Complex exposures created by leases
(By Dan Corbin, CPCU, CIC, LUTC)
When the new simplified Commercial General Liability (CGL) policy was introduced in 1986, it was expected to help solve some coverage problems. While the jury is still out as to whether all the coverage problems have been solved, there is one issue that can be settled. The so-called simplified CGL policy is anything but simple! The CGL policy is one of the more complex policies sold by producers. The fact that it must be adapted to a wide range of business enterprises and exposures is a contributing factor to its inherent complexity.
Liability assumed by contract is one of the exposures addressed by the CGL policy. As with many of the coverages provided in the policy, contractual liability emerges from an exclusion—or rather an exception to an exclusion. Exclusion 2.b. first carves out of coverage all liability incurred for bodily injury and property damage because of the insured’s assumption of that liability in a contract or agreement. Then the exclusion leaves untouched, by way of exception, the liability assumed in an “insured contract” and the covered liability that exists in the absence of a contract.
The first exception is what we call the CGL contractual liability coverage and the second exception just clarifies the exclusion’s intent not to disturb coverage that has been independently provided in the policy.
The key to understanding contractual liability in the CGL policy is understanding the meaning of “insured contract.” For this, an excursion into the definition section of the policy will be necessary. There we find a list of five types of contracts (items a. through e.), a blanket inclusion of certain contracts (item f.) and then some more exclusions. The five types of contracts are:
- a lease of premises;
- a sidetrack agreement;
- an easement;
- an indemnification of a municipality; and
- an elevator maintenance agreement.
These contracts are equivalent to the five contracts listed as an “incidental contract” covered by the 1973 edition of the ISO CGL policy. Blanket contractual coverage (item f. in the current CGL edition) had to be added to the 1973 edition by means of the Broad Form CG 04 04 endorsement. With this addition, any assumption of third-party liability for bodily injury and property damage (not otherwise excluded) that results from an occurrence becomes an “insured contract.”
In contrast, the current edition of the CGL policy includes blanket contractual coverage (item f.), but may be removed from the policy by means of the Contractual Liability Limitation CG 21 39 endorsement, which eliminates coverage for all but the five specified types of contracts. Contractors, in particular, need this blanket contractual coverage. Be warned that the removal of it will result in a significant gap in protection.
For this resource kit, the limitations of contractual coverage in the CGL policy for a lease will be examined. A lease of premises is a covered contract. A significant number of businesses must lease premises in order to conduct their necessary operations. From a risk management point of view, a lease represents potential liability for the business owner. Liability from a lease is usual and customary and, therefore, a natural subject for coverage in the CGL policy. However, the coverage provided for a lease does not necessarily include all liability that a lessee assumes. Performance on the terms of the lease is one potential liability that is not covered. Despite what the name might imply, contractual liability coverage does not include exposures relating to a breach of contract.
Before we place boundaries around the lease coverage in the CGL policy, a word of caution is appropriate. It’s not enough for a client to know what liability assumptions are insured. It is equally important to know the full extent of the exposures the lease creates for the client, which may not be covered by the CGL policy. Although there is some standardization to be found in lease provisions, the agreement between lessor and lessee is limited only by their needs and the creativity of their attorneys. You may have noticed that many attorneys prepare leases that are ambiguous with respect to insurance terms, making it difficult to assess the exposure.
You can never assume anything about a lease. I don’t know how a producer can properly serve a client without attempting to identify the exposures created by the lease. Even the client’s attorney may overlook an exposure that a producer has been trained to recognize. Am I suggesting that a producer inspect the leases of clients? Only if you can do it in a professional manner, because whatever you undertake to do for a client must be done with appropriate skill and diligence. While you may not be able to procure insurance to protect your clients from all of the exposures found in leases, you will be able to inform them of the exposures and prompt them to develop a risk management strategy.
Typical exposures in a lease involve: 1) physical property relating to the tenancy, and 2) third parties who are affected by the tenancy. Each of these exposures is provided limited protection by the CGL policy. The one that truly represents contractual liability, and receives the broadest treatment, is the third-party liability of the lessor that has been assumed by the lessee. Liability incurred by the lessor is being transferred to the lessee, which means the lessee is holding the lessor harmless for its responsibilities to third parties.
Note: The lease of premises coverage is not restricted to assumed tort liability, as are the blanket contracts covered by item f. in the definition of an “insured contract.” As a consequence, assumed contractual liability involving bodily injury and property damage resulting from an occurrence would be covered in addition to tort liability. For example, suppose a lessor has assumed liability in a maintenance contract and then uses the lease to get indemnified by the lessee for the liability assumed by the lessor in that maintenance contract.
