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Insurance coverage for defective construction

This article was written by Michael Dew, a Vancouver lawyer who practices civil litigation. Click here for contact information and further details about Michael’s practice. This article provides only information, not legal advice. If you require legal advice you should consult a lawyer. 

Most contractors have commercial general liability (“CGL”) policies which they hope will protect them if they get sued for harm arising out of their work. Similarly, contractors are often named as insureds on property insurance policies that cover construction projects and hope that if a loss arises out of their work during the currency of the construction project they will be covered by the property insurance policy for the project. However, both CGL policies and property policies typically exclude coverage for losses arising from faulty or improper material or workmanship, and historically courts held that such policies provided somewhat limited coverage for claims made in relation to defective construction by the policy holders.
Positive news for contractors is that the decision of the Supreme Court of Canada in Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada, 2010 SCC 33 (“Progressive Homes”), and the recent decision of the British Columbia Court of Appeal in Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2011 BCCA 178 (“Bulldog Bag”), have apparently increased the scope of coverage for defective work. 
This paper reviews some of the basic principles of insurance applicable to CGL and property insurance policies, and discusses what appear to be positive changes to the law under Progressive Homes and Bulldog Bag.
Insurance policies may be written on an “occurrence” basis, or on a “claims-made” basis.
Occurrence policies obligate the insurance company to pay for claims arising out of occurrences during the policy period regardless of when the claim is reported. In some situations the claim might be made many years after the construction was completed and it is therefore important to always keep copies of occurrence policies in case a claim is made in the future.
Claims-made policies protect an insured against claims that are made (i.e. reported) during the policy period and may cover claims for acts occurring prior to, or during, the claims-made policy period.
Both CGL and property insurance policies may be written on either a claims-made or occurrence basis.
It is fundamental to a successful insurance claim that the loss involve an “accident”, or “fortuity”. A loss is not accidental, or fortuitous, if it is deliberately caused by the insured.
Adopting the definition of accident as “an unlooked-for mishap”, it is possible that an act may be negligent, but still an accident. Indeed, the most common form of insurance claims, motor vehicle accident claims, are for “accidents” which result from negligence and which could normally have been avoided by greater care. Consistent with this, in a case involving the collapse of a crane, the Supreme Court of Canada has said that a loss resulting from faulty workmanship could be an accident:
That a mishap might have been avoided by the exercise of greater care and diligence does not automatically take it out of the range of accident. Expressed another way, “negligence” and “accident” as here used are not mutually exclusive terms. They may co-exist.
(Canadian Indemnity Co. v. Walkem Machinery and Equipment Ltd. [1976] 1 S.C.R. 309 at 315).
Insurance policies are contracts and subject to slight modification to account for the context, general principles of contractual interpretation apply:
Insurance policies form a special category of contracts. As with all contracts, the terms of the policy must be examined, in light of the surrounding circumstances, in order to determine the intent of the parties and the scope of their understanding. Nevertheless, through its long history, insurance law has given rise to a number of principles specific to the interpretation of insurance policies… They apply only where there is an ambiguity in the terms of the policy.
(Jesuit Fathers of Upper Canada v. Guardian Insurance Co. of Canada, 2006 SCC 21 at para. 27).
Insurance policy provisions dealing with coverage fall into three categories:
1.      Insuring agreement: define what is covered.
2.      Exclusion clauses: reduce the scope of coverage by narrowing the coverage provided by the insuring agreement.
3.      Exception clauses: broaden the scope of coverage by narrowing the application of exclusion clauses.
Consider the following wording from the policy considered in Bulldog Bag:
1          The Insurer agrees to pay on behalf of the Insured all sums… that the Insured shall become obligated to pay by reason of the liability imposed by law upon the Insured or assumed by the Insured under contract (as defined herein), for compensatory damages because of:
(c)        property damage (as defined herein) due to an accident or occurrence (as defined herein).
6          This insurance does not apply under Insuring Agreement 1(c) to claims for property damage to:
(a) goods or products manufactured or sold by the Insured; or
(b) work done by or on behalf of the Insured where the cause of the occurrence is a defect in such work, but this exclusion shall only apply to that part of such work that is defective.
