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Insurance companies are not jumping at the chance to pay construction-defects claims. There is an ongoing struggle over insurance coverage for defective construction, and the courts continue to draw the boundaries of what the policies cover and what they do not.

One general category of risk that insurance companies often point to as not being covered is “business risk.” The business risk doctrine is the idea that insurance is not meant to cover risks within the policy holder’s control. But general doctrines do not determine coverage issues. Instead, the actual policy language controls.

On April 22, 2004, a division of the Colorado Court of Appeals held that a contractor’s insurance policy did not cover economic damage caused by the contractor’s partially-completed defective work. McGowan v. State Farm Fire and Casualty Co., 2004 WL 856511 (Colo. App. April 22, 2004). The McGowans contracted with Eagle Summit Construction Co., Inc. (“Eagle Summit”) to build a 3,200-square-foot house for them. Dissatisfied with the quality of Eagle Summit’s work, the McGowan’s terminated Eagle Summit after rough framing was complete, and hired another contractor to finish the project.

The McGowan’s sued Eagle Summit, seeking to recover the costs for competing their home per the original plans. And the trial court awarded the McGowans approximately $400,000.00 damages for the costs of repairs to correct construction errors and to complete the house according to contract specifications.

State Farm Fire and Casualty Co. (“State “Farm”) had issued contractor’s policies to Eagle Summit for the period during the construction of the McGowan’s home. The policies covered sums that Eagle Summit was legally obligated to pay as damages because of damage to property caused by an “occurrence” during the policy period. After receiving their judgment, the McGowans attempted to collect the judgment against State Farm. But the trial court determined that State Farm did not have to pay the judgment because of the faulty workmanship exclusion (one of the key business-risk exclusions) in the CGL policy. The Court of Appeals agreed.

The faulty workmanship exclusion is often found at Exclusion j(6) of many CGL policies. The faulty workmanship exclusion excludes coverage for property damage to “that particular part of any property that must be restored, repaired or replaced because your work was incorrectly performed on it. . . . ”

This exclusion precludes coverage for the costs to repair or replace defective work discovered while the insured is still performing its work. The faulty workmanship exclusion includes an exception for damage covered by the products-completed operations hazard. That exception “includes all . . . property damage arising out of your product or your work except products that are still in your physical possession or work that has not yet been completed or abandoned. . . . ”

The Court of Appeals held that the faulty workmanship exclusion clearly applied to the McGowans’ claim/judgment against Eagle Summit. According to the Court:

The McGowans were . . . seeking to recover the expenditures they were required to make to repair the damage caused by Eagle Summit’s faulty and incomplete work. Thus, their claims fall squarely within [the] Exclusion . . . , as the trial court properly concluded.

The Court also held that the “products-completed operations hazard” exception to the faulty workmanship exclusion was inapplicable. By definition, products-completed operations hazard exception applies only to work that is “deemed completed.” Eagle Summit was terminated after rough framing. Thus, its work was not completed. In fact, the McGowans sued Eagle Summit for the cost to complete their home.

While not necessarily a ground-breaking decision, McGowan does raise a couple of issues worth noting. First, plaintiffs’ lawyers will have to keep this decision in mind when deciding who to sue, and for what causes of action.

For instance, the result would not have necessarily be the same if the McGowans had received judgments directly against Eagle Summit’s subcontractors for negligence. The McGowans could have brought negligence actions directly against Eagle Summit’s subcontractors who had finished their work. And the subcontractors’ insurance carriers would not necessarily be able to rely on the faulty workmanship exclusion, or the property-being-worked-on exclusion typically found at exclusion j(5) of many CGL policies. If the subcontractors’ work was completed, then the products-completed operations hazard exception would likely apply, thus allowing coverage.

Second, McGowan illustrates the importance of requiring performance bonds, and the results if you don’t. An owner considering terminating a contractor (or contractor considering terminating a sub) for faulty workmanship should also keep the lesson learned from McGowan in mind. Termination-for-cause clauses typically allow the owner to recover from the terminated contractor certain cost overruns. But if the terminated contractor is judgment proof, the owner should not have any delusions, after McGowan, of recovering against the terminated contractor’s insurance carrier. As the Court of Appeals noted, CGL “policies . . . are not intended to be the equivalent of performance bonds.”