image: used under license from shutterstock.com defect ... › files › 2016 annual meeting ›...

Defect, Damage and the LEG Concept

Image: used under license from Shutterstock.com

Mark S. Katz, Esq.Partner

Mound Cotton Wollan & Greengrass LLP

(P) 212-804-4513

(C) 516-380-2249

[email protected]

Michael GibbonsSenior Legal Counsel

Munich Re

(P) +49 89 3891 8108

(C) +49 1603 699 723

[email protected]

mailto:[email protected]


Agenda

2

01 02 03

04Manifestation of a

defect

All Risks Property

Insurance

Damage, Fortuity,

Indemnity

Defect or Damage?

Allocation of Risks Defect Exclusions

LEG Concept

LEG 2

LEG 3

Image: used under license from Shutterstock.com Image: used under license from Shutterstock.com Image: used under license from Shutterstock.com

Image: used under license from Shutterstock.com Image: Ulrike Myrzik + Manfred Jarisch, Munich Re

05Takeaways

01 Allocation of Risks

Image: Munich Re

Risk Map

5/27/2016 4

PD/DSU

Defect coverage and the LEG exclusions

Bodily

Injury

Owner

Main Contractor

Sub – Contractor Sub – Contractor Sub – Contractor

InsolvencyDefective/Not fit

for purpose

Breach of

Contract

Build the whole thing

Get PD/DSU insurance

Supply

that part

Build

that part

Design

that part

Fire/

Nat Cat

THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY

Where do the risks belong?

Business Risk Liability Insurance Property Insurance

Project not built as

agreed

Rectifying defects

Not fit for purpose

Wear and tear /

deterioration etc.

Delay

Insolvency

5/27/2016 5

Professional Indemnity

(architects, engineers

etc.)

Performance Bond

Manufacturer’s

Warranty

CGL – PD or Bodily

Injury (incl. following

defects)

Workers compensation

All risks of physical

damage

Nat Cat / Fire

Resultant damage from

defects

Finding a balance:

Business Risk or Property Insurance?

Defect coverage and the LEG exclusionsTHIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY

02 All Risk Property Insurance


The All Risks Physical Damage Proviso relies on a

definition of damage

Insuring clauses

“This Policy ... insures against all risks of direct physical loss of or damage to...”

“sudden physical loss or damage from any cause, other than those specifically

excluded”

All risk coverage generally provides protection against all [external]

perils that could cause physical loss or damage unless excluded. It

is an alternative to Named Perils coverage. All risks, however,

pertains to perils (i.e, the “risks”) and does not mean “all losses”.

5/27/2016 7Defect coverage and the LEG exclusionsTHIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY

02 Damage, Fortuity, Indemnity

Image: Ulrike Myrzik + Manfred Jarisch, Munich Re

What can damage mean?

U.S.

“physical loss or damage strongly implies that there was an initial satisfactory state that

was changed by some external event into an unsatisfactory state”

5/27/2016 9

U.K.

“Damage requires a changed physical state ... being harmful in the commercial context”

Canada

“Altered physical state”, “permanent deformity”

Australia

A physical alteration or change, not necessarily permanent or irreparable, which impairs

value or usefulness

Image: Munich Re

Image: Munich Re

Image: Munich Re

Image: Munich Re


London Engineering Group

“include[s] any patent detrimental change in the physical condition of the Insured

Property”

LEG 3/06


Physical loss or damage:

(a) has to happen (i.e. not will happen)

“a discrete event”

include a change or alteration in state.

Must have at one time been fit.

Bright line: defect/manifestation of a

defect <> damage by an ensuing peril

(b) by chance

neither expected nor intended (subjective

test)

Is inevitability fortuitous? Only if it is a

certainty...

Damage must occur from external

source: no longer applies unless

provided for in the policy

Negligence is fortuitous:

all risk policy or a no risk policy?

