Articles|May 24, 2021
Damage to Property Under Construction Caused by Construction Defects
By Jeff Cavignac
President CPCU, RPLU, ARM
Direct damage to property under construction caused by faulty or defective work or defective materials has been a coverage issue for decades. Two specific policies, the Commercial General Liability (CGL) for the contractors building the structure and the Builder’s Risk Policy on the project both are sources of potential coverage.
A CGL policy protects the Named Insured (the Contractor in this case) from third party liability arising out of the insured’s operations that results in either bodily injury or property damage. Damage to property caused by poor workmanship or defective materials would qualify as property damage. To understand how the CGL policy might respond to claims such as these, we need to evaluate several exclusions in the CGL policy.
CGL policies cover “property damage”, defined as physical injury to tangible property including loss of use of such property, and loss of use of tangible property that has not been physically injured. Exclusion M provides that there is no coverage for loss of use of property that has not been physically injured due to a defect in the work. This is significant because it means that there is no CGL coverage for defective work without physical injury to the work. Let’s look at an example. Prior to completion, inspection reveals that windows were not properly installed, making them prone to leaks. No leaking has occurred. Removing and reinstalling the windows delays the project two weeks. Owner makes a claim against the GC for lost rental income for the 2 weeks. There is no CGL coverage because the loss of use was purely due to defective work, with no physical injury. Remember the CGL only covers liability that results in bodily injury or tangible property damage.
There are two additional exclusions applicable to property damage in the course of construction. These are exclusions J.5 and J.6.
Exclusion J.5 excludes property damage to that particular part of property on which the insured or its contractors are working if the property damage arises out of their work. This exclusion typically applies where a mistake in performance causes damage. Resultant property damage caused by the mistake would be covered, but damage to “that particular part” that caused the loss would not be covered. Let’s say an electrical contractor causes a fire while working in the mechanical room that triggers the fire suppression system building-wide, causing widespread water damage. The exclusion applies only to the electrical components in the mechanical room damaged by fire.
Exclusion J.6 excludes property damage to that particular part of property that must be repaired or replaced because the insured’s work was defectively performed on it. For example, a concrete subcontractor improperly mixes a concrete batch, resulting in a section of the foundation that cracks causing a shift in the structure. Structural components supported by the faulty area are damaged. The section needs to be demolished and re-poured and major repairs are needed to the rest of the structure. The re-pour is excluded but the damage to the rest of the structure is not.
In both cases, the CGL affords coverage for physical damage to the work caused by defects or defective work: basically, the ensuing damage. In neither case would the General Liability policy cover that particular part that was either worked on or must be repaired or replaced due to defective work.
Project-Specific CGL Coverage (OCIP’s and CCIP’s) needs to be considered in a different light. Nearly every OCIP or CCIP written today will include an exclusion for property damage to the insured project during the course of construction (note that a small minority of insurers may remove this exclusion if you can provide evidence of a LEG 2 or 3 endorsement, more on that below). These are often referred to as “Course of Construction” or “Builder’s Risk Exclusions”. These exclusions are added with the expectation that the builder’s risk insurance should provide coverage for damage to the structure during the course of construction. Providing coverage under a first-party property form is preferred to a third-party liability form because it should eliminate any litigation. The key is negotiating broad and favorable terms under the Builder’s Risk policy. This can’t be emphasized enough. A well-written Builder’s Risk policy will include all stakeholders as insureds, comply with the contractual terms of the contract, consider and possibly include earthquake and flood, always include water-related damage other than flood, and ideally include not only resultant damage caused by defective work or materials but also, if available, damage to that “particular part” that caused the problem.
