Australia: Contract Works Material Damage insurance policies: what do the DE/LEG defect exclusions mean?

In brief - Body of law on exclusion meanings still developing

Design Exclusions and London Engineering Group exclusions are commonly used in project or construction all risks policies and range from the widest to the narrowest exclusions.

Indemnity may be avoided if insurer can prove physical loss or damage arose from excluded cause

A Contract Works Material Damage policy (previously known as a Project/Contractor's All Risk/Erection All Risks) provides no-fault occurrence cover for physical loss and damage to insured property on an all-risk basis arising from any cause not specifically excluded. The trigger for cover is damage.

Insured property may include all of the works, construction equipment, temporary buildings, existing structures and completed properties. It will also cover other matters such as third-party bodily injury and third-party property damage. The insureds include the head contractor, subcontractors and professional consultants (the latter for their on-site manual activities only).

Being "all risk", a project insurer must provide indemnity if an insured can show that physical loss or damage has been suffered, unless the insurer can prove that the physical loss or damage arose from an excluded cause in the policy. For projects of substantial size, the insured risk may be very significant (in the billions of dollars).

Two sets of precedent contractual exclusions for defective design or workmanship have been developed and are commonly used in Contract Works Material Damage policies:

  • the Design Exclusions (DE) written by the London CAR Group
  • the London Engineering Group (LEG) exclusions

There are some similarities between the two sets.

DE 1 and LEG 1/96

DE 1 and LEG 1/96 are the widest contractual exclusions and do not write back any cover for loss or damage caused by defects or workmanship.

Name Exclusion
DE 1 - Outright defect exclusion Loss or damage arising out of defects in material workmanship design plan or specification.
Name Exclusion
LEG 1/96 - Outright defects exclusion Loss or damage due to defects of material workmanship design plan or specification.

In Aspen Insurance UK Limited v Adana Construction Limited [2015] EWCA Civ 176 (which was not a case dealing with either a DE or LEG exclusion):

  • Adana entered into a contract to supply, deliver and install (but not design) a concrete crane base
  • Adana drilled holes into four reinforced concrete piles (constructed by another company) and inserted reinforcing bars/dowels into the holes which extended from the base of the holes and were inserted into the base of the crane
  • The crane base was then formed by pouring concrete into reinforced steel cages placed on top
  • Adana completed the work and departed from the site
  • A first crane was erected on the base and later a second heavier crane erected
  • The second crane fell backwards injuring the crane driver and causing damage to a nearby building and the crane itself

Expert evidence suggested that the collapse was due to a failure of the connections between the crane base and the piles in that, while the connecting dowels had not broken, they had not been installed to a sufficient depth to generate sufficient friction to resist the compressive and tensile loads of the second crane (which was too heavy for the base).

As the damage to the crane base, the crane and the neighbouring property was caused by either defective design or defective workmanship, this loss would therefore be excluded under DE 1/LEG 1/96.

Whether a defect is present or damage has occurred can involve difficult factual questions

In Messer UK Limited v Thomas Hardy Packaging Limited [2002] EWCA Civ 549:

  • Thomas Hardy acquired carbon dioxide from Messer for mixing with concentrate to make Bacardi Breezers
  • Messer's carbon dioxide was contaminated with benzene and Bacardi recalled the products and recovered the costs from Thomas Hardy
  • Thomas Hardy then sought recovery from Messer
  • The contract with Messer included clauses that purported to cap Messer's liability in respect to direct physical damage to property and exclude all liability for economic loss.

The Court found that there was no damage because the mix of concentrate and water itself ceased to exist (as was always intended) on mixing. The finished product that came into existence at the moment of creation was not damaged concentrate, but a defective new product (the lost concentrate had some value, but it was dwarfed by the value of the lost mixed drinks).

On the other hand, in Promet Engineering (Singapore) Pte Ltd v Sturge [1997] EWCA Civ 1358, cracking to the legs of an offshore accommodation platform caused by incorrect welding was not a "defect" but "damage" caused by latent defects (wrongly profiled welds and insipient fatigue cracks) making the legs unable to withstand the stresses to which the platform was subjected in the ocean.

DE 2

The DE 2 exclusion clause excludes damage to defective insured property and insured property that it supports or stabilises but, unlike DE 1, covers all other resulting damage. DE 2 may have significant implications depending on the damage occurrence. There is no LEG equivalent to DE 2.

Name Exclusion Write back
DE 2 - Extended defective condition exclusion Insured property that is defective in material workmanship design plan or specification.
Insured property that is supported by or stabilised by the defective insured property.
Loss of or damage to all other non-defective insured property.

