Contractors Beware: Avoid Loss Payable Traps

When damage occurs to property on a construction site, owners and contractors often rely on a Builders Risk Policy to cover the damage. If the owner holds the policy, the contractor is generally protected under the policy as either an "additional insured" or "loss payee."  An "additional insured" enjoys the benefit of being an insured under the policy, in addition to the policy owner. "Loss payees," on the other hand, may have very different rights.

There are two general loss payable clauses in Michigan. These are referred to as "ordinary" and "standard" loss payable clauses. "Ordinary" loss payable clauses direct the insurer to pay insurance proceeds of the policy to the "ordinary" loss payee, generally a lienholder, prior to paying the named insured. Under an "ordinary" loss payable clause, the loss payee has no right to recovery greater than the rights of the named insured, and the loss payee's rights derive from the named insured.  Because the rights derive from the named insured, breaches by the named insured may prevent recovery by the "ordinary" loss payee.[1]

Under a "standard" loss payable clause, the loss payee's rights are independent of the rights of the named insured (typically the owner); the rights are between the insurer and the loss payee.[2] As a result, a properly executed "standard" loss payable clause offers contractors protection above and beyond an "ordinary" loss payable clause, because it protects their right to payment irrespective of breaches by the named insured/owner.

If the relevant Builders Risk Policy has an "ordinary" loss payable clause, it is possible for a named insured to accidentally (or intentionally) prevent the loss payee from collecting insurance proceeds by failing to meet the terms of the insurance agreement or failing to bring a claim. This is especially frustrating if the contract limits a contractor's recovery to insurance proceeds only, but the contract also contains a broad duty of the contractor to indemnify the owner.  If there is no contractual way to require that an insurance claim be brought and the owner fails and/or refuses to make the claim as required under the Builders Risk Policy, the contractor may be required to honor its indemnification duties even though the Builders Risk Policy may ultimately not cover the contractor's loss because of the owner's policy breach. 

In order to avoid this trap, contractors becoming loss payees should ensure that when an insurable claim arises, the contractor has a contractual right within the Builders Risk Policy to require the owner to make a claim. Alternatively, contractors should enter into agreements with the owner which require the owner to file a claim or face penalty, or permit the contractor to make a claim on the owner's behalf.  By taking these actions, contractors ensure a claim is brought and proceeds are distributed to the contractor to cover losses.

Navigating construction insurance risks is difficult and Clark Hill's Construction Practice Group is here to help. You should always consult an attorney before entering into insurance arrangements on your construction projects. If you have any questions or would like assistance developing a contract that protects you, please contact Kevin Hendrick at 313-965-8315, khendrick@clarkhill.com, Zachary A. Rowley at 313-965-8262, zrowley@clarkhill.com, or another member of Clark Hill's Construction Law Team.

[1] Foremost Ins Co v Allstate Ins Co, 439 Mich 378, 383-84; 486 NW2d 600 (1992).

[2] Id.