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Construction Defect Coverage

Defective Construction as an Occurrence: Witnessing the "Occurrence" Farewell Tour?

Patrick Wielinski | April 1, 2008

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Gavel on building plans with construction helmet and measuring tape

As described in previous articles in this column, Insurance Law: Construction Defect, 2007 saw the issuance of a number of much-publicized opinions on the subject of defective construction as an occurrence, mostly from the highest courts of several states. Those courts rejected the arguments of some insurers that damage to a construction project arising out of the performance of defective work in breach of the insured's contract is foreseeable and therefore does not meet the definitions of "occurrence" and "property damage" in the commercial general liability (CGL) insurance policy.

Similar results are being reached by courts in 2008. Those 2007-2008 cases include:

  • Travelers Indem. Co. of Am. v. Moore & Assocs., Inc.>, 216 S.W.3d 302 (Tenn. 2007)
  • Lamar Homes, Inc. v. Mid-Continent Cas. Co.>, 242 S.W.3d 1 (Tex. 2007)
  • Lennar Corp. v. Auto-Owners Ins. Co.>, 151 P.3d 538 (Ariz. App. 2007)
  • U.S. Fire Ins. Co. v. J.S.U.B., Inc.>, 2007 WL 4440232 (Fla. Dec. 20, 2007)
  • Auto-Owners Ins. Co. v. Pozzi Window Co.>, 2007 WL 4440389 (Fla. Dec. 20, 2007)
  • Aten v. Scottsdale Ins. Co.>, 511 F.3d 818 (8th Cir. 2008)

The most recent in this line of cases is Auto Owners Ins. Co., Inc. v. Newman>, 2008 WL 648546 (S.C. Mar. 10, 2008).

This line of cases is remarkable for its consistent adherence to the policy language in determining that unexpected and unintended property damage to a construction project is an accident within the definition of occurrence, and going on to apply the exclusions in the policy. Of those exclusions, the courts primarily addressed the "Your Work" exclusion, together with its exception for property damage arising out of subcontractor work for the insured.

Considered together, these cases not only establish a clear trend, but amount to something of a "farewell tour" as to the "no occurrence for breach of contract" argument. As stated, most of these cases were described in my February 2008 article, 2007 Defective Construction Insurance Cases, but the newly issued opinion of the South Carolina Supreme Court in Auto Owners v. Newman> warrants additional discussion. In fact, so far, it is the most important date or gig on the "Farewell Occurrence Tour." It is also a harbinger of perhaps another tour of various jurisdictions, the "Property Exclusion Reunion Tour," in that the parties to insurance disputes will now refocus on the applicability of exclusions in the policy since the existence of "occurrence" and "property damage" as to construction defects in appropriate cases has now been reaffirmed.

The L-J v. Bituminous> Fallout

The "breach of contract as no occurrence" argument has had no more checkered history than in South Carolina. By way of background, in 2005, the South Carolina Supreme Court issued a much-publicized opinion, L-J, Inc. v. Bituminous Fire & Marine Ins. Co.>, 621 S.E.2d 33 (S.C. 2005). That opinion was pointed to by many as spelling the end of CGL coverage for property damage arising out of defective construction. In that case, the court held that damage to a roadway due to cracking caused by a subcontractor's work was not an occurrence since the only damage was to the road, the insured contractor's work.

Despite that pronouncement, federal district courts in South Carolina continued to certify questions to the South Carolina Supreme Court as to whether its holding in L-J v. Bituminous> applied to deny coverage for numerous claims involving property damage to other parts of a building caused by continuous exposure to moisture which results from faulty workmanship.

That same issue was addressed by the federal district court in Okatie Hotel Group, LLC v. Amerisure Ins. Co.>, 2006 WL 91577 (D.S.C. Jan. 13, 2006), where the court determined that L-J v. Bituminous> stood for the proposition that no occurrence exists if the damage is restricted to the defective work itself. However, if the damage extends beyond the defective work to otherwise nondefective work, there is an occurrence. In Okatie>, the court ultimately upheld coverage for a claim involving water intrusion damage to the interior of a hotel resulting from defective work.

The question certified by these courts to the Supreme Court of South Carolina was whether damage to other nondefective portions of a construction project due to water infiltration constitutes an occurrence of property damage under a general contractor's CGL policy. Pending the answer of the certified question, the various federal cases were stayed.

The Auto Owners v. Newman> Case

The certified question was answered by the South Carolina Supreme Court in mid-March 2008, in Auto Owners Ins. Co., Inc. v. Newman>, 2008 WL 648546 (S.C. Mar. 10, 2008). That case was hand-picked by the court pursuant to South Carolina procedure, essentially for purposes of answering the certified question from the federal courts.

