Law and Insurance

Texas High Court Allows CGL Coverage of Construction Defects

Lamar Homes, Inc. v. Mid-Continent Casualty Co., #05-0832 (Tex. August 31, 2007)

In a watershed decision, the Texas Supreme Court has decided that a commercial general liability (CGL) insurer must defend insured contractors and builders against lawsuits alleging damage caused by the insured's construction defects.  The critical insurance coverage issues are whether a contractor's defective work could constitute an "occurrence" (basically, an accident) and whether damage to the insured's construction work (as opposed to other property that the insured did not work on) could constitute "property damage" (physical injury to or loss of use of tangible property).  This decision resolves one (or perhaps two) of the biggest insurance-coverage debates of the decade and will have lasting influence on how other coverage disputes will be analyzed under Texas law over the basic insuring language of the now ubiquitous CGL policy insuring agreement .

Facts.  The homeowner plaintiffs sued the builder, Lamar Homes, after discovering cracks and leaks attributed to faulty construction of the foundation.  The builder's CGL insurer refused to defend or indemnify the lawsuit asserting that: (1) the alleged faulty workmanship was not an occurrence because it was the result of deliberate conduct (i.e., breaching one's contract), not an accident; and (2) damage to an insured's own work or products could not be property damage under the "economic loss rule" (barring a plaintiff from recovering tort damages for economic losses resulting from a breach of contract). 

Economic-Loss Rule.  If I buy a defective toaster that explodes, my claim against the seller is limited to my economic loss, the remedy allowed under contract law (what I paid for the toaster), unless the explosion also damaged other property or caused bodily injury, in which case I can recover tort damages for the seller's negligence (or - the jackpot - punitive damages if I can prove gross negligence).  The insurer in Lamar Homes asserted that CGL policies cover only torts, not breach of contract.  Therefore, damage to the insured's work cannot be property damage under a CGL policy.

Occurrence.  The court first found that faulty workmanship could be the result of accidental conduct because a deliberate act can be performed negligently.  Much ink has been spilled on this issue, to which the Court has added the following formulation paraphrasing one of its earlier decisions:

[A] claim does not involve an accident or occurrence when either direct allegations purport that the insured intended the injury (which is presumed in cases of intentional tort) or circumstances confirm that the resulting damage was the natural and expected result of the insured's actions, that is, was highly probable whether the insured was negligent or not.

The Court was careful to say that "whether an insured's faulty workmanship was intended or accidental was dependent on the facts and circumstances of the particular case."  Presumably, if the insured deliberately substituted an inferior ingredient or used substandard materials to cut costs, the defective workmanship would not be a covered occurrence.  If, on the other hand, the defective work was the result of shoddy work by shirking employees, the builder could not be denied a defense. 

But the thing to remember is that this is a duty-to-defend case.  The Court restricts its analysis to the allegations in the pleadings, not to the actual facts of the particular case.  From now on, a lawsuit alleging negligent workmanship, without much detail, will trigger the CGL insurer's duty to defend.

Property Damage.  The second issue is perhaps even more important.  If a court relies on the economic-loss rule to bar CGL coverage for a property-damage claim because it "sounds in contract," does that mean that conduct in the performance of a contract could never be covered?  If even part of a plaintiff's claim was breach of contract, a court might be persuaded to dismiss it because it "sounds in contract".  The Lamar Homes Court short-circuited the whole line of inquiry by putting the economic-loss rule out of insurance law.  "It is a liability defense or remedies doctrine, not a test for insurance coverage."  More importantly, the Court held that CGL policies are not restricted to covering torts. 

Dissent.  Three Justices filed a vigorous dissent, primarily attacking the majority's rejection of the economic-loss rule.  "Selling damaged property is not the same thing as damaging property."  The dissent also argues that the Court is following the minority view of courts across the country, but the majority dispute this assertion.

In the final analysis, as the Court observes, CGL policies will not necessarily cover defective workmanship because so-called "business-risk" exclusions target for elimination damage to the insured's work and replacement of the insured's defective products.  Nevertheless, as the Dissenting Opinion points out, the practical effect in many cases will be that small subcontractors, who typically bear the responsibility for covering the general contractor and the owner in construction mishaps, will end up carrying a larger portion of the risk, and their premiums may rise.  Also, insurers will almost surely be required to defend more construction-defect lawsuits.

The Lamar Homes Court also holds that a Texas statute allowing a penalty for delayed payment of "first-party claims" does applying to defense costs an insured incurs under a CGL policy.  But that is an issue for another day.

