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Out of Left Field: Subrogation Claims Against A/Es
By Steven G.M. Stein, Esq.,
Stephen E. Ray, Esq.,
& Carl L. Popovsky, Esq.


INTRODUCTION

Design professionals are subject to a variety of different claims arising from their design and construction administration services. Owner's claims for alleged design errors, and claims brought by injured workers and others for personal injuries, are well known to most architects and engineers. Many design professionals, however, are unfamiliar with subrogation claims brought by insurance companies against project architects or engineers for damages resulting from the partial or complete destruction of a structure in a construction calamity.

WHAT IS SUBROGATION?

Subrogation is generally defined as the substitution of one person in the place of another with reference to a lawful claim, demand or right. The substituted party, known as the "subrogee," succeeds to the rights of the party whose "shoes he has stepped into."

A common example of a subrogation claim involves an automobile insurer which pays the claim of its insured who is injured by a negligent motorist. The general rule is that the insurance company, having paid the loss sustained by its injured policyholder due to the wrongful act of another, is "subrogated" to the rights of the policyholder -- meaning that the insurance company has the right to step into its insured's shoes and sue the wrongdoer. Conversely courts will not allow the insurance company to maintain a suit against its own auto insurance policyholder, even if the insured driver caused the accident, because that would defeat the purpose of insurance.

Construction projects from time to time experience catastrophes such as fire, collapse, water damage or vandalism. Such hazards generally are insured by an Owner's or Contractor's "builder's risk" policy. As discussed below, the project Architect or Engineer, may, under certain circumstances, be sued by the builder's risk insurer in a subrogation action after one of these catastrophic events occurs.

BUILDER'S RISK INSURANCE

Builder's risk insurance is a particular kind of property insurance that typically covers only losses resulting from damages to the incomplete structure under construction. Builder's risk insurance often is referred to simply as "property insurance." Typically, either the owner or the contractor is required, by the terms of their contract, to obtain builder's risk insurance for the proposed project. For example, Paragraph 11.3.1 of the standard AIA General Conditions (AIA Document A201) requires the owner to purchase and maintain property insurance for the entire Work at the site on a replacement cost basis. The "Work" is broadly defined in Paragraph 1.1.3 of the standard AIA General Conditions to include the construction and services required by the contract documents, whether completed fully or partially. Paragraph 11.3.1.1 of the standard AIA General Conditions requires that the property insurance be on an "all-risk form" (e.g. the policy covers all perils which are not specifically excluded). Significantly, the standard AIA General Conditions require the property insurer to cover reasonable compensation for the architect's services and expenses required as a result of the insured loss. Paragraph 11.3.1.3 requires the owner to pay costs not covered because of deductibles in the insurance policy obtained, unless the contract specifies a deductible amount, in which case the contractor covers the deductible. If the owner does not intend to purchase the property insurance required by the contract, then the standard AIA General Conditions require the owner to notify the contractor in writing prior to commencement of the project and the contractor may then purchase the builder's risk insurance and charge the cost to the owner.1

If a calamity occurs at the jobsite during construction, the builder's risk insurance company will send a team of adjusters to the field to evaluate the loss. Assuming that the insurance company acts in good faith and that the loss is covered by the policy, the insurance company likely will pay the policyholder (which will be the owner if the parties use the standard AIA General Conditions) and/or the named beneficiaries of the policy for their proven loss. It is likely that the design professional will have little property of value at the site, and therefore may not be involved in any adjustment. However, if the insurance company determines during its investigation that the reason for the calamity was a design error (e.g. such as a collapse caused by underdesigned structural steel or a pipe rupture caused by an improper piping schedule), the issue is whether the builder's risk insurance company can maintain a suit against the architect or structural engineer.

Note that the builder's risk insurance compliments, but typically does not overlap, the general contractor's general liability policy. The contractor's general liability policy (as described, for example, in paragraph 11.1 of the standard AIA General Conditions) covers claims for damages to all property other than to the Work.

