Posted on May 14, 2015
Subrogation waivers are an integral part of construction contracting and project risk management. When an insurance company pays a claim, they acquire the rights of their policyholder to sue the person or entity they believe was at fault for causing the loss and to recover what was paid under the policy. This is the legal relationship known as subrogation. In a typical construction project, an insurance company who pays for an owner’s property loss can turn around and sue the contractor (or subcontractor) to recover what was paid. Project stakeholders long ago recognized the disruptions that subrogation claims could cause, and so began using contract forms that waived subrogation claims, with the intent that all insured losses would remain with the insurance company who paid them. These contracts would also require each stakeholder to purchase insurance to cover the risks each of them retained so those risks needed to be insured only one time on the project – by the stakeholder who retained that risk. Most contracts require the owner to provide property insurance on an “all risk” basis because it is sensible for the owner to insure its own property during construction.
These subrogation waiver clauses in construction contracts are frequently challenged, usually by insurance companies, leaving courts to decide whether the insurance company has to bear that loss or can try to pass it on to the person they think was at fault. If parties to a construction contract believe they have contractually eliminated an insurance company’s ability to sue them, when suits nonetheless get filed, it would represent a very significant exposure to the sued party if allowed to proceed. Such was the case decided this week by the Indiana Supreme Court.
In a decision handed down yesterday by the Indiana Supreme Court in Jefferson County, Indiana v. Teton Corporation, the Court told the owner that they could not sue the contractor (and its subcontractors) for fire loss damages allegedly caused by a subcontractor’s negligence, because the owner’s property insurance covered those damages, and the owner had waived its subrogation rights via AIA contract form. This decision left the financial loss for the fire damage exactly where the contract allocated it – with the insurance company.
The project at issue involved the renovation of the Jefferson County Courthouse. During construction, the owner alleged the roofing subcontractor negligently started a fire while using a torch. The courthouse sustained significant damages that far exceeded the contract value, but were paid by the owner’s insurance company under a property insurance policy. The owner filed suit against the contractors to recover damages it sustained from the fire loss that were unrelated to repairing the contractors’ work, even though those damages were covered by its property insurance.
The parties used the 1987 version of the AIA A201 general conditions document as part of their contract, which contains the AIA contract forms’ ubiquitous waiver of subrogation clause. Specifically, the contract stated, “The Owner and Contractor waive all rights…for damages…to the extent covered by property insurance…” The current version of the general conditions document, A201-2007, still uses this waiver of subrogation language today without substantive change. The same language is used in most other AIA contract forms as well.
The owner argued that the waiver clause did not apply, because it intended to waive subrogation rights only with respect to insurance money that paid to repair the contractors’ damaged work, and not to money that paid for losses to other parts of the property. There are cases in other states that support this narrow reading of the waiver clause, and in those states, the owner’s claim probably would have succeeded. However, the Indiana Supreme Court (like the courts in most states) rejected this argument, holding as a matter of contract law that, because the contract plainly states the waiver applies “to the extent” the damages “are covered by property insurance,” the claim is decided based upon whether the damages are covered by the insurance, not on where the damage occurred or what kind of damage it is. Because the owner’s property insurance paid all the damages they were trying to recover from the contractors, the Court concluded that the claim was waived by the AIA contract language, and the lawsuit could not proceed.
The courts in most other states who have decided the issue (about a dozen) follow this approach, including Ohio. In the case of Westfield Ins. Group v. Affinia Development LLC (5th Dist. 2012), 2012 Ohio 5348, the Fifth District Court of Appeals ruled that Westfield Group could not pursue a contractor and subcontractor for fire damages that Westfield paid to an owner for a fire loss that occurred during a construction project, because the parties had used an AIA A201-2007 contract form that included a subrogation waiver clause. Like the owner in Jefferson County, Westfield claimed the waiver should not apply to damages it paid to areas of the property unrelated to the contractor’s actual work. The 5th District interpreted the waiver broadly and found that subrogation rights are waived for anything the insurance company pays – regardless of the kind or nature of the damage.
The AIA contract forms have used an industry standard (and well accepted) waiver of subrogation clause for years. The idea behind the waiver is to allocate the risks to insurance companies (who receive premiums for taking the risk), not to an owner or contractor. Without a waiver of subrogation, the law permits an insurance company to file suit against the person or entity that was actually at fault for causing the loss to recover back any money the insurance company had to pay its policy holder under the policy. By blocking subrogation claims, project stakeholders eliminate lawsuits or arbitration claims against each other to reimburse insurance companies who are paid to assume the specified risks. The Jefferson County ruling is significant because it comes from Indiana’s highest court – making it the law in that State, and helps solidify this legal rule as a majority position of the courts in other states.
Fixing specific losses to individual insurance policies is important in the construction context because it keeps project costs down by allowing the risk to be insured only one time. If subrogation claims were permitted, then each stakeholder would have to insure themselves for the same risks, and the project would be over-insured; if a loss occurred and was paid, then one or more of the stakeholders would find themselves in litigation with an insurance company over it.
The Jefferson County case enforced the standard AIA contract form subrogation waiver language, thereby lending predictability to those projects utilizing AIA contract language, as well as other forms of agreement with similar language. Now we know how the courts will read it. This also means the industry should watch for modifications to such language that is proposed during contract negotiations by stakeholders seeking to limit or restrict the subrogation waiver at the insistence of their respective insurers – who are often involved in contract negotiations. Anytime the risk transfer or balance on a construction project is altered, it leads to unintended consequences.
There are good reasons the construction industry uses waiver of subrogation clauses in industry standard contracts – not just AIA contracts. It is important for the courts to enforce these clauses as they were intended, but also for stakeholders to be on the lookout for those who may try and alter that balance. If you have questions regarding subrogation waivers, contract provisions, or any other aspect of Ohio construction law, please contact Todd Harpst or Nick Horrigan, at Harpst Ross, Ltd. – Business Lawyers for the Construction Industry®, at (330) 983-9971 or email@example.com or firstname.lastname@example.org.
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