Chapter 10

Insurance and Bonding

Summary:

Insurable risks inherent in public works contracts are outlined in this chapter. The various types of construction insurance coverage available to the involved parties are summarized. This chapter also discusses the two major forms of bonding (payment and materials bonds and performance bonds), and the differences among bonding, insurance and surety litigation. Further, two legal cases are discussed that illustrate the complex subject of insurance coverage litigation. The Cates Construction case is cited and discussed with regard to surety litigation.

§ 10.1 Insurable Risks

Many risks are inherent in the construction of new public works projects, and to the extent possible, those risks should be protected against with a comprehensive program of liability and property insurance coverage. The primary risks of a project are covered in Chapter 2. However, it is critical to observe that many of these risks are not insurable or must be carefully negotiated as part of the project’s insurance program.

§ 10.2 Construction Insurance

Insurance is a major part of the public works process. Public agencies, design professionals, and construction firms must all address this area when becoming involved with any public works construction project. Consultation with an insurance specialist is highly recommended before entering into a public works contract.

§ 10.2.1 Coverage Issues

The following is a brief overview of the various types of coverage and policies generally available. It is important to note that the highly-complex fabric of construction insurance policies and exclusions — along with insurance company marketing and claims practices, the impact of case law, and the dynamics of the litigation process — often does not meet the coverage expectations of design professionals, contractors and public agency owners.

The major coverages for construction projects are divided into liability policies and property policies. Liability policies protect the insured against legal liability and defense costs for claims asserted by third parties for negligent injury to persons or property. Generally, there must be an occurrence, often thought of as an accident or unexpected consequence that leads to actual damage.

The principal liability coverages are set forth in Commercial General Liability (CGL) Policies carried by virtually all parties to the construction process. There are many written exclusions in these policies, and whether they extend to products liability, completed operations, explosion and underground liability, environmental impairment, contractual liability, professional liability, workmanship, subsidence, ultra-hazardous activities (such as blasting), and other potential losses, depends on the policy language and manner of issuance.

As some contract insurance requirements are at minimal limits, most construction firms also carry umbrella coverage ranging from $1 million to $250 million and beyond. There are two substantial dangers in professional liability policies that are typically issued to design professionals, environmental remediation firms, and other construction participants. These policies are typically written on a claims made basis. Thus, if a claim is not made during a specific policy year, the policy will not cover the loss, even if the loss or negligent acts occurred during the policy year. Also, these policies may contain “wasting aggregate” provisions, meaning that as defense funds are expended, the policy limits decrease by the amount of defense funds.

The existence of a professional services exclusion in an insurance policy does not always resolve whether there is coverage. In North Counties Engineering, Inc. v. State Farm General Ins. Co. (2014) 224 Cal.App.4th 902, the lack of coverage for design work did not prevent a claim for coverage for construction negligence, where the insured provided both types of services.

An important form of liability coverage is contained in Workers’ Compensation and Employers Liability policies. Workers’ Compensation is really no fault insurance. The policy will cover specified loss amounts for injuries to workers that are incurred in the scope of their employment. Generally, Workers’ Compensation serves as a bar against suing the employer in typical employee injury claims.

Employer’s Liability insurance covers more esoteric claims by employers under various state statutes and theories of liability. Workers’ Compensation is required for contractors operating in California. The typical property policy covers loss, destruction or damage to property owned by the insured. There are also policies for equipment floaters, auto coverage, goods in transit, etc. A major form of policy carried by most owners is the Builder’s Risk Policy. The typical insurance policies provided by general contractors and subcontractors on a particular project are set forth in Article 11 of the AIA A201 General Conditions.

Each of the participants in a public works project has its own set of coverages and exclusions. In fact, it is not uncommon for 50 to 100 policies to be involved in a major public works construction accident or dispute. Conflicts often arise between subcontractors’ insurance provisions and eventually affect the owner because of the inconsistency among policies. As such, an Owner Controlled Insurance Program (OCIP) is a common provision of large public works projects.

In this regard, it is critical to evaluate the insurance program, and the resulting covered and retained risks with regard to these additional criteria: limits and deductibles, named insured status, additional insured status, waivers of subrogation, written indemnity agreements, and the quality and financial strength of the respective carriers, and self-insurance programs.

There are several types of insurance policies that contain traps for the unwary. For example, the so-called “self-consuming, or “wasting aggregate” policies may be worth far less than their face policy amounts. In these types of policies, the amounts expended by the carriers for defense costs reduce the available coverage amounts. Thus, a hard fought case may leave no policy limit for an adverse verdict.

On rare occasions, insurance companies will attempt to issue policies to general contractors or others with these provisions, which should be highly discouraged. There is a tremendous distinction between a certificate of insurance, which states generally the type of policy that has been issued, and the policy itself. Only a review of the insurance policy, with its policy limits, deductibles, insurance declarations, named and additional insureds, and exclusions will yield the true nature of coverages afforded by the policy. Finally, it is much easier to forge or alter a certificate of insurance than create an entire fraudulent policy form. Certificate forgery is a common problem in the industry. A certificate is not legal proof of insurance coverage.

§ 10.2.2 Insurance Coverage Litigation

The litigation of insurance coverage claims is extremely complex, as it involves highly technical policies and mountains of ever-changing case law. Extrinsic evidence of what is intended to be covered by a policy can include discovery of the insurance company’s claim adjustment manuals and other internal documents.

