The New Business Risk Rationale:
"Economic Loss," "Property Damage," and the "Economic Loss Rule" (Part 1)
December 2003
This 2-part column explores a property damage-related
myth which holds that where the property damaged is the subject of the insured’s
contract, there can be no property damage or occurrence.
by Patrick
J. Wielinski
Cokinos, Bosien &
Young
The last column in this series described the development of "coverage myths" that relate to commercial general
liability (CGL) insurance coverage for defective workmanship. The focus in that
column was on the alleged need to demonstrate the existence of damage to a third
party’s property to make out a claim for covered "property damage" arising out
of defective work. Such a mythical "requirement" is often put forward despite
a lack of support in the policy language.
This two-part column explores another property damage-related myth, a myth
that borrows from the "economic loss rule" to hold that where the property damage
is to property that is the subject matter of the insured’s contract, there can
be no "property damage" or even no "occurrence." Once again, this position enjoys
no support in the policy language itself, and as is pointed out in these articles,
it amounts to another restatement of the attempt to overextend the "business
risk doctrine" to exclude all coverage for defective work, even though the exclusions
in the CGL policy provide coverage for some classes of business risk. In fact,
the resort to an "economic loss rule" analysis appears to be a reaction to the
lack of success that the business risk argument has met before the courts in
coverage litigation involving construction defects.
The first part of this article deals with the debate itself, while the second part addresses the economic loss rule
analysis.
The Background of the Debate
There has always been a historical tension between CGL coverage for defective
construction work and what insurers have traditionally referred to as an uninsured
"business risk." This tension gained momentum with the 1973 revisions to the
Insurance Services Office, Inc. (ISO), CGL form when the exclusion for property
damage arising out of work performed by the named insured was split from the
exclusion for property damage arising out of the named insured’s product.
At the same time, ISO promulgated the Broad Form Property Damage Endorsement
(BFPDE) to the standard CGL policy form. That endorsement expanded the coverage
under the 1973 form by modifying the "work performed" exclusion so as to provide
an insured with coverage for property damage arising out of the defective work
of its subcontractors. It also narrowed the exclusion, in the operations context,
to property damage to "that particular part" of the work on which operations
are being performed, out of which the property damage arises or that must be
repaired or replaced because the insured’s workmanship was faulty.
Nevertheless, the argument persisted that, despite the attachment of a BFPDE
to an insured contractor’s CGL policy, all property damage arising from defective
workmanship, including property damage arising from a subcontractor’s defective
work, constituted an uninsurable business risk. This argument was supported
by frequent reference to authorities including, a law review article, Roger
Henderson, Insurance Protection for Products
Liability and Completed Operations—What Every Lawyer Should Know, 50
Nebraska Law Review 415 (1971) and a subsequent case which cited the Henderson
article, Weedo v Stone—E Brick, Inc., 405 A2d
788 (NJ 1979), both of which employed an analysis based on CGL coverage unmodified,
i.e., unexpanded, by the BFPDE.
Therefore, these seminal authorities and the numerous cases that followed
them reached the erroneous conclusion that defective workmanship is a business
risk that is uninsurable per se, even though the intent behind the BFPDE was
to limit the business risk concept and to provide coverage for certain categories
of that risk.
Of course, numerous courts refused to ignore the limitations placed on the
business risk concept by the BFPDE, upholding coverage for insured contactors,
particularly for property damage arising out of the defective work of subcontractors.
Nevertheless, through the 1986 revisions to the CGL form, ISO sought to clarify
the limitations on the business risk concept by the revised exclusions of the
BFPDE as applied to CGL coverage for defective work. Major clarifications such
as the "subcontractor exception" (Exclusion l) and the "particular part" limitation
on the operations in progress and the faulty workmanship exclusions (Exclusions
j(5) and (6)) were recognized by the courts as expansions of coverage even in
some states that had previously embraced the business risk doctrine as to the
1973 ISO forms. Knutson Constr. Co. v St. Paul Fire
& Marine Ins. Co., 396 NW2d 229 (Minn 1986) (describing the deletion
of the language "on behalf of" from Exclusion O of the 1973 form by Exclusion
z of the BFPDE as a "slight difference in wording" that did not affect the result
that the insured contractor's business risks were nevertheless excluded), with O’Shaughnessy v Smuckler Corp., 543 NW2d 99 (Minn
App 1996) (recognizing the effect of the subcontractor exception in Exclusion
(l) of the 1986 CGL form as providing coverage to a general contractor for the
business risk of property damage arising out of the work of subcontractors).
Due to the circumscription and limitation of the business risk doctrine,
particularly by courts that remained true to the underwriting intent and applied
the limiting effect of the property damage exclusions, other arguments were
raised as to the denial of coverage for defective work claims. These arguments
have evolved into an attempt to eliminate coverage without the necessity of
applying the exclusions in the policy. These attempts involve reliance on the
"legally obligated" requirement in the insuring agreement;1 the definition of "occurrence";2 and non-policy
based "defenses" such as the "conversion of the CGL policy into a performance
bond."3 All of these efforts have met with varying
levels of success, a situation that contributes to the development of additional
arguments, including the economic loss/property damage arguments that are the
subject of this column.
