Legal Year in Review

Throughout 2009, there have been several important and interesting cases that will likely impact various sectors of the insurance industry. While this piece is not intended to be a complete review of all 2009 insurance cases, it will provide a quick summary of some of the important cases decided by courts around the country in 2009.

Auto Owners Insurance Company v. Virginia T. Newman,
2009 WL 2851211 (S.C., September 8, 2009)

In recent years, construction-defect coverage litigation has quickly become a hot topic in insurance law. While some states' courts have yet to address this issue, the majority of jurisdictions that have addressed it are split as to whether faulty workmanship constitutes property damage caused by an occurrence under the coverage grant of a traditional commercial general liability (CGL) policy.

A recent decision by the South Carolina Supreme Court may represent a considerable shift with respect to the state's analysis regarding insurance coverage for claims based upon allegations of faulty workmanship. While Auto Owners Ins. Co. v. Newman has not yet been released for publication and, therefore, is still subject to revision or withdrawal, the court in Auto Owners distinguishes its holding from prior South Carolina Supreme Court's holdings, particularly L-J v. Bituminous Fire & Marine Ins. Co., 621 S.E.2d 33 (S.C. 2005). It is also important to note, however, that the court did not overrule and/or criticize its previous holding in L-J.

In Auto Owners, a homebuilder's general commercial liability insurer sought a declaratory judgment that its policy did not provide coverage for a homeowner's claim for damages caused by the negligence of a construction subcontractor relating to the installation of stucco siding. According to the complaint, “the application of the stucco did not conform to industry standards,” and permitted water to seep into the home and cause severe damage to the home's framing and exterior sheathing. The insurer disclaimed coverage for the homeowner's claim. Specifically, the insurer argued that the South Carolina Supreme Court's previous holding in L-J precluded coverage for property damage caused faulty workmanship because such property damage was not caused by an occurrence.

In L-J, a developer hired a general contractor to perform the site development and road construction for a project. The general contractor then hired subcontractors to perform the majority of the work. However, after construction was completed, the roads began to deteriorate allegedly as a result of negligent road design, preparation, and construction. The developer then filed suit against the general contractor. The general contractor's insurer disclaimed coverage for the developer's claims. The general contractor then filed a declaratory judgment action against its insurer. Specifically, the general contractor claimed that its insurance carrier was obligated to cover the damages associated with the deteriorating road.

The South Carolina Supreme Court found that, although the deterioration to the roadways may have constituted property damage, the various negligent acts of the subcontractors upon which the developer based its claim did not constitute an occurrence for which the policy provided coverage. Specifically, the court in L-J concluded that because the negligent construction only caused damage to the defective work product itself, (i.e., the road), such a claim was merely for faulty workmanship. Thus the court in L-J held that, because faulty workmanship is not something typically caused by an accident or by exposure to the same general harmful conditions, the developer's claim did not allege an occurrence.

In Auto Owners, the South Carolina Supreme Court distinguished the facts presented in Auto Owners from the facts presented in its prior holding in L-J. Specifically, the court in Auto Owners held that the fact that “the defective stucco allowed for continuous moisture intrusion resulting in … damage to the home's exterior sheathing and wooden framing … establish that there was 'property damage' beyond that of the defective work product itself, and that therefore, the homeowner's claim is not merely a claim for faulty workmanship typically excluded under a CGL policy.”

In support of the distinction discussed above, the court briefly examined the history of the CGL policy in the home construction industry. The court noted that, generally, “[a] CGL policy in the home construction industry is designed to cover the risks faced by homebuilders when a homeowner asserts a post-construction claim against the builder for damage to the home caused by alleged construction defects.” However, the court also noted that CGL policies typically include several construction-specific exclusions designed to exclude from coverage certain types of property damage. In the context of construction-defect claims, a common exclusion at issue is the “your-work” exclusion, which bars coverage for property damage to the insured's work.

However, the court noted that in 1986, the insurance industry amended the “your-work” exclusion to provide an exception if the work was performed by a subcontractor on behalf of the insured. This exception has become commonly known as the subcontractor exception to the “your-work” exclusion. According to the court in Auto Owners, in adding the subcontractor exception, “the insurance industry extended liability coverage for property damage to the contractor's completed work arising out of work performed by a subcontractor.”

Thus, the court held that by interpreting the term “occurrence” in accordance with whether there was property damage beyond the defective work itself would give full effect to the subcontractor exception in the “your-work” exclusion. Consequently, applying the foregoing principles to the facts in Auto Owners, the court held that because the allegedly defective stucco, which was installed by a subcontractor, permitted water intrusion that allegedly caused severe damage to the home's framing and exterior sheathing, which was non-defective, there was an occurrence under the policy.

While the decision in Auto Owners distinguished itself from the South Carolina Supreme Court's previous holding in L-J, the dissent in Auto Owners believed that L-J should have barred coverage for the homeowner's claims. Specifically, the dissent argued that the general contractor's work product was the entire home which included the stucco, framing, and exterior sheathing. The dissent in Auto-Owners agreed with the majority opinion that L-J stated that “there may be coverage where faulty workmanship causes third-party bodily injury or damage to property other than the contractor's work product.” However, because the dissent found that the entire home was the contractor's work product, it concluded that there was no occurrence under the policy.

