The basic principle of risk transfer is to shift responsibility for payment of specified losses from one party to another. In the construction industry, risk transfer is most often used in the form of construction contracts where a General Contractor transfers risk of loss to Subcontractors. Construction contracts usually include indemnification and hold harmless agreements as well as insurance provisions that outline the coverages and limits each party is required to provide and maintain. These contracts will typically also contain language designed to specify the order by which the various insurance policies will respond in the event of a loss.
The insurance requirements below are an example of the provisions commonly found in construction contracts. For illustration purposes, ABC Construction will be utilizing these provisions with a subcontractor.
- General Liability Insurance: Prior to commencement of work, subcontractor shall purchase and maintain, at subcontractor’s own expense, ISO Commercial General Liability occurrence coverage with minimum limits of $1,000,000 Each Occurrence; $2,000,000 General Aggregate, and $2,000,000 Product-Completed Operations Aggregate. ABC Construction, Owner and Architect shall be named as additional insureds on a primary and noncontributory basis. Subcontractor’s coverage must include completed operations and a provision that coverage cannot be cancelled until 30 days prior written notice has been given to ABC Construction.
- Umbrella Liability Insurance: Subcontractor shall also provide Umbrella or Excess Insurance, over and above Employers’ Liability, Commercial General Liability and Automobile Liability on a “follow-form” basis with minimum limits of $5,000,000 Each Occurrence.
ABC Construction’s contractual intent is to ensure that the Subcontractor’s General Liability and Umbrella Liability coverages respond first, on a primary basis, in the event of a loss involving the Subcontractor. The common belief is that with this contract language, a loss would have to first exhaust the Subcontractor’s $1,000,000 General Liability limit and $5,000,000 Umbrella Liability limit prior to ABC Construction’s insurance paying on the loss.
In this example, the contract language utilizes the concept of “vertical exhaustion” where the Umbrella Liability coverage is assumed to follow the underlying General Liability coverage with additional insured status.
However, many contractors would be surprised to learn that some states no longer utilize vertical exhaustion. State specific court cases have established legal precedent for application of “horizontal exhaustion” which makes the historically used contract language obsolete and poses a significant threat to upstream parties on construction projects.
The horizontal rule requires that all applicable primary (General Liability) policies be exhausted before any umbrella coverage is triggered. The following claim scenario for ABC Construction illustrates how a large casualty claim would actually be adjusted:
- A liability loss of $6,000,000 occurs on ABC Construction’s project as a result of the Subcontractor’s negligence.
- A lawsuit is filed by the injured party against ABC Construction seeking $6,000,000 in damages.
- ABC Construction then tenders the claim to the Subcontractor’s insurance carrier citing additional insured status. ABC Construction assumes that the Subcontractor’s $1,000,000 General Liability policy and $5,000,000 Umbrella Liability policy will be sufficient to cover the claim.
- The Subcontractor’s insurance carrier grants coverage, provides defense and agrees to indemnify ABC Construction up to the $1,000,000 General Liability Limit. In regards to the Subcontractor’s Umbrella Liability, the carrier cites the “other insurance” provision in their policy and determines that their Umbrella coverage is excess over all other collectible insurance, including ABC Construction’s General Liability policy.
- Consequently, the Subcontractor’s Umbrella policy will not respond until the General Liability policies of the Subcontractor and General contractor are both exhausted.
The original intent of ABC Construction’s contract was to transfer risk of loss to the subcontractor and ensure that $6,000,000 of casualty coverage was guaranteed on a primary basis. However, as this claim example illustrates, the insurance provisions in ABC Construction’s subcontract are insufficient for establishing coverage priority in states utilizing the Horizontal Rule of Exhaustion.
Blog post contributed by Matt Honea, a Commercial Insurance Advisor at Taggart Insurance and member of the Blueprint Construction Unit. He is well respected within the construction community and a frequent presenter and contributor at industry events. Blueprint is a division of Taggart Insurance designed to meet the unique risk management needs specific to construction and development activities.