Why should a construction professional pay attention to contractual risk transfer? For starters, neglecting it could put a contractor out of business, or at least increase insurance costs.
A general contractor (GC) was hired to complete a new high-rise project, including demolition of the existing structure. The GC hired a local demolition subcontractor, but failed to focus closely on risk transfer. The demolition contractor provided a certificate of insurance and Additional Insured endorsement to the GC. There was a written scope of work agreement. Two days into demolishing the existing six-story structure, a wall collapsed, killing five workers. The GC and the demolition contractor were each charged with five counts of manslaughter and for numerous alleged safety violations. Suit was brought by the families of the deceased workers. In discovery, it was revealed that the demolition contractor had an exclusion on its General Liability policy for work at heights above four stories. As a result, the GC was left with an uninsured subcontractor as a co-defendant and the potential for a judgement in the tens of millions, with little if any recourse available. What could have been done to protect the GC?
By their very nature, construction projects involve a variety of entities that work together in pursuit of the same goal to successfully complete the project. From the developers down to the various subcontracting trades, written contracts dictate the who, what, where and how of the project. Good contracts are of the utmost importance to ensuring successful projects. Contractors who have failed to realize the importance of Contractual Risk Transfer have been put out of business, sometimes arising from one single loss incident.
Contractual risk transfer typically comes in the form of insurance and written contracts between parties, such as the GC and the demolition subcontractor above. With insurance, the contractor pays a premium in exchange for the insurance carrier agreeing to pay claims made against the contractor. While insurance is required to do business, it is a costly part of project overhead, which must be factored into bids. High insurance premiums can significantly cut into the profitability of contractors, especially if claims experience is poor. One key concept to managing insurance costs comes in the form of savvy contractual risk transfer between parties. All too often, contractors end up paying for a claim that was caused by someone else.
A prudent strategy for contractors should be to promote equitable risk transfer, with those responsible for the risk, bearing the risk. There are common pitfalls that contractors face in dealing with contractual risk transfer practices.
Certificates of Insurance
Many contractors feel a level of safety and peace of mind when obtaining a Certificate of Insurance (COI). Unfortunately, a COI is not an actual form of risk transfer, and it serves only as a snapshot in time showing insurance coverage. All too often, a certificate is accepted directly from the other party. This seems like common sense, but it occurs more than people would like to admit. Anyone with a photocopier or PDF editing software can fake a COI. However, fraudulent COIs are just the beginning of the problem. A contractor could provide a COI one day and then cancel the policy the very next day. If an Additional Insured endorsement is not present, the certificate holder will never know until there is a loss. In addition, many COIs are in fact accurate, but the underlying policies could have severely limiting exclusions, such as with the case study above. Some unethical contractors and insurance brokers may willingly buy highly restrictive policies to reduce costs and to be able to show evidence of insurance. In the example of the demolition contractor above, the GC (or its broker) could have requested the actual policies for review. Some insurers even have reputations for selling limited “bare bones” policies which often exclude the most significant exposure inherent to the contractor’s business, such as work from heights.
Additional Insured Endorsements
Additional Insured (AI) Endorsements provide an added level of protection when a COI is issued. Essentially, the AI endorsement affords the certificate holder coverage under the policy, with some restrictions. One benefit to an AI endorsement is written notification of policy cancellation. With that being said, there are common pitfalls nonetheless. In the absence of a written contract, an AI endorsement may not be enforceable. Also, if the underlying policy does not cover a claim due to exclusion, the AI endorsement would be worthless. Lastly, a subcontractor’s limits may not be adequate to cover the full value of the loss, even if the AI endorsement functions as intended.
A contract is not always a lengthy written document with legal counsel’s input; it can be as simple as a purchase order. Often smaller, less sophisticated contractors will rely on very basic written agreements as their primary form of contracts, which creates a significant exposure to another upstream party. Issues arise when a contract does not include insurance provisions, especially an indemnification (or hold harmless) clause. The indemnification clause in a written contract should essentially prevent the other party from taking legal action for something that was caused by that party.
One key pitfall to be aware of is the reality that a contract may be deemed unenforceable in a court of law. In the case of an unenforceable contract, having the other elements listed above, such as a Certificate of Insurance with Additional Insured endorsement, is critical. Please note, as this article does not purport to provide legal advice, it is always best practice to retain legal counsel for all contracts that an entity enters into. In the case study, if a properly drafted contract had been in place between the demolition contractor and the GC, it would have been possible for the GC to file a suit alleging breach of contract for failure to procure proper insurance. The demolition contractor’s assets could then be available to help indemnify the GC named in the suit.
While contractual risk transfer can seem like a daunting and complex task, it can be used to protect construction companies from liabilities that should not be their responsibility. Having legal counsel with experience in construction and legal precedents of the local jurisdiction should be of paramount importance. Experience shows that it is a worthwhile investment that could prevent a bankrupting judgement from destroying all of the hard work that has built the business.