In brief:
A recent U.S. Federal District Court decision has ruled in favour of insurance buyers and against insurers attempting to restrict coverage under a Contract Works clause known as LEG3 after it was described as “ambiguous”.
LEG stands for the London Engineering Group, a consultative body in England that provides a forum for discussion and education to member insurers and reinsurers (including Lloyds syndicates) on engineering risks.
Over a quarter of a century ago, the London Engineering Group developed different LEG defect exclusions for Contract Works policies, each of which provide different levels of coverage for damage to works caused by defective designs, workmanship and/or products.
Damage caused by defects during the construction of a project can often be significant (potentially running into the millions or tens of millions of dollars), however, due to the nature of these types of losses, the coverage afforded to insured parties under Contract Works policies can often be difficult to understand and interpret, resulting in contentious Contract Works insurance court decisions over the years, particularly in Australia.
In Australia, courts generally rely on and examine in detail the words and language used in the policy wording to ascertain the original intent of coverage being afforded. It is therefore important that insureds under Contract Works policies fully appreciate the differences in coverage available under the various LEG (and/or other defect) exclusions.
What happened?
The world’s first LEG3 court decision has reignited conversations about defects exclusions under Contract Works policies across the construction insurance industry, but will this decision change anything and what can insurance buyers in Australia learn from this decision?
On 29 September 2023, Judge Lamberth in the District of Columbia in the USA handed down a decision in the case of South Capitol Bridgebuilders v Lexington Insurance Company that substantially broadened the generally accepted interpretation of LEG3 cover under Contract Works wordings.
For Lexington, a leading U.S. based insurer, and other insurance companies (as well as potentially principals and contractors) involved in construction projects in the District of Columbia and other jurisdictions with similar laws, this case potentially has significant implications. More locally in Australia, Lockton anticipates this case is unlikely to have any real impact on the industry.
Varying legal interpretations and arguments
The claim involved a defect in the construction of a bridge where “poor vibration of concrete resulted in construction malformations known as 'honeycombing’ and ‘voiding’ which harmed the structural integrity of the bridge”.
There were several legal arguments put forward by both parties. The most critical issue centred around the Judge's interpretation of the word “damage” in the policy wording; specifically whether voids in the concrete piers created by inadequate vibration of the concrete by the contractor during pouring, also referred to as honeycombing, constituted “damage” under the Contract Works policy wording.
This element of the case was made more complicated by the absence of a definition within the policy wording. However, most Contract Works policy wordings in the Australia market include a definition of “damage”.
Notwithstanding the absence of a definition within the wording, most common law jurisdictions around the world have well defined case law that regard damage as a “happening” or a change in physical condition as opposed to simply a “condition”.
Based on case law in other common law jurisdictions around the world, the honeycombing in the concrete piers in itself would not generally meet the definition of “damage” and therefore not trigger the insuring clause (and subsequently the defects exclusion) under a typical Contract Works policy.
Although decisions in other jurisdictions are not binding in courts of all jurisdictions, they are often used to help better understand similar legal arguments and interpretations in the case in question. However, in this case the Judge did not consider that Lexington had sufficiently explained “why the Court should consider them persuasive” and as a result, did not consider these when interpreting coverage afforded to the builder under the Contract Works policy.
So how was "damage" interpreted? The Judge relied on a well-known legal dictionary to determine the “plain, ordinary, and popular meaning of [this] term” under the policy. The definition of “damage” under this dictionary was described as “loss or injury to person or property” or “any bad effect on something”.
Based on this definition, the Judge determined that the honeycombing of the concrete piers did in fact constitute “damage”, triggering the insuring clause under the policy and subsequently the LEG3 “write-back” clause in the exclusion.
A unique interpretation
Whilst this case will undoubtedly generate a lot of discussion with construction insurance industry pundits around the world, the unique interpretation of the Judge in this case means that we anticipate this will likely have minimal impact across the industry more broadly, particularly for Australian based organisations not operating within the same jurisdictional confines of this case.
That said, this case does provide a timely reminder of the importance of LEG (and other defects) exclusions under Contract Works policies and the often dramatic differences in coverage afforded to insureds by the different LEG clauses.
