Defect or damage: Pragmatism needed in construction claims

Zurich recently hosted a webinar on the tricky and uncertain field of damage or defect claims in the construction sector. Exclusions are used to define the scope of cover available under an all-risks policy and try and bring more contract certainty. But, at the end of the day, collaboration and pragmatism are also needed from all parties to reach satisfactory results.

The fine and often blurred line between damage and defects in construction claims remains a highly uncertain area for risk managers with exposures in this high-value sector, who need to choose their partners wisely as a result, according to Bernadette Hackett, global relationship leader and head of the global construction industry community at Zurich Insurance in London.

Ms Hackett recently hosted a webinar on this important topic along with colleague Christopher Lynch, head of property and construction claims at Zurich France; Marcus Gresham, managing director of Charles Taylor Adjusting; and Stephen Tester, partner at CMS Cameron McKenna LLP.

Ms Hackett explained that the dividing line between defects and damage is important but can be difficult to distinguish on some construction claims. She explored the challenges that this often unclear and potentially expensive distinction can present, and how they can be overcome in practice.

“Without doubt, defects is one of the trickiest areas to establish cause of loss, who it is attributable to and whether you have some form of recourse,” said Ms Hackett.

Material damage covers – such as those found under a contractors’ all-risks (CAR) policy – do, of course, protect a project’s physical assets against unexpected damage. But it is imperative for the insurance manager to be aware that this policy is not intended to guarantee quality of work by covering losses that result solely from defects, explained Ms Hackett.

Problems that are caused by ‘pure’ defects are primarily a contractual issue, or one for the responsible party’s professional indemnity insurer. When defects have caused damage, a CAR policy is triggered and the cover available is determined by exclusions in the wording, she added.

“Distinguishing between defects and damage is therefore important for determining whether, and the extent to which, there is recourse under a material damage cover,” explained Ms Hackett.

“However, the dividing line between these concepts is not easy to distinguish in practice and often presents complex challenges on construction claims that involve defects,” she said.

The situation has improved for insurance managers in recent times. Historically, the CAR market was unwilling to provide cover for damage resulting from defects. But the position has improved during the last 35 years and CAR policies now provide broad cover for such damage events.

The scope of cover available is determined by exclusion and this is where the insurance manager needs to read and understand their policy carefully to avoid future nasty surprises and difficult conversations with the CFO.

Ms Hackett explained that a policy’s defects exclusion is typically drawn from one of two established sets of London market wordings – the London Engineering Group defects clauses (LEG) or the London market defects exclusions (DE). She added that while these are exclusions, some of the clauses contain important “write-backs” that address how the policy will respond to claims for damage caused by defects.

The LEG and DE wordings give policyholders the option to buy incremental cover for events involving defects.

The broadest exclusions within each set (LEG1 and DE1) are absolute defect exclusions. The narrowest exclusions (LEG3 and DE5) preserve cover for resultant damage, but exclude any costs that improve on the original design, plan, specification or materials.

“In the large project and major contractor insurance market, few, if any, ever choose to completely exclude damage caused by defects,” explained Zurich’s Mr Lynch. “I have personally never seen a policy that contains narrower exclusions than LEG2 or DE3. Most customers will buy a policy that covers consequential damage to non-defective property, or opt for even wider coverage (LEG3, DE4 and above) in return for an enhanced excess and additional premium.”

Mr Lynch gave an example to illustrate the kind of questions that insurance managers need to consider.

A defective mix of concrete can result in low-strength concrete within a pile that then causes a piled wall to collapse. This kind of event means it is difficult to distinguish between defect and damage because they are often so closely intertwined. To make matters more complicated, each increment of the LEG and DE clauses introduces further distinctions and thus can require a very complex factual analysis to establish the extent of recovery available.

“You need to first separate out and attach costs to a number of distinct concepts. These might include: defective property; property free from defects; the constituent part deemed to be defective; consequential damage; and aspects that might be considered improvements,” explained Mr Lynch.

“While this can be relatively simple, circumstances can easily arise where these distinctions are not so easy to make, which creates uncertainty over what is and what is not excluded by these clauses,” he added.

Concrete can be especially challenging because it is unlike a piece of machinery where a defective bolt and the resultant damage caused are easily separated.

Concrete defects can stem from a range of sources that are difficult to identify and the resultant structures frequently intertwine with other insurable property.

Given the various clauses that are typically bought, it is clear how uncertainty can easily arise for even the slightest variation in circumstances.

Challenges can easily arise when applying these LEG and DE clauses. Unfortunately, very few judicial decisions actually exist to offer any meaningful guidance, explained Mr Lynch.

“While lack of litigation is usually an indication of clarity, the opposite is actually true for the LEG and DE clauses. In fact, because such ambiguity exists there is, understandably, a preference to settle claims on a pragmatic basis in order to avoid the uncertainty of litigation,” he added.

“It would take cases at Supreme Court level to deliver ultimate clarity, which looks an unlikely development. In the meantime, it is therefore down to insurers, brokers and policyholders to work together and find appropriate solutions when challenges do arise,” continued Mr Lynch.

The bottom line is that brokers and their clients choose the LEG and DE clauses to determine an appropriate level of protection against damage caused by defects.

“When the situation is clear cut, and recovery is not available under material damage cover, we will always be open with the customer and broker about this from the outset,” said Ms Hackett.

“There may still be other sources of recovery available – perhaps in contract, or via other insurance covers, such as professional indemnity – and we will prompt our brokers and customers to consider these and take further advice where appropriate,” she added.

“Crucially, when the coverage position is unclear and the application of these clauses presents challenges, we have to work collaboratively and find a solution. We are in the business of paying claims, and we always start from that position. We work hard to form genuine relationships with our brokers and customers so that when such challenges do arise, we can work together to find a constructive solution,” concluded Ms Hackett.