are performing operations, if the “property damage” arises out of those operations;

J(6)  That particular part of any property that must be restored, repaired or replaced because “your work” was incorrectly performed on it.

The term “your work” is defined to include work or operations performed by you or on your behalf (thus, work done by subcontractors “becomes” the work of the general contractor) for the purposes of these exclusions.

The intention of these exclusions is to exclude coverage for defective work because of the moral hazard of doing so (coverage would encourage sloppy workmanship because the carriers would have to pay to put it right).  However, because these exclusions are restricted to the damage to “that particular part” of the property that needs correction because of the defective work, they do not apply to consequential damage to other parts of the same project which are not defective.

Text books published by the American Institute for Chartered Property Casualty Underwriters (the very books that CPCU’s1  all over the country learn from) make this abundantly clear.  In its discussion of exclusion J(5), one text notes:

The reference to “that particular part” is important.  No coverage applies to “that particular part” of real property damaged while work is being performed on it.  But, by inference, coverage does apply for damage to any other part of the property besides “that particular part,” as long as it is not otherwise excluded.”

Malecki, Horn, Wiening & Flitner, Commercial General Liability Insurance Vol. 1 (Third Edition, AICPCU 1995 ) at 95 (emphasis is original).  The text goes on to give an example of a contractor erecting a steel frame building, and by accident a beam falls from the hoisting crane, damaging other parts of the framework that had already been constructed.  The text instructs that the contractor’s CGL policy “would cover the damage to the property damaged by the beam that fell.  The property damaged by the beam was not ‘that particular part’ of real property being worked on at the time of the accident.”  Id.

A recent Texas case highlights the basic misunderstandings that the carriers are making with respect to these exclusions.  In Mid-Continent Casualty Co. v. JHP Development, Inc., 557 F.3d 207 (2009), a contractor (JHP) partially built a condominium project, finishing the foundations, walls, roofs, windows and doors.  The contract called for work to stop at that point, and only be finished as the individual condos were sold by the developer.  Still to be done was painting, flooring, plumbing and electrical fixtures, and activation of the HVAC system.  However, several months later, water intrusion problems became apparent, causing damage to interior drywall, stud framing, electrical wiring and wood flooring.  JHP’s insurer, Mid-Continent, denied the claim.

In the subsequent declaratory relief action and the appeal that followed, Mid-Continent argued (among other things) that exclusions J(5) and (6) applied.  The appellate court held that J(5) was inapplicable as it only applies to ongoing operations, and because all work had stopped at the project for a prolonged period of time, no operations were ongoing.  557 F.3d at 211-12.

The court also held that the “that particular part” language of exclusion J(6) meant that it too did not apply to the claim.  The court explained that “the plain meaning of the exclusion . . . is that property damage only to parts of the property that were themselves the subjects of the defective work is excluded.”  Id. at 214-15.  The court also noted that if insurers had wanted to exclude all damage to a project caused by any defective work in that project, they could easily have written the words to do so.

Distinguishing other cases interpreting exclusions “that bear some resemblance to exclusion J(6)” as a bar to coverage, the JHP court noted that in those cases the exclusionary language was different.  The court also criticized a decision by the South Carolina Supreme Court which had barred recovery for a similar claim because it said the CGL policy was not designed to insure business risks.  Citing the Texas Supreme Court, the JHP court noted that “‘such preconceived notion[s] . . . must yield to the policy’s actual language,’ and that ‘coverage for business risks depends, as it always has, on the policy’s language . . .’”  Id. at 216-17 (citation omitted).

Given the CPCU texts’ clarity, the thoughtful and intelligent analysis by some courts, and the clear view of such insurance coverage experts as IRMI (the International Risk Management Institute)2, that these exclusions do not bar coverage for non-defective work that is damaged because of defective work, it is surprising that some carriers are continuing to argue to the contrary.

1 The CPCU designation is the insurance industry’s highest accreditation – the equivalent of the CPA designation in the accounting world.