Had there been a project policy with DE 2 in Aspen, the likely result would be that:

  • damage to the concrete base block is excluded as it was defective insured property
  • damage to the crane is also excluded as insured property that is supported or stabilised by the base block (which was defective insured property)
  • damage to the other insured property is covered if it is damaged and it is non-defective insured property

Pilkington United Kingdom Ltd v CGU Insurance Plc [2004] EWCA Civ 23 concerned a case where glass panels, installed in the roof of a train station, were defectively manufactured and 13 (of the approximately 3,000 installed) fractured in situ.

The owner of the station elected not to remove the remaining panels but instead installed safety features in case any further fractures occurred. The owner sued the main contractor for the costs and the main contractor sued Pilkington, which manufactured and supplied the glass.

The defective insured property (the glass panels) did not cause loss or damage to any non-defective insured property. The loss suffered related only to remedying the consequences of the defect.

A project policy with a DE 2 exclusion in this situation would not cover any of the loss or damage actually suffered. However, had the glass damaged other parts of the station, or, for example, the non-defective roof parts in which the glass had been installed, that damage would have been covered (provided that it was not supported or stabilised by the glass).

DE 3

The DE 3 exclusion clause excludes loss or damage for insured property that is defective in design or workmanship, but writes back cover for loss or damage to insured property that is not defective and which is damaged in consequence. It is narrower than DE 2 because there is no exclusion for insured property that is supported by or stabilised by the defective insured property. This is a significant narrowing.

Name Exclusion Write back
DE 3 - Limited defective condition exclusion Insured property that is defective in material workmanship design plan or specification. Loss of or damage to all non-defective insured property

Charnway Ltd v Iron Trades Mutual Insurance Company QBD, 19 April 1988 (unreported) dealt with a DE 3 style exclusion clause.

A subcontractor was required to carry out a waterproofing procedure that required it to bond a rubber product to concrete and thereafter apply a laminate, a steel plate and a further layer of laminate.

The subcontractor failed to bind the rubber product to the concrete and the waterproofing was therefore defective.

To remedy the defect, the top two layers of laminate were removed and the deck flashing was replaced and mended.

The subcontractor made a claim under the policy for the cost of removing and replacing the two layers of laminate.

The Court was asked to consider whether the cost of removing and replacing the laminate was excluded pursuant to the following exclusion clause:

"The company shall not be liable for the cost of repairing, replacing or rectifying property which is defective in design material or workmanship, but not excluding damage to other property hereby insured resulting therefrom."

The Court separated the "property" that suffered loss or damage from defective design or workmanship (ie the concrete and the rubber product) from the "property" that did not but was damaged (ie the laminate).

It is important to note the process that the Court took to separate the items of work which were defective from those that were non-defective. Failure to carry out this analysis may have led to the erroneous conclusion that all of the waterproofing was defective and therefore no cover was available at all.

The Court held that the exclusion clause wrote back cover for the loss or damage to the two layers of laminate and this was covered under the policy.

Similarly, in Graham Evans & Co (QLD) Pty Ltd v Vanguard (1986) 4 ANZ Ins Cas 60-689, the Court held that a DE 3 exclusion provided cover for damage to non-defective second and third coats of paint which occurred because the first coat of paint was defective (due to being applied in too dilute a form) and began to flake off.

Had the Bacardi case dealt with a DE 3 style exclusion, the loss of the finished product (ie the most valuable claim) would still be excluded because the mixed drink did not come into existence until after the mixing of defective carbon dioxide and non-defective pre-mix. The mix was defective from the moment of its creation.

DE 4

The DE 4 exclusion clause excludes loss or damage to defective parts but writes back cover for loss of or damage to non-defective parts. This is a narrower exclusion than DE 3 because it requires an analysis at the level of constituent parts of defective insured property rather than defective insured property in toto.

DE 4 is commonly used for machinery erection risks where a single defective part (eg a threaded bolt) may damage the whole machine causing catastrophic failure and great expense.

Name Exclusion Write back
DE 4 - Defective part exclusion Loss or damage to any parts, components or items of insured property which are defective in material workmanship design plan or specification. Loss of or damage to non-defective parts, components or items of insured property.

In Walker Civil Engineering Pty Ltd v Sun Alliance and London Insurance plc (1999) 10 ANZ Ins Cas 74-81, the Court considered a DE 4 exclusion.

A contractor constructed three fibreglass sewage pumping stations which leaked and were defective. The contractor demolished the fibreglass tanks and built concrete ones instead.

As part of the rectification, the tank machinery and components (including the pumps) had to be removed and replaced (even though they were not themselves defective).

The Court had to determine whether the following exclusion clause applied to the tank machinery and components:

"This insurance does not cover loss or damage directly caused by defective workmanship, construction or wear or tear or mechanical breakdown or normal upkeep or normal making good but this exclusion shall be limited to the part which is defective and shall not apply to any other part or parts lost or damaged."