Fortuity – an unexpected and unintended accident

5/27/2016 10Image: used under license from Shutterstock.com Defect coverage and the LEG exclusionsTHIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY

Indemnity Principle

You get back what you had before

“to their condition immediately

before the loss”

“with material of like kind and

quality, less betterment”

Betterment/improvements are

(specifically) excluded

Indemnity Principle

5/27/2016 11Defect coverage and the LEG exclusionsImage: used under license from Shutterstock.com THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY

Just to go over the main principles

5/27/2016 12Defect coverage and the LEG exclusions

Insurable risk (physical damage)

vs.

Entrepreneurial risk (mere defects; breach of contract)

All perils: defect as a covered peril?

Ensuing loss from a separate peril

Already happened, and by chance (not expected nor intended)

You get back what you had before (not something better)Indemnity

Principle

Risk

Allocation

All Risks

Fortuity

Detrimental change in physical condition

Bright line:

defect/manifestation of a defect <> damage by an ensuing peril

Damage


A little quiz

If there is damage as a result of a defect, what is the combined effect on

coverage in an all risk policy* of:

Physical Damage Proviso

+ Fortuity

+ Indemnity Principle / betterment exclusion?

Covered: costs to repair all physical damage

(incl. the defective part)

Excluded: costs incurred to improve the original

property

5/27/2016 13

* without considering exclusions


Q

A


02 Defect or Damage?


Just defective is not damaged

A detrimental change in physical state is required (i.e. no performance bond here!)


U.S. Law - Prior to LEG Exclusions - Generally Requires an ensuing

loss from a separate peril.

DamageDefect vs.


How changed or altered a physical state do you need

for a defect to become damage?

Faulty workmanship which results in the installation of a bent structure

Tests show that paint works met bonding standards when completed, but 2

years later no longer do, with some areas (15%) visibly peeling and cracking

Concrete that has weakened and displays small/medium/large cracks

A concrete slab that has deflected further than designed

Microscopic / visible / large cracks in a

faulty weld or

tunnel wall

Wire-brushing of metal which results in microscopic scratching (and leakage

occurs), repairable by brushing again with plastic brush


Do these three stages exist?

5/27/2016 17

Defect Manifestation Damage


03 Defect Exclusions


Traditional U.S. Defect ExclusionsTypical Wording Found in U.S. Policies

This Policy does not insure:

…

Against the cost of correcting or making good defective design, plan or specifications,

faulty material, or faulty workmanship; however, this exclusion shall not apply to direct

physical loss, damage or destruction resulting from such defective design or specifications,

faulty material, or faulty workmanship.

* * *

This Policy shall not pay for:

…

Loss or damage caused by or resulting from faulty or defective workmanship or material or

design, but this exclusion shall not apply to physical damage resulting from such faulty or

defective workmanship or material.


‘Resulting from’ or “ensuing” language – often referred to as the “ensuing

loss” provision. Restores coverage for losses arising from the excluded peril -

- i.e. defect -- if caused by separate & independent peril.

U.S. Market clauses traditionally only cover

‘ensuing loss’

Starting point: exclude the cost of making good a defect or loss or damage

caused by or resulting from a defect

Exception: “This exclusion shall not apply to physical loss or damage resulting

from such fault, defect ...” (i.e. ensuing loss)

Not Covered: manifestation of a defect or damage to the defective part

“If the original loss was also considered an ensuing loss, then the exception

would swallow the exclusion”

Covered: “losses wholly separate from the defective materials themselves.”

Generally requires a separate peril resulting from the defect that causes a

different type of damage.

5/27/2016 20

Note: damage to the defective part itself is generally not covered


Traditional U.S.-written Defect ExclusionsInterpretation of the Ensuing Loss Provision


“this exclusion shall not apply to direct physical loss, damage or destruction resulting from

such defective design or specifications, faulty material, or faulty workmanship.”

Generally, the mere manifestation of the defect that causes the defective

component to fail is not a covered ensuing loss:

Court held there was no peril separate from and in addition to the initial excluded peril of the welding

failure and kettle rupture because the spillage of molten zinc was part of the loss directly caused by

the excluded peril, not a new hazard or phenomenon.

