Casualty insurers normally do not expect to pay the cost of their insureds simply doing a good job. Insurers typically view their contracts as assuming the risk of delineated consequences – damages – if the insured’s work causes other loss, but insurers normally expect the insured to bear the cost of correcting their own work that was initially not properly performed. That “business risk” allocation is not arbitrary. It is supported by sound logic. Any rational plan should be self-executing, which in turn requires that the insured must have an economic incentive – skin in the game – to do its work correctly.
In the construction defect field, achieving that straightforward objective before the courts has proven remarkably difficult. Insurers have tried varying, sometimes overlapping, approaches. Much litigation has focused on “business risk” exclusions (“your work,” “work product” and, less frequently, “impaired property” exclusions) in standard ISO comprehensive general liability (CGL) policies.
In recognition of the difficulty that insurers face in bearing the burden of proof with respect to such exclusions, and the sometimes undue parsing of exclusion language by courts under the guise of finding ambiguity, some insurers have turned to writing variations on coverage for ongoing or completed operations.[i] However, insurers have also sought clear, straightforward routes to achieve the proper business risk allocation through the policy insuring clause. One line of argument addresses whether construction defects meet the policy’s requirement of an “occurrence” involving an “accident.” A separate argument focuses on whether the costs associated with the insured’s defective work constitute “property damage.”
The California Court of Appeal decision in Regional Steel Corp. v. Liberty Surplus Ins. Corp., 226 Cal.App.4th 1377 (June 13, 2014) provides a recent look at the latter issue: when are, and are not, damages allegedly resulting from an insured’s work insured “property damage”? The court provided a clear response in the context of a subcontractor, holding that a subcontractor’s defective work, as well as the “rip and tear” cost of accessing and repairing that work, are not property damage.
Regional Steel was decided by a division of the Second Appellate District, which encompasses the Los Angeles area and which is an influential appellate district in California. Liberty Surplus Insurance Corporation issued a wrap policy to JSM Construction, Inc. JSM was the general contractor on a 14-story retail, residential and parking mixed use reinforced concrete building. Regional Steel Corporation (Regional Steel), an additional named insured under the wrap policy, subcontracted to provide reinforcing steel, or “rebar.” Another subcontractor, Webcor Construction, Inc., was engaged to supply and pour the concrete that encased Regional Steel’s rebar. During the course of construction, a city building inspector determined that certain tie hooks that Regional Steel installed on the rebar were inadequate and required replacement.
After Regional Steel sued JSM for nonpayment of the contract price, JSM cross-complained against Regional Steel, Webcor and others for damages resulting from repairs that required JSM to open up numerous locations in the concrete walls, weld reinforcements to the steel placed by Regional Steel, and otherwise strengthen the inadequate installation. JSM also alleged that other defendants had caused a related delay in completion of the project resulting in loss of use, loss of rental income and other damages. Webcor filed an indemnity cross-complaint against Regional Steel. The trial court granted summary judgment, holding that Liberty Surplus did not have a duty to defend Regional Steel. The Second District affirmed.
In a key ruling, the Second District held that the cost of repairing Regional Steel’s defective work, including the cost of opening the concrete to make those repairs, was not “property damage” within the definition of the Liberty Surplus policy. The policy defined property damage as “[p]hysical injury to tangible property, including all resulting loss of use of that property … [¶] [ ] Loss of use of tangible property that is not physically injured … shall be deemed to occur at the time of the ‘occurrence’ that caused it.” The court noted that the law is in conflict concerning whether construction defects that are incorporated into a whole property constitute property damages for purposes of a CGL policy, particularly where the defective work or material must be removed or repaired to comply with building code or health and safety standards. Id. at 1391-1392.
The appellate court cited F&H Construction v ITT Harford Ins. Co, (2004) 118 Cal.App.4th 364, for its conclusion that “the basic purpose of liability policies, ... ‘are not designed to provide contractors and developers with coverage against claims their work is inferior or defective. The risk of replacing and repairing defective materials or poor workmanship has generally been considered a commercial risk which is not passed on to the liability insurer.” Id., at 1392.[ii] The Regional Steel court characterized as inapposite cases that “involved contamination by hazardous materials that were incorporated into a whole, and did not involve the incorporation of defective workmanship in to a construction project.” Id., at 1393. The court held that the allegations that Regional Steel “failed to install the proper tie hooks, and its failure to do so necessitated demolition and repair of the affected areas [were] squarely within the rule of F&H Construction that this type of repair work is not covered under a CGL policy.” Id.
Regional Steel is also noteworthy because the court was willing to look closely at the pleadings and decide the duty to defend based only on specific allegations directed at Regional Steel. For example, although JSM’s cross-complaint alleged that Webcor’s concrete floors were out-of-level and had experienced cracking, the pleadings did not allege that those defects were caused by Regional Steel’s work. Neither did a duty to defend arise from the conclusory allegations of Webcor’s cross-complaint for indemnity against JSM’s claims. Id. [iii]
Regional Steel¸ which dealt with claims against a subcontractor, does not address the scope of what will be considered “defective construction” with respect to a developer or general contractor under either a standalone CGL policy or a wrap policy. The developer is responsible for the entire project, but the developer does not perform any of the work that is actually defective. There may be disputes concerning whether an entire constructed building or improvement is the developer’s “work” for purposes of applying the definition of “property damage.” [iv] Although courts sometimes hold that exceptions to exclusions do not broaden the insuring clause, developers can be expected to note that since the mid-1970s ISO CGL forms, first within the Broad Form Property Endorsement and then within the policy itself, provide subcontractor exceptions to the normal “your work” exclusion. This argument has been advanced in support of the contention that interpreting the policy as a whole requires coverage for defects caused by others with whom the insured contracts. Similar issues will exist with respect to an insured general contractor and defects caused by subcontractors.
Nonetheless, Regional Steel provides useful support for an insurer’s argument that its insuring clause does not extend coverage to the cost of correcting the insured’s defective work. Insurers’ arguments that such damages do not constitute an “occurrence” have been rejected in a number of states and criticized by some commentators as not sufficiently grounded in the language of the policy. Regional Steel presents a thoughtful, rational alternative basis for an insurer to deny financial responsibility for the cost of defects that should remain the insured’s business risk.