Reading the above policy wording in the order listed above (i.e. coverage agreement, exclusion, exception), consider whether a contractor would be insured if water ingress through defective window seals installed by the contractor damaged drywall installed by the contractor, and the owner sued the contractor for the cost of replacing the drywall: 
1.      Does the insuring agreement provide coverage for the particular risk? The damaged drywall is likely to be considered “property damage”, and the window seals are likely to be found defective due to an “accident”. Therefore it appears that there would be coverage under the insuring agreement. 
2.      If there is coverage for the risk under the insuring agreement, is that coverage taken away by an applicable exclusion? The exclusion applies to work done by the contractor, and depending on how broadly one interprets the phrase “such work” in clause 6(b) (i.e. is it the entire project, or just the window seals?), the exclusion may be found to apply.
3.      If coverage for the risk is excluded by an applicable exclusion clause, is the risk brought back into coverage by an exception to the exclusion? The words “that part of such work that is defective” create an exception which restricts the application of the exclusion to that part of the work that is defective, in this case the window seals. Therefore, it seems that even if the drywall was included in the phrase “such work” contained in the exclusion, it would be brought back into coverage by the exclusion.
Therefore, it appears that there is coverage under the insuring agreement, coverage is excluded by the exclusion clause, but then liability for replacing the defective drywall (although not the window seals themselves) is brought back into coverage by the exception to the exclusion clause.
The general purpose of insurance policies is to indemnify the insured i.e. to pay out amounts that will cover losses that the insured would have had to bear personally absent insurance. The duty of the insurer to pay out when the preconditions for coverage are met is called the “duty to indemnify”. The scope of the duty to indemnify is determined by interpreting the insuring agreement, exclusions, and exceptions to exclusions, as described in the preceding section.
A second major duty imposed on insurers under most liability insurance policies is the duty to defend, which requires the insurer to pay the legal costs of defending claims against the insured. Unlike the duty to indemnify, without which there would be no liability insurance at all, not all liability insurance policies specify a duty to defend for all types of losses.
Generally speaking, the duty to defend is expressly stated in the wording of the policy and absent wording specifying a duty to defend the insured may have to incur the legal costs of defending the claim even though it might be covered by the insurer if a settlement is reached or judgment is ordered.
It is sometimes said that the duty to indemnify is broader than the duty to defend because the duty to defend may be triggered by a lawsuit alleging facts which if proven will result in coverage, even though those facts may never be proven. Thus, a benefit of liability insurance policies that specify a duty to defend is that the insurer will bear the cost of defending frivolous law suits which are ultimately dismissed.
Where a lawsuit against the insured includes some allegations which are covered by insurance and some that are not, the insurer will only be required to pay the cost of defending the claims within coverage. Similarly, where some claims are covered and others are not, the insurer will only be required to indemnify the insured for covered claims. 
In order to preserve the right to coverage it is important that policy holders comply with the notice provisions contained within the insurance policy. Failure to do so can jeopardize coverage.
Generally, giving proper notice requires the insured to:
1.      Have a copy of the insurance policy (make sure you have the right one!)
2.      Read the policy to determine the steps required to give proper notice.
3.      Follow those steps described in the policy for giving notice.
If in doubt, consult your broker or obtain legal advice: it is better to report a potential claim that fails to materialize, than to not report a claim that unexpectedly materializes
As noted above, in Canadian Indemnity Co. v. Walkem Machinery and Equipment Ltd. [1976] 1 S.C.R. 309 the Supreme Court of Canada indicated that collapse of a crane due to negligent workmanship was an accident. However, in the context claims for insurance coverage for defective construction, some courts, citing policy concerns about turning insurance policies into performance bonds, restricted the meaning of the word “accident” and held that defective construction was not an “accident” unless it caused damage to third party property.
In GCAN Insurance Company v. Concord Pacific Group Inc., 2007 BCSC 241 the insured contractor sought coverage for construction deficiencies that led to water ingress resulting in damage to the structural components of the wall assemblies and deterioration of the interior finishes of the building. The court held that that the insurer was not required to defend the insured with respect to the claims, partly on the basis that defective construction was not an accident:
[I]n the context of an insurance policy covering physical injury to tangible property, defective construction is not an “accident” (and therefore coverage is excluded) unless there is damage to the person or property of a third party.
(GCAN Insurance Company v. Concord Pacific Group Inc. et al, 2007 BCSC 241 at para. 95).