A/E'S WEAPONS AGAINST SUBROGATION CLAIMS

The design professional has two contractual weapons to ward off potential subrogation claims brought by property insurance companies. Those contractual provisions are (1) clauses indicating that the A/E is one of the insureds under the builder's risk policy; and 2 waiver of subrogation provisions by which the property insurer's right to bring a lawsuit against the A/E has been waived by the owner and contractor.

A/E as an Insured Under Builder's Risk Insurance

In the same way that an auto insurance company cannot sue its own auto insurance policyholder, even if the policyholder caused the accident, the majority rule, which is followed in Illinois, is that a builder's risk insurer cannot sue "one whose interests are insured". Village of Rosemont v. Lentin Lumber Company, 144 III.App. 3d 651, 494 N.E. 2d 592 (1st Dist. 1986). The critical question then is whether the A/E is one whose interests are insured by the builder's risk policy.

The Status of the Law

Each party named as an insured in an insurance policy meets the criteria of being "one whose interests are insured" so long as the court finds that the named party had an "insurable interest" in the covered property. Builder's risk policies commonly are written to protect specified parties for losses to covered property.(2) The contractor, for example, may have an insurable interest in the covered property prior to the time the owner accepts, and pays for, the completed project. Similarly, the owner may have an insurable interest in portions of the covered property which are accepted prior to final completion of the project. The question remains whether a design professional has an insurable interest under a builder's risk policy.

In Dyson & Co. v. Flood Engineers, Architects, Planners, Inc., 523 So.2d 756 (Fla. App. 1988), the court expressly answered this question in the affirmative. In Dyson, the City of Pensacola contracted with Flood Engineers to design and engineer the specifications for the construction of a sewage treatment plant. Under the General Conditions of Dyson's contract, Dyson was required to maintain builder's risk insurance on the project to protect the interests of Dyson, the City and Flood Engineers from various hazards to the work. Dyson obtained builder's risk insurance, but the policy named only Dyson and its subcontractors as insureds, leaving the interests of Flood Engineers and the City seemingly unprotected.

A fire occurred at the plant during a performance test of certain portions of the completed project. Dyson was paid more than $200,000 pursuant to the builder's risk insurance policy for damages caused by the fire. The builder's risk insurer then filed a subrogation action against Flood Engineers alleging that Flood's negligent design caused the fire. The court first found that Dyson had breached its contractual obligation to name Flood as an insured, and that therefore, Dyson's insurer had no subrogation rights against Flood so long as Flood had an "insurable interest" in the property destroyed.3 Significantly, the court next held that the project engineer had an insurable interest which could be protected under the builder's risk policy and barred the property insurer's subrogation action against the project engineer. The court reasoned that Flood risked liability for damages arising out of destruction to the property, and that this was sufficient "insurable interest" in the property.4

The above described case, although well reasoned and illustrative of the modern trend, is not beyond challenge. There remains a split in authority among courts as to whether a builder's risk insurer can maintain a subrogation action against one of the insureds for damages caused by the insured's negligence to the property or to the Work of other insureds. A growing majority of courts will not allow an insurance company to sue one whose interests are insured and have denied such claims. Those courts generally have stated that public policy reasons support barring subrogation claims by insurance companies, including the costs of subrogation litigation which would be borne by the public through increased construction costs.

Nevertheless, a minority of courts have held that a builder's risk insurer can recover from a negligent insured payments made for damage to the property or the Work of other insureds. These courts emphasize that the prohibition of an insurer suing its own insured should extend only to payments made by the insurer with regard to the negligent insured's own property.

Contract Drafting to Maximize Status as an Insured

In order to avoid the uncertainties of litigation, steps may be taken during contract negotiations to maximize a design professional's protection under a builder's risk insurance policy.

Typically, two written agreements govern the relationships between the design professional and the other parties: the owner-design professional agreement and the owner-general contractor agreement (which includes general conditions). Presuming such agreements are open to negotiation, they both should reflect the parties' intent to have the design professional included among those whose interests are insured under the builder's risk policy.

First, the design professional should insist that it be named as an insured under the owner's (or the contractor's) builder's risk insurance. To accomplish this result, the design professional should insert language both in its contract with the owner and in the general conditions of the owner/contractor agreement. Using standard AIA documents as examples5, the following modifications to the standard AIA Documents B-141 and A-201 should be utilized:

Second, both the B-141 owner-A/E agreement and the A201 General Conditions should be amended to include a statement acknowledging that the A/E has an insurable interest in the project under the builder's risk policy.

