Construction Defect and General Liability for Builders

Construction defect

What Is Construction Defect?

A construction defect is property damage to your work. In the case of a builder, your work is normally the entire house or construction project.

The cause is usually a defective design, defective product, defective installation or a combination of these. Property damage to your work is evidenced by problems such as fire damage, water damage, moisture damage, bending, warping, cracking, breaking, sagging, chipping, fading, peeling, mold, fungus, pollution, and so forth.

The construction defect crisis

The building industry constantly experiments with new building products and techniques trying to reduce costs, become more efficient, and add value. Sometimes these products don’t stand the test of time, which may lead to unforeseen problems  that result in construction defects. Examples include EIFS (synthetic stucco), Masonite, Georgia Pacific siding, polybutylene plumbing, and, more recently, Chinese drywall.

Regionally, in the Southeast, the first wave of large-scale lawsuits arose over EIFS. The insurance industry fully funded a gravy train for plaintiff attorneys in this area. That’s due to most of the costs being covered by insurance policies of the manufacturers, distributers, builders, and installers. The EIFS epidemic seemed to fuel more and more construction defect lawsuits of all different types.

As a result, two trends emerged. The first is that most insurance carriers left the market place and refused to write General Liability insurance for builders. They reasoned they couldn’t make a profit at any premium level. A perfect example is the Maryland Casualty/Zurich program known as HBIS. Once the leading insurer of builders in the country, they eventually closed shop.

The second trend is the remaining carriers in the market for builders learned a lesson from the EIFS epidemic. They decided that they didn’t want to be a funding source for another plaintiff-attorney feeding frenzy. They decided to attack the problem by adding a multitude of exclusions to the policy form to reduce and/or eliminate coverage for construction defect lawsuits.

Construction Defect Exclusions

EIFS or Synthetic Stucco Exclusion

This exclusion appeared on all builder policies for many years. If you’re a builder and are still installing EIFS or doing EIFS repair work, you need to buy a special General Liability policy from the high-risk marketplace to cover this exposure.

Soil Movement Exclusion

A major problem in some parts of the country and a major source of construction defect lawsuits is expansive soils. It’s possible to pick up coverage for this risk through certain homeowner warranty products such as HBW 2-10.

Fungus, Mold, and Mildew Exclusion

Insurers added this exclusion almost immediately when the toxic mold lawsuits began to appear. This exclusion effectively cut off the builder’s General Liability policy as a funding source for plaintiff attorneys looking to make toxic mold the next EIFS gravy train.

This exclusion is usually limited to property damage, so it’s possible to still have some coverage if the lawsuit papers allege bodily injury or sickness in addition to property damage. If this is the case, the policy will typically provide legal defense for the entire lawsuit but will only pay any settlement or adverse jury verdict attributable to the bodily injury portion of the damages. If you’re concerned about this exclusion, you can buy a special Mold and Pollution Liability policy from the high-risk marketplace that has a minimum premium that starts out in the $2,500 to $5,000 range.

Absolute Pollution Exclusion

This is a powerful exclusion with potential consequences well beyond what you normally think of as pollution. This is exemplified in the Chinese Drywall crisis where it’s alleged that drywall from certain plants in China releases noxious fumes that cause corrosion of metal in the home, a foul odor, and health problems. Pollution is defined as any solid, liquid, or gaseous contaminant or irritant. The insurance carriers plan on denying these claims by using the Absolute Pollution Exclusion.  Once again, if you’re concerned about this exclusion, you can buy a special Pollution Liability policy from the high-risk marketplace.

Products and Completed Operations Exclusion

This is an unacceptable exclusion because it has the most devastating impact of all the exclusions. Quite simply, it eliminates coverage for all bodily injury and property damage that occurs after the home has been sold. You definitely don’t want this one on your policy.

Damage to Your Work Performed by Subcontractors on Your Behalf Exclusion

Also known as CG2294, this is the most complicated and difficult to understand of all the construction defect exclusions. To understand it, review the basic “property damage to your work exclusion” under the General Liability policy prior to the introduction of CG2204.

Property Damage to Your Work Exclusion

For many years, a standard General Liability policy form issued to a contractor had exclusion L. This takes away coverage for lawsuits alleging property damage to the contractor’s work arising out of such work. However, the policy language makes an exception and gives back coverage if a subcontractor on behalf of the insured contractor performs the damaged work. In other words, this property damage exclusion does not apply to a builder that subs out work. This meant that the General Liability policy provided much broader coverage to a general contractor as opposed to a subcontractor.

But around 2004, most insurance carriers providing General Liability policies for builders started adding Exclusion CG2294 or a similar endorsement to the policy. This takes away the special coverage exception for general contractors such as builders and leaves them without important coverage for property damage to their work.

Damage to Your Work Performed by Subcontractors on Your Behalf (CG2294)

The impact on builders of Exclusion CG2294 is far-reaching. The reason is that a builder’s “work” is the entire house. The best way to illustrate the extent of the risk to a builder is to look at an example:

Suppose a sub installs faulty electrical wiring that later results in a fire, which destroys the entire house and injures its occupants. Assume the damages to the electrical wiring installed by the sub are $20,000, the damages to the rest of the house are $230,000, the damages to the contents are $125,000, and the injuries to the occupants will result in damages of $500,000.

