Beware. It lurks. Ill-defined. Morphing. Misunderstood. But, potentially, very dangerous to the unwary. The co-insurance defence.

What, then, is the co-insurance defence? It arises most often where parties to a construction contract take out a single insurance policy for the benefit of all parties against specified risks – for instance, physical loss or damage to the works, including where the loss is caused by the fault of one of the parties.

The rationale for the defence runs something like this. Where the contract provides that the parties have agreed for a particular loss or damage to be covered by insurance for their mutual benefit, those parties are prevented from pursuing a claim against their co-insureds for that same loss or damage. This is because the parties have agreed to look to the insurer, rather than each other, to make good the loss. Such an arrangement, in theory, avoids litigation.

The key point is that the source of the co-insurance defence is the construction contract itself rather than anything in the insurance policy. It is the contractual allocation of risk that ultimately matters. This means there can be plenty of scope for legal argument about what the contract actually means and the scope of the insurance cover contracted for. The question that must be answered is whether the parties have intended to create an insurance fund that is to be the sole avenue for making good the specified loss; or whether the existence of the fund co-exists with an independent right of action for breach of contract.

The fact that the contract is the source of the co-insurance defence has important consequences.

For instance, just because the employer and contractor are insured under the same policy does not, by itself, mean they cannot bring claims against one another in relation to an insured loss. The position can be particularly confusing where a project policy covers contractors and subcontractors “each for their respective rights and interests”. This wording may not open up the co-insurance defence, if the underlying contract does not support such a defence.

Conversely, the co-insurance defence may be available, even if the insurance policy contemplated in the contract is not taken out. The same is true where insurers void the policy that has been taken out. If this happens due to the contractor’s conduct, the employer’s remedy is likely to be a claim against the contractor for breach of the (express or implied) contractual obligation to do nothing which would invalidate the insurance. In such cases, the employer is not suing the contractor for the insured loss.

Rather, the employer sues for the loss of the insurance fund that should have been available.

But even if the co-insurance defence is available, that is not an end of the matter. A contractor must still comply with its contractual obligations, for instance to reinstate the works damaged by fire. The joint insurance may cover the fire damage, but it does not cover loss arising from a breach of contract. Any failure to carry out reinstatement works required by the contract will give rise to a claim in damages, regardless of co-insurance.

But what happens if the insurance fund is insufficient to pay for the reinstatement works? In that case, the parties must look to the allocation of risk under the contract. And that can be far from clear.

Contractors and consultants outside the project insurance need to be especially careful. Consider the facts of Co-Operative Retail Services Ltd (“CRS”) v. Taylor Young Partnership, one of the leading cases in this area of the law. The dispute arose from a major fire in 1995 that damaged CRS’s new headquarters while under construction. CRS issued proceedings against the architects and engineers for the damage caused. They, in turn, issued contribution proceedings under section 1 of the Civil Liability (Contribution) Act 1978 against the main contractor (Wimpey) and a sub-contractor (Hall) on the basis that they were also liable to CRS for the fire damage. However, a contribution claim could only be made against Wimpey and Hall if they were liable to CRS for the fire damage. The House of Lords confirmed that, because Wimpey and Hall were co-insureds with CRS, they were not so liable.

The result: the architects and the engineers were left facing the full extent of CRS’s claim without any chance of getting a contribution from Wimpey and Hall.

So, whether you’re inside or outside the insurance tent, beware.

Visit Axiom Advocates at the Scottish Construction Summit on Thursday.