The case involved defective stucco work performed by the insured homebuilder's subcontractor. Specifically, defective stucco application by a subcontractor allowed water to seep into the home, causing severe damage to the home's framing and exterior sheathing. Relying on the plain language in the policy, the South Carolina Supreme Court found there had been an "occurrence" of "property damage" caused by the subcontractor's defective work. The Auto Owners v. Newman> case is quite remarkable in that it severely limited and effectively abrogated the prior opinion of the South Carolina Supreme Court in L-J, Inc. v. Bituminous>, in which the court, less than 3 years earlier, had held to the contrary.

In its analysis of "occurrence," the court determined that the insurer's argument that the property damage caused by the subcontractor's defective work was foreseeable, and thus expected and intended since it arose out of the insured's breach of contract, was "unreasonable" in that no insured homebuilder would expect its subcontractor to perform negligently. Applying that common-sense logic, the court affirmed the trial court's award of damages for rough carpentry, windows and doors, thermal and moisture protection, and interior and exterior finishes as demonstrating the existence of the underlying water damage to the home resulting from the defectively applied stucco. In addition, because this underlying moisture damage could neither be assessed nor repaired without first removing the entire stucco exterior, the allowance for replacement of the defective stucco was covered by the CGL policy as a cost associated with remedying the other property damage that resulted from an "occurrence."

In Auto Owners v. Newman>, the court also took the opportunity to clarify its citation to High Country Assoc. v. New Hampshire Ins. Co.>, 648 A.2d 474 (N.H. 1994), in its prior L-J v. Bituminous> opinion. In L-J>, the South Carolina Supreme Court used High Country> as an example of a case upholding coverage where defective workmanship resulted in property damage. It regarded the facts of High Country> as setting out covered property damage caused by continuous exposure to moisture to other work, rather than simply a claim for the contractor's defective work that was outside the scope of CGL coverage. Confusion over the citation to that case in L-J> was created because the facts of High Country> were substantially similar to those in L-J>, and also to the state and federal cases involving water infiltration.

In L-J>, the South Carolina Supreme Court had distinguished between "a claim for faulty workmanship versus a claim for damage to the work product caused by the negligence of a third party," noting that the latter would be covered under a CGL policy. In looking to clear up confusion arising out of that aspect of L-J>, the court stated in Newman> that, "given our analysis of High Country> in the L-J> opinion, it should be clear that this Court intended the 'third party' language to refer to subcontractors who are not a party to the CGL policy between the insurer and the contractor." Although the South Carolina court did not expressly overrule L-J in Newman, this "clarification" represented an attempt to backtrack from its prior holding that deprived many construction insureds of coverage, contrary to the policy language.

It should be noted that the result in Auto Owners v. Newman> was achieved through reliance on the definitions of occurrence and property damage, although neither of those definitions appears to make any distinction, in terms of "accident," or "physical injury to tangible property," as to whether the insured's defective work damages other work. The same result, and perhaps a result "truer" to the policy language, could have been achieved through reliance on the exclusions, particularly the subcontractor exception. The court discussed and relied on that exception in tandem with the definitions of occurrence and property damage to achieve essentially the same result.

The Property Damage Exclusion Reunion Tour

As evidenced by this discussion, the judicial trend in many jurisdictions appears to be the rejection of the theories previously utilized by insurers to deny coverage in construction defect insurance disputes, such as the breach of contract versus tort distinction and the economic loss rule, none of which have any basis in the policy language itself. Instead, those courts tasked with determining coverage issues are now focusing again on the actual terms of the policy, including the policy exclusions. As such, momentum for a Property Damage Exclusion Reunion Tour is building. Below are some of the more noteworthy opinions issued in 2007-2008 in which various courts construed and applied property damage exclusions in disputes involving defective workmanship, either as a part of the Reunion Tour, or sometimes as the closing act on a double bill on the Occurrence Farewell Tour after the existence of an occurrence had been upheld.

For example, in Lamar Homes, Inc. v. Mid-Continent Casualty Co.>, 242 S.W.3d 1 (Tex. 2007), the court traced the expanded coverage provided under the CGL policy for certain business risks, recognizing the effect of the broad form property damage (BFPD) endorsement which culminated in the insertion of the subcontractor exception into exclusion (l), the your work exclusion, into the CGL policy in 1986. By incorporating the subcontractor exception into the your work exclusion, the insurance industry specifically contemplated coverage for property damage caused by a subcontractor's defective performance.

Similarly, in U.S. Fire Ins. Co. v. J.S.U.B., Inc.>, 2007 WL 4440232 (Fla. Dec. 20, 2007), the Florida Supreme Court recognized the applicability of the subcontractor exception to exclusion (l), the your work exclusion, by upholding coverage for the insured builder for property damage to homes caused by inadequate site preparation performed by a subcontractor. The Florida Supreme Court rejected the argument that to apply the exception would create coverage through an exclusion. It also concluded that to uphold coverage under the CGL policy would not convert the policy into a performance bond.

