With multi-family construction booming in Colorado and elsewhere around the country, most general contractors and developers are turning to project-specific wrap-up insurance programs to insure such projects. Whether structured as an Owner Controlled Insurance Program (OCIP) or a Contractor Controlled Insurance Program (CCIP), the benefits of wrap-up programs include the ability to tailor coverage to the onsite construction exposures at a particular project and to avoid disputes among multiple insurers by insuring all of the key players under the same program.

Wrap-up programs can and should be negotiated rather than standard form policies. While this provides an opportunity to customize the insurance to the project, it is also rife with potential pitfalls. This advisory is the first in a three-part series examining some common issues that, if ignored, can create significant obstacles to achieving your goals with a wrap-up program.

Defense Within Limits Increasingly Common in Wrap-Up Programs

Increasingly, wrap-up carriers are including defense fees and costs within the policy’s limits. This means attorneys’ fees and costs incurred defending the insureds will reduce the limits of insurance available to settle or pay a judgment against the insureds. Such policies are often called defense within limits, burning limits, eroding limits, wasting limits or “Pac Man” policies. The way in which insurers are capturing defense fees and costs and counting them against policy limits is not always obvious. Project owners and contractors who may wish to object to, or at least plan for, insurance programs with defense fees within limits must read wrap policies carefully.

Standard CGL Coverage Places Fees & Costs Outside of the Limits of Insurance

All wrap-up programs include a primary and at least one excess layer of commercial general liability (CGL) insurance. CGL insurance requires the insurer to defend and indemnify the insured against claims brought by third parties alleging damages from property damage or bodily injury caused by an occurrence (i.e., an accident). One of the main liability exposures in multi-family construction is a construction defect lawsuit. A CGL policy is the first line of defense against these lawsuits and one of the primary reasons contractors and developers purchase wrap-up coverage.

In standard CGL policies, the payment of defense fees does not deplete or erode the limits of insurance. The insurer’s duty to defend terminates only after the insurer exhausts its limits through payment of a judgment or settlement, but while the duty to defend is ongoing, the policy sets no monetary limit on the amount of reasonable attorneys’ fees and costs that may be expended in defending the insured.

Also relevant to the treatment of defense fees within limits is the Supplementary Payments provision. The Supplementary Payments provision in standard CGL policies generally obligates the insurer to pay for a host of items with respect to any suit it defends, including expenses the insurer incurs, court costs taxed against the insured, prejudgment and post judgment interest, and others. In most standard ISO forms, this provision states: “[t]hese payments will not reduce the limits of insurance.” The defense fees and costs fall within these supplementary payments.

Eroding Limits Historically Reserved for Certain Claims Made Policies

By contrast, Directors & Officers (D&O) policies and certain types of professional liability policies typically include eroding limits. In these policies, the defense fees and costs reduce the limits of insurance available to pay a settlement or a judgment against the insured. Any ambiguities in such provisions should be construed against the insurer and some states prohibit or regulate claims made policies with wasting limits. As a result, some such policies contain a conspicuous, express notice to the insured disclosing the wasting limits with verbiage such as: “This policy contains provisions that reduce the limits of liability stated in the policy by the costs of legal defense and permit legal defense costs to be applied against the deductible.”

Carriers Burying Defense Within Limits in Supplementary Payments Provision

Increasingly, wrap-up insurers are including defense within limits in manuscript CGL policies (i.e., insurance policies custom designed for a particular project) without providing a conspicuous notice to the insured. Instead, these carriers are simply eliminating one critical word in the fine print on the supplementary payment provision, changing “[t]hese payments will not reduce the limits of insurance” to “[t]hese payments will reduce the limits of insurance.” In reviewing a lengthy policy, it is easy to overlook this small change, but it potentially has great significance.

What Do Eroding Limits Mean to Your Company?

Before your wrap-up program is bound, it is critical that owners and contractors understand whether defense fees and costs will erode or deplete the limits available to settle or pay a judgment. Addressing this issue up front, will allow owners and contractors to mitigate against the following issues.

1. Contract Compliance. On a construction project the required insurance limits are governed by contract. Defense fees that erode policy limits could create contract compliance issues where one party may interpret a defense within limits policy as not meeting policy limits set by the contract. To ensure compliance with contractual requirements, it is critical to understand whether the defense fees erode those limits. Make sure all parties to the contract agree the limits provided comply with the contract documents.
2. Conflict of Interest. A policy with wasting limits creates a potential conflict of interest between the insurer’s self-interest in defending vigorously to reduce its indemnity obligation, and the insured’s interest in protecting the limits for a settlement or adverse judgment. Defending a case through trial may deplete the limits to the point where an adverse judgment in any amount will exceed the policy limits. Insureds must remain vigilant in monitoring defense costs on a wasting limits policy.
3. Duty to Defend May End Sooner. The limits of a wasting policy will be exhausted more quickly than an identical policy without wasting limits. This means the first layer insurer’s obligation to defend your company is more likely to terminate before trial. Insureds must make sure the excess/umbrella carrier will step in with minimal disruption to the defense.
4. Multiple Insureds Can Wipe Out Limits. One of the central purposes of a wrap-up program is to “wrap” all of the key players within one set of policies. With wasting limits, this can lead to even further depletion through costs of the defense for multiple insureds. Some parties address this in the contracting phase by requiring that all parties use the same defense lawyers unless prohibited by a conflict of interest.

As always, it is essential to work with a good broker and, ideally, an insurance coverage lawyer, when negotiating a wrap-up program.