If these modifications to the contract documents are made, and a subrogation claim is initiated against the A/E by the builder's risk insurer, the design professional will have a strong argument that, as a matter of law, it has an insurable "interest" in the project and summary judgment should be available in favor of the A/E against the builder's risk insurer.

Contractual Waiver of Subrogation Claims Involving Damages to the Work

The participants in a construction project generally are willing to agree to shift the risk of loss during construction from themselves to an insurer by looking solely to property insurance proceeds to pay for any losses to the Work which they may sustain. To accomplish this result, the owner or contractor must obtain property insurance and the parties must mutually waive their rights against one another for damages caused by specific events to the extent of the insurance proceeds. When the insured contractually agrees to waive its rights against another - and if the court upholds that provision - then the insurance company has no rights against the other party when it steps into the insured's shoes.

A contractual waiver of damages covered by builder's risk property insurance is contained in the current edition of the standard AIA documents. As noted above, Section 11.3 of the General Conditions requires an owner to obtain property insurance with all-risk coverage for the Work. Section 11.3.7 of the General Conditions contains an explicit statement that the owner and contractor waive all rights against each other and the Architect, the Architect's consultants, and others for damages caused by fire or other perils to the extent covered by property insurance. Similarly, the AIA-B141 owner/architect agreement contains the following mutual waiver of rights provision in Paragraph 9.4:

The courts have generally found these provisions to be "unambiguous" and dismissed subrogation claims brought by property insurers against design professionals and contractors.6 The waiver of claims provision in the current (1987) version of the AIA A201 form recently withstood an argument made by a builder's risk insurer that the provision was an exculpatory provision (a clause that unilaterally relieves one party from the effects of its own future negligence) and therefore unenforceable as a matter of public policy. The Supreme Court of New Hampshire disagreed, finding that the waiver was part of a comprehensive scheme among the parties to shift construction risks to various insurers. Chadwick v. CSI, Ltd., 629 A. 2d 820 (1993).7

In one noteworthy decision, however, the North Carolina Supreme Court ruled that provisions similar to the current AIA standard form were ambiguous and denied the architect's motion to dismiss the subrogation claim. In that case, St. Paul Fire and Marine Insurance Co. v. Freeman-White Associates, Inc., 322 N.C. 77, 366 S.E. 2d 480 (1988), the architect entered into a contract with the plaintiff hospital to design a 130-bed hospital and medical center. The architect was assisted by a structural engineer. While subcontractors of the construction manager were pouring concrete to form the project's south-wing roof, the south wing collapsed, causing extensive property damage. The owner was compensated for the damage by St. Paul Insurance Company under the owner's builder's risk policy. Thereafter, St. Paul filed a subrogation complaint against the architect asserting, among other things, that the architect's negligent design caused the collapse.

The contract between the owner and the architect was the 1980 edition of the Standard Form Agreement between Owner and Architect, Construction Management Edition (B-141/CM) with certain modifications which incorporated by reference the 1980 Edition of the General Conditions (A201/CM). That Standard Form Agreement contained explicit provisions by which the owner and architect waived all claims against one another for damages to the Work. The parties, by separate document, added a paragraph to the owner-architect agreement which required the project architect to maintain a professional liability insurance policy providing coverage for errors and omissions committed by the architect and the architect's consultants. The issue before the court was whether the contract documents unambiguously established that the owner agreed to waive its rights against the architect, looking only to the builder's risk insurance policy to cover damage to the project itself.

The North Carolina Supreme Court held that the contractual waiver of rights provisions were ambiguous and susceptible to conflicting interpretations. The court reasoned that one of two possibilities existed: (i) either the parties intended for the Owner to waive all claims against the architect which were covered by builder's risk insurance or; (ii) the parties did not intend for the architect to benefit from the builder's risk insurance but instead intended that the architect insure its errors and omissions with professional malpractice coverage, thereby negating the waiver of rights. The court noted that the contract documents did not on their face require that the architect's interests be insured under the builder's risk policy and that the waiver did not extend to the architect's liability arising from the preparation of the plans and specifications.

