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December 14, 2015

Texas rejects Incorporation Theory in CGL insurance coverage

In a very important insurance coverage case, the Texas Supreme Court, on certified questions from the 5th Circuit Court of Appeals, recently rejected the incorporation theory in CGL insurance coverage, i.e. the question of whether incorporating a defective product into another product causes property damage. Briefly, US Metals installed flanges in constructing a refinery processing unit for Exxon. During testing before the processing unit was put into operation, Exxon discovered the flanges leaked and were defective. US Metals replaced the flanges but had to cut them out which destroyed the original welds, coatings, insulation and gaskets, thus the fix necessitated physical injury to tangible property. Exxon claimed millions in damages for the replacement costs and for loss of use of the processing unit. US Metals settled with Exxon and claimed indemnification under its commercial general liability policy with Liberty, which denied coverage.

The Court described as “convoluted” the terms of the standard-form CGL for property damage coverage, citing the property damage definition, exclusion K (damage to ‘your product’), exclusion M (damage to impaired property), and the definitions of ‘your product’ and ‘impaired property’.

The questions to be answered were: (1) is property physically injured simply by the incorporation of a faulty component with no tangible manifestation of injury? and, (2) is property restored to use by replacing a faulty component when property must be altered, damaged and repaired in the process?

The Court considered the use of the words ‘physical injury’, concluding that here no actual damage had occurred because the flanges were replaced before put in operation and the increased risk of harm was not enough. If that was enough, then it would be hard to imagine a non-physical injury, and the word ‘physical’ would be superfluous. Leaks from the flanges here never caused injury – they were replaced before leaks caused injury. The Court noted that it was already settled law in Texas that a defective product that causes damage is not an occurrence until the damage actually happens, so it would be inconsistent to now find there was damage at the time of incorporation. Thus, the Court holds the Exxon processing unit was not physically damaged merely by the installation of faulty flanges by US Metals.

However, the units were physically injured in the process of replacing the flanges. Thus, the repair costs and downtime damages would be property damage covered by the policy unless exclusion M applied (denies coverage of damages to impaired property, defined as property that could be restored to use by the replacement of the defective product). The Court noted that there is no limitation in the policy wording, nor could it be inferred, that would add the phrase “without affecting or altering the property in the process.” “Coverage does not depend on such minor details of the replacement process but rather on its efficacy in restoring property to use.” The units were restored to use by replacing the flanges and the units were therefore impaired property to which Exclusion M applied.

These are questions that arise under a general liability policy on a regular basis, so having this guidance is useful to an understanding of how the impaired property exclusion applies in an everyday context. The Court noted that it was not its place to help or hurt the construction or the insurance industries, and the policy wording should be changed if a different result is desired. It will take a change to the standard CGL forms for that to occur.

We are happy to answer any questions generated from this new significant decision by the highest court in Texas.