5th Circuit Asks Texas Supreme Court To Determine Effect of Actual Notice When Insured Fails To Forward Lawsuit

Note: Texas Supreme Court answered this question in the negative (see my discussion at Crocker Opinion).

Crocker v. National Union Fire Ins. Co., 466 F. 3d 347 (5th Cir. 2006)

Two Texas federal district courts have reached opposite answers to the following question: When the insured is sued and fails to send a copy of the lawsuit to the liability insurer as required by the policy, may the insurer refuse to cover the claim or defend the lawsuit, even though the insurer had actual knowledge of the lawsuit?  The US District Court for the Western District of Texas said no in Crocker.  However, recently, in East Texas Medical Center Regional Health System v. Lexington Ins. Co. (E.D. Tex. July 12, 2007), a court in the Eastern District said yes.  So the 5th Circuit wants the Texas High Court to sort it out.

The facts of the two cases are somewhat different, but the fundamental question is, I believe, the same.  In Crocker, a nursing home employee allegedly injured a patient who sued both the employee and the nursing home.  The nursing home's liability policy also covered the employee as an additional insured.  Unfortunately, the employee was fired soon after the accident and did not know that he was entitled to a defense from the insurer.  The insurer and the attorney it hired to defend the nursing home had a copy of the lawsuit and knew that the employee was a defendant.  Indeed, the attorney even deposed the employee.  Yet no one told the employee that he was entitled to a cost-free defense.  Despite some attempts to contact the employee, the insurer admits that it never told him the insurer would provide a defense.  The case resulted in a judgment against the employee, which the insurer refused to cover because the employee failed to forward a copy of the lawsuit to the insurer.  The lower court ruled in favor of coverage based on the insurer's actual knowledge of the lawsuit.

East Texas Medical Center (ETMC) had a claims-made malpractice liability policy under which it was responsible for paying and handling the first $2 million of covered claims.  The policy nonetheless required ETMC to provide notice of claims and copies of lawsuits to the insurer.  It was ETMC's practice to enter new claims and track their progress in a computer database made available to the insurer.  The claim in question was asserted and recorded a few weeks before the policy expired.  At first, ETMC did not think the claim would exceed its $2 million deductible.  Several months after the policy expired, however, ETMC learned at a deposition the serious nature of the injuries and sent written notice to the insurer, who denied the claim.  The court in the coverage lawsuit found that ETMC breached the policy by failing to forward suit papers to the insurer within the policy period, as required by the claim-made policy.  The court held that the insurer's actual awareness of the claim from the database did not excuse the insured from having to send the insurer the lawsuit.  Further, the court refused to consider whether the insured's failure prejudiced the insurer because of the claims-made nature of the policy (i.e., courts routinely hold that an insurer does not need to prove that failure of notice prejudiced the insurer's interests.)

Risk managers of companies that self-insure substantial layers of liability risk should take special note of the ETMC case.  I have noticed that many risk managers are reluctant to report claims where, as in this case, the insured is responsible for investigating and paying most small claims.  Too often a sleeper claim comes along which doesn't loom large as a multi-million risk until well into litigation.  Then it may be too late.  Most insurance companies will assert notice defenses available to them.  The best advice is to notify early and often.

Report Details Fraudulent Claims-Adjustment Practices in Homeowner Insurance Industry

In response to widespread insurance abuses reported in the 1960's and 1970's, many states, including Texas, instituted consumer protection laws to curb sharp practices and punish insurers that delay or refuse to pay meritorious claims.  According to a recent article by David Dietz and Darrell Preston published on Bloomberg.com (Home Insurers' Secret Tactics Cheat Fire Victims, Hike Profits), homeowners are facing a current wave of abuses designed to underpay property losses.  The authors provide numerous details of how such large insurers as Allstate and State Farm train adjusters to make low ball offers for damaged or destroyed homes and fight vigorously if the policyholder holds out for full replacement cost.

Perhaps most disturbing is evidence developed through discovery in several lawsuits across the country that insurers have relied on advice of consultants, particularly a New York-based consulting firm called McKinsey & Co., advising insurers on methods to raise profits by paying out less in claims.  For example, one powerpoint slide shown in a Kentucky court room entitled "Good Hands or Boxing Gloves" advises Allstate adjusters to make an initial low offer.  If the policyholder accepts the low offer, McKinsey's slide tells the adjuster to treat the person with good hands.  "If the customer protests or hires a lawyer, Allstate should fight back."

