When the damage counts - "Physical damage" trigger in insurance policies

Cover under Contractor's All Risks insurance policies and Material Damage policies is typically triggered by 'physical loss or damage' to the property insured. Similarly, cover under third party liability policies might be triggered by the insured being legally liable to a third party for 'physical damage' to their property. If there is no 'physical loss or damage', then there will be no cover under the policy. If there is 'physical loss or damage', you then need to look at the other policy terms to see if the policy will respond – the cause or the amount of the loss may be excluded by a specific policy exclusion or deductible. Sounds straightforward enough, but disputes can and do arise as to whether 'physical loss or damage' has occurred so as to trigger insurance cover. This article considers some of the recent English cases which give useful guidance on how those disputes will be resolved.

What does 'physical loss or damage' mean?

You might think the answer is obvious and in most cases it is. If someone accidentally drives a bulldozer into a wall causing the wall to collapse, common sense will tell you that the wall has sustained 'physical damage'. But the answer isn't always so obvious. To take a couple of examples:

1. 100 defective blocks are used in the construction of a wall, is that on its own sufficient to constitute 'damage'?
2. A wall is accidentally painted red instead of green, is it 'damaged'?

The recent court decisions suggest that the answers would be (1) No where the blocks do not cause or sustain ensuing damage as a result of the defect; and (2) Yes (but 'damage' having occurred, you would then need to check if cover is excluded by another provision in the policy such as a specific defects exclusion)(Footnote).

Guiding principles

To work out if there has been 'physical loss or damage' sufficient to trigger insurance cover, the first place to start is with the policy wording. It may define 'physical loss or damage'. Assuming it doesn't, then the term will be interpreted to have its everyday meaning in the context of the policy. There are no hard and fast rules here but the following general principles can be derived from the decided cases to assist you in working out if 'physical loss or damage' has occurred:

• For there to be 'damage', there must usually be a physical alteration or change in the property insured (for example, in its appearance, shape, colour or other physical characteristics).
• The change must usually impair the value, usefulness or normal function of the property said to be damaged (but note, this no longer appears to be a strict requirement, at least in the case of third party liability policies that provide cover for liability for damage to third party property).
• The change does not necessarily have to be permanent or irreparable to constitute 'damage', but mere temporary loss of use is probably insufficient.
• If the insured property merely loses value, that is not sufficient on its own to constitute 'physical loss or damage'.
• The physical loss or damage must be fortuitous to be recoverable. Expected or intended damage sustained as a result of voluntary conduct of the insured would not normally be covered because it does not happen by chance, but by choice of the insured.

AMEC Engineering v Norwich Union (2003)

The first and last points above have been emphasised in the recent Technology and Construction Court case of AMEC Engineering v Norwich Union, in which Judge Seymour QC decided that AMEC was not entitled to recover from its insurers costs incurred in knocking down a sea wall in order to remove and replace defective blocks installed in that wall.

Facts

When AMEC originally built the sea wall for the Government of Jersey, AMEC had (non-intentionally and non-negligently) installed 104 pre-cast concrete blocks that did not comply with the contract specification due to inadequate cover of reinforcement. The Jersey Government required AMEC to 'break out' the defective blocks and replace them with blocks that complied with the specification. AMEC argued that the cost of doing this was covered by its insurance because the principal insuring clause in its Contractor's All Risks policy provided AMEC with an indemnity in respect of "loss of or damage to the insured property" which included the sea wall.

Decision

The Judge thought it was quite plain that the principal insuring clause in the policy did not extend to providing AMEC with an indemnity in respect of the cost of replacing items manufactured by AMEC which were defective. He said:

"Items which have been produced by AMEC during the course of its business which are merely not up to the standard required by a particular contract, as was the case with the blocks AMEC replaced, cannot be said to have been lost and cannot in any meaningful sense be said to have been damaged."

The damage inevitably sustained to the 104 blocks and the rest of the sea wall during the process of 'breaking out' and replacing the defective blocks was not covered by the policy because it was not fortuitous but was an ordinary consequence of AMEC's voluntary conduct in replacing the defective blocks. On this, the Judge said that:

"It would be a bizarre result if AMEC could fail to perform its obligations under the contract by manufacturing and installing defective blocks, an ordinary commercial risk of the type run by civil engineering companies in the course of their business every day, and then claim the cost of necessary rectification work under a Contractor's All Risks policy on the ground that the removal of the defective work so that it could be replaced with work of the quality required by the contract involved 'damage' to the defective work."

Note

If AMEC had suffered a loss due to ensuing damage caused by the defects in the blocks, e.g., if the defects had caused the sea wall to collapse, it is arguable that AMEC should have been entitled to its costs of repairing the sea wall. Coverage in such an instance will depend on the terms of the defects exclusion in the policy. As it was, no damage had been sustained to the blocks or the sea wall by the time the remedial works came to be carried out, apart from rust staining in some only of the blocks. There was a policy exclusion relating to rust and in any event, the Judge held that the rust damage did not cause any loss to AMEC because the rust stains were not the reason that the Jersey Government had required AMEC to replace the defective blocks.

