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.
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, 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, 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 will be explained, 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, 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.
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.
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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.
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.
Exclusion (o) under the 1973 CGL form states that the insurance does not apply to "property damage to work performed by or on behalf of the named insured arising out of the work or any portion thereof, or other materials, parts or equipment furnished in connection therewith."
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