Another reported practice is the use of computer programs, including "Colossus" and "Xactimate," that allegedly calculate insured losses and systematically underpay policyholders without regard to the validity of each individual claim.  This article also reports on insurer practices of rewarding adjusters who underpay claims.

At a time when insurance company profits have increases year to year, despite Katrina-related losses (the article reports property-casualty profits up 49% in 2006), reports like these may well spur another cycle of consumer protection legislation.

5th Circuit Asks Texas Supreme Court To Declare When "Property Damage" Occurs Under Standard CGL Policies

One Beacon Insurance Company v. Don's Building Supply, Inc. (5th Cir. August 8, 2007)

The list of key insurance coverage cases pending before the Texas Supreme Court has just grown.  (For a list of insurance cases pending before the Texas High Court, see Pending Insurance Cases).  The Federal 5th Circuit Court of Appeals faced a common dilemma under Texas law: Under an occurrence-based commercial general liability (CGL) policy, when does "property damage" occur?  In other words, what must happen with the policy period: actual physical injury or the noticeable manifestation of that injury? 

In this case, homeowners sued their builder for installing a defective insulation product resulting in leaks that caused progressive yet hidden damage over a number of years.  The homeowners claimed that most of the actual physical injury to the structure took place during One Beacon's policy period (more than two years before suit was filed), but, to avoid a two-year statute of limitations, they invoked the "discovery rule" and argued that limitations period must be extended because the damage was so hidden as to be "inherently undiscoverable" until the damage became noticeable or manifested.

A CGL policy covers damage that "occurs" within the policy period.  The policies in this case were in effect more than two years before suit was filed when the physical injury existed but before it was discovered.  The 5th Circuit noted that Texas cases disagreed as to when property damage occurs.  Some cases, including the 5th Circuit itself (in Guaranty Nat'l Ins. Co. v. Azrock Indus., Inc. 211 F.3d 311 (5th Cir 1998)), had held that property damage occurs when it becomes manifest or identifiable.  However, the court noted that a few Texas cases applied an "exposure rule" holding that damage occurs when property is exposed to injurious conditions (see Pilgrim Enterprises, Inc. v. Maryland Cas. Co., 24 S.W.3d 488 (Tex. App.--Houston [1st Dist.] 2000, no pet.))  The Texas Supreme Court has yet to settle this issue, usually called "trigger of coverage," concerning both bodily injury and property damage (see American Phys. Ins. Exch. v. Garcia, 876 S.W.2d 842 (Tex. 1994) (noting various trigger-of-coverage approaches applied by courts, including "manifestation" and exposure, without deciding which should be applied.)

The One Beacon court faced a second dilemma.    The homeowner plaintiffs alleged in the pleading that actual damage was continuing and progressive and occurred during the policy period, but remained undiscoverable for purposes of the discovery rule (extending the time allowed to bring a lawsuit until the damage is discoverable) until sometime after the policies expired.  The 5th Circuit did not know whether a plaintiff's assertion of the discovery rule should affect the determination of the trigger of coverage. 

  Accordingly, the One Beacon court exercised its authority to certify two questions to the Texas Supreme Court:

1. When not specified by the relevant policy, what is the proper rule under Texas law for determining the time at which property damage occurs for purposes of an occurrence-based CGL policy?
2. Under the rule identified in the answer to the first question, have the pleadings in lawsuits against an insured alleged that property damage occurred within the policy period of an occurrence-based CGL policy, such that the insurer's duty to defend and indemnify the insured is triggered, when the pleadings allege that actual damage was continuing and progressing during the policy period, but remained undiscoverable and not readily apparent for purposes of the discovery rule until after the policy period ended because internal damage was hidden from view by an undamaged exterior surface?

Texas Governor Signs Joint Resolution Opposing Federalization of Insurance Regulation

Governor Rick Perry today signed a joint Senate and House resolution of the 80th Legislature affirming support of continued state regulation of the insurance industry and opposing pending congressional legislation that would allow federal chartering of insurance companies.  See Federal Regulation of Insurance Industry.  The Independent Insurance Agents of Texas (IIAT) drafted the resolution sponsored by Texas State Sen. Kip Averitt and State Rep. Craig Eiland.  The resolution emphasizes the advantages of state regulation because it provides stronger consumer-protection laws and more streamlined and  prompt attention to problems.