In the Glenfed case,163 after an insured real estate developer’s excess insurance carrier denied coverage of the insured’s claims, the insured brought an action for declaratory relief and reformation, as well as damages for breach of contract and breach of the implied covenant of good faith and fair dealing.

Reformation means the court interprets the contract using reformed or modified terms intended to affect the original intent of the parties. During discovery, the trial court denied the insured’s motion to compel production of the insurer’s claims manual, finding that the insured had failed to show good cause for its production.164 The court of appeal ordered the trial court to: (1) void its order denying the insured’s motion to compel production of the insurer’s claims manual; and (2) enter a new order granting the motion. Although a party who seeks to compel production of documents must show “good cause” where there is no privilege issue or claim of attorney work product, that burden is met simply by showing relevance.165 Since claims manuals are admissible in coverage dispute litigation, it follows that they are discoverable. As for this manual’s relevancy, the Insurance Code requires insurers to maintain guidelines for processing claims, and these guidelines are maintained in claims manuals.166 Since virtually all policies detail the manner in which claims must be presented, the instruction manual for the insurer’s employees was very likely to address such policy terms. Also, in this type of litigation extrinsic evidence as to reasonable expectations of the insured may be admissible at trial. Even if it was inadmissible at trial, the claims manual could lead to the discovery of other, relevant evidence that was admissible.167

§ 10.3 Bonding

The concept of surety bonds is simple. If the contractor defaults or does not pay its subcontractors and suppliers, then the surety will be responsible for those debts. The bonding company will then seek repayment by the contractor from the collateral or assets pledged by the contractor in securing the bond.

In some instances, the surety may assist or even step into the contractor’s shoes and pursue claims against the owner for project issues that may have been responsible for the default. In other situations, the surety may simply preside over the liquidation of the contractor’s assets. The bonding company then pursues the contractor and its ownership for repayment, generally under corporate and personal indemnity agreements. However, as we will see, the realities of bonding and suretyship are far more complex.

There are two major forms of bonds, those that: 1) guarantee the payment of the general contractor’s subcontractors (the so-called payment and materials bond); and 2) those that guarantee the actual performance of the general contractor (performance bond).

Unlike insurance policies, the bonding companies are not assuming the contractor’s risk of non-payment or performance, which remains with the contractor. In the event of insolvency or failure of performance of the contractor, the bonding company is obligated to complete the project and pay the subcontractors and materialmen. It may seem that the surety takes the largest risks on the project, but that exposure is tempered by several factors. First, the surety writes a bond for the entire contract amount, a daunting amount. But at any moment in the project, the actual exposure of the surety is far less than the penal amount of the guarantee. At the beginning of the project, the contractor is still owed the entire revenue of the project, so the risk is that the project has been bid too low.

At the end of the project, the surety is responsible for completion costs, but that amount may only represent a small percentage of the overall project cost. The surety’s greatest risk lies in the “fog of war” during the project, when the owner’s payments should be keeping track with and applied to the contractor’s progress and payments to its labor, materialmen and subcontractors. As such, sureties closely watch the progress of major projects, as well as the balance sheets and income statements of their contractor clients.

Dealing with contractor’s bond sureties, in Fed. Ins. Co. v. Superior Court (1998) 60 Cal.App.4th 1370, the court found that a subcontractor’s claim on a payment bond must be stayed by the court, along with the subcontractor’s claim against the general contractor, pending the outcome of the general contractor/subcontractor arbitration proceeding and pursuant to the arbitration provisions found in the subcontractor/contractor contract.

Bonds also differ from insurance policies when a bonding company becomes insolvent. When an admitted insurance carrier becomes insolvent, the State of California Insurance Guarantee Fund provides certain financial protections to policyholders. However, there is no State of California guarantee fund for sureties or bonding companies.

Bonds also differ from insurance in that the claimant on the bond does not have the right to sue the surety for bad faith, as set forth by the California Supreme Court in Cates Construction, Inc. v. Talbot Partners (1999) 21 Cal.4th 28. The Supreme Court stated: “This case presents issues relating to the contract and tort liability of a commercial surety to a real estate developer under a bond guaranteeing the contract performance of a general contractor on a multimillion dollar condominium construction project. For the reasons set forth below, we conclude that the bond at issue contractually obligates the surety to pay damages attributable to the general contractor’s failure to promptly and faithfully perform its contract obligations by the agreed date. We further conclude that, as a matter of law, the developer may not recover in tort for the surety’s breach of the covenant of good faith and fair dealing implied in the performance bond. In light of these conclusions, we reverse the judgment of the Court of Appeal insofar as it affirmed the underlying award of tort damages for breach of the implied covenant and permitted an award of punitive damages.”

As a result of Cates Construction, supra, bonding companies responding to claims against their principals may simply reiterate back the claim and contract positions of the contractor, indicating the surety’s belief that their principal is not in breach, or that monies are not owed. This can mean the bond becomes little more than a guarantee of any ultimate judgment against the contractor for non-performance or non-payment.

However, the surety is obligated to perform a prompt review of the claim and take a position on whether or not the surety is obligated to perform or pay funds on behalf of the contractor. The track record of sureties taking over projects for defaulting contractors varies greatly. They have a statutory obligation to investigate, but often seem to take inordinate amounts of time to make a decision as to whether to proceed with the job or back the contractor in its claims and allegations of material breach by the owner. When a surety does take over a job, it will often charge substantial consulting and legal services that it will eventually seek to recover from the contractor, its principal, under its indemnity and collateral agreements. Thus, investigating the quality, reputation and financial strength of the bonding companies is a critical issue for owners, subcontractors and material vendors.