Builders risk claims routinely involve complicated and aggressive debate about the interplay between covered physical loss and uncovered faulty work. However, denials on this front have recently experienced a noticeable uptick in frequency, creativity, and aggressiveness. The insurer arguments concentrate in two key areas with a common theme – that any damage associated with a construction defect is not covered:
- Defective construction does not qualify as a “physical” loss to trigger the insuring agreement; and
- Any natural results of defective construction are excluded as faulty workmanship, even with favorable LEG 3 or similar language.
Neither of these arguments should impede access to coverage in the majority of scenarios. To ensure as much, it is incumbent on the savvy policyholder to understand the insurer tactics, be prepared to spot them early, and have thoughtful counter positions at the ready to address them decisively.
As it happens, one very recent case did just that – issuing a definitive victory for policyholders on both fronts. More on that a little later.
A Not So “Satisfactory State” – Do Not Pass Go, Do Not Collect $200
Builders risk policies are built on a basic premise – there needs to be a physical event to trigger coverage under the insuring agreement. Though there are a myriad of situations that meet this criteria (including loss of functionality and loss of use fact patterns), the law typically only requires “a distinct, demonstrable, and physical alteration” of the structure or physical appearance of the insured property.1
Most claims involve straightforward, irrefutable property damage, and so the application of this rule for many cases should be simple: one need only identify the “physical” change at issue (e.g., water damage). From there, any questions concerning coverage limitation (e.g., exclusions or sublimits) become the insurer’s burden.
Many insurers have attempted to flip this paradigm on its head and argue that any construction project (or component part thereof) that includes a construction defect from inception has never been in a “satisfactory state” in order to transition to a damaged state. Thus, they contend, the policyholder does not carry its burden to trigger the insuring agreement and the coverage analysis never proceeds past step one of the process (Do Not Pass Go; Do Not Collect $200). For those readers familiar with the evolution of arguments proposing “construction defect is not an ‘occurrence’” under CGL policies, this tactic will sound hauntingly familiar.
However, a careful study of legal history yields the definitive truth: There is no precedent or authority to support this position in the builders risk context.
The Beginning: Satisfactory State Has Nothing to Do with Construction Defects
The argument begins with the 1990 case of Trinity Industries, Inc. v. Insurance Co. of North America,2 where the Fifth Circuit described the physical loss requirement in this way:
[t]he language ‘physical loss or damage’ strongly implies that there was an initial satisfactory state that was changed by some external event into an unsatisfactory state—for example, the car was undamaged before the collision dented the bumper. It would not ordinarily be thought to encompass faulty initial construction.3
Although the court was merely describing the elemental nature of physical change - insurers would later co-opt this phrasing to press a more aggressive, anti-coverage position.
Thirteen years later, the “satisfactory state” language resurfaced in AFLAC, Inc. v. Chubb & Sons, Inc.4 (notably, not a builders risk case). In that case, AFLAC sought declaratory relief under two Chubb policies for remediation costs incurred following conversion of its computer systems from two-digit to four-digit date recognition capability in anticipation of the Year 2000 (“Y2K”) computer problem. The court held there was no coverage based on its view that AFLAC was not seeking coverage for a fortuitous event, but merely “an ordinary cost of doing business—that is, a maintenance and renovation expense in the nature of the cost of upgrading its computer systems and software upon a known design limitation.” As a result, the court ruled that there was no coverage for “sums expended to improve or better property wholly apart from any indemnification purposes.”
The court concluded that the phrase “direct physical loss or damage” contained in an all-risk policy:
contemplates an actual change in insured property then in a satisfactory state, occasioned by accident or other fortuitous event directly upon the property causing it to become unsatisfactory for future use or requiring that repairs be made to make it so.5
However, like Trinity Industries, the AFLAC court denied coverage once again without any analysis taken regarding the initial “satisfactory state” of the covered property. Specifically, was the data in a satisfactory or unsatisfactory state prior to the fortuitous event of “Y2K”, and why? The court performed no analysis of this issue.
