Risky Business--Contractor Insurance, Part 1

Introduction; Too Much of a Good Thing? 

Woody Allen once complained, "There are worse things in life than death. Have you ever spent an evening with an insurance salesman?" Granted the insurance vendor may not be the life of the party, but most people and businesses need to mitigate life's risks, especially the contractor trying to compete in the low-margin bid world of physically dangerous construction. One of a contractor’s biggest but necessary costs of doing business is insurance. A contractor’s insurance costs increase along three dimensions—higher premiums, bigger deductibles, and less coverage. The purpose of this 3-part contractor insurance series is to offer some suggestions for assessing the adequacy of a contractor’s insurance coverage and stressing its impact on repayment ability. Part 1 and Part 2 offer an introduction to a contractor’s basic insurance needs—property, liability, vehicles, and workers comp, and Part 3 suggests a way of stress-testing the contractor’s ability to cover both its insurance expense and its deductible exposure as part of evaluating overall cash flow repayment ability.

Part 1: Identifying and Assessing a Contractor’s Business Insurance Needs

Contractor Insurance: Higher Deductible, Less Coverage, Pricier Premium

                Industry observers reckon that the construction industry’s collective cost of insurance has risen in response to both natural and unnatural (man-made) events. Man can certainly be blamed for the calamities of terrorism and war, plague and pestilence, but Mother Nature has been hard at work, too, in the shape of increasing volatility in global climate patterns of drought and flooding, hurricanes and tornadoes, blizzards and freezes.. Therefore, for commercial lender and construction borrower alike, the sum of higher premiums, larger deductibles, and narrower coverage must be added to the list of factors to consider in evaluating repayment ability.   How much self-insurance risk from higher deductibles and narrower coverage can the borrower and guarantors absorb and still remain viable?    Other lines of business may have more flexibility in finding a cost-effective, premium-deductible-coverage mix, but contractors simply have fewer options. The contractor’s business environment is a tangled web of civil law, government regulation, and public policy requiring the typical contractor to carry payment and performance bonding on its larger jobs, provide workmen’s compensation coverage for its employees, pay regularly into state and federal unemployment insurance funds, and insure the company against damage and loss to its principal and human assets. Perhaps more than any other line of business, the inherent higher risks of construction make adequate and sufficient insurance a necessary and critical cost of doing business for the contractor.

Contractor Insurance Requirements[i]

A construction business needs much the same insurance coverages as any other business, as well as other types of insurance specific to the industry. Ideally, the contractor uses an insurance agent who has experience with contractors and who works with insurance companies that specialize in construction risks. Therefore, the contractor’s usually needs these basic insurance coverages—property insurance, liability insurance, business vehicle insurance, and workmen compensation insurance.

Property Insurance. The purpose of property insurance is to provide critical financial assistance in the event of a loss so that the contractor can continue to operate with as little disruption as possible. Property insurance alone is just one part of an overall risk management and disaster recovery plan. On average, businesses that devote resources to risk reduction and risk control have fewer insurance claims. Firms with a good record on claims generally have more insurers competing for their business, so that they are able to find coverage more easily and often at a lower price than companies that have more losses.

Business Owners Policy (BOP). Insurers offer a variety of property insurance policies. There are policies that cover only a single peril, or cause of loss, such as a fire insurance policy, a crime policy or an electronic equipment policy, and then there are policies that include several different coverages in a single “package.” Many business owners find it more convenient and economical to purchase a package policy providing protection against many types of loss in a single policy, and many insurers rely on a package policy format referred to in the insurance industry as the Business Owners Policy (BOP). The following discussion draws on the standard BOP format. Specifically, the policy usually covers:

•        Any buildings the business owns and much of the property needed to run the business as named in the policy "Declarations," generally the first pages of the policy. Structures are covered as well as permanently installed fixtures, machinery and equipment; outdoor fixtures; items used to maintain or service the building, such as appliances; and additions under construction. Buildings can be insured at their "actual cash value"—what they are worth—or their "replacement cost"—what it would cost to replace them with new construction. To keep up with the increasing cost of rebuilding, the policy’s limit of insurance for covered buildings typically rises automatically by a set percentage each year.

