Construction Defect Liability Coverage

Analyzing Coverage For Construction-Defect Liability

Carl Salisbury
February 8, 2011

Courts across the country struggle with whether commercial general liability insurance policies cover claims against contractors for faulty construction. Some have analyzed the standard provisions in a CGL policy and applied the coverage properly, consistent with well-known insurance concepts.

Others have been confused by provisions such as the so-called business risks exclusions or by the concept of a covered “occurrence,” and have confirmed the denial of otherwise covered claims. Recently, a New Jersey Superior Court judge joined the former group, concluding that a contractor’s CGL policy provides coverage for construction-defect liabilities.

Port Imperial Condominium Association Inc. v. K Hovnanian Port Imperial Urban Renewal Inc., HUD-L-2054-08 involved claims by a condominium association against various contractors for alleged design and construction defects that caused water infiltration and damage to the interior of its building. The court initially found that construction defects do not constitute a covered “occurrence” and that damage from such defects is not covered “property damage.”

On a motion for reconsideration filed by the condominium association and the general contractor, the court conducted a careful review of the law and a reexamination of the policy provisions. What follows is a discussion of Judge Barry P. Sarkisian’s analysis in Port Imperial and an explanation of why he was correct to vacate his prior ruling and to find coverage.

The CGL policies at issue in Port Imperial — and CGL policies generally — say that they cover an “occurrence,” which is defined as “an accident, including continuous or repeated exposure to conditions, which results in bodily injury or property damage neither expected not intended from the standpoint of the insured.” (Recent versions of the standard CGL policy place the “neither expected nor intended” language into an exclusion.) The policy defines “property damage” as:

"1) Physical injury to or destruction of tangible property which occurs during the policy period, including loss of use thereof at any time resulting therefrom, or 2) loss of use of tangible property that has not been physically injured or destroyed provided such loss of use is caused by an occurrence during the policy period."

The Port Imperial court considered the exclusions that insurance companies routinely raise to justify denying coverage for construction-defect claims. When courts deny coverage for such claims, it is usually on the basis of these so-called business risks exclusions. Judge Sarkisian, however, did not fall into the trap of expanding the reach of these relatively narrow provisions.

The “business risks” exclusions come in three flavors: “damage to property,” “damage to your product” and “damage to your work.”

The “damage to property” exclusion says that the insurance does not apply to “[t]hat particular part of real property on which you or any contactors or subcontractors working directly or indirectly on your behalf are performing operations,” nor does it apply to “[t]hat particular part of your property that must be restored, repaired or replaced because ‘your work’ was incorrectly performed on it.”

There is an exception to this for “property damage” included in the “products-completed operations hazard.” That is, if damage falls within the “products-completed operations hazard,” then the “damage to property” exclusion simply does not apply.

The “products-completed operations hazard” is set forth in the definitions section of the CGL policy, but courts uniformly treat it as an affirmative grant of coverage for certain kinds of damages arising from a contractor’s product or work. If bodily injury or property damage occurs away from premises the contractor owns or rents and arises from the contractor’s faulty workmanship or product, then the damage is covered under the “products-completed operations hazard.”

Simply stated, it covers damage caused by a contractor’s faulty construction or workmanship once the work is complete — as, for example, after the contractor delivers the fully constructed building to the owner.

The “damage to your product” exclusion says, simply, that it does not cover “‘property damage’ to ‘your product’ arising out of it or any part of it.”

Finally, the “damage to your work” exclusion eliminates coverage for “‘property damage’ to ‘your work’ arising out of it or any part of it and included in the ‘products-completed operations hazard.’” But there is an exception to this exclusion, as well, if the damage or the work out of which the damage arises was performed by a subcontractor.

Is it any wonder that some courts get the scope of these various provisions wrong? They are not light reading.

Nevertheless, imbedded within this turbid language are the outlines of the kinds of damage the policy was intended to cover and the kinds it was not. The task for courts is to distinguish one from the other. The Port Imperial court found a “clear distinction” between damages that are subject to the “business risks” exclusions and those that are covered because they fall within the “occurrence” definition of the CGL policy.

The court discovered support in the New Jersey Supreme Court’s decision in Weedo v. Stone-E-Brick Inc., 81 N.J. 233 (1979), a case that, ironically, insurance companies often cite to support denial of construction-defect claims. There is, indeed, language in Stone-E-Brick that appears to support a broad denial of coverage: “The consequence of not performing well is a part of every business venture; the replacement or repair of faulty goods and works is a business expense, to be borne by the insured-contractor in order to satisfy customers.”

The Stone-E-Brick decision, however, distinguished between a true business risk and the risk of “injury to people and damage to property caused by faulty workmanship.” Unlike the business risk, “where the tradesman commonly absorbs the cost attendant upon the repair of his faulty work, the accidental injury to property or persons substantially caused by his unworkmanlike performance exposes the contractor to almost limitless liabilities.”

