Recent ruling risks causing problems for construction policyholders as insurers move to restrict cover

Work is underway to review “egregiously ambiguous” insurance clauses that tackle construction defects after an unexpected ruling in the US raised fears that cover for damaged buildings under construction all risk (CAR) policies could become limited or withdrawn altogether.

Experts at our recent Construction Risk Management Europe Conference explained that members of the London Engineering Group (LEG), a consultative body for insurers, will soon deliver a definition of damage that will hopefully suit all parties, clear up some of these problems and help maintain cover. They added that discussions over new wordings for LEG3 and related clauses, which are various construction defects exclusions, are ongoing and will hopefully deliver a long-term solution.

Almost 30 years ago, LEG created a set of defects exclusions for contract works policies that provide different levels of coverage for damage caused by construction defects.

Last September saw the world’s first court decision on the most generous of the three clauses, LEG3, and it sent shockwaves through the construction insurance market.

In short, a US Federal District Court ruled in favour of insurance buyers and against insurers that were attempting to restrict coverage under LEG3 after finding the wording was “egregiously ambiguous”.

The ruling in South Capitol Bridgebuilders (SCB) v Lexington Insurance Company substantially broadened the generally accepted interpretation of LEG3 cover and led to moves to quickly adapt the wordings in a bid to stop insurers pulling back from CAR cover, particularly in the US, where the product is known as Builder’s Risk.

SCB was hired to build the new Frederick Douglas Memorial Bridge, which is the biggest public works project in the history of the District of Columbia. The design involves three consecutive steel arches on either side of the bridge, which are supported by concrete abutments on either side of the river, and by two v-shaped concrete piers that provide support towards the centre of the river.

The concrete was placed in each of the abutments and piers in separate pours, with workers standing within the formwork and vibrating the concrete in order to achieve even placement. But because the vibration was inadequately carried out, the concrete never achieved its desired effect. So when the concrete had dried and the formwork was removed, the policyholder saw that the concrete contained voids, referred to as “honeycombing”. The honeycombing diminished the concrete’s weight bearing capabilities, and meant that the concrete had to be repaired so that an even distribution of concrete, without honeycombing, was achieved.

SCB submitted a claim on the basis that the honeycombing constituted “damage” and triggered the main insuring clause in its policy, which was not excluded by LEG3.  Lexington refused indemnity.

The judge in the District of Columbia had to rule on three key issues.

• Did the honeycombing of the concrete components constitute damage, so as to trigger the main insuring clause of the policy?
• Is the meaning of the LEG3 clause unambiguous?
• If the meaning of the LEG3 clause is ambiguous, how should that ambiguity be resolved?

The judge ruled that the honeycombing was damage rather a defect and that LEG3 is “egregiously” ambiguous.

While this might seem like a decent result for insurance buyers, David Pryce, senior partner at Fenchurch Law, which only works for policyholders and brokers, said the “unbalanced ruling risks meaning cover for damaged construction works is withdrawn altogether” and so clearly isn’t the good news that it first appears.

“I am on record, unusually as policyholder representative, saying I don’t think the policyholder should have won in this case and I think it is dangerous that they did. It’s not just a problem for insurers, it is a problem for policyholders as well,” said Pryce, who specialises in construction risks.

“That is a huge problem from a policyholder perspective because when my clients buy a CAR policy or a builders risk policy, they want the best cover available. LEG3, along with DE5, provides the best cover in the market. If insurers are going to begin withdrawing the availability of LEG3, that is a huge problem,” he explained at the event, held in association with UK risk management association Airmic, IMIA, LEG and the IRM.

“And South Capital causes another problem because it gives rise to the question of whether US courts are going to construe what damage means under a builders risk policy to actually encompass things we wouldn’t regard as damage but merely property that was in a defective condition. This could cause an even bigger problem, with builders risk insurers potentially deciding not to provide any cover at all because clearly none of them are interested in providing cover for property that is merely defective,” added Pryce.

He stressed that it is therefore in the interest of all parties to sort the problems out.

Fellow speaker Darren Smart, who is a former chairman of LEG but stressed he was not speaking on behalf of the group, said the SCB ruling was so damning of LEG3 that the international construction market is effectively withdrawing the “damaged” LEG3/06 wording from its library of clauses. “So we have to find a way to get around this,” said Smart, who is global head of construction at Allianz Commercial.