More recently, Mama Jo’s, Inc. v. Sparta Insurance Company6 incorporated the “satisfactory state” citation from AFLAC into its opinion. The case revolved around a restaurant seeking to recover from its insurer the costs it incurred from the remediation of the establishment due to the migration of dust and construction debris from construction roadwork adjacent to the restaurant and contended that this dust and debris constituted “direct physical loss” to the restaurant under their policy.
The court disagreed with this characterization and found that the plaintiff could not show that the construction dust and debris caused the alleged “direct physical loss” to their awnings, retractable roof, HVAC system, railings, and audio and lighting system due to lacking expert testimony. Regarding the cleaning of this equipment to maintain a certain standard that would deem it presentable and suitable for its patrons, the court ruled that “cleaning is not considered direct physical loss.”
Once again, despite a citation from AFLAC regarding the implied “satisfactory state” supposedly inherent in determining property damage, Mama Jo’s rejection of property damage and thus coverage did not hinge on any assessment of the initial state of the aggrieved property. Rather, denial of coverage resulted from the inapplicability of cleaning costs in the policy’s definition of “property damage” and the inadmissibility of the “expert” witnesses that plaintiffs put forward.
Another string of cases from 2021 incorporating the “satisfactory state” citation into their opinion involved insureds seeking to recover from losses incurred from shutdowns spurred by the COVID-19 pandemic. These cases, Sun Cuisine, LLC v. Certain Underwriters at Lloyd’s London7, Atma Beauty, Inc. v. HDI Global Specialty SE,8 and Clay Hotel Partnership, Ltd. v. Tokio Marine Kiln Syndicate 1880,9 follow a very similar fact pattern and outcome from the courts. A restaurant, a salon, and a hotel walk into federal court in the Southern District of Florida. All three seek coverage for the loss of business income resulting from the suspension of their businesses during the local government’s shutdown amidst a pandemic.
All three opinions cited “satisfactory state” in their analysis and summarily denied coverage on grounds irrespective of any analysis of the initial “state” of the property before the event. Once more, the denials were grounded in the apparent lack of any physical damage that spurred the loss of business.
Despite the use of the satisfactory state language, there was no actual discussion or analysis of the initial state of the covered property prior to the event and whether or how the event (a pandemic) made the covered property unsatisfactory (i.e., damaged) when it was covered by the COVID-19 virus.
Here is the critical takeaway: These cases do not involve construction, much less the concept of construction defects, and none of them change a simple, immutable detail -- that physical damage is physical damage irrespective of the initial state of property.
Insurers Take Their First Big Swing, and Strike Out: The South Capitol Decision
Unsurprisingly then, when this argument was recently presented to a District of Columbia Federal District Court (applying Illinois law) as a matter of first impression, the Court flatly rejected it.
On September 29, 2023, the Court issued its ruling in South Capitol Bridgebuilders v. Lexington10 ™ The insurance claim involved the compromised structural integrity of the Frederick Douglas Memorial Bridge. Essentially, poor vibration of concrete – necessary to ensure the concrete fully filled into formwork - caused “honeycombing” and “voiding” in the concrete and decreased strength such that the bridge support structures would not be able to support live loads and had to be replaced.
Lexington presented the “satisfactory state” argument to the Court, who rejected the argument and emphatically held that the insuring agreement was satisfied:
- “On the undisputed facts, [Policyholder’s] inadequate vibration caused a decrease in the weightbearing capacity of the bridge and its support structures. A decreased weightbearing capacity is surely an injury, or at the very least a bad effect, on the bridge and its support structures.” (emphasis in original)
- “A change that results in a reduction in the weightbearing capacity of a bridge is an ‘alteration’ to that bridge.” (emphasis in original)
- “…malformities stemming from defects in material workmanship are unambiguously within the scope of coverage.”
- “[Policyholder] purchased an ‘all risk’ insurance policy for construction of a bridge. One such risk, inherent in any complex construction project, is damage from errors of workmanship.”