Economic Loss versus "Property Damage"
The position that damage arising out of defective workmanship is not "property
damage" within the coverage of a CGL policy is frequently framed in terms of
economic loss. In other words, the contention is often made that the cost of
repairing or replacing defective work is an economic loss that is not covered
under the policy. Under many circumstances, such costs may not be in fact covered.
Take for example, the costs of repairing or replacing work that is known to
be defective, but that has not yet failed. See Travelers
Insurance Co. v Eljer Manufacturing, Inc., 757 NE2d 481 (Ill 2001), discussed
later in this column.
A problem is created, however, when an economic loss argument is used to
divert attention away from the exclusions in the policy, or even away from the
definition of "property damage," in connection with reviewing coverage for defective
work claims under a CGL policy. In other words, initially approaching coverage
for defective work claims from the perspective that economic loss is per se
not covered is, in reality, backward. Somehow, the existence of "property damage"
is avoided if it is called something else: economic loss. Rather, the inquiry
should focus on whether the claim involves "property damage," as defined in
the policy, i.e., physical injury to tangible property or loss of use of tangible
property.
If the definition of property damage is not satisfied, then the claim may
in fact involve mere economic loss, but not because economic loss is not covered,
but rather, because there is no property damage. If, in fact, there is property
damage, then the exclusions must be applied before a definitive coverage determination
can be made.
Recently, the off-the-cuff assertion that defective work claims involve mere
economic losses has often been combined with a companion assertion that this
result is in accord with the economic loss rule. Of course, and as discussed
in part 2 of this article, references to neither "economic loss" nor the "economic
loss rule" can be found within the CGL policy itself. Thus, this analysis misdirects
the attention of the insured and the courts away from the policy itself toward
vague and largely irrelevant concepts.4
Economic Loss and Defective Work Claims
As previously stated, to be covered under the policy, a claim, including
a defective work claim, must meet the definition of "property damage." That
is, it must involve "physical injury to tangible property, including all resulting
loss of use of that property," or "loss of use of tangible property that is
not physically injured." Then the claim is evaluated in light of the property
damage exclusions, an exercise that will eventually confirm or eliminate coverage.
Nevertheless, the steppingstone to the exclusions is the definition of property
damage.
One of the most recent cases to engage in an in-depth analysis of property
damage versus economic loss in the context of CGL coverage for defective work
is Travelers Insurance Co. v Eljer Manufacturing, Inc.,
757 NE2d 481 (Ill 2001). In that case, the insured manufacturer of the Qest
polybutylene plumbing system sought coverage for the costs of replacing leaky
plumbing systems, including plumbing systems installed in homes where the systems
were replaced prior to the development of an actual leak. The damages sought
against the insured manufacturer were the costs of replacing the system and
diminution in value of the homes.
The court determined that "tangible property suffers a ‘physical injury’
when the property is altered in appearance, shape, color or another material
dimension," and went on to state as follows:
- Conversely, to the average mind, tangible property does not experience
"physical injury" if that property suffers intangible damage, such as diminution
in value as a result of a failure of a component, such as the Qest System
to function as promised.
Based on the standard CGL definition of "physical injury," the Illinois Supreme
Court concluded that the mere installation of the Qest plumbing system, without
some physical injury to the home itself, did not constitute an "alteration in
appearance, shape, color or other material dimension" and thus, did not constitute
property damage.
In making that determination, the court relied on Bituminous Casualty Corp. v Gust K. Newberg Construction Co., 578 NE2d
1003 (Ill App 1991), to support its holding. In that case, the State of Illinois
sought recovery against a contractor for various acts and omissions in installation,
design and manufacturing of a heating, ventilation, and air-conditioning system,
including the expense of repairing the system since it did not properly cool
the building. In discussing that case, the Eljer court stated as follows:
- Thus, the Bituminous ruling holds that
intangible damage such as diminution in value resulting from a product’s
failure to perform as promised, does not constitute a "physical" injury
within the post-1981 policies.
It should be noted that the reference to "post-1981 policies" by the Eljer
court is to the 1986 edition ISO policy form that is issued to the vast majority
of insureds and includes the standard property damage definition.
Finally, the Eljer court concluded that economic
losses do not involve property damage, as follows:
- We hold that the appellate court below correctly concluded that indemnity
coverage under the post-1981 policies at bar is not triggered by "[p]urely
economic losses, such as damages for inadequate value, costs of repair or
replacement, and diminution in value" that result from "a product’s inferior
quality or its failure to perform for the general purposes for which it
was manufactured and sold … absent physical injury to tangible property."
[Citation to lower court opinion omitted, editing in original.]
The Eljer opinion involved a complex set of
facts and in effect overruled a decision of the U.S. Court of Appeals for the
Seventh Circuit that had reached essentially the opposite result. See Eljer Manufacturing, Inc. v Liberty Mutual Ins. Co.,
972 F2d 805 (7th Cir 1992). But, for all of its complexity, it must be remembered
that the Eljer case involved a class of claims at the very fringe of property
damage: those that involve the costs of repairing or replacing defective work
or products prior to actual failure. In that instance, the claims do not involve
physical injury to tangible property, and any loss of use is likely to be excluded.
In contrast, most defective work claims will likely involve physical injury
to tangible property, even though the damage may be to the work itself. Then
the exclusions will determine coverage, and not abstract principles such as
"economic loss" or the economic loss rule.
Part 2 of this article will address the economic
loss rule.
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.