Dear prudence

Contractors are generally loath to fall out with their professional indemnity insurers. Any publicity in the courts tends to reflect badly on both parties. Contractors also have to have one eye on the level of their renewal premiums. The lack of reported cases may therefore not reflect the number of underlying disputes.

One area that often gives rise to arguments is the issue of how far a contractor can recover from its insurer the costs of taking pre-emptive action that averts the prospect of a third-party claim (which would otherwise be claimed against the insurers under the policy).

Suppose, for example, that a contractor is entitled to be indemnified in respect of sums that it becomes liable to pay to any third parties arising from design errors carried out by its consultants.

Suppose that it becomes aware of a design error by its consultant, but manages to spot the error and effect a redesign before work begins? It has avoided a third-party claim, but at the expense of some delay to the project, with knock-on costs.

You might think that where a contractor acts prudently in spending money to avoid such a claim, it should be in no worse a position than if it had simply sat back and done nothing.

However, that was not the case in Yorkshire Water Services Limited vs Sun Alliance, decided by the Court of Appeal in 1997.

In that case, an embankment on a waste tip failed, causing sewage sludge to be deposited into a nearby river. The water authority, as operator of the waste tip, carried out urgent flood-alleviation work to prevent damage to the nearby property of third parties that would otherwise have lodged claims. The insurers refused to pay, on the grounds that their liability under the policy was to indemnify the operator against its legal liability to pay loss or damage to a third party – whereas here, no such liability had been incurred.

Contractors spend a good deal of time drafting documents such as building contracts – they would do well to devote the same amount of attention to their professional indemnity policies

The court agreed. The prompt action of the authority in averting a claim was irrelevant. The court refused to say that the authority had a duty to act so as to mitigate third-party claims.

The effect of this decision is often overridden in particular cases by the policy wording. Typical wording may provide, for example, that the contractor is indemnified against costs and expenses "necessarily incurred in respect of any action taken to mitigate a loss or potential loss that would otherwise be the subject of a claim under the policy". There may be arguments here over whether the precautionary action has been "necessarily" incurred. Subject to that, the contractor would expect to be indemnified.

However, a relatively small change in the wording can make the issue more controversial. For example, if the contractor is to be indemnified for the costs of action taken "to remedy defects in the works", one can envisage an argument by insurers that the contractor does not get the costs of precautionary action, because there is, as yet, no defect in the works. Such an argument would appear to be completely unmeritorious. It effectively penalises the contractor for acting sensibly. Nevertheless, the legal outcome is not certain and could depend on the contractual definition of "the works", and in particular, whether that covered preparatory work relating to the building.

What is interesting here is that nuances of this sort in policy wording can lead to very different financial outcomes. These nuances are often not scrutinised by contractors at the time that the policy is written.

A further issue that sometimes arises is: exactly what outlay is the contractor indemnified against? Plainly it can recover the payment of damages to the employer, and sums due to subcontractors for delay and disruption. The contractor's own profit is often specifically excluded. But what about prolongation and disruption losses? Again, the wording is often crucial.