Lexington even presented much of the case law discussed above. The Court determined that these “cases, while perhaps impressive in quantity, are wanting in relevance.” The cases cited involved Covid-19 closures and claims against CGL policies, which are distinct from builder’s risk policies. Ultimately, the Court gave careful consideration to Lexington’s cited cases and concluded:
Finally, in a footnote, Lexington cites a half-dozen cases— none of which interpret Illinois law—to argue that “damage” in builder's risk insurance contracts requires some “initial satisfactory state” or otherwise precludes recovery for defective construction. Lexington does not bother to explain how these nonbinding cases are analogous or why the court should consider them persuasive. Moreover, the larger issue with this bucket of cases is an issue applicable to all of the cases that Lexington cites: the agreement in this case is simply different. Full stop. No case Lexington cites involves a similar construction project or a similar insurance policy that was similarly modified. The Court must give effect to the intent of the parties before it in construing an insurance policy. Even if it were the case that some other analogous policies have defined damage differently—which Lexington has not demonstrated —Lexington would at best be able demonstrate an ambiguity, which would still be resolved in favor of coverage.11
South Capitol thus is an essential trump card for policyholders to use when confronted with this insurer position. With any good fortune, it will hasten the eventual demise of untenable “satisfactory state” arguments in the context of construction-related risk under builder's risk policies.
LEG 3 Language Does Not Mean What Insurers Think It Means
Many insurers have also advanced arguments for non-coverage via the LEG12 faulty workmanship exclusion – including LEG 3, which is widely accepted as the most policyholder-friendly variation (often requiring additional premium to boot!). A common LEG 3 exclusion provides:
The Insurer(s) shall not be liable for:
All costs rendered necessary by defects of material workmanship design plan or specification and should damage occur to any portion of the Insured Property containing any of the said defects the cost of replacement or rectification which is hereby excluded is that cost incurred to improve the original material workmanship design plan or specification.
For the purpose of the policy and not merely this exclusion it is understood and agreed that any portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship design plan or specification.
The insurer argument is constructed on the final paragraph (“shall not be regarded as damaged…”) and follows the same simple logic as the “satisfactory state” argument: if something begins in a state of defect, it can never be damaged.
Not only does this argument fail analytically, but it flies in the face of common underwriting representations that LEG 3 is intended to be the narrowest version of these types of exclusions, precluding only the cost to improve upon a defect during repairs. All other damage – including the faulty work itself – remains covered.
This result is universally understood throughout the insurance industry. One insurance company’s National Construction Property Director has described its application in this manner, “the measure is to subtract the hypothetical costs of fixing a defect immediately before the damage occurred.”13 Further, the “costs to remedy resultant damage to property supported by defective property” are “typically covered,” and further provides an illustrative example of how the LEG 2 language works:14 Imagine a scenario where project designers miscalculate the stress upon bolts that secure roof panels placed on top of a steel-framed industrial unit, resulting in a collapse. Under common LEG language, the cost to replace the defective bolts would be excluded, but the cost of repairing/replacing the roof panels and walls that suffered damage because of the faulty bolts is covered.
Until very recently, the only case law analyzing “LEG” language came from Canada and the United Kingdom. Those results further confirm this is the correct application. For example, in Acconia Infrastructure Canada Inc., v. Allianz Global Risks US Ins. Co., 2015 BCCA 347 (CanLII), the Court of Appeal for British Columbia found:
that the intent of [the LEG 2 exclusion] is to exclude those costs rendered necessary by one of the named defects, but is limited to costs “which would have been incurred if replacement or rectification of the Insured Property had been put in hand immediately prior to the said damage.” In other words, the excluded costs are only those costs that would have remedied or rectified the defect immediately before any consequential or resulting damage occurred, but the exclusion does not extend to exclude the cost of rectifying or replacing the damaged property itself; the excluded costs crystallize immediately prior to the damage occurring and are thus limited to those costs that would have prevented the damage from happening.
