S.E.C. Real Estate Observer

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Like any other business, the bottom line is unquestionably important to property owners. One of the major items that affect the bottom line is damage to the property and repairs or replacement of the damaged property. The damage can be caused by either man made or natural disasters. When this occurs, the necessary ingredient to repair or replace the property is, of course, having the necessary funds. In order to obtain the funding, one of the immediate responses of property owners and their advisors is to litigate against the general contractor or sub-contractors alleging defective construction, design, or supervision of the building of the
property.

While the path of construction defect litigation is certainly an option, it is important to understand what happens once the claim is made so property owners can evaluate whether this is the best route to take to obtain the necessary funding. Assuming the contractors have insurance, the first thing these entities should do is to place their liability carriers on notice. The liability carriers will typically argue that there is no “occurrence” stating that defective construction is not an accident and/or the construction defect exclusion precludes coverage even if there is an “occurrence.” There are a number of decisions around the country which support the insurance companies’ position that construction defect allegations do not constitute an “occurrence” and thus there is no coverage. See e.g. Brosnahan Builders, Inc. v. Harleysville Mut. Ins. Co., 137 F. Supp. 2d 517 (D. Del. 2001); Westfield Ins. Co. v. Sheehan Construction, et.al., 580 F. Supp.2d 701 (S.D.IN 2008); Kvaerner Metals Div. of Kvaerner U.S., Inc. v. Commercial Union Ins. Co., 589 Pa. 317, 908 A.2d 888 (2006); Nas Sur. Group v. Precision Wood Products, Inc., 271 F. Supp. 2d 776 (M.D.N.C. 2003). In fact, a number of states have attempted to circumvent these court decisions by passing legislation that construction defect claims do constitute an occurrence. See e.g. Colo. Rev. Stat. Ann. § 13-20-808 (West); AR ST § 23-79-155; S.C. Code Ann. sec. 38-61-70.

Since construction defect litigation will likely trigger a coverage dispute between the contractor or subcontractor and their respective carriers, typically declaratory judgment litigation will then be filed seeking a court determination that that there is, or is not, coverage. In the meantime, while the coverage dispute is occurring, the property owner is paying counsel to prosecute the construction defect case which is stalled due to the declaratory judgment litigation.

Moreover, even if the property owner has a good case, if there is no coverage, it is often difficult to get money out of the contractor. This, of course, leaves the property owner with property that still needs to be repaired, ongoing litigation and mounting attorneys’ fees. Not the hoped for result.

One of the most overlooked options the property owner has is to file a claim with its own property carrier or builders risk carrier. These are potential immediate sources of funding waiting to be tapped if the claim is handled correctly. Most importantly, the money goes directly to the insured property owner and can be used to do many different things, in addition to repairing the property (depending upon the policy language).

The following is a summary of the all risk policy and ensuring loss provision which play an important role in this process. It is important to ensure that your builders risk or property polices have the necessary language to ensure that you are well protected and poised to have additional sources of money should a loss occur. The correct language helps bring money to the table so the repairs or replacement to your property can be done faster and easier, thereby protecting your bottom line.

All Risk Policies

Commercial and residential property policies, as well as builders’ risk policies can be all risk policies. All risk policies typically provide that the carrier “will pay for direct physical loss to property described in Dwelling, Other Structures, or Personal Property resulting from an occurrence.” All risk insurance policies protect the insured in cases where the loss or damage to property is difficult or impossible to explain. The insured’s burden under an all risks policy is limited. The insured need only show that a fortuitous loss occurred. A fortuitous event is any event that is dependent on chance. Pillsbury Co. v. Underwriters at Lloyd’s, London, 705 F.
Supp. 1396, 1399 (Dist. Minn 1989). The insured need not prove the cause of the loss or damage. Pillsbury Co. 705 F.Supp. at 1399. The burden then shifts to the insurer to prove that an express exception to coverage applies, as well as the dollar amount that should be excluded from coverage. Id.