The trial court decision in Progressive Homes, a case that also dealt with claims brought against a contractor with respect to damage caused by water ingress in residential buildings, came to a similar conclusion:
[D]efective construction is not an “accident” unless there is damage to the property of a third party…
(Progressive Homes Ltd. v. Lombard General Insurance Company of Canada, 2007 BCSC 439 at para. 43).
In the appeal of Progressive Homes to the Supreme Court of Canada it was held that no general principle should be applied that defective construction is only an accident when it results in damage to third party property. Instead, in every case the plain wording of the policy should be considered to determine whether the loss in question arises from an accident:
[W]hether defective workmanship is an accident is necessarily a case specific determination. It will depend both on the circumstances of the defective workmanship alleged in the pleadings and the way in which “accident” is defined in the policy. I, therefore, cannot agree with Lombard’s view that faulty workmanship is never an accident. This Court’s jurisprudence shows that there is no categorical bar to concluding in any particular case that defective workmanship is an accident.
(Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada, 2010 SCC 33 at para. 46).
The Supreme Court of Canada reiterated the definition of accident as an “unlooked for mishap” and confirmed, in the context of construction cases, that just because a loss might have been avoided through greater care, that does not mean that the loss was not accidental.
In the subsequent case of Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2011 BCCA 178 the insured manufactured and supplied plastic bags to be used for packaging manure. Due to defective ink, the labeling printed on the bags degraded when brought into contact with moisture and as a result the manure had to be removed from the defective bags and repackaged. The insurer, acknowledging the significance of the decision in Progressive Homes, did not even contest that failure of the ink to permanently adhere to the bags constituted an “accident”:
AXA concedes that in light of Progressive Homes, the trial judge’s reasoning in the case at bar can no longer be supported, particularly as it relates to … whether faulty workmanship can constitute an “accident” or “occurrence”… the insurer concedes that the faulty workmanship that resulted in the defective bags qualifies as an “accident” or “occurrence” within the meaning of the policy.
(Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2011 BCCA 178 at para. 25).
Further, the British Columbia Court of Appeal, which had acknowledged arguments regarding policy concerns when it heard the Progressive Homes case before it was appealed to the Supreme Court of Canada, confirmed that policy considerations should not be allowed to override the wording the policy itself: 
Notwithstanding the argument noted by this court in Progressive Homes that such an interpretation would “convert CGL policies into performance bonds”, the Supreme Court of Canada found “no categorical bar” to the notion that defective workmanship might constitute an “accident”.
(Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2011 BCCA 178 at para. 23).
Although it will depend on the policy wording in every case, in light of the foregoing it seems less likely that in the future negligent construction will be found to be non-accidental.
Losses arising from defective work generally fall into three categories:
1.      cost of repairing defective work itself;
2.      cost of repairing property damaged by defective work; and
3.      economic losses associated with defective work.
Considering a leaky condo claim as an example, items in each of the categories listed above may be as follows:
1.      cost or removing and replacing defective caulking that allowed water ingress;
2.      cost of replacing drywall damaged by water ingress; and
3.      business losses suffered by building tenant while office shut down during drywall replacement.  
The following sets out considerations that apply to losses in each category.
Historically, some cases said that the defective work product of an insured could be considered “damaged property” leading to insurance coverage.  For example, in Gulf Plastics Ltd. v. Cornhill Insurance Co., 1990 CanLII 588 (B.C.S.C.) a defective chemical used in the manufacture of plastic bags used in the frozen food industry resulted in the bags not sealing properly. The court ruled that because the plastic bags were not capable of operating as intended, they were within the meaning of “property damage”:
Under the authority of Attorney General of Ontario vs. Fatehi, [1984] 2 S.C.R. 536, the plastic film devoid of its intended property can be seen as something which ceased to be bag-making film by reason of the plaintiff's wrongful act in supplying faulty material to Flexpack. In the Fatehi case, the presence of accident debris on a road, even though there was no damage that altered the physical nature of the road, was held to be something that caused the road to cease to be a road in the sense of a traffic-carrying facility. That was considered by the court to be damage to the property of the owner of the road. In the same way, Flexpack as owner of the film has suffered damage to its property because the film has been deprived of one of the qualities that gave it utility and value, that is, the property of being sealed by heat treatment.
In my opinion however, this film was physically injured by the loss of its vital property.
(Gulf Plastics Ltd. v. Cornhill Insurance Co., 1990 CanLII 588 (B.C.S.C.)).
