The Myth of "Third-Party" Property Damage
May 2003
There has been varying judicial application
of standardized commercial general liability (CGL) insurance policy definitions
to claims involving defective work, and the coverage myths that have arisen
as a result. These myths, after being repeated often enough, assume a life of
their own. One such myth holds that an insured seeking coverage for a defective
work claim must demonstrate damage to a third-party’s property, as opposed to
the insured’s own work.
by Patrick
J. Wielinski
Cokinos, Bosien &
Young
A myth is a "popular belief or tradition that has grown up around something
or someone."1 Myths are associated with
nearly every facet of life—historical, political, social, popular—to name a
few. Insurance coverage is no different, and it is not immune from its own set
of myths. Even the commercial general liability (CGL) insurance policy, with
terms that have been standardized for many years, has become the subject of
something akin to its own body of mythology.
The standardized terms of the CGL policy themselves are a contributing factor
to the development of these myths. That policy has been the subject of a great
deal of court interpretation in coverage litigation between construction insureds
and their insurers. Unfortunately, courts have reached greatly varying results
when applying these definitions to claims involving defective work, despite
the standardization. Obviously, when courts reach varying interpretations as
to standardized policy language, at least some of these varying results must
run counter to the language of the policy itself.
Coverage myths develop as a byproduct of the policy standardization since
court interpretations are frequently cited and relied on by the parties in subsequent
coverage litigation. This creates the tendency to propagate and extend even
the more questionable of these interpretations so that they are applied (questionably)
to resolve future claims. Worse yet, these questionable interpretations sometimes
get applied to legitimate claims resulting in their questionable denial. Along
the way, these types of misinterpretations, after being repeated often enough,
assume a life of their own. In other words, they assume the stature of "myths"
and the misconceptions associated with them are difficult to overcome in the
handling of future claims, even in litigation involving those claims.
The Significance of Third-Party Property Damage
The many coverage issues surrounding CGL coverage for defective work has
led to a large body of case law interpreting and applying the CGL policy in
the context of such claims. One of the myths that has emerged from that case
law surrounds the concept of "third-party" property damage. Specifically, this
myth holds that an insured seeking coverage for a defective work claim must
demonstrate damage to a third-party’s property, as opposed to the insured’s
own work. Otherwise, there can be no covered "occurrence" of "property damage,"
as those terms are defined the policy.
In reality, this "requirement" has no support in the definitions of those
terms. Rather, it is the exclusions directed at limiting coverage for property
damage involving the insured’s own defective work that render the existence
of third-party property damage an important element of most defective work claims.
As stated above, claims arising out of defective work must involve "property
damage" caused by an "occurrence" in order to be covered under the CGL insurance
policy. This is because the insuring agreement of the policy states that the
insurer will "pay those sums that the insured becomes legally obligated to pay
as damages because of ‘bodily injury’ and ‘property damage’ to which this insurance
applies." Thus, the existence of "property damage," as defined in the policy,
is required in order to trigger the insuring agreement. "Property damage" is
defined in the CGL policy as follows:
- Physical injury to tangible property, including all resulting loss of
use of that property. All such loss of use shall be deemed to occur at the
time of the physical injury that caused it; or
- Loss of use of tangible property that is not physically injured. All
such loss of use shall be deemed to occur at the time of the ‘occurrence’
that caused it.
The definition is itself deceptively simple, imposing only two requirements:
(a) that the damaged property be tangible; and (b) that the property be physically
injured or if not physically injured, that its use be lost. The definition makes
no differentiation between damage to the insured’s own work and the work or
property of third parties. The obvious conclusion is that physical injury to,
or loss of use of, the insured’s own work qualifies as "property damage" under
the policy. Ultimate coverage, however, is subject to the policy exclusions.
Likewise, there is no "third-party" property damage requirement in the definition
of "occurrence" in the standard CGL policy. That definition defines "occurrence"
as follows: An accident, including continuous or repeated exposure to substantially
the same general harmful conditions.
Despite the absence of any mention of damage to third-party property in either
the definition of "property damage" or "occurrence" in the policy, courts have
had a tendency to engraft that requirement into their treatment of insurance
coverage for defective work claims. Thus, the third-party property damage requirement
as to property damage and occurrence under the CGL policy has assumed the stature
of a coverage myth.
