Home improvement, - close-up of handyman laying tile

A common insurance question asked by our owner/developer clients when they discover that their completed project has defects is whether their own insurance will cover the cost to fix the defect or any damage from the defect.  While trying hard not to sound like the proverbial lawyer, we often have to say “it depends.”  What it depends on is multifaceted and includes, among other considerations, the cause of the defect, whether there is more than one cause (and what those causes are), what the defect is (inherent in the product or component, or impacting another component), whether there is damage to another element of the project (often referred to as “resulting damage”) or just the design or the work itself is defective, and, of course, what exactly the Builder’s Risk policy says (and if there are any exceptions to the various exclusions in the policy).

In a recent unpublished opinion from the California Court of Appeal, Olympic & Georgia Partners v. Arch Specialty Insurance Co. (No. B264647, 2d Dist., Div. 2, July 28, 2016), these questions played out in a very expensive way for the owner and developer of a 54-story high-rise, mixed-use development that consisted of a Marriott hotel on the bottom floors, a Ritz-Carlton hotel on the middle floors, and 212 Ritz-Carlton luxury condominiums on the upper floors.  As expected, the owner (the LLC) hired a general contractor, which hired two subcontractors to install stone flooring in the condominiums.  The subcontractors split the complete installation of the stone assembly by room.  Again, as expected, the LLC had secured a Builder’s Risk policy—actually eight via a consortium, with each holding less than 10% of the risk, although the language of the policies was essentially the same.  Every policy was an “all risk” policy, insuring “all risks of direct physical loss or damage to insured property” during construction, subject to exclusions.  Two key exclusions, B and C, which are common, excluded the costs to repair any “faulty or defective workmanship” unless the loss was caused by an “insured peril,” and then the “ensuing loss or damage only” would be covered, and they also excluded coverage for fixing the defect unless the loss or damage caused by an insured peril is the result.  Yet still, the policy would cover the ensuing loss or damage only under the second key exclusion.

Relevant to the above question, the LLC submitted a claim to the Builder’s Risk insurers for hairline cracks that had been discovered in the stone in some of the condominium units.  Not surprisingly, scope and cost estimates varied for the repairs, from $7.5 million by the insurers to $21.5 million with an additional $16 million in related costs calculated by the LLC.  An investigation of the loss was conducted by all involved.  It was determined that an uneven application of mortar thickness under the stone caused shrinkage movement that resulted in the hairline cracks. The poor application was itself the result of the architect’s inadequate plans and the project manual erroneously directing thicker application of mortar to level the uneven floors.  There was no dispute that an overly thick application of mortar was the “primary” cause of the hairline cracks.  Following the insurers’ investigation of the causes, the policy language and the damage, the insurers denied the claim in whole.  The LLC sued the insurers on several grounds and, relevant here, sued them for breach of the insurance contracts for denying coverage under the policies.

On cross-motions to have the trial court decide the interpretation of the policies and whether there was coverage, the trial court granted the insurance companies’ motion and denied the LLC’s motion.  Importantly, because it was undisputed that “the overly thick mortar bed was the primary if not exclusive cause of the cracking of the natural stone,” the court concluded that Exclusions B and C applied, barring coverage for the “cost of making good” defective design and defective workmanship. Court of Appeal opinion at 8. The trial court further concluded that the “ensuing loss” exception to those exclusions did not apply, reasoning that “the cracking of the natural stone was not a severable ‘ensuing loss’ such that it qualified for the exception to the exclusion.”  Id. After considering two questions on these issues, the appellate court affirmed the ruling, precluding the Builder’s Risk policies’ obligations for coverage of the multimillion-dollar claim:  “(1) is the cost of repairing the stone part of the ‘cost of making good’ the faulty design and workmanship with the mortar, so as to be excluded from coverage by Exclusions B and C; and, if so, (2) is the damage to the stone a ‘direct physical loss or damage by an insured peril,’ so as to be covered by the ‘ensuing loss’ exception to Exclusions B and C?” Id. at 10-11.

In addressing these questions, the Olympic & Georgia Partners appellate court noted: “A ‘cost of making good’ provision excludes from coverage a contractor’s ‘own work,’ thereby placing ‘the risk of replacing or repairing [a contractor’s] defective work or product’ on that contractor’s insurer rather than the general contractor or builder’s insurer. [Citations omitted.]”  Id. at 11 (first brackets and emphasis in original).  And “[b]ecause only one subcontractor installed the flooring in any given room, and because it is physically impossible to replace the mortar without replacing the stone sitting atop it, the ‘cost of making good’ provision excluded from coverage the cost of replacing or repairing the stone as well as the mortar. [Citations omitted.]”  Id.  As to the second exclusion, the “ensuing loss,” the court found that existing California law makes it “clear that an ‘ensuing peril’ provision applies only if there is, in fact, a second and subsequent ‘peril.’” Id. at 13.  In short, the court reasoned that because “the original, excluded peril (the defective mortar) directly caused the very damage for which the insured is seeking recovery (the cracked stone),” there is no coverage under the “ensuing peril” clause.  Id.

The reason this is important for our owner/developer clients, as well as our general contractor clients, is the ongoing consideration of “Risk Management” and where the risk is placed for defective work in construction projects.  As was the case here, the Builder’s Risk policies (and other property policies) have standard exclusions for faulty or deficient work, and they have more and more robust “ensuing loss” limitations.  An owner/developer should therefore not rely too heavily on its own insurance policies for protection.  Although not discussed in the case, it is also expected that the owner/developer sought coverage from the general contractor and subcontractors, and perhaps others, and their insurance policies.  Several issues could be in play there as well to limit or exclude coverage or damage recovery against the parties at fault, including perhaps waiver of consequential damages, limitations of liability, “your work” exclusions in the subcontractor’s insurance policies, no direct claims against the subcontractors as the “work” assembly was inclusive of the mortar and stone (and thus no tort damages), possibly no professional negligence by the designers, and lack of coverage for resulting damage under the general contractor’s policies.  As well, particularly given the size of the loss, it is possible that no ready cash for any breach of contract would be forthcoming for the repairs and replacement by the contractors involved.  Finally, a consideration for our owner/developer clients is whether a performance bond that included the warranty period and did not terminate at substantial completion would be a consideration for allocation of the risk and placement on the parties that are responsible for the damages to the LLC, such as is evident in a high-profile project such as this one.  See our prior articles on insurance and bonds for additional relevant information and my prior blog regarding common CGL insurance limitations, which could be at play in this case too.  Of course, our first and last recommendation is a strong and robust Risk Management program, with field inspections during the course of construction by a highly qualified independent construction consultant.  Catching defects early in the field is wildly less expensive than the costs to repair after the project is complete.