IIAT President-Elect Frank Swingle announced his support for the resolution saying that, "Independent agents understand the need for efficient and effective regulation of our business, but we don't believe that that can be achieved in Washington, and neither do Texas lawmakers."  The resolution is being distributed to President George Bush, U. S. representatives and senators, as well as selected senior officials.  For a fuller discussion of this resolution see Insurance Journal: "Gov. Signs Texas Agents' Resolution Opposing Federal Regulation"

Another “Additional-Insured” Coverage Riddle: Court Misses Key Distinction

Aubris Resources, LP, f/k/a United Resources, L.P. v. St. Paul Fire & Marine Ins. Co., (N.D. Tex.  July 26, 2007)

 

In this case, it appears both the court and the additional insured may have missed the key issue in determining whether an insurance company had a duty to defend an additional insured.  United Resources (“United”) entered an Oilfield Services term Agreement with J&R Valley Oilfield Service, Inc. (“J&R”) in which J&R agreed to purchase liability insurance and add United as an additional insured to the policy.  The agreement also contained several indemnity clauses including one requiring United to indemnify and hold harmless J&R for liabilities caused by United’s negligent acts.  (Note well: as discussed below, this indemnity is not enforceable and will not in fact obligate United to indemnify J&R.  For as fuller discussion of this vexed issue under Texas law, see Risk Shifting Agreements Article).  J&R procured a policy issued by St Paul Fire and Marine Insurance Company (“St Paul”) that contained an endorsement adding United as an additional insured to the policy.  However, the endorsement excluded “obligations for which United has specifically agreed to indemnify [J&R].”

 

A J&R employee was injured at the work site and later died.  His family and estate sued United for negligence.  The plaintiffs initially sued J&R but later dropped it from the lawsuit.  United sought defense and indemnity from St Paul who denied coverage based on the indemnity exclusion.  St Paul argued that the lawsuit alleged a claim for which United was required by the Oilfield agreement to indemnify J&R, which falls squarely within the exclusion.  The court agreed.

 

The court held that that United had agreed to indemnify J&R for United’s negligence.  The plaintiffs alleged that United was negligent.  The policy excluded claims for which United was obligated to indemnify J&R.  End of story.  No coverage.  But no one in the case, neither United nor the court, focused on the fact that the indemnity fails to meet Texas’s “fair notice” rule that an indemnity must expressly state that it covers the indemnitee (J&R) against the indemnitee’s negligence.  The Oilfield Agreement protects J&R only against the indemnitor’s negligence and so fails to pass muster under Texas law.  United would be justified in refusing to defend or indemnify J&R against any claim seeking legal liability against J&R. 

 

Therefore, the lawsuit is not an “obligation” of United to defend or indemnify J&R and should not trigger the indemnity exclusion in the policy.

New York Regulators Allow Marsh to Amend Settlement

As reported in a story by Lavonne Kuykendall in today's Wall Street Journal, Marsh & McLennan Cos. announced an amendment to the 2005 settlement of contingent-fee and bid-rigging litigation brought by then New York Attorney General Eliot Spitzer.  The settlement required Marsh to give up more than $800 million a year in revenue from contingent fee commissions, often ill-disclosed payments by insurers to brokers for volume business.  Contingent commissions have been renounced by many in the risk industry, including the Risk and Insurance Management Society, an association of risk managers.  See Blog on RIMS Call to End Contingent Fees. 

The amendment will allow Marsh to charge insurers for services it provides to customers, if those charges are fixed at the time the policy is written or renewed.  This is the second amendment to the settlement.  In August 2006, New York regulators permitted an amendment to allow Marsh to accept commissions from insurers where Marsh worked for the insurer in the capacity as a managing general agent or underwriting manager.  Marsh competitors, Aon Corp. and Willis Group Holdings executed similar amendments in 2006 and expect to obtain a similar amendment to the one announced today.

5th Circuit Pours Out Katrina Insurance Claims: Holds Flood Exclusion Unambiguously Bars Coverage

Most of the insurance lawsuits for property damage caused by Hurricane Katrina, both personal and commercial, hinge on the application of an exclusion for damage caused by flood.  The Fifth Circuit Court of Appeals in New Orleans yesterday settled that question in favor of insurers.  See  In re Katrina Breaches Litigation.  In most cases, the lions share of the property loss was caused by inundation after the canals and levees failed rather than the direct effects of wind and rain on homes and offices.  The policyholders argued that the levees failed in part because of negligent design, construction, and maintenance of levees along three canals.  The flood exclusion, they argued, was never intended to exclude damage resulting from human negligence.  The court, applying Louisiana law held that the policy exclusion was unambiguous and excluded damage caused by flood regardless of what caused the flood.