Perhaps some of the blame for the propagation of coverage myths lies with
commentators, including the author of this column. For example, in the discussion
of the definitions of "occurrence" and "property damage" in Insurance for Defective
Construction: Beyond Broad Form Property Damage Coverage, the author discussed
this issue in terms of the dichotomy between the insured's own work and damage
caused by that work to third-party property. That discussion, found in chapters
3 and 5 of the book, reports on case law that recognizes this dichotomy, rather
than analyzing it.
A more thoughtful analysis, as set out in this column, demonstrates that
the distinction between damage to third-party property versus the insured's
own work, for the purposes of the definitions of
"occurrence" and "property damage," is a distinction without substance
as long as the claim involves physical injury to tangible property. Of course,
whether that tangible property constitutes the insured’s own work or third-party
property may prove significant for purposes of application of the exclusions
and ultimate payment of the claim.
Examples from the Case Law
The prevailing confusion over the myth of the third-party property damage
requirement is best illustrated by some brief case law examples. In Hartford Casualty Co. v Cruse, 938 F2d 601 (5th
Cir 1991), the owners of a home filed an action for breach of warranty, negligence,
and deceptive trade practices against a contractor who performed defective foundation
leveling services on their home. The defective foundation leveling caused diminution
in the house's market value after repairs, and resulted in out-of-plumb doors,
windowsills, and countertops, as well as separation of interior walls from the
floor, and cracked drywall.
In denying the claim, the insurer argued that the damages to the home were
excluded under Exclusion (o), the work performed exclusion, and that there was
no "occurrence."2 As to the application
of Exclusion (o), the court held that it applied only to the cost of repair
of the foundation itself; that is, the insured's work, and did not apply to
the diminution in value of the home that remained after correction of the insured's
faulty work and to repair costs for other property such as drywall, floors,
doors, window sills and other surfaces. As to the "occurrence," the court carried
the same analysis over to that issue, stating as follows:
Considered in tandem with the business risk exclusion, the "occurrence"
requirement illuminates the allocation of risk. Direct (as opposed to consequential)
damages that naturally flow from a breach of contract are conclusively presumed
to have been in the contemplation of the parties and may therefore constitute
expected or intended damages. A comprehensive general liability policy does
not cover this cost of doing business. A builder who fails to abide by the
specifications of a contract, for example, by substituting a weaker building
material, may by that breach produce expected property damage to his or
her work, and may thus fail to show a covered "occurrence."
But "an occurrence takes place where the resulting injury or damage was
unexpected and unintended, regardless of whether the policy holder's acts
were intentional." [Citations omitted.] The requisite accident may inhere
in the scope of the damages … With the extensive damage to the Cruses' home,
we find an occurrence sufficient to trigger coverage.
As can be seen, the court extended the business risk rationale behind Exclusion
(o), the work performed exclusion, to its "occurrence" analysis, making the
somewhat wooden distinction between the expected or intended nature of damage
to the insured's own work as opposed to damage to third-party property. At the
core of the court's analysis is the assumption that damages arising out of a
breach of contract are somehow less expected or intended by a contractor/insured.
The inherent problem with this analysis is the assumption that construction
contractors expect or intend to breach their contracts.
As discussed below, many CGL claims involve property damage to an insured
contractor's own work resulting from property damage which it neither intended
nor expected to cause through the defective performance of its contract. These
damages should be no less an "occurrence" than damage to a third party's property
under the definition above.
The rationale of Hartford v Cruse was extended
by the court in Federated Mutual Insurance Co. v Grapevine
Excavation, Inc., 197 F3d 720 (5th Cir 1999). That case involved a Wal-Mart
project in which Wal-Mart withheld the contract balance due the general contractor
to correct defective work allegedly performed by the insured excavation subcontractor.
Specifically, Wal-Mart complained that the select fill installed by the insured
failed to meet specification for the project and damaged the crushed stone sub-base
and asphaltic concrete installed by another subcontractor.
The trial court upheld the insurer's denial of coverage, finding that the
allegations against the insured set out an alleged breach of contract that produced
damages that could not be characterized as unexpected or unintended in light
of the insured's alleged failure to meet contract specifications.
In reversing, the Fifth Circuit Court of Appeals relied on allegations that
the insured negligently damaged the work of another contractor, the paving contractor.
The court applied cases including Hartford v Cruse,
discussed above, for the proposition that courts consistently have held that
damage wreaked on the work product or property of a third party, as opposed
to that of the insured, is presumed to have been unexpected and, therefore,
constitutes an accident or occurrence. The court specifically found support
for that holding in the "your work" exclusion in the policy before it, as well
as the business risk analysis from Hartford v Cruse,
quoted above. The court stated that when a third party's work has been damaged,
it "is presumed to have been expected, and, therefore, constitutes an accident
or occurrence."