Assuming that the electrical sub carries his own General Liability policy, his policy will pay for all damages except for the $20,000 damages to the electrical work he installed. Remember, his own policy has an exclusion for property damage to his work that will preclude coverage for damage to his own work. If the builder has exclusion CG2294 on his policy, it will not cover the remaining $20,000 of damages for the electrical work. As a result, both the electrical sub and/or builder will share out-of-pocket liability of $20,000.

Now assume the electrical sub does not carry a General Liability policy because he went out of business shortly after the house was completed. If exclusion CG2294 is on the builder’s policy, the builder will have coverage for the damages attributable to both the contents and bodily injury to the occupants. However, he won’t have any coverage for property damage to the faulty electrical work or for the resulting damages to the rest of the house. This amounts to $250,000 of out-of-pocket exposure.

More about CG2294

Some carriers offer less severe versions of CG2294. One carrier we represent with a less severe version still excludes damage to the faulty work itself. But he’ll cover resulting property damage to the non-faulty work. In the fire example, this policy won’t cover the $20,000 of damages to the faulty electrical work. But it will cover the resulting $230,000 in damages to the rest of the house.

Also, carriers using CG2294 may offer a buyback option in some states to builders who qualify based on their favorable loss records and use of mandatory subcontractor agreements. One carrier we represent will offer a CG2294 buyback for a 12%, which has a policy limit of $250,000 and each claim is subject to a $5,000 deductible.

If you have CG2294 on your policy, we recommend you purchase the buyback. Alternatively, take a look at another carrier offering a less severe version that allows coverage for resulting property damage to non-faulty work.

Case law takes away construction defect coverage

Exclusion CG2294 cuts off coverage for construction defect claims for builders, but there is another way that builders can lose coverage for construction defect. The court system can take away coverage by adverse rulings that set precedent.

Under the General Liability policy, coverage must be triggered by bodily injury or property damage resulting from an “occurrence.” An occurrence is synonymous with the term “accident.” Many courts rule that faulty construction is not an accident and therefore not covered under a General Liability policy. An accident is defined by using terms such as unexpected result, unforeseen, and not planned. The courts reason that faulty workmanship being the ordinary and natural consequence of the failure to comply with contractual and governmental regulations is not an accident. Other courts have ruled that the General Liability policy was not meant to act as a warranty or performance bond for faulty construction, and, as a result, faulty workmanship is not an occurrence.

I disagree with the logic behind rulings that faulty workmanship is not an accident. I think most contractors intend to perform the work properly, but unknowingly make some type of mistake that result in a problem. But, my opinion doesn’t matter. What matters is the courts in about a third of the states that ruled property damage to a contractor’s own work resulted from faulty workmanship is not an occurrence and isn’t covered.

Be aware of the position of your state on the no-occurrence claim denial issue because this has a major bearing on your coverage for construction defect.

How To Protect Yourself Against Construction Defect

Below are several strategies for protecting yourself against construction defect litigation.

  1. Find out if you have exclusion CG2294 on your policy. If you do, inquire about purchasing a buyback or ask to get a quote from another carrier that has a less restrictive version that provides coverage for resulting damage to non faulty work.

 

  1. Practice contractual transfer through the use of a very good subcontractor agreement. We can provide an excellent form for you to use. The subcontractor agreement should include mandatory insurance requirements for the sub including Workers’ Comp and General Liability. Each policy must meet certain minimum specs. Quality General Liability insurance carried by your subs is your first and best line of defense against construction defect lawsuits. In addition, the agreement should contain a hold harmless/indemnification provision in your favor.

 

  1. Attempt working only with subs in business for a number of years with an excellent reputation for quality workmanship and standing behind their work. These subs are more likely to be in business over the long term. They’ll likely continue carrying a General Liability policy that will be in force for years. Remember, their policy will only respond to a lawsuit if it’s in force at the time of the occurrence of the bodily injury or property damage. Many builders don’t understand this and mistakenly think that it merely being in force can trigger the sub’s coverage when the work occurred.

 

  1. Consider using a Home Owners Warranty product on the sales of all new home starts. Many experts believe the dispute resolution services provided by these warranties help to prevent construction defect lawsuits. Also, at least one homeowner warranty product provides coverage for soil movement claims.

 

  1. If you have concerns about the common exclusions for EIFS, mold, or pollution, policies can be purchased from the high-risk marketplace to cover these exposures. Most of the minimum premiums are in the $2500 to $5000 range and prices can increase from there depending on the amount of work you’ll be performing.

 

  1. Make sure you have a well-documented file and keep complete records, including certificates of insurance from subs and all subcontractor agreements. Also, it frequently pays to be willing to spend several thousand dollars to make a claim go away as opposed to always standing on principal. You need to protect your insurance loss record to make sure that future coverage is affordable and available.