United States: Insurance Insight - Texas Supreme Court Clarifies Extent Of Coverage For Construction Defects Under CGL Policies

In a matter of first impression, the United States Court of Appeals for the Fifth Circuit certified four questions to the Texas Supreme Court arising from an insured's claims that its liability for a refinery owner's replacement costs and downtime damages is covered by its commercial general liability (CGL) policy. U.S. Metals, Inc. v. Liberty Mut. Grp., Inc., No. 14-0753, 2015 WL 7792557, at *1 (Tex. Dec. 4, 2015).

The insured supplied flanges for use in constructing refinery processing units. The flanges were welded to piping and then covered with a coating and insulation. However, the flanges leaked and had to be replaced, resulting in delayed operation of the units for several weeks. The refinery sued the insured for the cost of replacing the flanges and for damages for the loss of use of the units. The insured settled with the refinery and then sought indemnification from its CGL insurer.

The insurer denied coverage, and the insured sued in federal district court to determine its rights to a defense and indemnity under its CGL policy. Id. at *2. The insured argued the refinery's property was physically injured by the installation of the flanges and also during the replacement process. Id. The court granted summary judgment in favor of the insurer. Id. On appeal, the Fifth Circuit certified to the Texas Supreme Court four questions that raise two issues: 1) whether property is physically injured simply by the incorporation of a faulty component with no manifestation of injury; and 2) whether property is restored to use by replacing a faulty component when the property is altered, damaged, and repaired in the process. Id. at *3.

In an opinion issued on December 4, 2015, the Texas Supreme Court concluded that the policy does not cover most of the damages claimed. Id. at *4. The court explained that all damages for which the insured claimed coverage arose out of the defective flanges, and thus exclusions for damages to "your product" and "impaired property" of the policy applied. Id. at *2. The policy excluded damage to property, or the loss of its use, if the property was not physically injured or if it was restored to use by replacement of the flanges. Id. Thus, the Texas Supreme Court noted that the existence and extent of coverage depended on whether the refinery's property was 1) physically injured or 2) restored to use by replacing the flanges. Id.

In response to the Fifth Circuit's certified questions, the Texas Supreme Court found that the installation of the faulty flanges alone did not physically injure the units. Id. at *6. The court reasoned that the policy covers "injury" but it does not cover every injury; it covers only "physical injury."  Id. at *4. Thus, the court suggested that if the increased risk of danger from the units' operation by using installed, leaky flanges "amounted to physical injury within the meaning of the CGL policy, then it is difficult to imagine a non-physical injury."  Id. (emphasis in original). By only covering a "physical injury," the policy suggests a difference with non-physical, non-covered injuries. "Otherwise, the requirement that injury be 'physical' would be superfluous."  Id. "[P]hysical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system."  Id. at *6. Essentially, had the flanges actually leaked in use and the leakage damaged other property, that would have been a physical injury, but mere incorporation of the defective flanges into the units was not.

However, the Supreme Court did find that the units were physically injured in the process of replacing the flanges because they were welded to pipes; as a result, the flanges had to be cut out, pipe edges resurfaced, and new pipes put in. Id. Thus, repair costs and damages for the downtime were "property damage" covered unless a certain exclusion in the policy—Exclusion M—applied. Id. Exclusion M denied coverage of damages to impaired property, defined by the policy as property that could be "restored to use by the . . . replacement" of the faulty flanges. Id.

The Supreme Court concluded that the units were restored to use by replacing the flanges and were therefore impaired property to which Exclusion M would apply. Id. at *7. Tangentially, the insulation and gaskets destroyed in the process were not restored to use—they were replaced—and therefore did not constitute impaired property to which Exclusion M applied. Id.

Admittedly, "the result in this case has a perverse aspect to it."  Id. at *6. Essentially, since a defective product that causes damage is not an occurrence until the damage actually happens, if the refinery had been negligent or even reckless, and an explosion had occurred, the insured would not be denied coverage for want of "physical injury."  Id. However, because the refinery exercised care and caution, preventing any actual "physical injury," the insured was not entitled to indemnity for the costs of remedying the installation of the faulty flanges. Id.

Several associations of contractors and insurer groups have argued opposite one another as amici curiae. Some contractor associations argue that the construction industry needs insurance to manage the risk that one contractor's work will damage the entire project resulting in significant disruption. Id. (citing Brief of Amici Curiae Associated General Contractors of America, Texas Building Branch–Associated General Contractors of America, ABC of Texas, American Subcontractors Association, Inc., and ASA of Texas, Inc., in Support of Appellant U.S. Metals, Inc., at 10–11). On the other hand, two insurer groups argue that it would be bad policy and encourage moral hazard to allow contractors to insure against the quality of their own work. Id. (citing Brief of Amici Curiae American Insurance Association and Property Casualty Insurers Association of America in Support of Defendant-Appellee Liberty Mutual Group, at 3–4). The insurer groups argued that the "impaired property" exclusion is consistent with the longstanding role of business risk exclusions in denying coverage to the risk that a business might be obliged to repair or replace its own defective work. Brief of Amici Curiae American Insurance Association and Property Casualty Insurers Association of America in Support of Defendant-Appellee Liberty Mutual Group, at 3.

The Texas Supreme Court received motions for rehearing from both sides on January 20, 2016, and is currently receiving amicus briefs. Your Dentons team will continue to follow these issues and any related developments in the Texas market. The immediate take-away is to fully understand your CGL policy coverage benefits, what "physical injury" means in your agreement, and what actions could possibly lead to "physical injury." 

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