However, certain courts have said that policy factors count against allowing insurance for defective work:
I am, however, satisfied ... in the context of the whole Insurance Policy that it was intended by the parties to be a general liability insurance policy and not a performance bond...
(Pier Mac Petroleum Installation Ltd. v. Axa Pacific Insurance Co., 1997 CanLII 4252 (B.C.S.C.)).
If the insurance proceeds could be used to pay for the repairing or replacing of defective work and products, a contractor or subcontractor could receive initial payment for its work and then receive further payment from the insurer to repair or replace it. Equally repugnant on policy grounds is the notion that the presence of insurance obviates the obligation to perform the job initially in a good and workmanlike manner
(Privest Properties Ltd. v. Foundation Co. of Canada, 1991 CanLII 2346 (B.C.S.C.) citing Ohio Casualty Insurance Co. v. Bazzi Construction Co. Inc., 815 F. 2d 1146 (C.A. 7th circ. 1987)). 
Such cases sometimes said that defective construction was not “property damage” unless the property damaged was third party property, and this frequently prevented recovery for defective work product under insurance policies.  For example, in the Privest Properties case mentioned above the contractor, who was being sued for the cost of removing asbestos insulation from a building, argued that the claim was for “damage to property” and so was covered by its liability insurance policies. The court said that the insurer was not required to defend the action because the toxic insulation had not caused “damage to property”:
So far as Canadian law is concerned, it seems clear that unless there has actually been personal injury or damage to other property, the cost of repairing or replacing defective work is considered to be pure economic loss rather than damage to property…
(Privest Properties Ltd. v. Foundation Co. of Canada. Ltd. 1991 CanLII 2346 (B.C.S.C.), emphasis added).
[T]he mere presence of a defective product in an otherwise sound structure does not, in itself, constitute damage to property.
(Privest Properties Ltd. v. Foundation Co. of Canada. Ltd. 1991 CanLII 2346 (B.C.S.C.)).
Similarly, in GCAN Insurance Company v. Concord Pacific Group Inc. et al, 2007 BCSC 241 it was decided that the insurer was not required to defend an action for defective construction because defective construction was not “property damage” under the insurance policy in that case.
The Policies use the term “tangible property” in their definition of “property damage” which… has been interpreted not to include the cost of remedying defects in the insured’s “own work”. In other words, a CGL policy is not a performance bond. 
(GCAN Insurance Company v. Concord Pacific Group Inc. et al, 2007 BCSC 241 at para. 93).
In Progressive Homes Ltd. v. Lombard General Insurance Company of Canada, 2007 BCSC 439 the trial judge summarized the law (as understood at that time) as follows: 
In sum, GCAN confirms that Swagger stands for two propositions which, I think, govern the outcome of the application in the case at bar:
1.      liability insurance policies governing physical injury to tangible property do not contemplate the artificial division of work of the party responsible for that work into component parts for the purpose of establishing resultant damage, unless that is the clear intention of the entirety of the policy;
2.      defective construction is not an “accident” unless there is damage to the property of a third party
(Progressive Homes Ltd. v. Lombard General Insurance Company of Canada, 2007 BCSC 439 at para. 43).
However, in the appeal of the last case mentioned above to the Supreme Court of Canada it was decided that allowing coverage for defective workmanship (by considering it to be “property damage” arising from an “accident”) would not turn CGL polices into performance bonds:
I am not persuaded by Lombard’s [the insurer] argument that equating faulty workmanship to an accident will convert CGL policies into performance bonds. There seems to be a fairly significant difference between a performance bond and the CGL policies at issue in this case: a performance bond ensures that a work is brought to completion…, whereas the CGL policies in this case only cover damage to the insured’s own work once completed… In other words, the CGL policy picks up where the performance bond leaves off and provides coverage once the work is completed.
(Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada, 2010 SCC 33 at para. 48).
The Supreme Court of Canada went further and indicated that policy factors and the stated (by insurers) “intention” of various policies should not play a significant role when interpreting the scope of coverage:
The focus of insurance policy interpretation should first and foremost be on the language of the policy at issue. General principles of tort law are no substitute for the language of the policy. 
(Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada, 2010 SCC 33 at para. 35).
Further, although it was not determinative to the final decision in the case, the Supreme Court of Canada said that:
1.      no general principle should be applied that “property damage” is restricted to third party property;  
2.      that property that contains defects may be considered “property damage” for the purposes of insurance policies; and
3.      that in every case the plain wording of the policy should be considered.