Only bodily injury and physical damage
As stated in the definition of “insured contract,” coverage for liability to third parties is restricted to “bodily injury” and “property damage,” as defined in the policy. Absent is coverage for the legal liability of all other kinds of damages, such as, mental and emotional anguish, financial loss and government fines.
You may be tempted here to plead coverage under Coverage B—Personal and Advertising Injury Liability. Unfortunately, exclusion 2.e. of that section makes it clear that liability assumed under contract is not covered. However, the ISO has made available its Limited Contractual Liability Coverage For Personal And Advertising Injury CG 22 74 endorsement, which restores only the three personal injury offenses of false arrest, detention and imprisonment. Needless to say, it should be carefully observed when a lease transfers legal liability for damages other than bodily injury and property damage.
The physical property, which is the subject of the tenancy, holds value to the lessee while his legal right to occupy exists, as well as to the lessor/owner. Traditionally, the lessor/owner insures the property. After all, her interest transcends that of any tenant. But because buildings are particularly vulnerable to fire damage and its causation frequently is attributable to the occupancy of the tenant, many leases hold the lessee liable for negligence in causing fire damage to the premises. (Of course, the property insurer is likely to pursue its right to subrogate against the negligent tenant anyway.) Since the potential for loss is quite severe, this exposure gave birth to the so-called fire legal liability coverage.
Fire legal liability
Fire damage coverage for occupied premises is an aberration of liability coverage. The care, custody and control exclusions of liability policies preclude coverage for damage to such property. In the case of the CGL policy, exclusion j.(1) specifies “property you own, rent or occupy” as property not covered for damage. However, the fire damage exposure highlighted in many leases finds a remedy in the exception to exclusions c. through n. when the loss involves damage by fire to premises “rented to you or temporarily occupied by you.” This exception constitutes the fire legal liability coverage of the CGL policy.
Several comments need to be made about fire legal liability coverage.
First. Coverage is limited to property rented or temporarily occupied. A policyholder occupying property not fitting the description expressed in this exception would be uninsured for fire damage to that property.
Second. The maximum CGL sublimit for fire damage under the ISO rules is $100,000.
Third. Although a lease is a covered contract and fire damage to rented or temporarily occupied property is not excluded, liability assumed in the lease for fire damage not caused by the negligence of the lessee/insured remains excluded. The definition of an “insured contract” eliminates (in item 9.a.) “that portion of the contract for a lease of premises that indemnifies any person or organization for damage by fire to premises while rented to you or temporarily occupied by you.” Therefore, the CGL policy’s contractual liability coverage does not include fire damage to rented or occupied premises. However, property damage liability does cover fire damage to this property when the insured is legally responsible due to negligence.
What we end up with for lease protection in the CGL policy is coverage for assumed bodily injury and property damage liability to third parties and limited coverage for causing fire damage to the premises (for values no greater than $100,000). Not covered by the CGL policy is liability for performance on the terms of the lease; that is, liability for breach of contract.
Unfortunately, modern leases have gone far beyond the scope of protection afforded by the CGL policy, sometimes inadvertently. This is particularly true with regard to liability for damage to the premises. If the lessee is only responsible for negligently causing fire damage to the premises, and the combined damage potential to both the property and its loss of use does not exceed $100,000, no further solution is necessary. But for the balance of this resource kit, we are going to be concerned with liability incurred beyond these parameters.
Range of lease provisions
In order to appreciate the insurance problems that leases can create for lessees, it will help to survey some provisions to be found.
- The lease could confirm liability for the lessee’s negligence that results in damage from designated perils besides fire.
- The lessee could assume liability, regardless of fault, for damage caused by designated perils.
- The lessee could be required to return the property at the end of the lease in the same condition as existed at the beginning of the lease. Just think of the difficult exposures this language could lead to—flood, war, wear and tear, termites, contamination, nuclear hazard, etc.!
- The lease could specify that the lessee purchase and maintain a property policy covering designated perils.
- The lessee could be held responsible for damage that exceeds the loss payable from the lessor’s property policy.
Most leases will have standard provisions that can be treated adequately with insurance, but there is always the possibility that the lessor’s attorney got creative to justify his fees.
Basically, there are five different approaches the lessee can take to guard against liability for damage to property that is the subject of the lease. Each must be evaluated on its merit in terms of cost, extent of protection, the cooperation required of the lessor and its overall ease of implementation.
- Property policy. Because a tenant has a “use” interest in leased property, in addition to an interest based on tort or contractual liability, a tenant has an enforceable insurable interest in such property. Some courts will acknowledge an insurable interest in the full value of the property. Consequently, a property policy may be purchased to cover the extent of the lessee’s interest in the property, as well as the interest of the lessor. An appropriate cause of loss form will be chosen to cover the perils indicated in the lease. The major drawback to this option, of course, is the cost born by the lessee.Should the lessee fail to purchase the policy or add the interest of the lessor to the policy, which is a breach of the lease agreement, there is no protection afforded by the contractual liability coverage of the CGL policy. Neither would the lessee be protected if the wrong peril form was selected, resulting in an uninsured loss for which the lease holds the lessee accountable. Keep in mind that these kinds of oversights can mean trouble for the lessee’s insurance agent, whether or not directly responsible for the oversight.