The dissent's reasoning is in accord with a recent construction-defect coverage decision by the Pennsylvania Superior Court. (See Millers Capital Ins. Co. v. Gambone Bros. Dev. Co., 941 A.2d 706 [Pa. Super. 2007]). In Millers, the court addressed the issue of whether water damage to a home's interior due to faulty workmanship associated with stucco exteriors could constitute an occurrence under a CGL policy. The insured developer in Millers argued that the resulting water damage constituted an occurrence even though the damage due to the faulty exteriors did not.

The court in Millers, however, rejected the insured's arguments and held in favor of the insurance carrier. Specifically, the court held that the underlying complaints alleged claims based upon faulty workmanship in that the homes were allegedly constructed with defective stucco exteriors. In Millers, when these alleged defects manifested themselves, “water damage resulted to the interior of the larger product — in this case, the home interiors.” Thus, because the resulting damage was limited to the insured's work/product — i.e., the entire home — there was no occurrence or accident under the CGL policy.

The Pennsylvania Superior Court's holding in Millers directly comports with the dissent's reasoning in Auto Owners. Specifically, if the general contractor's work/product is the entire home, then there has been no occurrence under an insurance policy if the only damage alleged is based upon claims of faulty workmanship that caused damage limited to the insured's work/product.

Additionally, it is important to note that the court in Millers rejected the insured's subcontractor-exception argument in that if faulty workmanship that results in damage limited to the insured's work/product is not an occurrence, then the subcontractor exception to the “your-work” exclusion would be rendered mere surplus. However, the court in Millers held that the insured's argument completely ignored the policy's coverage grant requirement of an occurrence. Thus, the subcontractor exception was not mere surplus because the policy's coverage grant only covered property damage caused by an occurrence. Consequently, in order to satisfy the policy's coverage grant, the court in Millers held that there must have first been a claim for property damage and/or bodily injury as a result of an occurrence.

At this time, it is yet to be seen what effect the South Carolina Supreme Court's decision in Auto Owners may have on construction-defect coverage litigation in South Carolina. For the time being, claim professionals should generally be aware of the subtle nuances and issues presented in construction-defect coverage cases, as discussed above. As demonstrated by the holdings in both Millers and Auto Owners, courts have taken a different approach with respect to analyzing coverage for construction-defect claims. Therefore, it is important for claim professionals to be cognizant of how courts in their respective jurisdiction have analyzed these issues.

Other Notable Decisions

Following is a list of some other notable and/or interesting insurance law decisions from the past 12 months.

Essex Ins. Co. v. Bloomsouth Flooring Corp., 562 F.3d 399 (1st Cir. 2009)

The First Circuit Court of Appeals, applying Massachusetts law, held that unpleasant odors from carpeting installed by an insured that permeated a building constituted physical injury to property under a CGL policy. Specifically, the First Circuit found that odors can constitute physical injury to property under a CGL policy if the odor is “permeating or pervasive.” (See sidebar below.)

Revelation Industries, Inc. v. St. Paul Fire & Mar. Ins. Co., 206 P.3d 919 (Mont. 2009)

As a matter of first impression, the Supreme Court of Montana held that facts known to an insurer, albeit outside of the complaint, must be considered by the insurer in determining whether it owes a duty to defend. Specifically, the court held that while there is no affirmative duty on an insurer to seek out information beyond the allegations contained in the complaint upon analyzing whether a duty to defend exists, “insurers that look at facts beyond the allegations in the complaint do so at their own risk, as they will be required to defend and/or indemnify based on information discovered.” Thus, an insurer may not simply ignore known facts — whether obtained via its own investigation or supplied to it by the insured — and look solely to the complaint in disclaiming coverage.

Liparoto Constr., Inc. v. General Shale Brick, Inc., 772 N.W.2d 801 (Mich. App. 2009)

The Michigan Appellate Division held that the discoloration of bricks on the exterior of a house after construction did not constitute an occurrence under the contractor's CGL policy.

In Liparoto, the insured general contractor built the brick exterior of a home. The bricks then became discolored because the lime-coating on the bricks reacted with an acid cleaner that the general contractor had used. The court held, however, that there was no occurrence under the policy because the alleged discoloration was confined to the insured general contractor's work.

Piermount Iron Works, Inc. v. Evanston Ins. Co., 963 A.2d 818 (N.J. 2009)

The New Jersey Supreme Court held that the state's administrative regulations — with respect to an insurer's duties upon expiration of an insurance policy — were inapplicable to surplus lines insurers. Specifically, the court held that the regulation's penalty provision that mandated continuation of coverage if an insurer failed to comply with the regulations did not apply to surplus lines insurers.

N.Y. Ins. Law S 3420(c)(2) (McKinney 2009)

On Jan. 17, 2009, the New York statute that required insurers to demonstrate material prejudice in order to disclaim coverage — based on an insured's failure to provide timely notice of a claim or suit — went into effect. “Material prejudice” is defined as that which “materially impairs the ability of the insurer to investigate or defend the claim.” This legislative amendment is important because, previously under New York law, insurers were not required to demonstrate prejudice upon disclaiming coverage based on late notice.

However, the statute as amended essentially utilizes a two-year threshold for considering prejudice. Specifically, if notice is provided within two years of the time required under the policy, then the insurer bears the burden of demonstrating prejudice. If notice is provided after two years from when it was required under the policy, then the burden is on the insured to demonstrate that the insurer was not prejudiced. Notwithstanding the foregoing, if the insured's liability has already been determined by a court or in binding arbitration, or if the insured has resolved the claim/suit by settlement or other compromise prior to any notice to the insurer, then there is an irrebuttable presumption of prejudice.