This case is an example of how the myth surrounding the need for third-party
property damage has gained strength. Once again, this case imports notions of
business risk more fully and carefully laid out in the exclusions contained
in the CGL policy. Those exclusions are better suited to differentiate between
the insured's own work and third-party property for purposes of coverage under
the CGL.
Another Perspective
Not all courts have taken this approach. Subsequent cases have rejected the
imposition of notions of third-party property damage and business risk on the
definition of "occurrence" in construction defect cases such as Federated v Grapevine. For example, in First Texas Homes, Inc. v Mid-Continent Casualty Co.,
2001 WL 238112 (ND Tex March 7, 2001), aff'd without opinion, 32 Fed Appx 127,
2002 WL 334705 (5th Cir 2002), the insurer argued that pursuant to Federated v Grapevine, a homebuilder's defective
workmanship at a home did not constitute an occurrence because the damage alleged
in the case was to a home designed and constructed by the homebuilder, and not
the work of a third party.
The court rejected this argument, stating that the relevant inquiry is not
whether the insured damaged his own work, but whether the resulting injury or
damage was unexpected and unintended. The court held that the underlying petition
against the homebuilder supported a claim that the damage sustained by the homeowner
was neither expected nor intended from the standpoint of the insured. The petition
alleged that the home was not of proper quality and was not designed or constructed
in a good workmanlike manner, and that the foundation was insufficient and resulted
in a foundation and home that were not properly designed or built.
Another recent case rejecting this line of argument is Fidelity & Deposit Co. of Maryland v Hartford Casualty
Insurance Co., 189 F Supp 2d 1212 (D Kan 2002). In that case, the owner
terminated the insured contractor and its subcontractor for alleged negligent
workmanship, suing them and their surety for breach of contract and negligence.
The claim involved the construction of a school, and after takeover of the project,
the surety discovered numerous defects in the concrete and masonry work performed
by Midwest Drywall, the subcontractor. Hartford, the subcontractor's CGL and
umbrella insurer, refused to defend and after settlement, Fidelity, the surety
for the insured contractor, took an assignment of the insured's claims against
Hartford.
One of the arguments raised by Hartford to deny coverage was that the defective
workmanship did not constitute an "occurrence." The court rejected this argument,
ultimately holding that damage that occurs as a result of faulty or negligent
workmanship constitutes an "occurrence" as long as the insured did not intend
for the damage to occur. It supported this determination with an analysis of
the interaction of the definition of "occurrence" and the property exclusions
in the CGL policy, as follows:
This outcome is consistent with the Kansas Supreme Court's pronouncement
that all relevant provisions of an insurance policy must be read together,
rather than in isolation, and given effect. [Citation omitted.] In this
case, the CGL and umbrella policies contained detailed business risk and
policy exclusions. The business risk exclusions contemplate that some construction
defects are covered and some are not. The policy exclusions become meaningless
if all construction defects are excluded from coverage because they do not
constitute an 'occurrence.' Because the parties included the business risk
exclusions, they could not have intended to exclude all construction defects,
whether negligently or intentionally caused.
In addition, Hartford argued that its policies did not apply because there
was no "property damage" as defined in the policies because the physical injury
cannot be to tangible property that is the work product of the insured. In other
words, it argued that since there was no damage to a third party's property,
there is no "property damage" involved in the claim. The court summarily rejected
this argument, stating as follows:
The definition of property damage in the policies does not limit the
coverage to property that is not in the possession of or work product of
the insured. F&D correctly points out that if the work product of the insured
can never come within the definition of property damage, then the exclusion
set forth in the policy to limit such damages would be without meaning.
The court concludes that the injury to the project allegedly caused by the
insured's faulty workmanship was caused by an "occurrence" and resulted
in "property damage," thus bringing the circumstances here within the policies'
coverage.
Quite properly, the court went on to apply the exclusions in the CGL and
umbrella policies before it in determining coverage for the defective masonry
and concrete work on the project.
A similar case is L-J, Inc. v Bituminous Fire & Marine
Insurance Co., 567 SE2d 489 (SC App 2002). In that case, the insured
site development contractor faced claims against it arising out of inadequately
compacted road base, which resulted in the deterioration of pavement in a subdivision.
All of the defective site compaction work was performed for the insured by subcontractors.
In response to the claim, the insurer argued that faulty workmanship can never
constitute an occurrence under a CGL policy.
