Seminario “El seguro industrial y la gestión de riesgos”

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Seminario “El seguro industrial y la gestión de riesgos”
Image: used under license from Shutterstock.com
Defect, Damage and the LEG Concept
Michael Gibbons
Mark S. Katz, Esq.
Senior Legal Counsel
Munich Re
(P) +49 89 3891 8108
(C) +49 1603 699 723
[email protected]
Partner
Mound Cotton Wollan & Greengrass LLP
(P) 212-804-4513
(C) 516-380-2249
[email protected]
Agenda
01
02
Allocation of Risks
03
All Risks Property
Insurance
Damage, Fortuity,
Indemnity
Defect Exclusions
LEG Concept
LEG 2
LEG 3
Defect or Damage?
Image: used under license from Shutterstock.com
Image: used under license from Shutterstock.com
04
05
Manifestation of a
defect
Takeaways
Image: used under license from Shutterstock.com
Image: used under license from Shutterstock.com
Image: Ulrike Myrzik + Manfred Jarisch, Munich Re
2
01 Allocation of Risks
Image: Munich Re
Risk Map
Fire/
Nat Cat
PD/DSU
Owner
 Build the whole thing
 Get PD/DSU insurance
Bodily
Injury
Main Contractor
Supply
that part
Build
that part
Design
that part
Sub – Contractor
Sub – Contractor
Sub – Contractor
Insolvency
Defective/Not fit
for purpose
Breach of
Contract
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
4
Where do the risks belong?
Business Risk
Liability Insurance
Property Insurance
 Project not built as
agreed
 All risks of physical
damage
 Rectifying defects
 Professional Indemnity
(architects, engineers
etc.)
 Not fit for purpose
 Performance Bond
 Wear and tear /
deterioration etc.
 Manufacturer’s
Warranty
 Resultant damage from
defects
 Delay
 CGL – PD or Bodily
Injury (incl. following
defects)
 Insolvency
 Nat Cat / Fire
 Workers compensation
Finding a balance:
Business Risk or Property Insurance?
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
5
02 All Risk Property Insurance
Image: used under license from Shutterstock.com
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”.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
7
02 Damage, Fortuity, Indemnity
Image: Ulrike Myrzik + Manfred Jarisch, Munich Re
What can damage mean?
U.S.
Image: Munich Re
“physical loss or damage strongly implies that there was an initial satisfactory state that
was changed by some external event into an unsatisfactory state”
U.K.
“Damage requires a changed physical state ... being harmful in the commercial context”
Image: Munich Re
Canada
“Altered physical state”, “permanent deformity”
Image: Munich Re
Australia
Image: Munich Re
A physical alteration or change, not necessarily permanent or irreparable, which impairs
value or usefulness
London Engineering Group
LEG 3/06
“include[s] any patent detrimental change in the physical condition of the Insured
Property”
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
9
Fortuity – an unexpected and unintended accident
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:

THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Image: used under license from Shutterstock.com
all risk policy or a no risk policy?
Defect coverage and the LEG exclusions
5/27/2016
10
Indemnity Principle
 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
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Image: used under license from Shutterstock.com
Defect coverage and the LEG exclusions
5/27/2016
11
Just to go over the main principles
Risk
Allocation
Insurable risk (physical damage)
vs.
Entrepreneurial risk (mere defects; breach of contract)
All Risks
All perils: defect as a covered peril?
Ensuing loss from a separate peril
Damage
Detrimental change in physical condition
Bright line:
defect/manifestation of a defect <> damage by an ensuing peril
Fortuity
Already happened, and by chance (not expected nor intended)
Indemnity
Principle
You get back what you had before (not something better)
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
12
A little quiz
Q
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
A

