Compensation for Damage Caused by Defects

Insurance - is an integral part of the investment and construction process, without which now just impossible to imagine it. The purpose of this article - to give an overview of additional conditions to the contract of insurance of construction and assembly risks relating to damages due to defects, as well as some aspects of their application.

INTRODUCTION
This talk reviews the intended effect of some wordings and highlights the various differences between them. It also outlines problems of application that can arise when the nature and extent of the insured “damage” to the “insured property” as a result of a “defect” is the matter of dispute. If taken as a matter of first impression, these issues ought to be straightforward, but the points can often involve significant financial sums, and as always when one is dealing with questions of language, more detailed analysis can often result in more than one answer to the same question. As will be seen, the English Courts encourage a straightforward practical approach to these issues and discourage overdetailed analysis.

THE BASIC “ALL RISKS” COVER
The origin of all risks/physical damage cover is that it covers accidental damage to the insured property from an external cause. In Gaunt’s Case (1921) the House of Lords stated that: “All risk insurance covers a risk not a certainty; it is something which happens to the subject matter from without not a natural behaviour of that subject matter being what it is... ” That rule has proven unacceptably narrow in practice. A material defect or a defect in design can result in very serious consequences such as catastrophic failure or explosion. Because the originating cause of the accident comes from within the insured property rather than from some external cause, such an event (although almost certainly accidental in the true sense) would not fall within the kind of cover defined by the House of Lords in Gaunt’s Case. Over the years, different markets have worked out different (but broadly similar) compromises. It is a question of trying to strike an appropriate balance between providing the insured with cover for the physical damage resulting from a design or material defect or poor workmanship, while at the same time not guaranteeing the adequacy or suitability of the work.

The insured contractor has an obligation to design and complete the works to the required standard and to rectify defects which are discovered during the currency of the project or the maintenance/ warranty period. The cost of rectifying inadequate performance should be borne by the insured as a commercial risk; but if some defect in material or design results in physical damage to the insured property, many policies will indemnify the contractor for that damage. At the present time, the 1995 Design Exclusion Clauses and the 1996 London Engineering Group Clauses, represent the balance struck by engineering and machinery insurers in this context.

THE DESIGN EXCLUS ION CLAUSES
There are five DE exclusions and three LEG wordings. The full text of each of these is set out in the Appendix to this talk and can be found in the conference pack. Broadly they fall into three categories.

Outright Exclusion
DE 1 and LEG 1 constitute an outright exclusion for damage resulting from defect. Cover provided by a policy containing these exclusions is the traditional all risk cover of the kind referred to in Gaunt’s Case. The damage must be referable to external and not internal causes. The exclusion is very broad. It is not expressed by reference to damage proximately caused by defect but damage due to defect, which is wider. Recently I was involved in a case of flood damage to a new office building during the course of a very severe storm. At first sight, there appeared to be a covered fortuity because this was a once in a 30 year storm which was almost certainly the proximate cause of the loss. However, the building was of a modern design with many terraces; these terraces incorporated the guttering and the guttering was designed in such a way that if it overflowed, the overflow ran inwards rather than outwards. The insurers were therefore able to argue successfully that the damage was due to defective design, notwithstanding the unusual storm.

Cover for Consequential Damage
Damage to the defective property, resulting from the defect, is excluded but damage to other property (or other parts of the property) occurring in consequence, is covered. Examples of this approach are LEG2 and DE clauses 2-4. DE2 and DE3 permit cover for damage to other property which is free of the defective condition and is damaged in consequence of the defect, but excludes damage to the defective property itself and any other property which is damaged to enable the replacement/ repair to take place.

The distinction between DE2 and DE3 is only that DE2 also excludes damage to property insured which relies for its support or stability upon the defective property, whereas DE3 omits that provision and thus allows cover in that respect. DE4 is a similar exclusion but is intended to apply in respect of machinery rather than straightforward building work, because it refers to “component part or individual item of the property” and provides that the exclusion will not apply to other parts or items of the property insured which are free from the defect. LEG2 adopts a fairly similar approach save that it does not specifically exclude damage to the defective property itself. The approach is to exclude the cost that would have been incurred to rectify the defect if that effort had been put in hand immediately prior to the damage. The advantage of this approach is that it avoids a need to distinguish between the “defective property” and “other property” - a consideration which (as I shall explain ) can become problematic.

Exclusion for Improvement or Betterment
The relevant clauses are DE5 and LEG3. These clauses permit cover for the damage to the defective property due to the defect within it, but exclude from the recoverable cost of repair any additional cost incurred relating to an improvement in the specification or other cost to improve the design so as to avoid the damage occurring again. DE5 also provides that property damaged in order to enable the repair to take place is not covered, but no specific provision to that effect is made in the LEG3 wording.

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Deputy Branch Director of the Insurance Company “Alliance ”, Member of the Expert Council of the State Duma Committee on Energy