The Court interpreted the words "any other part" as meaning a different part of the works to the "part which is defective". That being so, the machinery and components were not "any other part" but were installed with the tank, being the "part which is defective". Therefore the machinery and components were excluded.

The difficulty in interpreting the DE 4 exclusion lies in determining what is a "part" or "component" or "item" of insured property.

On a narrow view, an "item" could be an individual element of a particular piece of insured property (eg the blocks in a retaining wall). However, a more global view of "item" may mean the various pieces of insured property covered under the policy (eg each temporary structure constructed on site).

LEG 2/96

The LEG 2/96 exclusion excludes all costs that would have been incurred if replacement or rectification had been carried out immediately prior to the damage occurring. There is some conceptual similarity between LEG 2/96 and DE 3/DE 4.

Name Exclusion
LEG 2/96 - Consequences defects exclusion All costs rendered necessary by defects of material workmanship design plan or specification and should damage occur to any of the insured property containing any of the said defects the cost of replacement or rectification excluded is that cost which would have been incurred if replacement or rectification had been carried out immediately prior to the damage.

In Acciona Infrastructure Canada Inc v Allianz Global Risks US Insurance Company 2014 BSCS 1568, the design and construct (D&C) contractor constructed a hospital extension project.

During the construction it was discovered that concrete slabs that were being used were experiencing "over deflections" resulting in a concave depression in the centre of the slabs (i.e. the hospital's floors were not level). The D&C contractor claimed the costs of rectification under its "Course of Construction" all risks insurance policy, but the insurer denied cover on the ground that the slabs were defective.

The policy contained the following exclusion clause:

"All costs rendered necessary by defects of material workmanship, design, plan or specification, and should damage occur to any portion of the Insured Property containing any of the said defects the cost of replacement or rectification which is hereby excluded is that cost which would have been incurred if replacement or rectification of the Insured Property has been put in hand immediately prior to the said damage.
For the purpose of this policy and not merely this exclusion it is understood and agreed that any portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship, design, plan or specification."

The Court made some useful observations about interpreting the LEG 2/96 exclusion. The two components of the exclusion must be read together as a single exclusion with the opening phrase modifying the latter, and not read as two distinct exclusions or an exclusion with an exception.

The Court held that in order to determine what costs rendered necessary by the defect would have been incurred had replacement or rectification been put in place immediately prior to the damage, it is necessary to examine the costs that crystallised immediately prior to the damage occurring.

It was accepted that the costs to rectify the damage would have been the costs of implementing proper formwork and shoring/reshoring procedures, or incorporating additional camber into the formwork. This would have prevented the concavity in the hospital's floors.

There was no evidence to quantify what these costs would have been but they would have been minimal. Accordingly, no costs were actually excluded.

The Court of Appeal held that the Supreme Court did not err in interpreting the insurance policy (see Acciona Infrastructure Canada Inc v Allianz Global Risks US Insurance Co 2015 BCCA 347).

DE 5 and LEG 3/96

The DE 5 and LEG 3/96 exclusions are the narrowest. They exclude the costs of improving the original defect but otherwise cover loss or damage to both defective and non-defective insured property.

Name Exclusion Write back
DE 5 - Design improvement exclusion Costs of additional work resulting from, or improvements to, the defective original material workmanship design plan or specification. Loss of or damage to insured property (defective or non- defective).
Name Exclusion
LEG 3/96 - Improvements defects exclusion All costs rendered necessary by defects of material workmanship design plan or specification and should damage occur to any of the insured property containing any of the said defects the cost of replacement or rectification excluded is that cost to improve the original design workmanship plan or specification.

Had either of these exclusions applied in Aspen, the likely result would be that damage to the crane base, the crane and the neighbouring property would be covered and all that would be excluded would be the costs involved in improving the original design or workmanship (eg drawing new plans and the increased costs of longer dowels) which would be minimal.

The potential exposure that arises from DE 5 or LEG 3/96 policies can be difficult to predict.

It is often the case that the excluded cost is minimal because the only excluded element is the improvements. This could be, for example, the cost of a new design (which would be fairly low in the context of a large project) or the cost of installing supports where none existed before (essentially the cost of the parts, also minimal). Unlike the improvement, however, the cost of rectifying the resulting damage, indemnifiable under the policy, may be significant.

Exclusions and meanings of creation, defect and damage remain subject to debate

It is rare that lawyers and construction professionals get to debate subtle metaphysical questions. While a body of law on the meaning of the DE/LEG exclusions is developing, there will still be plenty of times where debate about questions of creation, defect and damage, and "what might have been" hypotheticals will have real and financial consequences.

Toby Blyth
Construction risk insurance
Colin Biggers & Paisley

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Aaron Bolton
 
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