Impaired Property Exclusion Application
December 28, 2015
The insured brought an action against its insurer to recover for breach of the duty to defend and indemnify the insured. In seeking guidance to determine the outcome of the case, the United States Court of Appeals for the Fifth Circuit certified questions to the Supreme Court of Texas. This case is U.S. Metals v. Liberty Mutual Group, 2015 WL 7792557.
The insured supplied flanges for use in constructing refinery processing units. The flanges leaked and had to be replaced to avoid the risk of fire or explosion. The claimant, ExxonMobil, sued the insured, U.S. Metals, for $6,345,824 as the cost of replacing the flanges and for $16,656,000 as damages for the lost use of the diesel units during the process.
U.S. Metals settled with ExxonMobil and then sought indemnification from its insurer, Liberty Mutual. The insurer denied coverage and the insured sued for coverage. The U.S. District Court entered summary judgment in favor of the insurer and the insured appealed. On appeal, the Fifth Circuit certified four questions to the Supreme Court of Texas: in the policy exclusions, are the terms “physical injury” and/or “replacement” ambiguous; if yes, are the interpretations of the insured reasonable; if the answer is negative as to physical injury, does physical injury occur at the moment of incorporation to the insured's defective product or does physical injury occur when there is an alteration in the color, shape, or appearance of the third party's product; and lastly, if the answer is negative as to replacement, does replacement of the defective product irreversibly attached to a third party's product include the removal or destruction of that product?
The Texas Supreme Court noted that the policy covered physical injury, and this means injury to material things, that is, real and tangible objects. In this instance, the actual physical injury resulted not from the installation but from the leaks. Moreover, the leaks from the flanges never caused injury because ExxonMobil replaced them to avoid any risk of injury. The court said it agreed with most courts from around the country that physical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system. Therefore, the court ruled that the diesel units were not physically injured merely by the installation of the faulty flanges.
However, the court went on, the units were physically injured in the process of replacing the faulty flanges. The original welds, coating, insulation, and gaskets were destroyed in the process and had to be replaced. This fix necessitated injury to tangible property, and the injury was unquestionably physical. Thus, the repair costs and damages for the downtime were property damages covered by the policy unless the impaired property exclusion applied.
The insured argued that because the flanges were welded in, restoring the diesel units to use involved much more than simply removing and replacing the flanges alone and so, the units were not impaired property as defined in the policy. The Supreme Court disagreed. The court said that the units were restored to use by replacing the flanges and were thus impaired property to which the impaired property exclusion applied. So, their loss of use is not covered by the policy. The insulation and gaskets destroyed in the process were not restored to use; they were replaced. They were therefore not impaired property (by definition) to which the impaired property exclusion applied and the cost of replacing them was covered by the policy.
As for the certified questions, the court answered: the answer to the first question is no; the second question is conditioned on a yes answer to the first question, so the court did not answer it; the third question is answered in the negative; the answer to the fourth question was that the units were impaired property as defined but the insulation and gaskets were not.
Editor's Note: The Texas Supreme Court rules in this case that incorporation of faulty flanges did not cause property damage covered by the policy; that is, incorporating a defective component into something is not in and of itself physical injury, even though there is intangible damage, such as diminution in value of loss of use. As for the application of the impaired property exclusion, the answer depended on whether the items damaged by the incorporation of the insured's faulty product could be restored to use.