Typically, when an all risk policy is at issue, carriers will argue that one of the exclusions apply. In other words, the carriers typically will have to admit that coverage is triggered and so will then try to rely on an exclusion to preclude payment of insurance funds. However, if you have ensuing loss language in your policy, it serves to essentially bring coverage back, depending on the loss, even when dealing with certain exclusions, including defective construction exclusions.

Ensuing Loss Language

The following policy language is an example of what is referred to as “ensuing loss” policy language:

“1. We will not pay for loss caused by or resulting from any of the following:
d. wear and tear, marring, scratching, deterioration;
e. inherent vice, hidden or latent defect or any quality in property that causes it to damage or destroy itself”

For the causes of loss described above, except collapse, we do cover resulting loss or damage to covered property unless the resulting loss is itself caused by a cause of loss described in Property Losses Not Covered.” Emphasis added.

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3 We do not cover loss caused by any of the following. However, any ensuing loss not excluded in this policy is covered.”
c. faulty, inadequate or defective:
(1) planning, zoning, development, surveying, sitting;
(2) design, specifications, workmanship, repair, construction, renovation, remodeling, grading, compaction;
(3) materials used in repair, construction, renovation or remodeling; or
(4) maintenance….” Emphasis added.

The ensuring or resulting loss exception typically results in coverage in the following situations:

• A resulting loss is covered even if a defective work, repair, construction or product is a “but for” cause of the loss. The intent of the exclusion and exception is to exclude only that portion of the loss attributable to the defective product. In other words, losses that are defective products are not covered, while those that result from the defective product are covered.
• The exclusion and exception, read together, operate to eliminate the conduct or defect from consideration in analyzing the cause of resulting damage; only the actual risk causing the resulting physical damage is subject to the coverage analysis.
• To the extent that cause is neither excluded nor excepted in the applicable policy, coverage exists for the damage which resulted from the defective product.

The following cases present situations where this type of “ensuing loss” policy language buttressed the insured’s claim where construction defects contribute to a loss. Buscher v. Economy Premier Assurance Co., 2006 WL 268781 (D. Minn. 2006); Phillips v. USAA, 146 SW 3d 629, 633 (Tenn. Ct. App. 2004). See generally, Pillsbury Co, 705 F. Supp. at 1400.

In Buscher v. Economy Premier Assurance Co., 2006 WL 268781 (D. Minn. 2006), the Minnesota district court found the carrier liable for the resulting or ensuing loss. There, water from wind-driven rain, melting ice, or snow penetrated the exterior building envelope of the insured’s home due to defective construction. This penetration caused physical damage to the interior wall assembly components. Wall cavities in the home contained high levels of moisture, which caused soft or questionable sheathing and damaged other components of the interior wall assembly. The Minnesota federal district court concluded that the policy’s construction defect
exclusion did not exclude water damage resulting from a construction defect. The district court reasoned that nothing in the language of the exclusion indicated that it extended to any loss resulting, however remotely, from construction defects. The district court further reasoned that the interpretation that the exclusion only extends to loss directly related to an actual construction
defect was consistent with the requirement that courts read exclusions in insurance contracts narrowly against the insurer.

Relying upon Buscher, a similar conclusion was reached by an Illinois federal district court in McGrath v. American Family Mutual Insurance Co., 2008 WL 4531373 (N.D. Ill. 2008). In that case, external water or moisture (rain, melting ice or snow, or ambient humidity) penetrated the exterior brick walls of the insured’s home. The insurer argued that the policy excluded any loss connected to or caused by a construction defect. The insureds, in contrast, argued that the policy only excluded losses directly related to the construction defect, such as the cost to correct the faulty brick walls. Because they sought only reimbursement for the loss
resulting from the interior water damage (damaged drywall, insulation and the like), the insureds contended that the exclusion was not applicable. The federal district court found in favor of the insureds and concluded that while the plain language of the construction or design defects exclusion expressly excluded the cost to correct the construction defect, the resulting damage
was covered.