House Committee Takes a Step Closer to Renewing Terrorism Reinsurance Bill

A week after the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises voted to extend the federal terrorism reinsurance law (see my post at Subcommittee Action), the House Financial Services Committee voted 49 to 20 to extend the 2002 legislation for an additional 15 years against the desires of the Bush administration.  If passed, H.R.2761 will expand federal participation in backstop insurance coverage losses caused by domestic as well as foreign acts of terrorism and will include coverage against nuclear, biological, chemical and radiological attacks, a provision not welcome by all insurers. 

The Bush Administration has opposed attempts to continue and expand the government program, while the insurance industry has been largely supportive, and argues that the federal backstop is necessary for the private market to be able to insure properties in locations at high risk of a terrorist attack.  The administration has urged that the government should not continue to be involved in the private market.  For a fuller discussion of this matter, see Insurance Journal.

Indiana Appellate Court Holds That Companies Acquiring a Predecessor May Seek Coverage From the Predecessor's Occurrence-based Liability Policies Even Without the Insurers' Consent

Most commercial general liability (CGL) insurance policies contain anti-assignment clauses stating that the policyholder may not assign the right to receive proceeds and other policy benefits to another without first obtaining the insurer's consent.  Up until a few years ago, the law of most states was that once a covered loss had occurred, the anti-assignment clause would not prevent the transfer of insurance rights to a purchaser.  Take, for example, fire insurance on a house.  If I purchase an insurance policy on my house and sell the house to another, the insurer may refuse to cover a fire loss if the house burns down after the sale.  The reason for this is that the insurance company has the right to decide whether the owner is a worthy risk.  The insurer has the right to decide if I am a careful property owner who will take care to avoid fire risks.  The person buying my house may not be so careful, so the insurer has the right to refuse to transfer the policy benefits to someone else.  But if the fire occurs before the sale, then arguably the insurer should not be able to refuse to pay for the loss, even to the purchaser, because the risk at the time of the loss was the same as the insurer had originally bargained for.  That, at any rate was the majority position.

In 2003, the Supreme Court of California reached a different conclusion in Henkel Corp. v. Hartford Acc. and Indem., 62 P.3d 69 (Cal. 2003), holding that rights to coverage under a CGL policy could not be transferred without the insurer's consent, even though the covered event had occurred before the sale of the policyholder to a successor company.  The Henkel court's reasoning was based on fairly arcane principles of property law that boiled down to a determination that a right to liability insurance proceeds was freely transferable (without the insurer's consent) only after that right was reduced to a fixed monetary sum.  The benefits due under a CGL policy are the right to a defense of a lawsuit and payment of a judgment or settlement of covered liabilities.  Those rights are reduced to a fixed amount only after a lawsuit is brought and resolved.  When one company purchases another, the purchaser usually assumes the seller's existing liabilities that arose out of conduct that may have occurred years before the sale.  Occurrence-based CGL policies cover liability-causing events occurring within the policy period, so the purchaser expects to receive, along with the seller's liabilities, the benefit of the seller's CGL policies in effect at the time of the occurrence.  The purchaser then must face the post-sale lawsuits for those pre-sale liabilities.  The Henkel case denied the purchaser the right to coverage without the consent of the insurer.

Now, the Indiana Court of Appeals has reached an opposite conclusion in Travelers Cas. and Sur. Co. v. United States Filter Corp., 2007 Ind. App. LEXIS 1661 (July 24, 2007).  In this case, U.S. Filter Corp. had purchased a company that had changed hands several times in the past but had continuously manufactured a product known as a "wheelabrator blast," a piece of heavy machinery that throws off silica as a by-product, thereby creating lots of silicosis liability over the years.  The court took note of the California precedent but cited a U.S. Supreme court case, Century Tablet Mfg. Co. v. United States, 94 S. Ct. 2516 (1974) for a distinction between the assignability of rights to insurance proceeds as opposed to other contract rights.  The key distinction is that, once a covered loss has occurred, the casualty is fixed and cannot be rescinded in the same was that an executory contract to sell may be rescinded.  Therefore, the Indiana court held that the purchaser obtained rights to coverage when it received the predecessor's liabilities.  The anti-assignment clauses in those CGL policies did not cut off rights to coverage because the covered occurrence were fixed at the time of sale.

It remains to be seen which way courts in other states will go.  For the record, Texas has long been in the minority holding that an anti-assignment clause prevents a purchaser from obtaining coverage even if the occurrence preceded the sale.  See Insurance Co. of Penn. v. Hutter, 2001 U.S. Dist. LEXIS 5800 (N.D. Tex. 2001).