The US builder’s risk market is dominated by manuscript forms. There are some consistencies, but each form must be carefully reviewed. With respect to coverage for property damage during the course of construction caused by defective work, domestic forms generally fall into two categories. The first type, which is less common, excludes all damage caused by, or arising out of faulty workmanship. This removes coverage for repairing defective work as well as for any damage to the project resulting from the defective work. These forms offer less coverage than the ISO CGL policy and should be avoided. The second, more common, domestic form excludes loss or damage caused by faulty work, unless the damage is caused by a covered cause of loss. These are commonly referred to as “ensuing loss exceptions”. Let’s say for example that a concrete subcontractor improperly mixes a concrete batch, resulting in a section of the foundation that cracks causing a shift in the structure. Structural components supported by the faulty area are damaged. The section needs to be demolished and re-poured and major repairs are needed for the rest of the structure. The re-pour is excluded but the damage to the rest of the structure is not because collapse is a covered peril. Most domestic builder’s risk policies with ensuring loss exceptions provide roughly the same scope of coverage for property damage during the course of construction as an ISO CGL policy. Neither policy provides coverage for the cost of replacing defective work, but both policies cover direct damage to the rest of the project caused by the defective work. In the case of a Builder’s Risk policy, this ensuing loss must be caused by a covered peril.
An underwriting syndicate in London came up with proposed endorsements that specifically address the faulty workmanship issue. Authored by the London Engineering Group (“LEG”), these have come to be known as “LEG1”, “LEG2” and “LEG3”.
LEG1 is the most restrictive. It excludes coverage for all loss or damage “due to defects of material workmanship, design plan, or specification”, whether damage to other property has occurred or not. LEG1 is the basic equivalent of the first category of US market forms that exclude all damage caused by defective work, without the “ensuing loss exception”.
LEG2 excludes coverage for all loss or damage “due to defects of material workmanship, design plan or specification”, but maintains coverage for insured property damaged by the defect, except for the cost that would have been incurred if the replacement or rectification had been done before the damage. LEG2 is roughly equivalent to the US market form with the “ensuing loss exception”. It covers resulting property damage to the project, but not damage to the part causing the problem. This makes LEG2 also roughly equivalent to an ISO CGL policy in terms of the scope of coverage for property damage during the course of construction.
LEG3 provides the broadest coverage. This endorsement extends coverage to not only the ensuing damage, but damage to that “particular part” that caused the damage. Coverage does not extend to costs “incurred to improve the original material workmanship, design plan or specification.” As long as there is resulting property damage, the LEG3 form covers all repair costs, including the cost of repairing or replacing the defective work. LEG2 and LEG3 each contain an additional provision stating that “it is understood and agreed” that insured property shall not be considered damaged “notes solely by virtue of the existence of any defect of material workmanship, etc...”. In other words, there must be a covered cause of loss to trigger coverage. In simple terms, LEG3 coverage excludes the cost to repair a defect where there is no resulting damage, and the cost of improvements over and above the original work. Here is an example: A concrete subcontractor improperly mixes a concrete batch, resulting in a section of foundation that cracks causing a shift in the structure. Structural components supported by the faulty area are damaged. The section needs to be demolished and re-poured and major repairs are needed to the rest of the structure. The re-pour is covered along with damage to the rest of the structure. If, as an added safety precaution, the foundation was reinforced with metal rods, the cost of adding the metal rods would not be covered. The LEG3 form provides broader coverage for damage caused by defective work than the ISO CGL policy. The ISO CGL policy does not cover the cost of repairing or replacing defective work whereas LEG3 does. It should also be pointed out that LEG3 Endorsements are usually not available on smaller projects or frame construction.
Final Comments - Insuring construction projects are complex. There are numerous stakeholders as well as significant exposures, General Liability, property under construction, pollution, workers’ compensation, professional liability, etc. The purpose of this article is to deal with a small part of that which is damage caused by faulty workmanship or components.
Here are a few things to keep in mind:
- It is always better to have a loss covered by a property policy than a liability policy to avoid the litigation costs, ill will and time litigation can take.
- Negotiate the most favorable Builders Risk terms available. All Builders Risk policies are different and all are negotiable.
- Understand how construction defects caused by faulty workmanship or defective products will be treated. Whenever possible a LEG3 type endorsement should be sought.
- Communicate the coverage provided, or lack thereof to the named insureds. Just because the broker knows it, doesn’t mean the insured knows it.
There is no substitute for taking the time to understand the risks of a project and negotiating favorable terms for ALL Stakeholders. A well-written and coordinated insurance program is a critical piece to a successful project.
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