Cover by way of an exclusion
LEG clauses are in fact exclusions under Contract Works policies with varying levels of “write back” in coverage.
These range from LEG1 (being the most restrictive) to LEG3 (being the broadest level of cover available). The basis of each LEG clause is an exclusion for damage arising from defects in materials workmanship design plan and specification.
The LEG1 clause is a full exclusion with no “write back” in coverage. This base exclusion is then broadened under LEG2 and LEG3 clauses by restricting the application of the broader exclusion to specific elements that are not to be covered.
The above clauses only operate effectively because of the broad nature of the insuring clauses under these policies which typically cover all “physical loss or damage to the property insured”.
Types of defects
LEG exclusions address three different types of defects:
1. Defective design, plan, specification
The design, plan and specification elements of this exclusion primarily relate to professional services performed by architects, engineers, designers and other specialists on a construction project.
It is not uncommon for loss or damage to occur to works under construction due to an error during design; these losses can be substantial, such as consequential damage due a failure in the integrity of a structure. Similarly, losses can arise under Contract Works policies in cases where the machinery or plant specified are not adequate and/or appropriate for the purpose required resulting in physical damage.
Professionals under construction projects are normally required to maintain Professional Indemnity insurance to cover losses due to errors in their services.
2. Defective Materials
Materials that are not fit for the intended purpose in the works can result in consequential damage to the works. For example, a concrete mix with too much water will lower the rate of chemical bonds forming resulting in a risk that the concrete will crack.
3. Defective Workmanship
Physical construction and/or assembly works at the project performed poorly or incorrectly can result in damage to the works. For example, a form worker may fail to include sufficient reinforcement in a slab floor resulting in the floor collapsing.
Comparison table of DE and LEG Clauses
LEG clauses are not the only type of defect exclusions in the construction insurance market; DE (or Defect Exclusion) clauses are an alternative to LEG clauses. DE clauses operate differently to LEG clauses and include two additional levels of cover (with five different clauses in total); as a result, coverage under LEG and DE clauses can differ significantly.
Notwithstanding, both are attempting to achieve similar outcomes. We have attempted to show the correlation between these two different types of defects exclusions in the below:
DE1
Excludes all loss or damage due to defective design, materials or workmanship.
DE2
Excludes property that is defective and property that relies for its support on the defective property, and access costs but gives cover for other insured property that is free of defect but is damaged by the defective property. There is no equivalent LEG Clause for DE2.
DE3
Excludes property that is defective and access costs but gives cover for other insured property that is free of defect and is damaged by the defective property.
DE4
Excludes any component part or individual item that is defective and access costs but gives cover for other parts or items of the insured property that are free of defect and damaged by the defective part.
DE5
Provides full cover for both defective and non-defective property provided there is damage to non-defective insured property as a result of the defect. No cover for the costs of improvements to the original design, plan, specification, workmanship or materials.
LEG1/96
Excludes all loss or damage due to defective design, plan, specification, materials or workmanship.
LEG2/96
Excludes any component part or individual item that is defective and access costs but gives cover for damage to property containing the defects and other parts of the insured property that are free of defect provided there is damage to the defective portion.
The measure is to exclude the costs of correcting the defect, which would have been incurred, had this been carried out immediately before damage occurred.
LEG3/06
Provides full cover for both defective and non-defective property provided there is damage to any portion of the property containing the the defect. No cover for the costs of improvements to the original design, plan, specification, workmanship or materials.
In the case of LEG3/06, “damage” has been qualified so as to include “any patent detrimental change in the physical condition of the insured property”. A change made to the original LEG3/96 clause in response to observations made in the 2005 Court of Appeal case Skanska Construction Ltd -v- Egger (Barony) Ltd. This case dealt with a dispute under a building contract not an insurance policy dispute.
How your insurance broker can respond
To cater for these potential circumstances, your insurance broker should ask the insurer to incorporate both exclusions with an option for the insured to determine the exclusion (and deductible) to apply.
Whilst the LEG Exclusion Clauses are more usually thought to be relevant to engineering risks on machinery erection/process engineering type projects rather than standard construction risks for building or civil engineering projects, it has become a matter of preference of the insured or insurers as to which are used.
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