•       Building contents, on or near the business premises that is used in the business. This would include such things as machinery, computers, raw materials or inventory. There is also coverage for any leased property, which the company may be contractually obligated to insure.

•     Property of others that is in the company’s care, custody and control to the extent that the contractor is legally liable for that property. This coverage is particularly important to a business, such as an equipment repair shop that earns revenue from servicing the property of others.

However, the basic BOP excludes some types of property from its coverage. For many of these items, such as money and securities or outdoor signs, insurance is available as an addition to the BOP for an additional premium. For items such as motor vehicles , however, the contractor must purchase a separate policy. Excluded property usually includes:

Floaters. The contractor needs property insurance to cover the real property the company owns and the personal property used in the business, such as office furnishings and computers, but the biggest personal property loss exposures may involve valuable machinery and equipment that moves around from job to job and is not covered by standard property insurance. Such movable property is insured by contracts insurers call "floaters."

An installer’s floater covers all kinds of machinery and equipment during transit, installation and testing at the purchaser’s premises. Even building materials may be covered, but the more usual coverage is for equipment or machinery that only contractors install, such as heating or air conditioning. The policy can be written to cover a single job or on a reporting form, meaning that the contractor provides the insurer with information about each new contract undertaken.

A contractor’s equipment floater insures any type of movable equipment not meant to move on public highways and so may cover such items as cranes, cement mixers, engines or power drills.   A tools and equipment floater covers the insured property, wherever it is used, and may include such items as hand tools, power drills, hoisting machines and power pumps.

Builders Risk Insurance. While under construction, a building has an ever-increasing value as more of it is completed, and builders risk insurance covers the building up to its value at the time of a loss. For example, if a tornado destroys the building when it is half finished, the policy covers one-half of the value the building would have had if completed. If a tornado wipes out the building when it is three-fourths finished, the policy covers 75% of the completed value. Alternatively, the contractor can report an actual amount for value completed to the insurance company each month to ensure that the coverage is in line with the most current value.

If the contractor rents or leases its premises, his lease should describe the contractor’s insurance obligations. If the sole tenant, the contractor may be responsible for insuring the building and may be responsible for continuing to pay rent even if the building is destroyed. Should a fire destroy the building, will the landlord or the tenant be responsible for debris removal?  The BOP also provides coverage for tenants' improvements and betterments such as fixtures, alterations, installations or additions that have been put into the space..

Insurance contracts always describe in some way the causes of loss that are covered, e.g., fire, lightning, most explosions, windstorm or hail, smoke from accidental fire, aircraft or vehicles (excluding those owned or operated by the business itself), riot or civil commotion, vandalism, automatic sprinkler leakage, sinkhole collapse, building collapse, volcanic action and certain types of damage from water or other liquids. However, a number of events that can cause property loss are not covered by the basic BOP. Some, such as employee dishonesty or breakdown of a steam boiler, are excluded from the basic BOP. Other events, such as wear and tear, are not covered because they do not meet the basic criteria for insurance of being accidental and unpredictable. Regular maintenance of property is not the insurer’s responsibility. Coverage for other events, such as flood and earthquake, are not needed by all businesses. Separate policies are available. Nuclear reaction and war are uninsurable because insurers cannot predict with any degree of accuracy the frequency of such events or amount of damage likely to occur. 

Other events that can cause damage but are usually excluded from the basic BOP include:

•        power failure (except when it causes loss or damage to computers and electronic data); failure of computer hardware or software;
•       robbery and burglary;
•       most instances of pollution; and
•      changes in humidity or temperature.

Also excluded is coverage for missing property where there is no physical evidence to show what happened to the property, such as with a materials shortage discovered after taking inventory.

