United States: Texas Supreme Court Weighs In On Physical Injury Under CGL Policy - Incorporation Or Actual Harm?

Case:   U.S. Metals, Inc. v. Liberty Mutual Group, Inc.
U.S. 5th Circuit Court of Appeals (Texas)
No. 14-0753

In what is an important case for property insurers and practitioners, the Texas Supreme Court responded to questions certified to it by the United States Court of Appeals for the Fifth Circuit. At issue was the definition of "physical injury" under the standard CGL policy.

ExxonMobil sued US Metals, with whom it had contracted to provide weld neck flanges for use in constructing diesel units for ExxonMobil refineries in Texas and Louisiana. The flanges were welded to piping of the diesel units; however, subsequent testing revealed some of the flanges were leaking and were apparently not as specified. ExxonMobil determined that the defective flanges increased the risk of fire and explosion and removed and replaced all of them. To replace the flanges, each flange had to be stripped of its temperature coating and insulation before cutting the flange out, the pipe surfaces had to be ground for rewelding, and then the flanges, and new gaskets, temperature coating and insulation were installed. This process was time-consuming and the work delayed operation of the diesel units for several weeks. Exxon Mobil claimed $6.3 million for the cost of replacing the flanges and $16.7 million for damages related to loss of use. US Metals settled with Exxon Mobil for $2.2 million, and claimed indemnification under its CGL policy.

The Texas Supreme Court reviewed the policy's Insuring Agreement and the "your work" and "impaired property" exclusions. In doing so, it also analyzed and applied the definitions of "property damage", "your product" and "impaired property." The Court first acknowledged that all of the damages arose out of the defective flanges, and noted that US Metals did not claim coverage for the flanges themselves. The Court then commented that its responses to the certified questions would turn upon two essential inquiries: (1) did the installation of the faulty flanges physically injure the diesel units when the only harm was the risk of leaks, and (2) was the property at issue restored to use by replacing the faulty components, even though property would inherently be altered or damaged during the repair process?

The court initially determined that injury alone was not enough to trigger the policy's coverage; rather there must be "physical injury." Thus, even though there may be an intangible, latent, or inchoate injury, – here, for example, the potential leaky flanges which increased the risk of danger from their operation and reduced the diesel units' value – the policy did not extend to nonphysical injuries. To find that it did, the Court noted, would require the court to find the policy's use of the word "physical" superfluous.

The Court next observed that the term "physical injury" had been considered by various courts resulting in essentially two lines of cases - one adopting the incorporation theory of physical injury and the other adopting the actual harm theory. In Eljer Manufacturing., Inc. v. Liberty Mutual Ins. Co., 972 F.2d 805, 808 – 809 (7th Cir. 1992) (Eljer I), the Seventh Circuit made an "Erie guess," concluding that the Illinois courts would reject the actual harm theory in favor of the incorporation theory in a claim related to defective plumbing systems. The Seventh Circuit reasoned that the purpose of insurance was to spread risk, and because the failure rate of the systems at issue was sufficiently high to find the product defective and induce a rational owner to replace his plumbing system before it leaked, the inclusion of the system in a home was a "physical injury" for which the CGL policy provided coverage.

However, the Texas Supreme Court recognized that nine years after Eljer I, in Travelers Insurance Co. v. Eljer Manufacturing, Inc., 757 N.E.2d 481, 496 (Ill. 2001) (Eljer II), the Illinois Supreme Court held the opposite – that incorporation of a defective component into something was not, in and of itself a "physical injury", even though there might be intangible damage such as diminution in value. The Texas Supreme Court further noted there were 12 state high courts that had considered the incorporation theory and interpreted "physical injury" under CGL policies and noted that five had rejected the theory expressly, while five had rejected it implicitly. The Court found only two state high courts that followed the incorporation theory.

The Texas Supreme Court ultimately aligned with those courts that found 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." The Court explained this holding was in accord with its other holdings finding that while faulty workmanship can be a basis of an "occurrence," faulty workmanship which merely diminishes the value of a home without causing physical injury does not involve "property damage." Also, the Court had previously found that the duty to defend did not arise under an occurrence policy when damage was discovered, but when it actually occurred. Further, the Court reasoned that since a defective product that caused damage would not constitute an occurrence until the damage actually happened, it would be inconsistent to find that a defective product that had yet to cause damage would nevertheless trigger an occurrence at the time of its incorporation.

The Court recognized what it called a "perverse aspect" to its decision. Had ExxonMobil failed to test or replace the flanges, and an explosion had resulted, US Metals would not have been denied coverage for the resulting damages. However, because ExxonMobil performed as it should, US Metals would not be entitled to indemnity for the cost of replacing the faulty flanges. Ultimately, the Court concluded that the diesel units were not physically injured merely by installation of the faulty flanges. Nevertheless, the Court found that the replacement of the faulty flanges caused physical injury to the diesel units, as the flanges had to be cut out, edges resurfaced, and new flanges welded in place. Further, the Court noted that the original welds, coating, insulation and gaskets were destroyed in the replacement process. Thus, the Court concluded that the repair costs and damages for downtime were indeed "property damages" covered by the policy – unless exclusion M for "impaired property" applied.

The Court then considered the definition of "impaired property" noting it did not restrict how the defective product was ultimately to be replaced. Consequently, the Court rejected US Metals' argument that the diesel units were not "impaired property" because they could not be restored to their use by simply replacing the flanges – as the replacement of the flanges necessarily affected or altered other property in the process. Interestingly, although the Court had recognized the extent of work necessary to replace the flanges, it commented here that, "Coverage does not depend on such minor details of the replacement process, but rather on its efficacy in restoring property to use." Inasmuch as the diesel units could be restored to use by replacement of the flanges, they were "impaired property" to which Exclusion M would apply. Thus, their loss of use was not covered under the policy. Notwithstanding such finding, the Court concluded its decision by finding the insulation and gaskets destroyed in the replacement process could not be restored to use, but had to be replaced. Accordingly, the Court concluded that they were not "impaired property" to which Exclusion M would apply, and thus the cost of replacing such would be recoverable under the policy.

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