- Legal liability policy. If the lessee is not obligated by the lease to provide primary coverage on the property, but is going to be liable for negligence in causing multi-peril damage to the premises, then the preferred policy would be the Legal Liability Coverage Form (CP 00 40). This policy can be purchased with the same choice of perils as the Building and Personal Property (BPP) coverage form, but at a fraction of the cost. In fact, the cost is one-quarter of the 80 percent coinsurance building rate. This policy also will pay damages for the property’s loss of use as long as the limit of liability is sufficient.The protection provided by the Legal Liability Coverage Form is described in the ISO manual as: “Coverage for damage for which the insured is legally liable arising from direct physical loss or damage, including loss of use, to tangible property of others in the insured’s care, custody or control up to the limit of insurance shown in the declarations.”Defense costs and many of the usual supplementary payments found in liability policies are covered in addition to the limit of liability. However, damages are payable only for tort liability, not merely because the responsibility for loss was assumed by contract. Although there is no coinsurance condition, care should be taken to select a limit that will encompass the entire exposure for damage to the property and its loss of use.
- Lessee as additional insured. In order to block the lessor’s insurer from subrogating against the lessee for losses covered by its policy, the lessee could be named as an additional insured on the lessor’s policy. As stated previously, a lessee does have an insurable interest in the property leased.Several problems can occur with this approach. First, the lessee may not be able to control the coverages provided in the policy, creating the possibility that protection would not exactly match the exposure in the lease. Second, the lessor may not want to take responsibility for updating the policy with additional insured endorsements, especially if it involves multiple tenants in the building. Third, the lessor may not want settlements under his policy encumbered with the interests of the lessee(s). Fourth, the “concealment, misrepresentation or fraud” provision (located in the Commercial Property Conditions CP 00 90) may create problems for all insureds, when only one insured actually voids the coverage. And fifth, the lessor’s insurer may be reluctant to add the lessee as an insured.
- Waiver of subrogation. This could be a very sensible noninsurance remedy for both parties. The lessor and the lessee could agree in writing to release one another for damage caused by either party to the property of the other. Both parties would accept responsibility for maintaining adequate protection, covering their own property with their own policies. The Transfer Of Rights Of Recovery Against Others To Us Provision (in the CP 00 90) even allows the insured (lessor) to waive rights against a tenant after the loss has occurred in order to preclude subrogation by the insurer.One potential glitch in this solution occurs when an inland marine policy is involved. The conditions in these forms may not specifically permit the insured to waive rights against the tenant. (There often are ways around this problem with inland marine forms or nonstandard property forms.) Also, it’s important to be aware of any exposures that have not been encompassed by the waiver.
- Revise the lease agreement. A final and obvious solution is to revise the lease so as to relieve the lessee of all liability for damage to the lessor’s property. However, lessors willing to do this might be a little scarce. Variations may be found which relieve the lessee from liability in the absence of willful and wanton negligence or from liability up to the amount of collectible insurance carried by the lessor.
Insurers and agent associations successfully induced the ISO to provide a better solution for premises rented on a short-term basis; for example, the rental of a hotel room on a business trip. The 1998 edition of the ISO CGL policy removes property damage exclusions j.(1), j.(3) and j.(4) for premises the insured rents with a term up to seven days. This short-term coverage protects the insured for damage to the premises, including personal property located inside the premises, when caused by any peril other than fire. Damage by fire, whether on a short-term or long-term basis, continues to be covered as provided in the exception to exclusions c. through n.—the fire legal liability coverage (which curiously covers only the premises, and not personal property, but is applicable to conditions of temporary occupancy without actual rental of the premises).
Because this short-term multi-peril legal liability coverage is subject to the same sublimit applicable to damage by fire, the Fire Damage Limit in Section III—Limits Of Insurance in the 1996 edition was changed to a Damage To Premises Rented To You Limit in the 1998 and later editions. It was at this time that the ISO’s companion rules filing increased the procurable sublimit from $50,000 to $100,000, which was a significant improvement. However, because of this sublimit and the restriction to rented premises, the CGL policy’s coverage for a short-term occupancy of premises may be an incomplete solution.
A variety of solutions can be matched to a variety of exposures found in leases. An awareness of a problem is usually key to solving it. Your professional objective to reduce your client’s exposure to loss requires that both you and your client be informed about the liabilities assumed in a lease of premises.