A case denying coverage based upon an exclusion is Burlington Ins. Co. v. Steve's Ag Servs., Ltd.>, 2007 WL 4357767 (9th Cir. Dec. 10, 2007) (applying Hawaii law). There, the court held that exclusion j(6), the faulty workmanship exclusion, applied to deny coverage to an insured contractor that logged state lands without a permit, since the claim for the value of the timber taken constituted an effort to repair and replace the insured's work within the meaning of the exclusion.

Another case is Bituminous Casualty Corp. v. Kenway Contracting, Inc.>, 2007 WL 1790685 (Ky. June 21, 2007), in which the court held that exclusions j(5) and j(6), the operations and faulty workmanship exclusions, did not apply to a claim which arose out of the unintentional demolition of an entire home when only the carport was to be demolished. Both exclusions were ambiguous since the policy did not define the terms "that particular part of real property" or "operations," and there was no allegation that any of the work on the carport itself was faulty.

In Calcasieu Parish Sch. Bd. v. Lewing Constr. Co., Inc.>, 2007 WL 4322161 (La. App. 2007), the court found that despite its previous finding of coverage, exclusion (k), the your product exclusion, or exclusion (l), the your work exclusion, applied to bar coverage for property damage to a floor installed in a school by the insured flooring subcontractor. The court did not differentiate between whether the insured's installation of the flooring was considered "your work" or "your product," but instead simply held that one of those exclusions would apply to deny coverage.

In addition, in Mello Constr., Inc. v. Acadia Ins. Co.>, 874 N.E.2d 1142 (Mass. App. Ct. 2007), the court applied exclusion (j), the faulty workmanship exclusion, finding that because the entire project was considered the insured general contractor's work, the "particular part" distinction in the exclusion was irrelevant, and thus the exclusion applied to bar coverage for the contractor's defective foundation work.

As explained earlier, in the Auto Owners v. Newman> case, the court recognized that the 1986 revisions of the standard CGL policy to clarify that the exception expanded liability coverage for property damage to a contractor's completed work arising out of work performed by the subcontractor. In that connection, the court found that coverage for damages arising out of the defective installation of stucco by a subcontractor was preserved by the subcontractor exception in this exclusion.

One of the early 2007 dates on the Property Exclusion Reunion Tour originated with the Tennessee Supreme Court in Travelers Indem. Co. of Am. v. Moore & Assocs., Inc.>, 216 S.W.3d 302 (Tenn. 2007). There, the court applied the subcontractor exception to exclusion (l) to uphold coverage for the insured general contractor for property damage resulting from the water penetration caused by the faulty workmanship of its window installer.

As can be seen, it appears that the argument that defective workmanship arising out of a breach of contract cannot be an occurrence under a CGL policy, which was somewhat successful in previous years, has been increasingly rejected in 2007. Even in states where that view was adopted, such as South Carolina, the courts appear to be reconsidering it. 1

The rejection of this argument was not extremely surprising, since based on the language of the policy itself and the notion that unexpected and unintended property damage arising out of faulty workmanship constituted an occurrence has been the majority rule for quite some time. In essence, the courts are simply restoring order on this aspect of construction defect coverage. Due to its nature, construction defect litigation invariably spawns considerable coverage litigation, since insurance coverage drives the defense and payment of what are often relatively large claims. That litigation should now shift back to the application of the property damage exclusions, the portions of the policies where these issues were traditionally and more properly addressed.

In keeping with the theme, construction insureds can expect the Property Damage Reunion Tour to play to packed houses in numerous other venues. However, as the property damage exclusion cases described above illustrate, reviews on the Reunion Tour will be mixed. In other words, even though issues surrounding "occurrence" and "property damage" may have receded, application of the relatively complex exclusions to complex construction defect scenarios will still require considerable time, attention, and creativity. At least for the time being, this author will likely not need to get a new gig.

Note: For an update on this topic, see CGL Exclusions May Impact Coverage for Occurrences Involving Defective Work (October 2009).

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do 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.



Nevertheless, it must be kept in mind that the Farewell Occurrence Tour has not reached all venues and the "breach of contract is no occurrence" position is still the law in a number of states. See, Kvaerner Metals v. Commercial Union Ins. Co.>, 908 A.2d 888 (Pa. 2006); Adair Group, Inc. v. St. Paul Fire & Marine Ins. Co.>, 477 F.3d 1186 (10th Cir. 2007) (applying Colorado Law); ACS Constr. Co. of Miss. v. CGU>, 330 2F.3d 885 (5th Cir. 2003) (applying Mississippi law); Burlington Ins. Co. v. Oceanic Design & Constr., Inc.>, 383 F.3d 940 (9th Cir. 2004) (applying Hawaii law); Essex Ins. Co. v. Holder>, 2008 WL 598160 (Ark. Mar. 6, 2008). A comprehensive survey of the case law on these issues is beyond the scope of this column. For a matrix of the status of the law on occurrence, property damage, and the major exclusions as applied to construction defect insurance coverage throughout the 50 states, as prepared and maintained by the author, see the IRMI Online edition of the author's book, Insurance for Defective Construction, Second Edition (2005), also available on that same website.