ON THE ROAD TO TETON: WAIVER OF SUBROGATION IN CONSTRUCTION CONTRACTS – A NEW TWIST ON AN OLD THEME
By: Charles B. Daugherty
Insurance companies are in the business of assessing risk and compensating insureds when the unexpected arises, but payment is not necessarily the last step in the claim process. As a general rule, upon payment of a loss, an insurer may step into its insured’s shoes and assert any right of action which the insured may have against a third person whose negligence or wrongful act caused the loss. This is the definition of subrogation. Subrogation is an instrument of economic efficiency because it forces negligent actors to bear the costs of their actions, which avoids externalities—the imposition of an activity’s costs upon others. When subrogation is precluded, externalities result because innocent actors bear the costs associated with the negligence of others.
The subrogation concept applies across many types of loss in many industries, including the construction industry. Subrogation in the construction context, however, is unique. Construction projects are complex endeavors. This complexity has posed a dilemma for many courts. Subrogation lawsuits delay valuable construction projects and result in costly and lengthy litigation. Commentators have noted that “in the construction setting, [an insurer’s subrogation action and] recovery can frustrate the intention of the participants and the participants’ insurers.”Consumers ultimately suffer from (1) delayed use of new facilities and (2) increased costs passed on by construction litigants. In response to this, many construction contracts, including the AIA’s standard forms, include subrogation-waiver clauses.
But precluding subrogation leads to externalities and economic inefficiency because negligent parties are not forced to bear the loss arising from their own negligence. These costs too are ultimately shouldered by the consumer. Like many states, Indiana has also grappled with these conflicting policies. Over the years, Indiana’s courts have upheld waivers of subrogation in the construction industry. Along the way, the subrogation-waiver landscape has been shaped by several construction disputes.
In its most recent announcement on the topic, Indiana’s Supreme Court took an expansive approach to subrogation-waiver clauses by holding that, under the language at issue, an insurer was precluded from recovering for losses to both “work” and “non-work” property. This short article Teton’s impact on the construction industry.
Teton and Its Impact
The Indiana Court of Appeals has addressed a “work” versus “non-work” distinction that has divided courts across the United States. Until this year, the Indiana Supreme Court had not weighted in on the issue. Teton changed that.
In 2004, the Indiana Court of Appeals adopted the “minority approach” by holding that subrogation waivers in standard AIA agreements are only effective to waive damages sustained to property that is subject to work under the contract, even if an insurance policy covers damages to other non-work property. But, in 2014, a different circuit adopted the “majority approach” by holding that subrogation waivers in standard AIA agreements are effective to waive damages sustained to any property covered by insurance, whether property that is subject to work under the contract or other non-work property. The Indiana Supreme Court granted transfer to address the split between the circuits
Teton arose out of a renovation and remodeling project at the Jefferson County courthouse. The first phase of the project involved repairs to the courthouse roof, flashing, gutters, and downspouts at a price of $87,280.00. The parties’ contract required Jefferson County to obtain separate property or builder’s risk insurance for the project.Instead, Jefferson County relied on its existing property insurance. The construction contract contained the following language:
11.3.5 If during the Project construction period the Owner insures properties, real or personal or both, adjoining or adjacent to the site by property insurance under policies separate from those insuring the Project, or if after final payment property insurance is to be provided on the completed Project through a policy or policies other than those insuring the Project during the construction period, the Owner shall waive all rights in accordance with the terms of Subparagraph 11.3.7 for damages caused by fire or other perils covered by this separate property insurance. All separate policies shall provide this waiver of subrogation by endorsement or otherwise.
11.3.7 Waivers of Subrogation. The Owner and Contractor waive all rights against . . . each other and any of their subcontractors, sub-subcontractors, agents and employees, each of the other . . . for damages caused by fire or other perils to the extent covered by property insurance obtained pursuant to this Paragraph 11.3 or other property insurance applicable to the Work . . . .
During construction, a roofing subcontractor allegedly caused a fire while soldering downspouts near the courthouse’s wood frame. The fire resulted in approximately $6 million in damages. Jefferson County filed a lawsuit against the contractor and its subcontractors. The contractor raised the waiver of subrogation clause as a defense, but Jefferson County argued that the waiver only applied to damages to the “Work,” as defined in the contract, meaning that Jefferson County should not be precluded from recovering damages exceeding $87,280.00 contract price for the renovation work.
The Indiana Court of Appeals held that Jefferson County waived its right to subrogate all damages claims covered by its property insurance, including damage to “non-Work” property. Noting that the majority approach furthers the underlying purposes of subrogation waivers by “avoid[ing] the predictable litigation over liability issues and whether the claimed loss was damage to Work or non-Work property,” the court applied the waiver of subrogation provision to all of Jefferson County’s property covered by property insurance. Jefferson County, therefore, could not recover.
On transfer, in a case of first impression, the Indiana Supreme Court affirmed the Court of Appeals and adopted the majority approach. The Court reasoned that “[t]he positioning and plain meaning of the word ‘covered’ restricts the scope of the subrogation waiver based on the source and extent of the property insurance coverage, not the nature of the damages or of the damaged property.”The Court held that “if property damages (of any sort) are “covered” by an insurance policy . . . , the waiver applies.”
Teton will impact construction-project participants, the insurance industry, and, ultimately, consumers. Teton, like cases before it, runs counter to classic economics’ externality aversion by placing the loss on an insurance company whose insured did not cause the loss. After Teton, those externalities are potentially greater because unrecoverable losses can extend beyond the price of the construction contract. What does this mean for the construction industry?
Construction is a contract-driven industry. Drafters are free to modify standard-contract insurance language in attempt to avoid Teton’s result. If the parties intend to restrict the scope of waivers to the value of the construction contract, they can presumably do so. But what incentive have they to take those steps? After all, the reason for laying the loss on insurance companies is to avoid time-consuming litigation and resultant project disruptions. Who is bearing this increased cost? Insurance companies are profit-seeking enterprises. When their exposure increases, premiums increase. Owners and contractors are also profit-seeking entities. When their insurance premiums increase, they attempt to pass the increased cost on to the ultimate users of their products and services. The consumer, therefore, ultimately pays a higher price for the same goods and services, despite playing no role in the negligent actions causing loss. This was true before Teton, but the recent decision appears to have increased that tax.
Teton teaches that Indiana, like the majority of states considering the issue, has determined that the costs to construction participants, the insurance industry, and, ultimately, consumers resulting from construction-project subrogation actions outweighs even the post-Teton era’s increased externalities resulting from shifting unrecoverable loss to insurers. Only time will tell if construction participants, as reflected by their contracts, will agree with this valuation.