Defect v Damage in Insurance Claims

Arguments over what makes for damage have given rise to many court cases, both in construction insurance and outside it. The key question that troubles both insureds and insurers have been what is the difference between damage and defect; damage being covered by insurance, and defects (and the effects of defects) being excluded generally or covered by varying degrees (see DE/Leg clauses).

The first rule as reiterated in the case Promet Engineering v Sturge,[1997] 2 Lloyds Rep 146 (The “Nukila”) - Court of Appeal, UK is that when interpreting an insurance policy, the term ‘damage’ should be given its ordinary meaning. The case related to the damage to an off-shore accommodation platform. The platform had three legs which were designed to extend and retract, so that the platform could be floated and towed into position. At their base, the legs passed through a steel box, which was designed to sit on the sea floor when the platform was in position. The steel box called the ‘spud can’, was strengthened by internal bulkheads and brackets and designed to be watertight. The spud can was attached to the legs by welds. Fatigue cracking was discovered. The cracks were caused by the normal action of the waves. The cracks had started within the welds but had spread to the top plate and internal structure of the spud can. The cracks were such that the platform was in danger of collapsing. The cracks were repaired and the owners claimed. It was found that the welds were not properly profiled and were therefore defective.

The policy covered indemnity for damage to the platform and was further extended for: “any defective part which has caused loss or damage to the [platform].” Insurers repudiated the claim as according to them there was no damage to the platform and even won the case in the lower court as that court decided that the manifestation of the cracks was the result of a latent defect becoming patent and no damage had been suffered.

At the appeal stage the Court of Appeal decided that there was damage within the meaning of the extension of the insurance cover. The court said: “It would be an abuse of language to describe the legs and spud cans as merely defective; on any ordinary use of language they were damaged. They were damaged by being subjected to stresses which they were unable to resist due to the latent defects, that is to say the wrongly profiled welds”.

Another important case was the Australian case of Ranicar v Frigmobile, [1983] 2 ANZ Ins Cas which concerned the transportation of scallops, destined for overseas export. However during a routine inspection in Melbourne, the scallops were found to have been stored at a higher temperature than prescribed. The scallops could be eaten under the Australian regulations, but they could not be exported. The insured argued that they were damaged by the fact they could not be exported and claimed on the policy. The court agreed with the insured. The court here also adopted the ‘ordinary meaning of the word damage’ principle. He said that damage required: “a physical alteration or change, not necessarily permanent or irreparable, which impairs the value or usefulness of the thing said to have been damaged.” The court said that the alteration in temperature had ‘undeniably involved a physical change to a substance and that change had the effect of removing one of the primary qualities which the scallops had – their exportability’. A change in temperature in itself was ‘a physical change’ and the scallops were less valuable in the sense that they could not be exported.

In order to claim, the damage must result in financial loss, usually in the form of expenditure to repair, reinstate or replace the damaged property. Financial loss will normally be evident from the fact that the damage has impaired the value or use of the property. However this will not always be so and where the damage does not cause financial loss, the insurance claim will not succeed. This was seen in the case of AMEC Civil Engineering Limited v Norwich Union Insurance Society Limited, [2003] EWHC 1341, England and Wales High Court.

In July 1993, AMEC was appointed as the contractors to carry out reclamation works in Jersey. As part of these works, AMEC was required to construct a sea wall from reinforced concrete blocks. The specification required the concrete to cover the reinforcement by 75mm. The blocks were cast in a mould at a pre-cast yard and progressively incorporated into the sea wall. During the course of the progress of the construction of the sea wall, random checks were carried out at the pre-cast yard, showed that the concrete cover over the reinforcement in some of the blocks was less than 75mm. 104 blocks were identified as having less than 50mm of cover and AMEC was required to replace the 104 blocks.

AMEC subsequently made a claim under its All Risks policy. It relied on the wording of the policy, "The Insurer will… indemnify the Insured in respect of loss of or damage to the Insured Property… arising from any cause whatsoever except as hereinafter provided." AMEC argued that 'arising from any cause whatsoever' must include loss relating to replacement of defective blocks. However, the exclusion relevant stated: “Loss of or damage to and the costs necessary to replace, repair or rectify that part of the permanent works which is in a defective condition due to a negligent design, plan, specification, materials or workmanship.”, based on which the insurer repudiated the claim. The court ruled in favour of the insurer and stated that, it was clear that on proper construction of the principal insuring clause in the Policy that it did not extend to providing to AMEC an indemnity in respect of the cost of replacing items manufactured by AMEC which are defective. AMEC’s financial loss stemmed from installing defective blocks in the first place ie the damage caused no financial loss.

What is important in defect exclusions is to justify a part of the insured property which is defective causing damage to another part of the insured property. The defect itself will be excluded but any consequential damage caused by the defect to other parts of the Works will be included. The problem is a part is capable of being used in a whole variety of ways depending on the context and this is where the difficulty lies. In the Australian case of Graham Evans v Vanguard Insurance, (1986) 4 ANZ Ins Cas 60-68934, coats of paint were held to be damaged after it was discovered that the primer was too thin and therefore defective. The cost of the damage to the top coats caused by the defective primer was held to be covered by the insurance contract. However in the case of Skanska v Egger, the court dismissed out of hand any attempt to claim that a defective sub-base to the flooring could be considered to have caused damage to the floor above, stating “That argument attempts to divide the indivisible. I see no prospect of any Court accepting that the sub-base damaged the rest of the slab above it.”

There is a time element in distinguishing between defect and damage. When a claim is notified, the insured property is in a defective/damaged condition, either because it has transitioned from a sound condition to a defective condition during the policy period, in which case it has been damaged, or because it was in a defective condition at the start of the policy period and the defect, in the design, workmanship, or materials, is merely discovered. In Promet Engineering (Singapore) Pte. Ltd. vs Sturge it was held that damage had occurred as cracking had initiated at the defective weld and, during the insuring period, propagated around the circumference of the spud can attached to one of the legs of the rig. The spud can was in a defective condition but, by reason of that adverse physical change as the crack developed, it was also damaged. After proving that the damage has occurred, the next issue will be to establish that the occurrence of that damage was fortuitous or accidental. The distinctions are subtle and insurers may not take the trouble to analyse and are likely to close the matter with the remark that damage was inevitable. Insureds will have an uphill task to get the claim, if there was a bonafide damage.