Revisiting CGL Coverage of Faulty Construction & the Subcontractor Exception

Introduction
 
As many in the industry know, construction can be risky business. Contractors have to manage construction risks associated with things like purchasing material, operating equipment and managing labor. One risk management tool contractors typically use is commercial general liability (CGL) insurance. For many, CGL policies are understood to cover risks resulting from events beyond the insured contractor’s control. But what about the risks posed by an insured’s subcontractor? For example, what if a commercial contractor hires a roofing subcontractor whose work is defective, resulting in property damage to the roof as well as other parts of the building? Would the contractor’s CGL policy cover its subcontractor’s faulty work?
           
Courts throughout the country have grappled with this issue—that is, whether a contractor’s CGL policy covers defective work claims when the work was performed by a subcontractor. If not covered, then contractors can be liable for the costs of replacing the subcontractor’s defective work.  
 
As a creature of contract, CGL policies are subject to state court interpretation. Consequently, two courts separated merely by state lines might have different interpretations of coverage under the same policy. This has been the case in recent CGL coverage litigation. For many states, like Indiana, courts find that CGL policies cover a subcontractor’s defective work when the insured contractor lacks effective control over the subcontractor. Conversely, a few states, as shown in a recent Ohio Supreme Court decision, identify a subcontractor’s work as a contractor’s uninsurable “business risk” and, thus, exclude resulting defects from coverage.  
 
CGL Coverage Background
 
Historically, insurers have limited CGL coverage to insurable risks that are beyond the contractor’s control. Insurers often defend this position by citing two fundamental insurance principles: the doctrine of fortuity and the moral hazard. First, the doctrine of fortuity limits insurance coverage to accidents (referred to in policies as “occurrences”) and excludes risk within the contractor’s control. Accordingly, insurers typically argue that CGL policies do not cover risks resulting from a contractor’s poor business judgment—that is, a business risk. For example, under a standard CGL policy, insurers would likely deny covering a contractor’s loss resulting from purchasing unreliable material. Specifically, the purchase was not an accident but a poor business decision that would likely result in a loss. Furthermore, insurers might suggest that covering such business risks would affect their ability to predict rates of loss and, therefore, require them to raise premiums.
 
Second, insurers typically cite the “moral hazard” public policy argument when denying CGL coverage for defective construction. Generally, if insureds are covered for losses they intend or expect to result from their actions, it will create a moral hazard that discourages them from being careful. For construction, insurers argue that a court’s endorsement of broad coverage for faulty workmanship will create a moral hazard that removes contractor incentives to perform work competently.

Over the years, however, CGL policies have undergone significant revisions as a result of changes in the construction industry. Prior to 1976, CGL policies simply excluded all “property damage to the work performed by or on behalf of” the contractor. Consequently, under the “Your Work Exclusion,” insurers excluded claims against subcontractor defective work performed “on behalf of” the contractor. However, during the 1970s, contractors began hiring subcontractors to perform specialized work instead of performing it themselves. This shift in the construction industry increased contractor efficiencies but reduced their effective control over sub-contracted work. Because sub-contracted work remained excluded from coverage under the existing CGL policies, this risk became unacceptable to many contractors.
 
Dissatisfied with the limits of the previous policies, contractors negotiated with insurers to revise CGL policies and adapt to the increased use of subcontractors. This resulted in the 1976 Broad Form Property Endorsement and then the 1986 CGL revision. Under the 1986 revision—the last major revision by the Insurance Services Office—insurers added the following exception to the Your Work Exclusion: For many in the construction industry, this became known as the “Subcontractor Exception” whereby a contractor’s CGL policy would now cover defective work performed by its subcontractor. However, not all states have adopted this interpretation of CGL policies.
 
Majority Approach Finding Coverage
 
Many state courts recognize the Subcontractor Exception and find CGL coverage for a subcontractor’s defective work. As the Indiana Supreme Court found in Sheehan Constr. Co., Inc. v. Continental Cas. Co.[1], the 1986 CGL revision supports a presumption of coverage unless proven that the contractor intended or expected the subcontractor’s work to be defective. Like Indiana, most state courts reject the fortuity and moral hazard arguments against coverage.  When insurers claim a subcontractor’s faulty work is not fortuitous or accidental, courts highlight the limited control contractors have over their subcontractors. In 2007, the Florida Supreme Court explained how a contractor’s limited control raises a presumption that, as it relates to the contractor, the defective work of its subcontractor is an insurable accident: Additionally, many courts have found the moral hazard concerns unpersuasive. Scholars challenge the idea that finding coverage for a subcontractor’s faulty work would discourage contractors from performing competently. Instead, they argue that reputational risks and litigation costs act as greater deterrents that incentivize contractors to take the proper precautions. 
 
Some states, like Colorado and Arkansas, have enacted legislation regarding CGL coverage and faulty workmanship. Under Colorado statutory law, courts must presume that property damage to a contractor’s work is accidental for the purposes of insurance unless proven that the contractor intended the damage to occur when the work was performed.[3]
 
Minority Approach Excluding Coverage
 
Although the laws in many states presume coverage for a subcontractor’s defective work, states like Kentucky[4] and Pennsylvania[5] have excluded it. Most recently, in October 2018, the Ohio Supreme Court adopted this minority approach of denying CGL coverage for a subcontractor’s work. In Ohio N. v. Charles Constr. Servs., Inc.[6], the court found that claims resulting from any defective construction—performed by the contractor or subcontractor—are not accidents and, thus, not fortuitous occurrences covered under the policy.
 
Unlike the majority approach, these state courts typically do not address the Subcontractor Exception provision in the policy. Instead, they find that defective construction claims do not even meet the threshold requirement of being an insurable risk. In contrast to the majority approach, these states denying coverage find that risks associated with hiring a subcontractor are “‘business risks’ that are normal, frequent or predictable consequences of doing business that the [contractor] can manage.”[7]
 
Instead of finding relief in court, these state courts suggest that, like their counterparts in Arkansas and Colorado, contractors take their coverage claims to the legislature and seek reform there.
 
Conclusion
 
Risk is inherent to construction work, and managing it is imperative to a contractor’s success. CGL insurance remains a viable risk management tool, especially in states, like Indiana, that generally find CGL coverage for defective work performed by a subcontractor. In the roofing scenario, the contractor’s CGL policy would generally cover the claims brought against it for the subcontractor’s work. In states like Ohio, though, contractors should take additional precautions when undertaking work in states where subcontractor defective work is generally not covered.

For more information, contact Christian Robertson or another member of our Construction Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.