The Freeman-White case underscores the need for care in altering the standard AIA documents. The following steps are recommended to avoid questions of ambiguity in utilizing the standard AIA documents:

  1. As noted above, the General Conditions should be amended to state that the builder's risk insurance insures the interests of the A/E and A/E's consultants in the Work as well as the interests of the owner, the contractor, the subcontractors and the sub-subcontractors; and
  2. If the A/E agrees to provide errors and omissions insurance, the owner-architect agreement should contain provisions to the effect that the A/E's agreement to provide professional errors and omissions coverage is intended to insure the A/E's responsibility for damages to persons and property other than the Work and to have no effect on the waiver of subrogation provisions in the contract documents. 8

CONCLUSION

There is a lack of definitive case law in the area of subrogation claims against design professionals for damages to the Work. As a result, there exists an exposure for such claims which is not well known to many design professionals. In order to minimize the design professional's exposure to subrogation claims, the design professional should, whenever possible, attempt to utilize standard form AIA documents with the various modifications described above. When it is not possible to utilize standard form documents, the design professional, to the extent that negotiation is possible, should insist that the owner or contractor purchase suitable builder's risk insurance and that such policy cover the design professional's interests in the Work.

Endnotes

  1. As will be discussed further below, an owner's failure to provide insurance as contractually obligated typically will preclude the owner from recovering from the other party for property damage which would have been covered by the insurance.
  2. As a matter of public policy, courts will only enforce insurance policies covering items in which the insured has an interest, the rationale being that an insured would have incentive to purposefully destroy an insured item that he did not value.
  3. A general principal of subrogation law prevents an insurance company from having any greater rights against a third party than the insured. Dyson breached its contract with Flood and thereby lost its right to recover from Flood under the same contract. When Dyson's insurer stepped into Dyson's shoes it also was precluded from reimbursement from Flood.
  4. The Supreme Court of Virginia has held that an architect also has an "insurable interest" in the property under construction because "the property constituted inchoate security for the payment of contract debts due to the contractor and architect for performance of the entire work." Blue Cross v. McDevitt & Street Co., 360 S.E. 2d 825,827 (Va. 1897) The architect obtained this favorable result even though the building damaged was substantially completed and partially occupied before pipe bursts caused the damage at issue.
  5. Although standard form AIA documents are used as examples herin, much of the discussion would apply to other standard form agreements, such as the Engineers Joint Contract Documents Committee (EJCDC) documents.
  6. For example, in South Tippecanoe School Building Corporation v. Shambaugh & Sons, Inc., 395 N.E. 2d 320 (Ind. App. 1979) a gas explosion and fire damaged an unfinished high school. The school district's building risk insurer paid for the damages and filed a subrogation claim against, among others, the school's architect. The parties used an old edition of AIA A201 form, which included a provision similar to the waiver language in A201 Paragraph 1.3.7. Even without looking to the owner-architect agreement, the court found that the parties clearly intended to shift the risk of property loss to the insurers and enforced the waiver of subrogation provision and granted summary judgment in favor of the architect.
  7. The court also held that the subrogation waiver clause applied not only to damages to the Work itself, but also to work adjoining or adjacent to the Work to the extent that the owner insured these areas.
  8. Note that the standard form of the EJCDC owner-engineer agreement contains a provision requiring errors and omissions coverage, and thus a similar modification is needed.

Attribution

Steven G.M. Stein, Esq., Stephen E. Ray, Esq., & Carl L. Popovsky, Esq. Stein, Ray & Conway ("SRC") is one of the largest firms in the United States exclusively devoted to construction law. SRC represents many of the country's largest owners, design professionals and contractors in contract formation, risk management and insurance, business counseling, and dispute resolution. SRC has handled some of the country's highest profile design and construction cases.

The information in this and all other RISK Administration Management Company articles is intended for information and risk management purposes only and does not constitute legal advice. For legal advice and assistance, please contact competent counsel in the jurisdiction of your professional practice.

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