The court summarized and described the application of LEG 2 as follows: it is “not actually an exclusion at all. Rather, it is a deeming clause that provides special treatment of losses or damage caused by faulty workmanship.” Id. at ¶ 64 (quoting PCL Constructors Canada Inc. v. Allianz Global Risks US Ins. Co., 2014 ONSC 7480, at ¶ 23).
The United States court system finally weighed in with South Capitol. In that case, the Court analyzed a Lexington version of LEG 3 (the more expansive and favorable upgrade to LEG 2) – and struggled mightily with its phrasing. Ultimately, the Court reasoned that the language is wholly ambiguous and must, therefore, be construed in favor of the policyholder.
The Court’s commentary can be summarized by the following excerpts:
- “The LEG 3 Extension is ambiguous—egregiously so. To understand this, one need only attempt to read it. In just three sentences, Lexington managed to squeeze in a run-on sentence, an undefined term, several mispunctuations, and a scrivener's error. The Extension is internally inconsistent and bordering incomprehensible. [Policyholder’s] statement that the Extension is ‘convoluted’ is an understatement.”
- “Thus, the Court rejects Lexington's invitation to ignore the unclear and error-riddled language of the Extension, which Lexington drafted, signed, and now seeks to rely on to deny coverage.”
- Describes the exclusion as “tangled” and “tortured”
“The Extension excludes replacement or rectification of costs incurred to ‘improve’ the original workmanship. But what does it mean to ‘improve’ the original workmanship?”
- Lexington argued the repairs of the honeycombing and voiding were “improvements”
- Court said no: “[T]he context of the Extension suggests that to improve means to make a thing better than it would have been if it were not for defective work. In fact, the Extension explicitly distinguishes the ‘cost incurred to improve’ work from ‘the cost of replacement or rectification.’” (emphasis in original)
The short-term, important takeaways:
- The LEG 3 provision does not adopt a “satisfactory state” position, as many insurers argue; and
- It was ultimately construed in favor of coverage, as is the customary underwriting intent.
However, the Court’s commentary is a strong indicator that typical LEG language is not the model of clarity the industry would hope for, and improvements will be needed to better ensure the parties’ intent is properly captured moving forward.
Several aggressive anti-coverage positions are routinely finding their way into even the most mundane Builders Risk claim – claims that should otherwise be promptly resolved and paid to allow impacted projects to proceed without delay. Ultimately, they should serve as no such impediment for the reasons outlined above – with South Capitol a strong supporting signal.
Special thanks to Anna M. Perry and Damian Barquin for their help with this article.
1MRI Healthcare Center of Glendale v. State Farm General Ins. Co. (2010) 187 Cal. App. 4th 766.
2916 F.2d 267 (5th Cir. 1990)
3Id. at 269-270-271
4260 Ga. App. 306, 581 S.E.2d 317 (2003)
5Id. at 319
617-cv-23362-MOORE/MCALILEY (S.D. Fla. Apr. 29, 2021).
72020 WL 7699672, 1:20-cv-21827-GAYLES/OTAZO-REYES (2020)
82020 WL 7770398, 1:20-cv-21745-GAYLES (2020)
92021 WL 6135140, 21-20058-CV-GRAHAM (2021)
102023 WL 6388974, 21-cv-1436 (RCL)
11Id. at 8 (emphasis added).
12London Engineering Group, also known as LEG, is a consultative body for insurers of engineering class risks providing a forum for discussion and education. The group produces various industry recognized papers, coverage clauses, and guidance notes. In this role, LEG develops form insurance language, including language extending the scope of coverage for loss arising from faulty workmanship. This language would be included in the LEG3/06 edition of the form insurance language.
13See Lori Montoya, Property Practice Lead, Zurich North America, Builder’s Risk and the Impact of LEG 3, IRMI Construction Risk Conference (November 7, 2016).
14Here, the endorsement is most similar to a LEG 3 coverage which provides even broader coverage than that of a LEG 3 endorsement.