Business Interruption Insurance. If the main business premises are destroyed along with much of the property used to operate the business, the contractor ought to consider business interruption insurance, also called business income and extra expense insurance.. Every day the contractor is unable to operate is a day of lost income, for both the individual owner and for the business. If the property damage or loss prevents the contractor from continuing to work, his clients may have to replace him. In order to keep his employees, the contractor must continue to pay their wages, even when the business is generating much less than normal income. Prudent contractors have disaster recovery plans that include insurance to cover lost income and extra expenses that can result from getting back on track after a covered loss. Because coverage for lost income and extra expenses is so important to continued business survival, it is part of the standard BOP. The policy covers actual loss of net business income that would have been earned had it not been necessary to suspend operations due to a covered cause of loss. The policy also covers continuing normal operating expenses such as utility payments and payroll. The insurer also will pay extra expenses incurred to avoid or minimize the suspension of operations, such as costs to relocate, and to equip and to operate replacement premises, as well as expenses to repair or to replace property and to restore lost information on damaged valuable papers and records.

Generally, these coverages are triggered only when the contractor suffers a direct loss from a covered cause of loss. If the cause of loss is an earthquake, there will be no coverage under the BOP. If the contractor must close due to someone else’s loss, there is no coverage. For example, a fire on the ground floor of the building might do no damage to the contractor’s offices on the third floor but causes the building to be shut down for repairs for a month. Business interruption insurance would not cover the contractor because there was not direct loss to the contractor from the fire.

The standard Business owners Policy (BOP) makes provision for adding optional coverage at an additional premium to cover a wide range of other items and events:

Liability Insurance. Since there is always a possibility that someone will sue the contractor and claim to have been harmed by the contractor’s work, the contractor will almost certainly need liability insurance. Even if the contractor is ultimately cleared of any wrongdoing, a determined plaintiff can tie up the business in legal proceedings for a long time, entailing significant defense costs. Liability insurance pays the cost of the contractor’s defense and protects the firm’s assets.

Everyone in society has a duty to take reasonable care that his or her actions do not injure others, and the same rule applies to business entities. Not properly repairing a pothole, not adequately lighting a dark stairway, or not training workers how to perform their jobs safely and legally can constitute negligence if a client, customer or member of the general public is injured as a result. The legal meaning of negligence is failure to exercise reasonable care.

The most efficient and least expensive way to purchase liability insurance is usually as part of a BOP which combines property and liability insurance in one contract. The liability insurer will pay damages that the contractor is legally obligated to pay as a result of “bodily injury,” “property damage” or “personal and advertising injury,” up to the policy limits and subject to the policy’s deductible. Punitive damages are generally not covered, although there may be some exceptions. Bodily injury means injury, sickness, disease or death; it may include injuries that are emotional or mental, such as post-traumatic stress syndrome or humiliation. Personal and advertising injury includes libel, slander or any defamatory or disparaging material or a publication or utterance in violation of an individual's right of privacy; infringing the privacy or copyright rights of another in the contractor’s advertisement; wrongful entry or eviction, or other invasion of the right of private occupancy; and false arrest or wrongful detention.

Liability coverage insures a sole proprietor, partners or partners named in the policy "Declarations," but only with respect to their duties on behalf of the business. The spouses of sole proprietors or partners are also covered. If the organization has officers and directors, they are insured, as are its stockholders, but, once again, and this applies to all parties, only with respect to their duties or liabilities in connection with the business. Employees and volunteer workers are insured for acts committed within the scope of their employment in the business.

Occurrence. The liability policy often refers to an “occurrence” Usually defined as “an accident, including continuous or repeated exposure to substantially the same harmful conditions.” An accident is an event that causes injury to the body, property, person or reputation of a third party whom the contractor did not intend to injure. An explosion or a car accident are examples of an occurrence that could result in bodily injury and/or property damage. The phrase “continuous or repeated exposure to substantially the same harmful conditions” in the definition of occurrence makes clear that the insurer covers situations where harm was done because of an ongoing situation. For example, a person who lived near an office building under construction might claim to have developed allergic asthma as a result of breathing dust from the construction activity.

Exclusions. There are several situations, people and circumstances excluded from the standard liability coverage. Injuries to employees are excluded because employees are usually covered for work-related injuries by workers compensation insurance. Liability for pollution or in connection with professional services is excluded because only some businesses need that coverage and it can be purchased separately. Auto liability is excluded because it is covered by a business owner auto policy, and damage to company property is excluded because it is covered by property insurance.

