Expert Commentary

The New Business Risk Rationale:

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.

Construction Defect Coverage
December 2003

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 the discussion of Travelers Insurance Co. v Eljer Manufacturing, Inc., 757 NE2d 481 (Ill 2001).

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, 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.


1This argument is most often made against the backdrop of the language in the CGL insuring agreement to the effect that the insurer "shall pay all sums that the insured becomes "legally obligated" to pay. Some insurers argue that this language limits coverage to only tort-based damages and not damages for breach of contract. Of course, this argument is frequently encountered in the defective construction context due to the fact that most construction work is performed pursuant to contract, of which defective construction work may be a breach. This argument met with some initial success, but was later debunked by the California Supreme Court in Vandenberg v Centennial Ins. Co., 982 P2d 229 (Cal 1999). More recently, other courts have held that damages incurred to repair a defective product pursuant to a contractual requirement constitute damages that the insured is "legally obligated" to pay under a liability policy. Venture Encoding, Inc. v Atlantic Mutual Ins. Co., 107 SW3d 729 (Tex App—Fort Worth 2003, petition denied). See also Wanzek v Employers Ins. Co. of Wausau, 667 NW2d 473 (Minn App 2003, review granted) (costs of repairing pool due to defective coping stone provided by insured’s subcontractor involved property damage and a contractual obligation to repair, thus constituting a covered legal obligation of the insured).

2This is a favorite argument used to deny coverage for defective work claims short of considering the effect of the narrowed exclusions. The split in authority between the traditional approach to occurrence, i.e., that property damage neither expected nor intended from the standpoint of the insured constitutes an occurrence, versus the view that property damage is the natural and probable consequence of failure to follow plans and specifications, has caused a split in authority throughout the United States. However, see King v Dallas Fire Ins. Co., 85 SW3d 185 (Tex 2002), in which the Texas Supreme Court reemphasized the language of the policy and reiterated the principle that bodily injury or property damage neither expected nor intended from the standpoint of the insured, irrespective of whether the acts giving rise to the bodily injury or property damage were intentional, constitutes an occurrence under Texas law.

3This argument, though easier to state than to justify, ignores the fact that a performance bond is a financial guarantee posted by the contractor in favor of the owner that the project will be constructed as set out in the contract documents. It also ignores the fact that the surety has a right of contractual indemnity against the contractor for any amounts paid out pursuant to the bond. Some claims, particularly claims that involve defective workmanship that cause damage to the project, can trigger both the CGL policy and the performance bond. In that instance, the CGL policy should respond first, particularly in light of the contractor’s indemnity obligations to the surety. Because of the contractor’s indemnity obligation, upon payment of a performance bond claim involving defective workmanship, the insured contractor’s rights under its CGL policy are frequently assigned to the surety for pursuit of subrogation.

4Analogizing to the current political climate cannot be resisted, where "voodoo economics" is used to divert attention from serious underlying economic issues.

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.

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