In the Bulldog Bag case discussed above involving ink rubbing off plastic bags packaging manure the insurer conceded that the defective bags were “property damage” arising from an “accident”, but argued that the own product exclusion prevented coverage under the bag manufacturers CGL policy. The British Columbia Court of Appeal rejected that argument and held that the loss being claimed was not for the defective bags themselves, but for damage to the customer’s product once packaged in the bags:
I find that the clause operates to exclude claims for damage to Bulldog’s bags, including loss of use thereof, but cannot be extended to compensation for Sure-Gro’s costs separating those bags from its products, repackaging in different bags, and salvaging the “old” product some months later.  
(Bulldog Bag Ltd. v. AXA Pacific Insurance Company, 2011 BCCA 178 at para. 33).
Thus, although the loss arose from the manure being contained in the defective bags provided by the insured, the insurer was found liable to cover the costs of salvaging the manure (90% of it was recoverable) and repackaging it into new bags.
Although own work/product exclusions will likely continue to prevent coverage for certain immediate losses (such as the direct cost of replacing defective product e.g. as was the case for the plastic bags in the Bulldog Bag case), it appears that following the decision of the Supreme Court of Canada in Progressive Homes courts will be more inclined to find defective work/products to be “property damage” resulting from an “accident”, and therefore more likely to allow coverage for losses more proximate to the defective work / product of the insured.
It is sometimes difficult to draw the line between defective work itself, and other property harmed by the defective work. For example, if a contractor constructs a house which is of good construction apart from the window seals, is the house defective or are only the seals defective?  
Faced with policies containing own work/product exclusions, insureds often try to restrict the defect to one part of the work, and argue that damage to the remaining parts is “resultant damage” which is covered by the insuring agreement and not excluded by any own work/product exclusions. This compartmentalization process is called the “complex structure” theory. The complex structure theory has generally been rejected in Canada such that insureds cannot break up closely related work into component parts and argue, for example, that the cost of replacing bricks should be covered because it was only the mortar that was defective (Bird Construction Co. v. Allstate Insurance Co. of Canada, [1996] 7 W.W.R. 609 (Man. C.A.)).
However, rejection of the complex structure theory will not always not prevent recovery where one part of a building damages another remote part: 
[I]f a defective central heating boiler explodes and damages a house or a defective electrical insulation malfunctions and sets the house on fire, I see no reason to doubt that the owner of the house, if he can prove that the damage was due to the negligence of the boiler manufacturer in the one case or the electrical contractor in the other, can recover damages in tort on Donoghue v. Stevenson principles. 
(Winnipeg Condominium Corporation No. 36 v. Bird Construction Co., [1995] 1 S.C.R. 85 at para. 15).
The possibility of coverage for a “less remote” example than an exploding boiler damaging a house that contained it was suggested in Swagger Construction Ltd. v. ING Insurance Company of Canada et al., 2005 BCSC 1269:
A defect in the structure may lead to damage to parts of the building that have no structural function and do not form part of an indivisible unit of structural elements. For example, a failure of the building envelope, such as is alleged in this case, may cause water damage to building elements that have an aesthetic or functional purpose but no structural significance. Carpeting and perhaps drywall could fall within this category. Although still part of the contractor’s work, it might be said that the property damaged is so far removed from the defective portion, both in function and the specific construction steps taken in relation to it, that it would arguably be called “other property”. 
(Swagger Construction Ltd. v. ING Insurance Company of Canada et al., 2005 BCSC 1269 at para. 46). 
Although the scope of applicability of the complex structure theory generally was not directly commented on in Progressive Homes, the Supreme Court of Canada held that an exclusion clause that excluded losses related to “that particular part of your work” constituted a contractual codification of the complex structure theory such that only coverage for the defect itself was excluded, and that the insurer was required to defend claims for damage to building elements other than the defective element itself. 
Coverage for economic losses resulting from defective work is often excluded from insurance policies. Although Progressive Homes and Bulldog Bag did not deal directly with recovery of consequential economic losses, such losses sometimes depend on whether the economic loss arose from property damage that occurred as a result of an accident and the broadening of those concepts in favour of insureds in Progressive Homes may lead to increased scope of recovery for economic losses.


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