Acme Galvanizing

No coverage for loss from buckling of marble facade that was caused by wear and tear - - the

non-excluded causes grew out of and were directly related to the excluded causes.80 Broad Street Co.

Costs to repair building foundation constructed with defective concrete were excluded by the

“faulty or defective workmanship or material” exclusion where no separate physical loss or

damage ensued.

Laquila Constr., Inc.

Where wall collapsed as a result of faulty workmanship, the costs to repair the collapsed wall

were not covered; in order for ensuing loss provision to be operative, there had to be “collateral

or subsequent damage or loss as a result of the collapse of the . . . wall.”

Narob Dev. Corp.

Finding that cracking in piles of a building during construction was excluded by virtue of the

policy’s faulty workmanship and cracking exclusions and that alleged resulting material

impairment of structural integrity to the building was not an ensuing loss

Alton Ochsner Med. Found.

The balance is easy – the insured pays for defects, the

insurer for damage to non-defective property! Right?

5/27/2016 22

Not covered....

Damage to:

Property free of defect

Damage to:

Defective Property

Covered!

Property free of defectDefective Property


Criticism: it can be hard to distinguish between defective

property, non-defective property, the mere manifestation of a

defect and ensuing damage caused by a seperate peril.

5/27/2016 23

Property free of defectDefective Property


Manifestation

of a defectDamage?

Original loss

(defect)

Ensuing damage

(separate peril)?

?


03 LEG Concept


Another Approach – The LEG Exclusions


The London Engineering Group – or, LEG – emerges:

Established, in part, “as a consultative body for insurers and reinsurers

active in the Relevant Classes in the London engineering, energy,

operational power and construction markets (the ‘Engineering Market’)….”

1990s: three defects exclusions crafted by LEG for use in various

applications, including the insurance of large infrastructure projects.

LEG exclusions provide varying degrees of cover

Initially adopted by European underwriters, but more recently have

found their way into property and construction policies in the U.S.

A Model “Outright” Defects Exclusion;

A Model “Consequences” Defects Wording

LEG1/96

LEG2/96

LEG3/96 A Model “Improvement” Defects Wording.



All costs rendered necessary by defects of material workmanship design plan

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 had 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.

A Model “Consequences” Defects WordingLEG2/96






is hereby excluded is that cost incurred to improve the original material






LEG3/96 A Model “Improvement” Defects Wording.

LEG Concept -

5/27/2016 28

All loss or damage due to defect

What is excluded?

Costs that would have been incurred if the property was

fixed immediately before the loss occurred

LEG1

LEG2

LEG3 Costs actually incurred to improve the original design etc.


04 Manifestation of a defect


Do these three stages exist?

5/27/2016 30

Defect Manifestation Damage


The English case law adds flesh to the bones of the

defect vs. damage debate - The Nukila Case (1997)


“If one is considering whether there is damage to the hull and whether

such damage is caused by a latent defect in the hull, it follows that the

damage must be something different from, something over and above

and incrementally greater than the defect itself.”

“Where the line is to be drawn is a matter of fact and degree”


Did Skanska throw a spanner in the works?

Skanska v Egger (2005)


In short, the court ruled that “‘loss and damage’ does not include the

manifestation of defective design or workmanship.”


Skanska to construct a wood chipboard factory for Egger. Defects in the floor slab caused it to

crack and break up when subjected to the weight of loaded vehicles. Slab to be torn out and

replaced

Construction contract: Skanska to “make good” “entirely at his own cost” any “defects, shrinkages

or any other faults which shall appear…” AND Skanska to obtain PD insurance

Insurance obtained excluded “[l]oss or damage caused by . . . [d]efects, error or omission in

design, workmanship, material plan or specification of the permanent works.”

Issue for the court: was cracking from the defects “loss or damage” that had to be insured?

Decision: “physical loss or damage of the kind which must be insured against under [the

construction contract]” did not include defects in design, work, workmanship, materials or goods,

for which the contractor was responsible under the contract.

