Construction defect lawsuits have caused the availability and coverage of general liability insurance for residential contractors to drop precipitously. If a residential contractor is able to obtain insurance policies at all, they are expensive and of little actual benefit. High self-insured retentions and/or deductibles have placed defect litigation risks squarely on the project owner and contractors.
Even the newly envisioned mixed-use developments – combining Class A commercial and retail with high-end residential space in a single complex – are subject to the curse of construction defect claims. Many contractors are finding their insurance coverage excluding such developments completely, as the residential component will most likely bring the project within the coverage of the residential construction defect statutes.
One response is for the owner to organize a “wrap” insurance program – also known as an Owner Controlled Insurance Program or OCIP. In essence, a wrap places all contractors on the project under the same insurance policy. All participants pay a portion of the policy premium, usually based on their insurance rate vis-à-vis their construction contract amount. The contractors must enroll and the premium is deducted from the contractors’ pay requests.
In addition to the wrap insurance policy, contractors are usually required to execute indemnification agreements protecting the project owner from all claims arising from construction. Many of these indemnity agreements require the contractors to defend the owner from all claims, regardless of who was responsible. While this combination of wrap insurance and indemnity does much to protect the owner from construction defect claims, it can leave the contractors virtually uninsured.
Construction defect lawsuits, especially those involving multi-family housing, often cost millions of dollars to litigate. Because of the anti-contractor bias of the construction defect laws, millions more are often needed for settlement of the case. Depending on the wrap policy’s limits, the litigation costs alone can exhaust the maximum liability of the policy.
Once the policy is exhausted, the contractors remain obligated under the contractual indemnification provisions to pay for the owner’s legal defense and any settlement or judgment issued thereafter. Such obligations, although rarely considered at the start of these projects, can be devastating to a contractor’s business.
To protect themselves on this issue, contractors must review the wrap policy’s maximum limits. If the policy limits are significantly below the actual construction project costs, contractors should be wary of accepting the contract. As a general rule of thumb, insurance coverage below 25 percent of the total development cost for the project will probably be insufficient to protect the contractor from a significant construction defect lawsuit.
Secondly, contractors would be well advised to have the indemnity provisions of the contract thoroughly reviewed, with an eye toward eliminating the indemnity provision entirely, or at least limiting the obligation exclusively to the contractor’s own negligent or intentional acts. By eliminating the indemnity obligations arising from the acts of the owner or other third parties, contractors can limit their exposure if the wrap insurance proves insufficient.
Finally, contractors should consider secondary insurance to cover any excess obligation beyond the wrap insurance policy limits. However, such backup coverage may be difficult to obtain and expensive depending on the adequacy (or lack thereof) of the primary wrap insurance coverage. Like all contracts, questionable provisions should be reviewed by the contractors’ legal counsel before being executed. Adequate insurance coverage is vital to the survival of contractors in the event of a construction defect lawsuit.