The court rejected this argument, and in a footnote, acknowledged the proposition
that an automatic denial of coverage on the basis of defective work cannot be
an occurrence, constitutes a "rehash" of the business risk doctrine, and depends
entirely on the court ignoring the terms of the CGL policy. Rather, the L-J court held that while faulty workmanship,
standing alone, may not constitute an accident, where the damage due to the
faulty site compaction extended beyond the cost of repairing the compaction
because of the failure to properly compact the roadbed led to the failure of
the road surfaces, there was an accident which was neither expected nor intended
from the standpoint of the insured. Note that all of this work was part of insured's
work under its contract.
The court went on to uphold coverage and to apply the "subcontractor exception"
to Exclusion (l) of the CGL policy which excludes coverage for property damage
to the named insured's work occurring after the project has been completed.
That exception states the exclusion does not apply where the faulty work was
performed by a subcontractor.
Another such case is Erie Insurance Exchange v Colony
Development Corp., 136 Ohio App 3d 406, 736 NE2d 941 (1999). In that
case, the trial court determined that the CGL insurer of the developer of a
condominium complex owed no duty to defend or indemnify the insured developer
in an action in which the condominium association asserted claims arising out
of defective construction of the complex. The basis for the trial court's determination
was that the insured's negligence in constructing and designing the condominium
complex did not constitute an occurrence of property damage within the meaning
of the policy. The appellate court reversed, rejecting this argument, and stating
as follows:
Erie cites numerous cases for the general proposition that a policy is
not a performance bond and, hence, does not cover claims for insufficient
or defective work or the repair and replacement of that work. [Citations
omitted.] While this general proposition is true, the rationale for the
proposition is not that the allegations of negligent construction or design
practices do not fall within the broad coverage for property damage caused
by an occurrence, but that, as discussed in the balance of this opinion,
the damages resulting from such practices are usually excluded from coverage
by the standard exclusions found in such policies.
* * *
Thus, contrary to Erie's position, Ohio case law indicates that allegations
that a building contractor breached its duty to construct or design a building
in a workmanlike manner are sufficient to invoke the general coverage provision
for property damage caused by an occurrence.
The court went on to apply exclusions in the policy, including the work performed
exclusion and the impaired property exclusion, to determine that certain elements
of the property damage were in fact covered under the policy.
It is obvious that the reasoning of these courts is the preferable approach
to give effect to all provisions of a CGL policy when applying that policy to
a defective work claim.
Why Bother?
The application of the definitions of "occurrence" and "property damage"
are essentially separate steps to be applied prior to applying the "business
risk" notions that are embodied in the property damage exclusions which are
most often invoked by a defective workmanship claim. Those exclusions include
the following.
- Exclusion j(5)—property on which operations are being performed;
- Exclusion j(6)—the faulty workmanship exclusion;
- Exclusion (l)—the work performed exclusion; and
- Exclusion (m)—the impaired property exclusion.
One may ask, "Why bother?" or "What's the difference?" The difference is
that when business risk-type notions get applied to the definitions of "occurrence,"
and "property damage," limitations as to those concepts get applied to all claims,
rather than those which embody only the true "business risks" as excluded by
the property damage exclusions listed above.
As the court in F&D v Hartford observed, the
presence of the property damage exclusions clearly indicates that there are
instances in which property damage to the insured's own work is not excluded under the CGL policy. A classic
example was provided by Insurance Services Office, Inc. (ISO), in one of its
circulars as to the scope of property damage provided under a CGL policy. In
that example, an insured subcontractor is erecting steel beams furnished by
the general contractor. The subcontractor is in the process of erecting a fifth
steel beam when this beam falls, resulting in damage to all five beams.
Under Exclusion j(5), only the "particular part" of the property on which
operations are being performed is excluded. In other words, coverage would be
provided for the four beams which had already been erected, and only coverage
for the fifth beam, the particular part upon which the insured was performing
operations, is excluded. Note that there is coverage for the first four beams
despite the fact that they are clearly part of the insured's own work, and not
third-party property.
This simple example illustrates the difficulties (and pitfalls) in applying
business risk notions to the definitions of "occurrence" and "property damage."
Other examples can be constructed out of the property damage definitions, all
of which illustrate the principle that while third-party property damage may
be an important element in the ultimate determination of coverage in any defective
work claim, it simply is not determinative of the existence of an "occurrence"
or "property damage" for purposes of the definitions in the policy. To uphold
the intent behind the CGL policy to provide a certain amount of coverage for
these types of claims, the notions of business risk and third-party property
damage should not become part of the mix until the exclusions are applied.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.