Stone-E-Brick found: “The risk intended to be insured is the possibility that the goods, products or work of the insured, once relinquished or completed, will cause bodily injury or damage to property other than to the product or completed work itself, and for which the insured may be found liable.”

It does not matter if the claims sound in contract or in tort. The Stone-E-Brick court said: “Whether the liability of the businessman is predicated upon warranty theory or, preferably and more accurately, upon tort concepts, injury to persons and damage to other property constitute the risks intended to be covered under the CGL.”

In short, CGL insurance will not pay to fix the faulty construction elements themselves. It will pay to cover the bodily injury or property damage that results from faulty construction.

Having determined the contours of the business risks exclusions, the Port Imperial court revisited the question whether construction defects can ever be considered “accidental.” An intentional act that causes unintended harm is the very heart of what an insurance policy covers. If it were otherwise, liability insurance coverage would be illusory. To cite an obvious example: the act of driving a car is intentional; the act of denting another motorist’s fender usually is not. Insuring against the risk of denting another person’s car is the reason we buy automobile insurance.

Likewise, Port Imperial held: “The accidental nature of an occurrence is determined by analyzing whether the alleged wrongdoer intended or expected to cause an injury. If not, then the injury is accidental, even if the act that caused the injury is intentional.”

Making a point often missed by other courts, Port Imperial observed that “general liability policies must be construed to provide coverage for consequential third-party property damage because otherwise insurers would have no reason to include business risks exclusions in their CGL policies.”

In other words, if the initial coverage grant excluded claims for faulty workmanship, the “business risks” exclusions would be redundant, because faulty workmanship would never constitute covered property damage under any circumstance.

The Wisconsin Supreme Court has also recognized this important point: “If the insuring agreement never confers coverage for this type of liability [i.e., for faulty workmanship] as an original definitional matter, then there is no need to specifically exclude it. Why would the insurance industry exclude damage to the insured’s own work or product if the damage could never be considered to have arisen from a covered ‘occurrence’ in the first place?”[1]

Ultimately, Judge Sarkisian concluded that the “damage to property exclusion” did not apply because the condo association’s claims fell “within the ‘products-completed operations hazard’” and because the exclusion simply “does not operate to bar coverage for consequential damages flowing from the insured’s operations.”

What the court is saying here is that the “damage to property” exclusion taketh away but then it giveth right back. While the exclusion precludes coverage for damage to real property on which the insured or its subcontractors are performing operations, and while it also excludes damage to property that must be repaired or replaced because the insured’s work was incorrectly performed on it, the entire exclusion simply goes away if the damage at issue falls within the “products-completed operations hazard.” That provision, remember, provides coverage for damage arising from work the contractor completes and turns over to the building owner.

The Port Imperial decision is consistent with the history and drafting of the CGL policy, which leaves no doubt that construction-defect claims are generally covered. In fact, insurance companies enjoy a great and undeserved windfall every time a court finds otherwise.

The modern CGL policy has gone through numerous revisions since its introduction in 1940. In a 1976 revision, contractors could purchase for the first time a “Broad Form Property Damage Endorsement” that narrowed the “damage to your work” exclusion, differentiating — as the policies in Port Imperial did — between damage that occurred before and after operations at a jobsite were completed, the former being excluded and the latter being covered. Then, in 1986, the insurance industry revised the CGL form again, adding the “damage to your work” exclusion. That exclusion, as we have seen, excepts work performed on a general contractor’s behalf by a subcontractor.

The reason for the subcontractor exception was as follows:

"[T]he insurance and policyholder community agreed that the CGL policy should provide coverage for defective construction claims so long as the allegedly defective work has been performed by a subcontractor rather than by the policyholder itself. This resulted both because of the demands of the policyholder community (which wanted this sort of coverage) and the view of the insurers that the CGL was a more attractive product that could be better sold if it contained this coverage."[2]

In other words, covering claims for a subcontractor’s faulty workmanship was a particular reason for the 1986 revision of the CGL policy. The Insurance Services Office, which is the insurance-industry trade association that drafts insurance policies, published a circular on July 15, 1986 confirming that the 1986 revision “covered damage caused by faulty workmanship to other parts of work in progress; and damage to, or caused by, a subcontractor’s work after the insured’s operations are completed.”[3]

Thus, the insurance industry wrote broad construction-defect coverage into the 1986 revision as a response to market demand and to make the CGL policy more attractive and easier to sell.

Having enjoyed the financial benefits of these policy revisions for a quarter century or more, insurers often deny construction-defect claims, as they attempted in Port Imperial, on the ground that such damage can never be “accidental,” or that defective construction is not “property damage,” or that faulty workmanship is an excluded business risk.

When they succeed in court, as occasionally they do, they not only eliminate a risk that their policies were specifically written and marketed to insure against, they also get to keep the extra premiums derived from coverage that was intentionally broadened in 1976 and 1986 to make the CGL policy more attractive to — and protective of — contractors in the construction industry.

In the end, the Port Imperial court was not to be fooled. Neither should any other court be fooled in the future.

http://www.law360.com/insurance/articles/223249