Manifestation: “[i]n this contractual scheme, the mere manifestation of a defect under ordinary

usage, which the contractor is anyway obliged to make good under the contractual scheme relating

to defects, cannot in my judgment constitute loss or damage to the slab for the purposes of the

insurance requirement…”

LEG clauses will likely be read by English courts in a

certain way

Damage:

Change in physical state

if wording distinguishes damage caused by a defect = something

different from, something over and above and incrementally greater

than the defect itself

That diminishes value (or usefulness)

Fortuity:

(a) has to happen (i.e. not will happen) – (discrete event?)

(b) by chance


An Alternate Ending

Acciona v Allianz (2014, Canada)


Builder’s risk policy (LEG 2) for a 500-bed hospital construction project

Concrete slab exhibited “over deflection” and cracking, requiring extensive remedial measures.

Insurers: loss excluded under LEG 2/96 as the costs to remedy the defect and all costs “rendered

necessary by” the defective work.

Court:

Cause – over deflection and cracking of the concrete slabs was the result of defective

workmanship in failing to properly support the slabs while curing

Damage – “… the over deflection and cracking of the concrete slabs falls within the Perils

Insured clause of the Policy in that it constitutes damage that was fortuitous.”

On LEG 2 exclusion:

precludes “those costs rendered necessary by [the defects], but is limited to . . . those

costs that would have remedied or rectified the defect immediately before any

consequential or resulting damage occurred.”

Exclusion did not apply to “the costs of rectifying or replacing the damaged property

itself,” but applied only to “those costs that would have prevented the damage from

happening.”

The Court, therefore, held that only the minimal extra costs that would have

been incurred to properly shore up the slabs (as opposed to the improper

shoring that was done) would be excluded.

LEG 2





is hereby excluded is that cost which would have been incurred if replacement

or rectification of the Insured Property had been put in hand immediately prior

to the said damage.





A Model “Consequences” Defects WordingLEG2/96

The LEG Exclusions Hypothetical


Consider the following situation:

A general contractor on a large high-rise construction Project installs rebar per

design specifications, which it is later discovered is not sufficient to support the

superstructure concrete..

LEG1

LEG2

LEG3

Typical U.S. Wording

The LEG Exclusions Hypothetical


Now, the under designed

rebar has failed before being detected

…

LEG1

LEG2

LEG3

Typical U.S. Wording

05 Takeaways

Image: Munich Re

If you only take away a few things from this complex

topic:


LEG 2: take all covered damage, subtract hypothetical costs of fixing defect before damage

occurred

LEG 3: take all covered damage, subtract actual costs for making the property better

‘Manifestation of a defect’ cases will give you headaches.

In fact most defect cases will give you headaches.

LEG 3 significantly raises exposure – use DE 5 instead of LEG 3 if you can05

01

02

04

Just defective is not damaged! LEG 2 & 3 require insured ‘damage’03


Munich Re Claims

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Munich Re

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“Perfection has one grave defect: it is apt to be dull.”W. Somerset Maugham, British playwright

© 2015 Münchener Rückversicherungs-Gesellschaft © 2015 Munich Reinsurance Company Image: used under license from Shutterstock.com

Mark S. Katz, Esq.Partner

Mound Cotton Wollan & Greengrass LLP

(P) 212-804-4513

(C) 516-380-2249

[email protected]

Michael GibbonsSenior Legal Counsel

Munich Re

(P) +49 89 3891 8108

(C) +49 1603 699 723

[email protected]



Disclaimer

Münchener Rückversicherungs-Gesellschaft (Munich Reinsurance

Company) is a reinsurance company organised under the laws of

Germany. In some countries, including in the United States, Munich

Reinsurance Company holds the status of an unauthorised reinsurer.

Policies are underwritten by Munich Reinsurance Company or its affiliated

insurance and reinsurance subsidiaries. Certain coverages are not

available in all jurisdictions.

Any description in this document is for general information purposes only

and does not constitute an offer to sell or a solicitation of an offer to buy

any product.

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