Endorsements. Endorsements can add liability coverage for specific circumstances, and among those most commonly added are:

•  Employment Practices Liability: Even if a business has just a few employees, the firm cannot entirely avoid the risk of a lawsuit charging some type of employment discrimination, whether based on sex, race, age or any one of a number of other characteristics. This is typically one of those exposures—much like the exposure to theft by trusted insiders—that employers tend to think “won’t happen here.”
• Liquor Liability: The Liquor Liability Endorsement provides coverage for bodily injury or property damage for which an insured may be held liable For causing or contributing to the intoxication of any person, furnishing alcoholic beverages to a person under the legal drinking age or under the influence of alcohol, or violating any statute, ordinance or regulation relating to the sale, gift, distribution or use of alcoholic beverages. Given the popularity of “topping-off parties in the construction business, this coverage should be considered.
•  Employee Benefits Liability: If the contractor has an employee benefits programs, there is a risk of being sued by employees or retirees charging there was negligent administration and management of the benefit plan. Even though the contractor may use a professional benefits administrator, the personal assets of the contractor’s in-house plan fiduciaries may be at risk if they are responsible for errors, omissions or breach of their fiduciary duties. The Employee Benefits Liability Endorsement covers this liability exposure.

Special Liability Coverages. Further, depending on the nature of construction and its risk exposures, a contractor may need one or more of the following types of special liability coverages:

•  Umbrella Liability Insurance – A big difference between property and liability risks is that a contractor can put a value on the property at risk, but there is no way to predict the amount of damages the contractor could be required to pay as the result of a catastrophic accident. For example, if a contractor were found liable in a school bus accident that injured children, the damages could be in the millions of dollars. Umbrella Liability—also known as Excess Liability Insurance—provides extra protection for catastrophic events. The primary policies are called “underlying” policies and are specifically listed, along with their limits, on the umbrella policy. Typically, the underlying policies are the primary general liability, auto liability and the employer’s liability section of the workers comp policy. The umbrella coverage starts to pay when a covered loss exhausts the primary policy’s per occurrence limit. Most umbrella policies exclude employment practices liability, professional liability, product recall coverage, workers compensation and coverage for asbestos-related claims, pollution, war and terrorism.
• Errors and Omissions Liability Coverage/Professional Liability Insurance – If the contractor provides any type of advice, expertise or professional service, he risks being sued by a customer, client or other party who claims he or she was injured due to the contractor’s negligent act, error or omission. This type of negligence is sometimes referred to as “malpractice.” Professional Liability Insurance, also called Errors and Omissions Liability Insurance, pays the cost of defense and any damages awarded, up to policy limits. Insurance companies have developed many specialized policy forms that respond to the individual risks characteristic of particular professions and services.
• Directors and Officers Liability Insurance (D&O) – D&O Insurance protects past, present and future directors and officers of a corporation from damages arising out of alleged or actual wrongful acts committed in their capacity as directors and officers. Some policies extend the same coverage to employees. The policies provide protection in the event of any actual or alleged error, omission, misstatement, misleading statement or breach of duty.

Closing and Summary: Property and Liability Done, On to Business Vehicle and Workers Compensation

Mark Twain would have not been a very good insurance advisor with suggestions like this, "Never put off until tomorrow what you can do the day after tomorrow,” but today you now have Part 1 out of the way summarizing insurance coverages for contractors. Look for Part 2 coming soon and offering an introduction to a contractor’s basic insurance needs—property, liability, vehicles, and workers comp, and Part 3 suggests a way of stress-testing the contractor’s ability to cover both its insurance expense and its deductible exposure as part of evaluating overall cash flow repayment ability. Remember, accidents do happen, and as A. A. Milne’s Eeyore points out, “They’re funny things, accidents. You never have them till you’re having them.”

[i] “Construction Contractors,” Insurance Information Institute, https://www.iii.org/publications/insuring-your-business-small-business-owners-guide-to-insurance/insurance-for-specific-businesses/construction-contractors