‘Additional insured’ coverage scope still evolving, still unclear

Application of ‘Contractual Liability’ exclusion also changing; practical steps may help to protect coverage

By Micah Skidmore, Haynes and Boone

In late June, I took my two daughters to watch the Texas Rangers open a three-game set against the Minnesota Twins.  Going into the ninth inning, the Rangers had built what appeared to be a solid lead: 5-0. Mere minutes into the ninth, a steady stream of fans began flocking to the exits, confident that the Rangers had locked in a win. Then it happened.  Minnesota scored four runs in quick succession, narrowing the Rangers’ lead to one run. The Rangers ultimately held on to win, but until the last batter struck out, it was too close to call.

Few things are ever certain in baseball, in life or in the law. Within the past year, Texas courts have thrown policyholders several curve balls, causing risk managers and in-house counsel to re-examine what used to be well-established principles regarding liability coverage for risks arising out of traditional master service agreements. Here are two evolving issues that policyholders should understand to avoid a late-inning upset: (1) determining the scope of “additional insured” coverage; and (2) the boundaries of the ISO CGL “Contractual Liability” exclusion.

Scope of ‘Additional Insured Coverage

As events developed in April 2010, few could have predicted the impact of the Deepwater Horizon disaster on insurance coverage for “additional insureds.” In March 2013, the Fifth Circuit Court of Appeals issued its first decision (“Deepwater Horizon I”) in a dispute over the scope of “additional insured” coverage available to operator BP under Transocean’s more than $750-million tower of general liability insurance. Initially, the court ruled that BP’s coverage as additional insured would be determined solely by the terms of Transocean’s insurance policies, without reference to the provisions of the drilling contract between Transocean and BP – because the insurance and indemnity provisions of the Transocean/BP agreement were “separate and independent.”

Then, only six months later, the Fifth Circuit pitched a “change-up” with a new opinion that withdrew the court’s March decision and referred the matter to the Texas Supreme Court in two “certified questions.” The Texas Supreme Court will now decide (1) “the scope of BP’s coverage as an additional insured, and whether the umbrella policy itself determines the extent of coverage, or the indemnity clauses in the Drilling Contract effectively limit BP’s coverage”;  and (2) whether so-called “sophisticated insureds” are entitled to have ambiguous policy terms interpreted in their favor.

Some of the uncertainty over the boundaries of “additional insured” coverage has been mitigated by new ISO CGL endorsements for both occurrence and claims made CGL forms. In relevant part, these endorsements provide that the scope and policy limits of additional insured coverage extend only to the degree required by contract.

While many policyholders may be consoled by the notion that additional insured coverage will be judged from the terms of an underlying service contract, anyone using these endorsements must make certain that their own expectations (and those of any counterparties) are clearly defined in the service contract or indemnity agreement that may ultimately influence the interpretation of the insurance policy. For residual risks under legacy policies, risk managers and in-house counsel will watch with interest the oral argument in the Deepwater Horizon matter scheduled for 16 September 2014 and the decision, which is anticipated no earlier than this winter.

If there are questions regarding the interplay between an existing insurance policy and an underlying service contract, policyholders and “additional insureds” will look to the Texas Supreme Court’s prior decision in Evanston Ins. Co. v. ATOFINA Petrochemicals Inc., 256 S.W.3d 660 (Tex. 2008) as an example of how the court has determined whether the insurance and indemnity provisions of a service contract are “separate and independent” and now occupies the focus of the parties’ analysis and argument in the Deepwater Horizon matter.

According to the Fifth Circuit’s decision in Deepwater Horizon I, “to render an additional insured provision separate from and additional to an indemnity provision, Texas law only requires the additional insured provision be a discrete requirement” i.e., “it need not be an entirely separate provision of the contract, and its independent status is not altered merely by the fact that the contract also includes a provision requiring the relevant party to obtain insurance to cover its liabilities under the contract.”  710 F.3d at 349.

The Texas Supreme Court and Texas courts at large have historically given the benefit of the doubt to “sophisticated” insureds in analyzing ambiguous policy terms. While it is still unclear whether any “sophisticated insured” exception will apply or what test may emerge for judging an insured’s sophistication, insureds may consider what overt indicia of sophistication might be eliminated or de-emphasized in the underwriting and placement of liability insurance.

If Texas were to leave the majority of other jurisdictions by adopting a “sophisticated insured” exception, this could be a game changer for policyholders and insurers.