Other recent cases concerning the meaning of 'damage' to property

Jan de Nul (UK) Ltd v AXA Royale Belge SA (2002)

In this case, the Court of Appeal decided that in the context of a third party liability policy, the mere deposit of unasked-for silt on land amounted to property damage, even though the silt did not adversely affect the value or use of that land.

The policy covered the insured for liability to a third party resulting from "damage to, destruction or loss of property". This was held sufficient to cover costs incurred by the Hampshire Wildlife Trust (the third party) to find out if the unasked-for silt deposited on its marsh had an adverse effect on the marsh's use as a feeding ground for waterfowl. The investigation actually found that no long term damage had been sustained to the marsh and there was no need to remove the silt. Accordingly the insurers had argued that the costs of the investigation could not be described as resulting from 'damage' to property. The Court of Appeal disagreed and said that:

"Damage is not an entirely objective concept purely related to value…If a skilful painter overpaints X's daubs unasked, he inflicts property damage for the purposes of this policy even if the world will pay more for the canvas now than it would have done before he came on the scene. If a lump of concrete is dropped on X's car, property damage has been inflicted even if someone can persuade an avant-garde gallery curator that the resultant object is a work of art worth more than X overpaid for the car. What if anything X can recover is a separate question…"

The result suggests that the second rule referred to above is not an absolute one - at least in the context of third party liability policies, 'damage' may be said to have occurred even though the value, usefulness or normal function of the property is not in any way impaired. It remains to be seen whether this principle will be extended to apply to claims under Contractor's All Risks or material damage policies.

Quorum v Schramm (2001)

This Commercial Court case concerned material damage cover of a Degas pastel worth several million pounds. The painting was stored in a strong room in a warehouse that caught fire. The fire did not get into the strong room but the painting was exposed to heat from the fire and humidity from water used to put out the fire. Experts gave evidence that these sudden environmental changes had caused irreversible sub-molecular changes to the painting at a chemical level, which gave rise to the risk of deterioration and shortening of life of the painting.

The insurance policy provided cover for "direct physical loss or direct physical damage of whatsoever nature" to the property insured. While confirming that the policy did not cover depreciation in value due to suspicion of physical damage, the Court was satisfied that the sub-molecular changes constituted 'direct physical damage' to the painting even though the damage was not visible and its extent could not be determined without testing which could not be carried out because testing would itself have damaged the painting. The insured owner of the painting was awarded £1.4 million representing the diminution in value of the painting due to its damaged physical state.

James Longley and Company Ltd v Forest Giles Ltd (2001)

This Court of Appeal case concerned a sub-contractor's third party liability policy relating to the construction of a new building at the University of Surrey Research Park. The vinyl flooring laid by the sub-contractor had a wrinkled or bubbled effect because the adhesive used had not adequately cured due to excessive moisture in the underlying Lytag screed. The main contractor spent £68,000 on remedial works to fix the flooring and paid the developer £160,000 in settlement of the developer's claim for damages arising from delay attributable to the bubbling effect in the flooring. The Court held that these sums were not recoverable under the policy.

The policy provided the insured (which included both the sub-contractor and the main contractor) with cover for sums which the insured was liable at law in respect of "damage to property". As the policy contained exceptions for defective products supplied by the insured and liability in respect of damage to property belonging to the insured, the Court held there was no relevant damage to third party property sufficient to trigger the insurance. If there was any 'damage', it was only to the vinyl floor and possibly the screed itself, these being products supplied and works performed by the sub-contractor and not third party property (e.g. property belonging to the main contractor or the developer). There was no resultant damage to any third party property and so there was no cover – it was simply the case that the works performed by the sub-contractor were defective and had to be redone. The Court noted that:

"it is not the usual intention, in a contractor's public liability insurance, to give cover in respect of defective workmanship which requires rectification but does not cause physical damage to the personal property of a third party or interference with a third party's property rights, as opposed to their purely economic interests."

Conclusion

The recent cases give some useful guidance as to what does and does not constitute 'physical damage' for the purpose of triggering insurance cover, a distinction on which substantial sums can turn. Both the AMEC and James Longley cases also serve as a reminder that "all risks" insurance policies and third party liability policies do not actually cover off all risks associated with faulty workmanship and design and are not intended to operate as a warranty or guarantee against design and construction defects. The fact that works are defective does not necessarily mean that they are damaged, and unless there is 'physical loss or damage' to property, there will generally be no insurance cover for the cost of repairing defects.

Footnote

Some defects in all risks insurance policies exclude cover for losses caused by faulty workmanship, design, plan or specification.

For further information contact Sonia Tame at [email protected]