Expert Commentary

Installation of Defective Product Is Not Physical Damage

Liability insurance is not a warranty of an manufacturer's product. It is only designed to provide coverage for accidental physical injury to property of others.


Claims Practices
February 2016

In U.S. Metals, Inc. v. Liberty Mut. Grp., Inc., 2015 Tex. LEXIS 1081, 59 Tex. Sup. J. 144 (2015), the Texas Supreme Court was asked to resolve a coverage issue by submitting certified questions to the Supreme Court so it could resolve a coverage dispute filed in federal court.

Facts of the Case

U.S. Metals, Inc. sold ExxonMobil Corp. some 350 custom-made, stainless steel, weld-neck flanges for use in constructing non-road diesel units at its refineries in Baytown, Texas, and Baton Rouge, Louisiana. The units remove sulfur from diesel fuel and operate under extremely high temperatures and pressures. ExxonMobil contracted for flanges made to meet industry standards and designed to be welded to the piping. The pipes and flanges, after they were welded together, were covered with a special high-temperature coating and insulation.

In post-installation testing, several flanges leaked. Further investigation revealed that the flanges did not meet industry standards, and ExxonMobil decided it was necessary to replace them to avoid the risk of fire and explosion. For each flange, this process involved stripping the temperature coating and insulation (which were destroyed in the process), cutting the flange out of the pipe, removing the gaskets (which were also destroyed in the process), grinding the pipe surfaces smooth for re-welding, replacing the flange and gaskets, welding the new flange to the pipes, and replacing the temperature coating and insulation. The replacement process delayed operation of the diesel units at both refineries for several weeks.

ExxonMobil sued U.S. Metals for $6,345,824 as the cost of replacing the flanges and $16,656,000 as damages for the lost use of the diesel units during the process. U.S. Metals settled with ExxonMobil for $2.2 million and then claimed indemnification from its commercial general liability (CGL) insurer, Liberty Mutual Group, Inc., for the amount paid.

All damages for which U.S. Metals claimed coverage arose out of its defective flanges. Under the policy’s Exclusion K, damages to the flanges themselves were not covered, and U.S. Metals did not claim them. Under Exclusion M, the policy did not cover damages to property, or for the loss of its use, if the property was not physically injured or if it was restored to use by replacement of the flanges.

Certified Questions

Liberty Mutual denied coverage, and U.S. Metals sued in federal district court to determine its right to a defense and indemnity under the policy. The court granted summary judgment for Liberty Mutual. On appeal, the Fifth Circuit Court of Appeals certified to the Texas Supreme Court the following questions.

  • In the "your product" and "impaired property" exclusions, are the terms "physical injury" and/or "replacement" ambiguous?

  • If yes as to either, are the aforementioned interpretations offered by the insured reasonable and, thus, must be applied pursuant to Texas law?

  • If the first question above is answered in the negative as to "physical injury," does "physical injury" occur to the third party’s product that is irreversibly attached to the insured’s product at the moment of incorporation of the insured’s defective product, or does "physical injury" only occur to the third party’s product when there is an alteration in the color, shape, or appearance of the third party’s product due to the insured’s defective product that is irreversibly attached?

The court said that a thing whose use or function is diminished by the incorporation of a faulty component can fairly be said to be injured, even if the injury is intangible, latent, or inchoate. Here, the installation of the leaky flanges—or at least potentially leaky and, in any event, below standard—could certainly be said to have injured—harmed or damaged—the diesel units by increasing the risk of danger from their operation and, thus, reducing their value. But, the court said, if that increased risk amounted to physical injury within the meaning of the CGL policy, then it is difficult to imagine a nonphysical injury. The policy’s limitation of coverage to damages from physical injury necessarily implied that there could be nonphysical, noncovered injuries. Otherwise, the requirement that the injury be "physical" would be superfluous. To give "physical" its plain meaning, a covered injury must be one that is tangible.

The Texas Supreme Court agreed with most courts that have considered the issue that the best reading of the standard-form CGL policy text is that physical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system. Since a defective product that causes damage is not an occurrence until the damage actually happens, it would be inconsistent to find that a defective product that does not cause damage is nevertheless an occurrence at the time of incorporation.

ExxonMobil’s diesel units were not physically injured merely by the installation of U.S. Metals’ faulty flanges, but the units were physically injured in the process of replacing the faulty flanges. Because the flanges were welded to pipes rather than being screwed on, the faulty flanges had to be cut out, the pipe edges resurfaced, and new flanges welded in. The original welds, coating, insulation, and gaskets were destroyed in the process and had to be replaced. The fix necessitated injury to tangible property, and the injury was unquestionably physical.

Thus, the court held, the repair costs and damages for the downtime were "property damages" covered by the policy unless Exclusion M applied. Exclusion M denied coverage of damages to impaired property—defined by the policy as property that could be "restored to use by the … replacement" of the faulty flanges.

The diesel units were restored to use by replacing the flanges and were therefore impaired property to which Exclusion M applied. Thus, their loss of use was not covered by the policy. But the insulation and gaskets destroyed in the process were not restored to use; they were replaced. Therefore, they were not impaired property to which Exclusion M applied, and the cost of replacing them was covered by the policy.

As to the questions certified to us by the Fifth Circuit, the first asked whether the terms "physical injury" or "replacement" were ambiguous as incorporated into the "your product" or "impaired property" exclusions of the CGL policy. The court said that the answer, in the situation presented, is "no." The second question was conditioned on a "yes" answer to the first and, thus, need not be answered. The third question asked whether installation of the faulty flanges alone physically injured the diesel units. The answer, the court said, was "no."

Conclusion

The result in this case has, as the Texas Supreme Court stated, "a perverse aspect to it." If ExxonMobil was negligent or reckless—had it not tested the flanges, or had it found the defect but decided to risk the danger of leaks—and an explosion had resulted, U.S. Metals would not be denied coverage for the damages to persons and property for want of physical injury. But, because ExxonMobil was careful and cautious, U.S. Metals was not entitled to indemnity for the costs of remedying the installation of the faulty flanges. The court said the text of the policy was clear and must be enforced.


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