Contract works policies contain exclusion clauses relating to the cost of rectifying defects in design, materials and workmanship, which offer rich grounds for disputes between underwriters and insureds. In a recent case, the Athenian civil courts had to decide whether the plaintiff was entitled to recover from its insurer part of the costs that it had incurred as a result of defective material being used in an underground communication construction project.
The insured, a construction company specialising in communications projects, was awarded a turn-key contract for the design and construction of an optical fibre grid. HDPE pipes (a type of flexible plastic pipe) were provided by a supplier and were used as the conduit for the optical fibres. During the installation process, some distortions were noticed on the pipes' surface and extensive tests were performed; they showed that more than one-third of the supplied pipes – a large number of which had already been installed – did not meet the agreed standard of withstanding a pressure of eight atmospheres (8At). This was found to be the result of a small amount of liquid lubricant accidentally leaking into the initial mixture during the manufacture of the pipes.
The defect was discovered in four batches and, as a result, approximately 35km of the 95km of already constructed grid had to be abandoned and replaced. The HDPE pipe supplier assumed the cost of the defective material's replacement per se. However, for the 35km, a new trench had to be excavated in order for the new conduit to be laid into. The contractor claimed from the insurer the cost of all of the relevant works (ie, the trenching, bedding, padding, backfilling and extraction of defective material in some cases). The insurer denied the contractor's claim, invoking an exclusion clause in the erection all risks (EAR) policy. The contractor filed a lawsuit before the competent Athenian court, seeking to be indemnified for its loss by the insurer. The exclusionary clause read as follows:
The Insurer shall not indemnify the Insured for… The cost of replacement, repair or rectification of loss due to defective material and / or workmanship. This exclusion shall be limited to the insured items directly affected, whilst material damage to correctly executed items resulting from an accident due to such defective material and / or workmanship is covered.(1)
The first-instance court rejected the plaintiff's argument that the defect exclusion clause was ambiguous. Rather, it found that the language used was unambiguous and that the facts were undisputed. The costs for which the contractor was seeking compensation were for the replacement of defective material – a clear exception in the policy. The first-instance court endorsed the defendant's position that the clause at play should not be interpreted, following the Supreme Court's jurisprudence, according to which the courts should construe contractual clauses only when there is room for doubt; if the language used is unambiguous, the clause is not construable and the courts should refrain from such process.
The claimant challenged this decision before the court of appeal. In its appeal, the contractor argued that the first-instance court should have interpreted the clause as it was complex and ambiguous, describing an exclusion to the cover and then introducing an exclusion to the exclusion. Further, the contractor argued that the terms 'insured items directly affected' and 'correctly executed items' were vague and not defined in the policy. The contractor asked the court of appeal to use the interpretative tools provided in the Civil Code – namely, that a contract is construed with the aim to establish the true intention of the parties (Article 173) and that contracts are interpreted according to the principles of good faith and common (business) practices (Article 200). The claimant argued that when reading the clause, the insured would reasonably believe that the term 'correctly executed items' include not only material objects that were not initially defective, but also works that were correctly executed and then, as a result of a defective material being used in the project, sustained material damage in the sense that they became useless and had to be dug all over again.
On the other hand, the insurer argued that the clause had a clear structure and an undisputable meaning: the cost of replacing defective material was unambiguously excluded from cover. Any trenching for the installation of new pipes, or even the extraction of defective pipes from existing trenches and their replacement with new pipes, could not be construed to fall under the scope of 'material damage to correctly executed items resulting from an accident due to such defective material', as no accident due to defective material had occurred and caused material damage to correctly executed items.
The court of appeal found in favour of the insurer, ruling that replacing defective material was clearly excluded. The insurer would have been liable only if an accident resulting from the defect of the 35km of defective pipes had caused material damage to any part of the other 60km of viable grid constructed by the insured.
Builders' risk policies (eg, Section I of EAR and CAR policies) are traditionally a form of all-risk, first-party cover, aimed at making the insured 'whole' after sustaining a covered sudden and accidental loss (not including betterment) which results in physical injury.
The European, Canadian and Australian markets mainly use the following exclusionary clauses to delineate the cover provided in builders' risk policies:
- Design Exclusions (DE) clauses, including:
- DE1 – total (outright) exclusion;
- DE2 – extended defective condition exclusion;
- DE3 – limited defective condition exclusion;
- DE4 – defective part exclusion; and
- DE5 – design improvement exclusion;
- London Engineering Group (LEG) clauses, including:
- LEG 1 – outright defects exclusion;
- LEG 2 – consequences defects exclusion; and
- LEG 3 – improvements defects exclusion; and
- Munich Re clauses, including:
- Munich Re Endorsement 14014 – total (outright) exclusion;
- Munich Re Endorsement 14016 – betterment exclusion; and
- Munich Re Endorsement 14115 – defective part only exclusion.
This case is notable because few courts internationally have been called to construe defect exclusion clauses. Policy clauses addressing designers' risk, manufacturers' risk and defect coverage contain notoriously complex and ambiguous language, mainly because describing the errors that can occur in construction is an extensive and complex exercise. It has been said that determining and delineating insurance liability in construction projects is similar to walking into a hall of mirrors, as coverage is determined not by the reality for which it is intended to reflect, but rather by the angle from which it is interpreted.(2) For instance, the difference between 'defects', 'damage', 'physical damage or injury', 'impaired property' and other synonymic language is a long-running discussion. A famous UK case that extensively addressed the issue was Pilkington v CGU (2004), which concerned tests of the glass roof of the Eurostar Terminal at Waterloo Station which showed that it was prone to fracture. The UK Court of Appeal held that the risk of future damage did not mean that the glass panes were actually damaged, since damage required some altered state which was absent at the time of the claim. The court found that physical injury was a condition for the policy to pay:
In the context of insurance law [this finding] makes commercial sense of an agreement which is designed to protect the insured against liability for physical damage to physical property and not to afford and indemnity by way of guarantee for the quality and fitness of the commodities supplied.
The Athens Court of Appeal's decision shows that – much like its UK counterpart – it will take a practical, literal approach when construing builders' risk policies rather than overanalysing the potential interpretation of each word in an exclusionary clause.
Endnotes
(1) Notably, this clause was in the 'exclusions' part of Section I of the EAR policy. The language used is a slight variation of Munich Re's "Special exclusions to section 1:… d)" wording for contractors' all risks (CAR) and EAR policies. Paragraph C of Munich Re's exclusions, exempting all losses due to faulty design, was also included in the current policy, without Endorsement 115 limiting the exemption to the defective part. Further, no Munich Re Endorsement 200 covering manufacturers' risk was included in the current policy, which would have addressed the loss more efficiently.
(2) Douglas Rees, Insurance Coverage for Construction Defects, Cooper & Scully PC, 2005.