+ Fortuity

+ Indemnity Principle / betterment exclusion?
 Covered: costs to repair all physical damage
(incl. the defective part)
 Excluded: costs incurred to improve the original
property
* without considering exclusions
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
13
02 Defect or Damage?
Image: used under license from Shutterstock.com
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.
Defect
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
vs.
Damage
Defect coverage and the LEG exclusions
5/27/2016
15
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
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
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16
Do these three stages exist?
Defect
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Manifestation
Damage
Defect coverage and the LEG exclusions
5/27/2016
17
03 Defect Exclusions
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Traditional U.S. Defect Exclusions
Typical 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.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
19
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.
Note: damage to the defective part itself is generally not covered
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
20
Traditional U.S.-written Defect Exclusions
Interpretation 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:
Acme Galvanizing
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.
80 Broad Street Co.
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.
Laquila Constr., Inc.
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.
Narob Dev. Corp.
Alton Ochsner Med. Found.
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.”
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
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
21
The balance is easy – the insured pays for defects, the
insurer for damage to non-defective property! Right?
Damage to:
Damage to:
Defective Property
Property free of defect
Not covered....
Covered!
Defective Property
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Property free of defect
Defect coverage and the LEG exclusions
5/27/2016
22
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.
Defective Property
?
Property free of defect
Manifestation
of a defect
?
Damage
Original loss
(defect)
?
Ensuing damage
(separate peril)
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
23
03 LEG Concept
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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.
LEG1/96
A Model “Outright” Defects Exclusion;
LEG2/96
A Model “Consequences” Defects Wording
LEG3/96
A Model “Improvement” Defects Wording.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
25
Another Approach – The LEG Exclusions
LEG2/96
A Model “Consequences” 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.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
26
Another Approach – The LEG Exclusions
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 incurred to improve the original material
workmanship design plan or specification.
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.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
27
LEG Concept -
What is excluded?
LEG1
All loss or damage due to defect
LEG2
Costs that would have been incurred if the property was
fixed immediately before the loss occurred
LEG3
Costs actually incurred to improve the original design etc.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
28
04 Manifestation of a defect
Image: used under license from Shutterstock.com
Do these three stages exist?
Defect
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Manifestation
Damage
Defect coverage and the LEG exclusions
5/27/2016
30
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”
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
31
Did Skanska throw a spanner in the works?
Skanska v Egger (2005)

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…”
In short, the court ruled that “‘loss and damage’ does not include the
manifestation of defective design or workmanship.”
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
32
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
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
33
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.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
34
LEG 2
LEG2/96
A Model “Consequences” 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.
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
35
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..
Typical U.S. Wording
LEG1
LEG2
LEG3
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
36
The LEG Exclusions Hypothetical
Now, the under designed
rebar has failed before being detected
…
Typical U.S. Wording
LEG1
LEG2
LEG3
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
37
05 Takeaways
Image: Munich Re
If you only take away a few things from this complex
topic:
01
LEG 2: take all covered damage, subtract hypothetical costs of fixing defect before damage
occurred
02
LEG 3: take all covered damage, subtract actual costs for making the property better
03
Just defective is not damaged! LEG 2 & 3 require insured ‘damage’
04
‘Manifestation of a defect’ cases will give you headaches.
In fact most defect cases will give you headaches.
05
LEG 3 significantly raises exposure – use DE 5 instead of LEG 3 if you can
THIS PRESENTATION IS FOR DISCUSSION PURPOSES ONLY
Defect coverage and the LEG exclusions
5/27/2016
39
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40
© 2015 Münchener Rückversicherungs-Gesellschaft © 2015 Munich Reinsurance Company
“Perfection has one grave defect: it is apt to be dull.”
W. Somerset Maugham, British playwright
Michael Gibbons
Mark S. Katz, Esq.
Senior Legal Counsel
Munich Re
(P) +49 89 3891 8108
(C) +49 1603 699 723
[email protected]
Partner
Mound Cotton Wollan & Greengrass LLP
(P) 212-804-4513
(C) 516-380-2249
[email protected]
Image: used under license from Shutterstock.com
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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