He explained that a LEG working group is addressing the problems thrown up by the ruling and looking to improve matters going forward.

“The LEG working group is in progress. Level one was responding to the judgment. Level two is the release of a definition of damage, and that is, hopefully, imminent. The underlying work is the reworking of those clauses,” said Smart.

The LEG is progressing with its work to address a definition of damage and review the existing suite of defects clauses.

The two experts from across the risk transfer divide are in agreement that the LEG clauses are poorly written.

“LEG3 is not brilliantly drafted. That is clear to everybody,” said Pryce.

“LEG3 is not ambiguous in my view. Read solely on its own, it is not ambiguous. But without a shadow of a doubt it is poorly worded. LEG2 and LEG3 are consistently shot at around the world for their use of language. It needs some simpler, plain language,” added Smart.

LEG’s statement on the judgement was as follows: “CAR and EAR [Erection all risks) policies are no guarantee of the quality or conditions of the works, and do not provide cover for defects.” But the very fact the LEG is having to issue such statements indicates that something needs to be done with these wordings, said Smart.

He and the insurance industry are clear that they consider the honeycombed concrete to be defective and not damaged.

“Pouring concrete effectively, correctly, so it doesn’t contain those flaws, is the fundamental entrepreneurial risk of a contractor. There is not an insurance policy designed specifically to pick up the risk of that work being done incorrectly in the first place. Having to do it again because you didn’t do it right is not something that is insured under a CAR or EAR builders risk contract works policy. That fundamentally is where the construction insurance market disagrees with the judgement and fundamentally is where we find ourselves having to reassess the adequacy of those clauses,” said Smart.

“So the number one issue that insurers are looking at now is ensuring there is an effective damage definition in every single policy,” he added.

Pryce also feels that the concrete was defective rather than damaged. While the lawyer says the ruling has thrown up problems for policyholders and insurers alike, he believes there can be a positive outcome if the market and its clients work towards a solution together.

“It has shone a light on an issue that we all probably knew about,” he said. “So for me the positive spin is to prompt us to redraft LEG3 and the other LEG clauses.”

Pryce has suggested a new LEG3 wording that he argues would make clear that insurers are covering the cost of fixing damaged but not defective property. It reads simply: “The insurer shall not be liable for that cost incurred to improve the original material, workmanship, design, plan or specification”. Pryce believes that is exactly what LEG3 intends to exclude.

And he believes there is an opportunity to go one step further and “overhaul” all of the LEG clauses and simplify the entire set of defects exclusions.

“Why don’t we overhaul the defects exclusions entirely? Because at the moment, we have two sorts of exclusion: the LEG clauses, which were always intended for EAR but are now used for a variety of CAR as well – and we have the DE clauses, which were originally intended for CAR policies but we never see in some parts of the world, such as the US. This is an opportunity for us to trim this down to a single suite of defects exclusions,” he said.

“We could start by creating one clause that deals with causation. LEG1 and DE1 are exactly the same currently and we only need one of those. You finish with a clause that deals with the cost of improvement – LEG3 and D5 do exactly the same thing. We only need one. Then there would be intermediate clauses concerned with property that has defective conditions before the damage accours. There you do need two different approaches, so keep LEG2 but have it specifically for EAR, and then you have a LEG2 CAR that could be modelled on either DE3 or DE4,” he added.

Smart said some of these suggestions have “real merit”, indicating a willingness on the part of the insurance industry to engage with buyer side representatives on this issue.

He also believes there could be the need to come up with a specific defects clause for concrete.

“Maybe it is no coincidence that the big issues that have been brought to the table over the last six months relate to concrete. Maybe the issue here is there needs to be some further thought into crafting some form of insurance defects response with regards to concrete. Concrete is meant to crack. We are going to have to deal with that,” he concluded.

Aon was the headline partner at our Construction Risk Management Europe conference. CCi a Rimkus company, Zurich, Allianz, QBE, Swiss Re Corporate Solutions, Hawkins, HDI, Scor, Wint Water Intelligence, Descartes and Fenchurch Law were also partners.

We will host our second Construction Risk Management Asia Conference in Singapore on 17 October. To find out more click here.