Construction Industry AIEs: Problems of Contract Interpretation and Solutions

Steckman, Lawrence A., Cleary, James J., Jr., Defense Counsel Journal

There's been a dramatic explosion in additional insured litigation, suggesting that there should be a better risk allocation

THIS article discusses recurring problems arising in construction industry declaratory litigation seeking judicial interpretations of additional insured endorsements (AIEs).(1) Its thesis is that endorsement language is often inadequate to express the risk allocation and insuring relationships these litigants have attempted to create, or may have assumed were created, by merely requiring that one party be named an additional insured on another person's policy. This article sets forth strategies and proposals that, if adopted, should help to preclude, minimize or simplify declaratory litigation seeking construction of these endorsements.

Part I introduces general vocabulary, discusses the construction industry players and identifies some of the advantages and disadvantages of using AIEs to allocate risk.

Part II identifies three recurrent categories of construction industry additional insured declaratory litigation, focussing primarily on the recent flood of cases in New York's trial and appellate courts, and identifies underlying problems in standard endorsement language.

Part III discusses negotiating and contractual-based strategies available to construction industry participants and their counsel to help avoid or minimize the problems discussed and identified in the Part II cases.

I. ADVANTAGES AND DISADVANTAGES OF AIEs

A. Statement of Problem and Basic Definitions

Agreements to procure insurance (APIs) are contractual arrangements in which one party to a contract agrees to procure insurance for another party's benefit. Such agreements are enforceable in New York.(2) In the construction industry, the API is frequently satisfied through inclusion of an AIE in one party's insurance policy. Under the AIE, the party promising to procure the insurance (the "promisor") makes the party for whose benefit insurance is being obtained (the "promisee") an additionally insured person under the promisor's policy (an "additional insured").(3)

Where the promisee negotiates its inclusion as an additional insured on the promisor's policy, it attempts to shift its own risk of loss to the promisor and, derivatively, the promisor's insurance carrier. The additional insured often assumes it has purchased adequate insurance coverage for its involvement with the named insured on the policy (the "named insured"). Frequently, the carrier providing the additional insured coverage, which is normally the named insured's own carrier (the "additional insured carrier") and the additional insured have very different ideas about the nature and scope of AIE-created coverage.(4)

When a claim is made following what the additional insured may believe to be a covered occurrence, the additional insured carrier may refuse defense or indemnification, or both. It may choose to involve the additional insured's commercial general liability (CGL) carrier in the claim. That carrier probably will have issued a separate policy in which the additional insured is the CGL carrier's named insured.(5) This places the additional insured in exactly the opposite position it expected when it required, through its API, that it be named an additional insured on someone else's policy-its own carrier ends up involved in a claim, through declaratory litigation, resulting in an increase in the additional insured's CGL policy premiums.(6)

Such disputes, for reasons discussed below, tend to result in particularly protracted and expensive litigation fro all parties. Although AIEs now (and generally) are regarded as a cost effective and adequate means of providing insurance coverage (the "traditional view"),(7) AIEs have not, in many construction cases, been cost effective or adequate contractual mechanisms to shift risk.

B. Construction Industry Players

The parties to construction industry risk-shifting lawsuits usually include the owner of a property (the "owner").(8) its general contractor (GC) or a construction manager (CM), which coordinates and schedules the construction work, and building trade employees of various subcontractors ("subs"), which perform the construction work. Site coordination is usually left to the GC, who maintains a small staff on the premises.

Often, the plaintiff is a sub's employee injured on site, who files a (direct) personal injury action against the owner and GC, but not against the employer sub, who is protected from such suits by workers' compensation statutes.(9) The defendant owner and/or GC, in the personal injury action, has, prior to current changes in the New York state Workers' Compensation Law, filed a third-party action against the plaintiffs employer, the sub, for contribution or indemnification.(10) The sub naturally looks to its insurance carrier to defend the action under its policy.

Prior to the injury and lawsuit, the sub, in additional insured cases, will usually have signed an API with the owner and/or GC as part of the quid pro quo of obtaining its subcontract. The API will have required the sub to name the owner and/or GC as additional insured on the sub's own insurance policy. Thus, the sub's insurer may be insuring two or more parties, with potentially adverse interests.

C. Advantages and Disadvantages of AIEs

Commentators have identified many positive attributes which recommend AIEs to construction industry participants.(11) These include:

1. They give the additional insured direct rights under the named insured's policy. Such rights would include a right to defense and, sometimes, indemnification under the named insured's policy. These rights may be asserted where, for example, the additional insured's own CGL carrier challenges whether it has a duty to defend and indemnify under its own policy. If the additional insured's CGL insurer chooses to wait until the underlying action is settled to determine its defense and indemnification responsibilities, defense and settlement costs may have to be born by the additional insured. Additional insured status, therefore, permits the additional insured to protect its defense and indemnification rights directly with a second insurer, rather than relying solely on the rights outlined in the indemnification clause of its own CGL policy.(12)

2. They may avoid the effect of standard exclusions in the named insured's own CGL policy, for example, the products exclusion and the failure to perform exclusion, which apply to the named insured only.(13)

3. They provide a partial safety net for the named insured's obligations to the additional insured under the hold harmless agreement with the latter should (a) the named insured become insolvent, or (b) the hold harmless agreement be invalidated by the courts.(14)

4. They generally prohibit the named insured's carrier from obtaining subrogation rights against the additional insured if the named insured experiences a loss caused by the additional insured.(15)