In Eckstein v. Cincinnatti Ins. Co., 469 F.Supp.2d 444, 445 (W.D. Ky. 2007), the insureds’ home suffered water damage. The Ecksteins brought claims in state court for faulty construction against the contractors and in federal court against Great Northern for breach of contract, bad faith and violation of the Consumer Protection Act. The federal court denied the insurance company’s argument that the insureds were judicially estopped to take what the carrier argued were “inconsistent positions.” The federal court specifically held that it:

“does not view Plaintiffs’ position as clearly inconsistent with its position in state court . . . in other words, the Ecksteins
acknowledged that faulty construction was the baseline problem. Their argument here is simply that events occurred after the faulty
construction, which arguably provide an exception to the ‘faulty construction’ exclusion. This is not an inconsistent position to that
taken in state court.” Eckstein, 469 F.Supp.2d at 452.

In Eckstein, the carrier relied, in part, on the “Faulty planning, construction, or maintenance” exclusion which provides:

“We do not cover any loss caused by the faulty acts, errors or omissions of you or any other person in planning, construction or
maintenance. It does not matter whether the faulty acts, errors or omissions take place on or off the insured property. But we do
insure ensuing covered loss unless exclusion applies. “Planning” includes zoning, placing, surveying, designing, compacting,
setting, specifications, developing property and establishing building codes or construction standards. “Construction” includes
materials, workmanship, and parts or equipment used for construction or repair.” Id. Emphasis added.

However, the Court noted that the policy covered ensuing loss (see emphasis added above). The Court found that there was nothing in the policy to indicate that an ensuing loss must be the result of a separate cause from the excluded loss. The Court explained:

“To the contrary, the policies are clear that faulty construction losses are excluded, but losses taking place afterward, or as a result
of faulty construction, are covered. The exclusions still apply despite the applicability of the ensuing loss provision. For example, water damage ensuing from a defective roof is covered as an ensuing loss, but the exclusion for faulty construction excludes coverage to repair the roof. Such an interpretation is consistent with the reasonable expectations of the insureds.” Id. at 454.

Depending upon the policy language, as long as insureds are requesting money to repair, for instance, the water damaged portion of their home; not money to repair defects, the carrier may owe coverage. Therefore, there is a difference between the cost to repair all the damage to the building, which includes any repair for defects, and the estimates to repair the water damage.

But often the insured is entitled to coverage, even if a defect or poor design or construction partially caused it. See also Sentinel Management Co., v. New Hampshire Ins. Co., 563 N.W.2d 296 (1997) (upholds ensuing loss exclusion for release of asbestos fibers and resultant contamination of insured apartment buildings).

In Phillips v. United Services Automobile Assoc., 146 S.W.3d 629 (Ct. App. Tenn. 2004), the court addressed the ensuing loss provision in another water damage context:

“We begin our analysis by noting that the plaintiff’s insurance policy, under the section entitled “Perils Insured Against,” broadly
insures “against risks of direct physical loss to [the plaintiff’s dwelling].” This broad grant of coverage, which obviously would
cover water damage, is then immediately followed by a list of exceptions to coverage.

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In addition, the policy excludes “[f]aulty, negligent, inadequate or defective … design, specifications, workmanship, repair,
construction … materials used in repair, [or] construction….”

However, any loss ensuing from such faulty workmanship or construction is covered, provided it is not excepted or excluded
elsewhere in the policy.” Phillips, 146 S.W.3d at 633 In Phillips, the plaintiff’s claim for water damage ensuing from the negligent installation of EIFS was a separate peril and coverage was provided under the policy:

“In summary, we hold that the plaintiff’s claim for water damage arising from the faulty design or negligent installation of EIFS is
covered under his insurance policy and is not excepted or excluded under the policy language. To the extent that the policy language
could be given another reasonable interpretation that would effectively deny coverage, the ambiguity that would be created by
two reasonable interpretations would, under the law, have to be resolved in favor of the interpretation favorable to the insured. Id.
at 636.

Conclusion

Your property or builders risk policies are important tools that should be used to protect the property owner’s bottom line. They can and should be reviewed to ensure that they have the correct language to allow the property owner to bring money to the table.