Optimizing Professional Protective Indemnity Coverage

What Is Professional Protective Indemnity Insurance?

Professional protective indemnity is a first-party coverage part within a CPrL policy. It provides excess coverage to the insured (the contractor) for any damages the insured incurs and is legally entitled to recover from the negligent design professional. It is an excess coverage, meaning it provides coverage for damages incurred in excess of the hired design professional's professional liability coverage.

In addition, this insurance provides an element of difference-in-conditions coverage. This means that if the underlying design professional's professional liability insurance was more restrictive than the terms under the protective indemnity coverage (for example, if the design professional's professional liability insurance contains a pollution or microbial matter exclusion, cost overrun or delay exclusions, or even habitational exclusions), the protective indemnity provides primary insurance, subject to any self-insured retention (SIR) that applies. The coverage is triggered when a contractor makes a claim for damages against a design professional's professional liability policy and then reports it to their own CPrL insurer.

The coverage concept is the easy part. When you start applying SIRs, minimum insurance requirements (MIRs), and contract language (specifically the limitations of liability provisions in professional service agreements with the design or engineering firms), it may be confusing to even the most technical insurance professional.

Applying the SIR

The protective coverage usually, but not always, carries an SIR. The SIR typically only applies in the event the underlying design or engineering firm's professional liability insurance is unavailable due to previous claims (impaired or exhausted limits of liability), exclusionary language, or canceled policies or if the minimum insurance requirement is not met. In the event the underlying design or engineering firm's policy limit is intact, the SIR typically does not apply.

To avoid having the SIR apply to the protective coverage part, insurers are usually willing to reduce the SIR to $0, essentially not applying an SIR to any indemnity payments. This requires the insurer to sit excess of whatever insurance is available to the insured from the design or engineering firm. If nothing is available, the insurer drops into a primary position, which is the most beneficial.

The Application of an MIR

Despite being referred to as a minimum insurance requirement, the MIR is a virtual attachment point set by the insurer. It may increase or decrease, depending on the amount of professional liability insurance available from the design professional at the time of claim. It assists in setting the underlying limit and subsequently enables the insurer to set price coverage based on that virtual attachment point since the actual limit of professional liability insurance carried by the architect or engineer will most likely be unknown.

Typically, insurers offering protective coverage require contractors to work with design professionals that have a minimum of $1 million in professional liability insurance. Most of the time this represents the MIR. This impacts coverage in the following two ways.

• No SIR will apply in the event the MIR is met at the time of the claim.
• The insurer will agree to waive subrogation rights against the negligent design professional, or otherwise, the insurer retains the right to subrogate back against the design professional for the incurred expenses.

However, many insurance professionals often mistakenly believe that the protective coverage applies in excess of $1 million if stated in the policy as the MIR. In reality, the MIR is just a minimum. Therefore, if the design professional is carrying $5 million in limits, which are intact at the time the contractor makes a claim, the protective coverage will sit excess of the $5 million and not in excess of the $1 million MIR.

Understanding the Impact of the Limitation of Liability Provisions

It is crucial to understand limitation of liability (LOL) provisions to ensure contractors maximize coverage under their professional protective indemnity coverage part. An LOL provision in a professional services contract caps the amount of damages the insured is legally entitled to recover from another party due to the other party's wrongdoing or negligent act, error, or omission.

There are primarily two types of LOL provisions in construction contracts: qualitative and quantitative. An LOL that excludes certain types of damages (such as punitive or consequential) is referred to as qualitative, whereas an LOL that includes a monetary cap on the parties' liability for recoverable damages is quantitative.

Imagine the LOL provision in a contract is limited to $500,000, but an error made by the design professional results in $2 million in damages. Depending on the jurisdiction and venue, the insured may be unable to recover more than $500,000 from the design professional because the insured contractually agreed to limit the design professional's liability to that level, and the protective indemnity coverage will only pay damages the insured is legally entitled to recover from the design professional. This applies even if the design professional has professional liability insurance of $1 million or more. This may leave the insured responsible for the remaining $1.5 million in damages.

Furthermore, some states consider LOLs to be unenforceable unless properly worded and fair. Other states find them totally unenforceable for reasons ranging from violation of that state's anti-indemnity statutes to public policy.

For instance, under a project policy where it is possible to scrutinize contracts with design professionals, it may be easier to identify the LOL. When you have identified the LOL, report it to the insurer. If it is high enough, the insurer will likely agree to attach excess of the LOL. If it is too low, the insurer will likely set an attachment point higher than the LOL, which requires the insured to pay the difference but allows a bit more certainty for the insured since their amount will be capped.

To address the problem with practice or corporate policies where there is a higher risk of missing an LOL in a contract, insurers may offer minimum-permissible limitation of liability endorsements. In the event the insured unknowingly accepts an LOL provision of less than $1 million, the coverage is afforded in excess of the $1 million set in the endorsement. Under this endorsement, the insurer provides a fixed attachment point, usually at $1 million. If the LOL is under $1 million, the insured pays the difference between the LOL and $1 million, leaving the insurer to pay above the $1 million and up to the total damages incurred.

The following are two real-life examples where protective indemnity coverage was helpful.

• A structural engineer hired by a design builder on a mixed-use project applied the incorrect building code, resulting in higher structural steel costs. The design builder incurred $5 million in additional costs due to the engineer's negligence. The design builder made a claim against the structural engineer for the additional costs; however, the engineer's professional liability insurance policy only provided $2 million in limits. The protective indemnity coverage part of the design builder's CPrL policy sat the excess of the engineer's practice policy to cover the remaining $3 million.
• A design builder on a large hotel project incurred $10 million in additional costs due to the negligence of its soils engineer misrepresenting the correct soil under the project site. The design builder brought legal action against the engineer, triggering the protective indemnity coverage under their CPrL policy. The soils engineer's professional liability insurance policy only had $1 million in limits. The design builder's protective indemnity coverage part sat the excess of the soils engineer's policy to cover the $9 million in loss.

It is vital to make sure every party understands the LOL provision stated in a contract. Before an insured accepts an LOL provision in a contract with a design professional, the insured should ensure an LOL endorsement applies to their CPrL policy to make the insured whole from any amounts incurred due to the negligence of the hired design professionals.

Timing of Payment

Another pivotal aspect of coverage is the timing of a payment under the protective coverage part. Keep in mind, this is excess coverage and, to access excess limits of liability, the underlying limit needs to be exhausted.

Exhausting the underlying limit is predicated on a third-party claim made by the contractor against the hired design professional. To the design professional's professional liability insurer, this would be a typical claim resulting in a potential payout years down the road. The slow resolution is due to it being excess coverage. More importantly, under the design-build delivery method, the construction firm must still ensure the project continues to progress toward completion.

Some insurers have modified their claims provisions to ease this burden and possibly provide payment sooner. These claims provisions provide the insurer with the flexibility to settle damages the insurer feels will breach the protective indemnity layer before the underlying insurer pays if it deems payment is appropriate. However, not all insurers offer such provisions, and the decision to pay before the underlying insurer pays typically resides with the insurer.

Wrapping Up

Protective indemnity coverage can be explained so simply—it's excess insurance purchased by the contractor for catastrophic design errors or engineering errors. However, to truly understand this coverage part, you need to understand the details. So, while protective professional indemnity may benefit construction firms that purchase CPrL insurance, not understanding the workings and requirements placed on the insured may minimize the benefit of such coverage—and, in some cases, possibly void coverage altogether.