2 See, e.g., Wielinski, Insurance for Defective Construction (Second Edition, IRMI 2005) at 183, and 191-93; Wielinski and Gibson, Broad Form Property Damage Coverage (Third Edition, IRMI 1992) at 69.

In residential construction projects, the builder usually hires a number of specialty subcontractors and typically requires that the builder be named as an additional insured on their general liability policies.  While builders may not expect to obtain defense or indemnification from a subcontractor for claims that do not arise from a subcontractor's work, nevertheless California law has provided a broad obligation for subcontractor insurance carriers to provide such a defense.  In 2001, the California Court of Appeals in Presley Homes, Inc. v. American States Insurance Company, held that an insurer's defense obligation under an additional insured endorsement covered all claims in the litigation, including claims for which there was no possibility of indemnity coverage.   The court noted that this was not a contractual requirement but a public policy decision that the court had adopted in Buss v. Superior Court, 16 Cal.4th 35 (1997).  After the Presley decision, subcontractors complained that their insurers were often required to defend builders and developers against construction defect claims that had nothing do to with the work performed by the subcontractor.  Horror stories about landscaping contractors having to defend builders for roofing defect claims, although probably more fantasy than fact, proliferated.
 
As a result of successful lobbying by the California Professional Association of Specialty Contractors, the California legislature passed Assembly Bill 2738, which became effective on January 1, 2009.  The new law applies only to residential construction defect claims and builds on a 2006 law (AB 758) that forbade a builder from requiring "Type 1" indemnity in subcontracts for residential construction.  The new law goes further and provides that a builder may not contract to require subcontractors to indemnify or insure a builder for construction defect claims that do not arise out of the subcontractor's scope or work, or that arise out of the negligence of the builder of the builder's other subcontractors or suppliers.  Although the new statute makes clear that Presley is still viable law in California, it also limits the additional insured coverage that may be provided to builders to the subcontractor’s scope of work.

For claims that are within the subcontractor’s scope of work, AB 2738 preserves the insurer’s obligations under Presley for coverage under validly issued additional insured endorsements, and in those cases subcontractor insurers still have an immediate obligation to defend builders.  No defense obligation is owed, however, until the builder provides written tender to the subcontractor specifically including all information provided by the claimant regarding the nature of the claim, and the relationship to the subcontractor’s work.  Upon tender, the subcontractor must elect to either control the defense and defend the builder through qualified counsel, or pay a reasonable share of the builder’s defense costs.  The election must be made within 90 days.  If the subcontractor elects to pay a reasonable share of the builder’s ongoing defense costs, it must pay within 30 days of invoice defense costs while the claim is pending.  The builder is required to allocate a share of defense costs to itself and all subcontractors to the extent claims are alleged to be caused by their work, acts or omissions.  A reallocation must occur within 30 days of final resolution of the claim, whether by settlement or judgment, if requested in writing, and the subcontractor bears the burden of proof on reallocation.  Penalties for subcontractor failure to timely and adequately perform in providing a defense include resulting compensatory and consequential damages, reasonable attorneys fees as well as reasonable contractual provisions for damages (e.g. liquidated damages), which builders are now likely to include in their contracts with subcontractors. 

The new statute leaves many open questions.  First, how will subcontractor insurers react to the choice regarding defending the builder?  While subcontractors have for years advocated for the right to control the defense they are providing to builders, one wonders, given the option to pay a share of the builder’s defense costs instead, whether subcontractor insurers will agree.  Second, what happens if several subcontractors decide to provide separate defenses for the builder?  Does this mean that one set of lawyers will defend the roofing portion of the claim, while another defends the plumbing portion and so on, all on behalf of the builder?   It will be interesting to see how this plays out.  AB 2738 also provides new requirements on builders and subcontractors when a residential project is insured under a so-called “wrap” insurance program.  Those provisions will be the subject of a later blog.