‘Contractual Liability’ coverage, exclusions

Another example of a late inning upset is the evolution of Contractual Liability coverage under liability policies. Conventional wisdom held that under ISO CGL Exclusion 2(b)’s exception for liability, the insured is obligated to pay “by reason of the assumption of liability in a contract or agreement” applied only when the insured assumes the liability of another party in an indemnity or hold harmless agreement. Then in Gilbert Texas Construction L.P. v. Underwriters at Lloyd’s London, 327 S.W.3d 118, 122 (Tex. 2010), the Texas Supreme Court held that the “Contractual Liability” exclusion could apply to the insured’s own liability, where the insured’s contract specifically required the insured to “repair any damage to those facilities, including those that are the property of a third party, resulting from failure to comply with the requirements of this contract or failure to exercise reasonable care in performing the work…”

In January of this year, the court distinguished Gilbert and expanded on its prior analysis in Ewing Construction Company Inc. v. Amerisure Insurance Co., 420 S.W.3d 30 (Tex. 2014). In Ewing, the court considered whether a general liability insurer had a duty to defend a contractor against allegations of negligence and breach of contract arising out of the construction of tennis courts outside a school in Corpus Christi, Texas.  Focusing on the “Contractual Liability” exclusion, the court ultimately found that “a general contractor who agrees to perform its construction work in a good and workmanlike manner, without more … does not ‘assume liability’ for damages arising out of its defective work so as to trigger the Contractual Liability Exclusion.” Id. at 38.

While the Ewing court’s conclusion was unquestionably correct, the analysis framed by Ewing and Gilbert inappropriately focuses on whether the insured’s liability exists under a contract or under principles of general law: “‘Assumption of liability’ means that the insured has assumed a liability for damages that exceeds the liability it would have under general law.” Id. at 37.

Doing so has allowed some jurists to take their eye off the ball – the terms of the exclusion itself. On 27 June, the Fifth Circuit Court of Appeals issued its decision in Crownover v. Mid-Continent Insurance Company, 2014 US App. LEXIS 12158 (5th Cir. 27 June 2014), holding that an insured contractor was not entitled to coverage for damages claimed for breach of express warranty to repair allegedly defective residential construction.

According to the court, the repair warranty, which obligated the builder to “promptly correct work … failing to conform to the requirements of the Contract Documents,” justified the application of the “Contractual Liability” exclusion simply because the warranty referenced compliance with the “contract documents” as opposed to “general law” requirements.

The court further held that the exception to the “Contractual Liability” exclusion for liability that would exist in the absence of a contract or agreement did not preserve coverage because there was no finding in the underlying construction defect arbitration of liability under any implied warranty, which would have been superseded by the express warranty at issue.

In short, energy policyholders are now left with the prospect that general liability coverage for a claim arising out of operations conducted on a well and governed by a service agreement may depend on whether the obligation allegedly breached is one that can be traced to the common law or a statute. The terms of the “Contractual Liability” exclusion do not speak in terms of the general law. The exclusion addresses the “assumption of liability” in a contract. By focusing on an esoteric distinction between liability that exists under a contract and liability that exists under the amorphous “general law,” courts have overlooked the more important distinction between “liability” that is assumed and a “duty” or “performance” that is promised.

There is no underwriting basis to conclude that, for example, an insurer familiar with the “Contractual Liability” exclusion undertook the risk that its insured would be called upon to repair a damaged wellbore because the insured failed to exercise reasonable care, but did not assume the risk that the insured would be obligated to repair the same damaged wellbore, when the obligation to do so stems from the terms of a contract.

This new version of the “Contractual Liability” exclusion “crowds the plate” such that the exceptions to the exclusion will never apply. If the terms “assumption of liability” already embody a distinction between liability that exists under a contract and liability that exists under the general law, the “Contractual Liability” exclusion’s exception for “liability … [t]hat the insured would have in the absence of the contract or agreement” is rendered meaningless. For their part, insurers have traded the certainty of the narrow “Contractual Liability” exclusion for the vagaries of Gilbert/Crownover formulation. It is a no-win situation.

Regardless of the logical fallacies of the analysis, there are nonetheless practical steps that insureds can take to avoid striking out over Contractual Liability coverage. Operators and service companies alike should be careful what they ask for in warranties from counterparties. Under the current state of the law, query whether an implied warranty is not preferred to the broadest of express warranties. Alternatively, when coverage is placed, insureds may yet succeed in modifying the “Contractual Liability” exclusion to apply, as originally intended and confirmed by a majority of jurisdictions, to liability of “another” assumed under a contract or agreement.

In the event of a claim or suit, the claimant should consider the merits and risks of formulating a complaint that relies solely on contractual and express warranty claims. Likewise, insured defendants should weigh the risk of eliminating alternative claims that arise under the common law. Such insureds might win a partial victory over liability only to lose the war for coverage.

Conclusion

It is the difficult business of risk managers and in-house counsel to manage the uncertain. Developments from the Fifth Circuit Court of Appeals and the Texas Supreme Court have caused policyholders to wonder whether insureds can hang on to long-standing expectations regarding the scope of “additional insured” coverage and the application of the “Contractual Liability” exclusion.  By understanding these developments, risk managers and in-house counsel can better position themselves to avoid a late-inning upset.

This article is based on a presentation at the 2014 IADC Contracts & Risk Management Conference, 14-15 October, Houston.