Owners and general contractors frequently try to shift liability risks downstream to subcontractors through insurance requirements.
In the event of a loss, the upstream party will tender the claim to the downstream party’s insurer, which then will cover all resulting liabilities and defense costs. Owners and general contractors seek to structure insurance this way for a number of reasons, including to save costs by buying less insurance, and to keep from reporting losses to their own insurers, which can drive up premiums.
Subcontractors have tried to resist efforts to shift risks downstream, and now some courts may be coming to their aid. Under judicially created insurance “allocation” rules, owners and general contractors may be forced to tap their own insurance, in addition to the subcontractor’s insurance, to help pay for defense costs and liabilities when a claim arises. This may be the case even when the subcontractor is also responsible for the claim, and when the subcontractor’s insurance is not fully exhausted.
The Illinois Kajima Decision
In an Illinois Supreme Court decision handed down last year (Kajima Construction Services, Inc. v. St. Paul Fire & Marine Insurance Co.), the general contractor required its subcontractor to obtain insurance naming the general contractor as an additional insured. The subcontractor obtained a $2 million primary policy and a $5 million umbrella policy. The general contractor also purchased a $1 million primary policy. During the course of the project, an injured worker sued the general contractor, and the claim was eventually settled for $3 million.
The subcontractor’s primary policy contributed $2 million toward the settlement, but the umbrella insurer refused to contribute the remaining $1 million, arguing the general contractor’s primary insurance must be exhausted first.
The Illinois Supreme Court agreed with the umbrella insurer. First, the court reaffirmed that under Illinois’ "targeted tender" rule, the general contractor had the right to pick between the two possible primary policies—the general contractor’s or the subcontractor’s policy—and tender the claim to only one. However, the court went on to hold that under Illinois’ horizontal exhaustion allocation rule, the general contractor had to exhaust all primary policies—including its own—before it could access the subcontractor’s umbrella policy.
In other words, the general contractor could not continue to tap the subcontractor’s insurance until its insurance was exhausted.
Potential Ramifications
As one of the few cases addressing allocation among concurrent construction-related policies, the Kajima ruling could have far-reaching ramifications.
First, while Illinois’ targeted tender rule is somewhat unique, its horizontal exhaustion rule is not. Several states, including New Jersey and Maryland, have similar allocation rules. If those states follow Kajima and interpret it broadly to require allocation among concurrent construction policies, they may require all potentially applicable policies to respond to a loss. In such cases, the courts might require that claims be tendered to both the general contractor’s and subcontractor’s insurers, and that those insurers evenly split all of the defense costs and liabilities among the available policies, even first dollars.
Another potential ramification of the Kajima decision is its effect on self-insured retentions. Rather than purchasing primary policies, some upstream parties elect to self-insure for certain amounts (the self-insured retention) and purchase insurance to cover only liabilities that exceed that amount.
Kajima does not address whether upstream parties would be forced to pay the self-insured retention amounts out of pocket before accessing a subcontractor’s excess coverage. But, some courts may conclude that losses must be allocated to these self-insured periods, thereby precluding coverage under a subcontractor’s excess policies until the general contractor pays its retained limits.
Consider Allocation Rules When Planning
Allocation rules vary among jurisdictions, but Kajima makes clear that applying these rules can upset owners’ and general contractors’ expectation that the downstream parties’ insurance will completely cover their claims. As a result, when deciding how to structure insurance for a project, parties should analyze the allocation law in the relevant jurisdiction and consider how it might apply in the event of a loss.
The upstream parties may still fully or almost fully shift the risk of loss to subcontractors through insurance requirements. For example, under Illinois law, upstream parties may want to require their subcontractors to purchase additional primary insurance rather than allowing the subcontractor to purchase a mix of primary and excess coverage. In this way, the upstream parties can take advantage of Illinois’ targeted tender rule to help ensure only the subcontractor’s insurance will respond.
However, in states that do not follow a targeted tender rule, but may apply a horizontal exhaustion or similar allocation scheme, owners and general contractors should not assume the additional insured endorsements in their subcontractors’ policies will fully protect them. Instead, these upstream parties may need to consider purchasing additional insurance, and perhaps reduce or eliminate self-insured retentions, to ensure they are adequately protected. These options may seem unappealing, but being caught with inadequate coverage is worse.
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Friday, September 3, 2010