5. They provide the additional insured with personal injury coverage, unavailable to the additional insured under the named insured's contractual liability coverage. Contractual liability policies generally provide only for bodily injury coverage, which is usually defined as coverage for actual injury to a person. Personal injury coverage, on the other hand, is coverage for enumerated offenses, such as libel, slander, violation of right of privacy, wrongful entry or eviction.(16)

In addition, and most critically, AIEs are generally available for a nominal sum.(17) They do not require the named insured to procure an entirely separate insurance policy for the additional insured. Initial savings in transactional costs and frequently time involved in procuring coverage clearly recommend the AIE.(18)

AIEs, however, have disadvantages that are not always obvious prior to the outbreak of litigation. For example:

1. From the sub's perspective, the naming of the owner/GC as additional insured on the sub's CGL policy dilutes the sub's policy limits.(19)

2. It also eliminates the insurer's subrogation rights against the additional insured and the additional insured's own CGL carrier.(20)

3. From the perspective of the additional insured, in the words of one commentator, "it may mean the loss of control over the defense, increased likelihood of coverage disputes, as well as exacerbated `other Insurance' disputes."(21)

4. Because the additional insured carrier owes the same obligation to the named insured and additional insured on the policy, and both are entitled to be treated as if they are insured under separate policies, the additional insured carrier's decisions with respect to defense and tender are complex. These problems run the gamut from allocation problems among carriers to issues regarding selection of either outside or in-house counsel to defend the action.(22)

5. The inherent conflict between the additional insured carrier, with its strong interest in using (or crafting) an endorsement that narrowly restricts additional insured coverage to vicarious liability for the named insured's activities and the additional insured's economic interest in obtaining the broadest possible coverage through its status as additional insured, creates an explosive situation in which declaratory litigation frequently ensues.(23)

This last factor is particularly serious. Carriers naturally proffer the narrowest interpretations of AlEs when additional insureds seek coverage for risks that they (the additional insureds) believed were insured.(24) The AIE is frequently a carrier's form endorsement. There is rarely arms-length bargaining between the sub and its carrier regarding scope of coverage under the AIE because the sub is not paying for the coverage or is paying only a nominal sum.(25) If the carrier ultimately disclaims coverage, the promisee's only recourse may be to sue the promisor's carrier in a declaratory action seeking construction of the endorsement.(26)

D. Complexity and Expense of Additional Insured Disputes

Obtaining declaratory relief in additional insured litigation, however, is complex because the AIE must be analyzed in the context of an API, which must itself be interpreted in light of the triangular relationship between the parties and their dual-insuring carrier.(27) In the context of (1) a negotiating process in which there may be little or no real bargaining because of the owner's superior bargaining power relative to its sub, (2) a drafting process in which the additional insured carrier and additional insured have clear, conflicting interests, (3) a review process that all too frequently is non-existent, cursory or uninformed because the sub is paying only nominal consideration for the owner/GC's additional insured coverage, and (4) the owner/GC frequently receiving only an insurance certificate, but not the policy and, critically, its endorsements, the seeds of future litigation are sown.

Declaratory judgment litigation tends to be expensive for related reasons. With little record of their actual intent and in the face of endorsement language frequently ambiguous, the litigation parties may urge very different versions, for example, of their oral conversations or what the bargain expressed in the API or AIE was meant to be. While evidence of conversations that might, in other contexts, for example, disputes between contract related parties, be deemed inadmissible, commentators have argued that such evidence should be deemed relevant and admissible in declaratory actions involving additional insureds and additional insured carriers.(28)

PART II. RECURRING ISSUES IN ADDITIONAL INSURED CASES

Narrow AIE language has generated many declaratory judgment lawsuits in which carriers, subs, owners and GCs have proffered their self-interested interpretations of clauses that often are vague as to whose negligence (and what kind of negligence) the carrier is actually insuring. A number of different types of declaratory judgment disputes involving AlEs recur in cases litigating the proper interpretation of these clauses. Three are discussed below. These and similar litigations probably could have been avoided by the parties use of more precise language to express their intended contractual commitments, as the courts examining them have, explicitly or implicitly, recognized, or by paying closer attention to the negotiation and review of the contractual mechanisms they have chosen to embody their bargain.

A. Nature of Coverage Disputes

Court adjudications regarding the nature of coverage frequently focus on whether an API or AIE provides "primary."(29) "excess"(30) or "co-insurance" coverage.(31) The promisor's carrier, faced with paying the additional insured's liability, tries to reduce its coverage responsibilities through a declaratory judgment action against all additional insureds' other liability carriers, arguing that the additional insured's other policies should provide at least some coverage on the underlying occurrence.

The nature of coverage cases logically falls into three categories. In the first, the policy under which the insured is named an additional insured is deemed primary and the additional insured's own CGL insurer's policy is deemed to be excess. In the second, the insured's CGL policy is deemed primary and the policy creating additional insured coverage is deemed excess. In the third, both the CGL and additional insured carrier are deemed to both be primary, and they usually are required to prorate contributions based on their relative policy limits.(33)

In Charter Oak Fire Insurance …

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Publication information: Article title: Construction Industry AIEs: Problems of Contract Interpretation and Solutions. Contributors: Steckman, Lawrence A. - Author, Cleary, James J., Jr. - Author. Journal title: Defense Counsel Journal. Volume: 65. Issue: 1 Publication date: January 1998. Page number: 78+. © 1999 International Association of Defense Counsels. COPYRIGHT 1998 Gale Group.

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