It’s common for a construction contract to contain a “waiver of subrogation” provision under “insurance requirements.” Unfortunately, these provisions are widely misunderstood. Although they’re designed to shield owners, contractors and subcontractors against lawsuits by insurers covering project-related claims, the protection offered may not be as extensive as you might think.

Understanding the concept

Subrogation is a legal concept under which an insurance company that covers a loss gains the right to “step into the shoes” of the insured. The insurer becomes “subrogated to” the rights of the insured, allowing it to sue any third party or parties allegedly responsible for the loss.

Suppose, for example, that an owner hires a contractor to build an office building. During construction, an electrical subcontractor causes a fire that does $3 million in damage to the building. If the owner’s property insurance or builder’s risk policy pays for the loss, the insurance company becomes subrogated to the owner’s rights and may sue the subcontractor for the damage it caused to the building.

Waiving the provision

The rationale behind waiver of subrogation is that the parties to a construction contract pay substantial premiums to buy insurance to protect themselves against certain risks. If an insurer pays a claim, the argument goes, it should bear the loss and not be permitted to pass it on to another party. Otherwise, insurance companies would rarely pay for anything. Another benefit of waiver of subrogation is that it avoids costly litigation that can result if an insurer goes after one or more parties to the contract.

For these reasons, most standard construction contracts, including the American Institute of Architects form documents, contain waiver of subrogation provisions. Typically, under these provisions, parties waive all rights against each other for damages caused by fire or other perils to the extent such damages are covered by builder’s risk or other property insurance.

Assessing your protection

Just because your contract contains a waiver of subrogation clause doesn’t necessarily mean that you’re fully protected. The breadth of protection depends on the terms of the parties’ insurance policies and the applicable law in the relevant jurisdiction or jurisdictions.

First, for an insured party’s waiver of subrogation to be effective, its policy must permit the insured to waive the insurer’s subrogation rights. Many standard property insurance policies authorize waiver of subrogation, but some require an endorsement.

Second, the treatment of subrogation waivers varies from court to court. Some courts, albeit a minority, make a distinction between work and nonwork damages. In other words, the waiver extends only to property that’s part of a contractor’s “work,” as defined in the contract. It doesn’t prohibit subrogated claims related to nonwork property.

So, in our previous example, the waiver of subrogation would apply only to the subcontractor’s electrical work; it wouldn’t prevent the insurance company from bringing a claim for damages to other parts of the building. (The “majority rule,” however, holds that a subrogation waiver bars claims by the insurer for both work and nonwork property.)

Getting the full picture

Before signing a construction contract that contains a waiver of subrogation, consult your attorney, CPA and insurance rep to get a full picture of its level of protection and potential impact on profitability.

© 2017

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