Topics Covered:

Introduction

Tracing the exclusion's evolution

Cases going both ways

Can the property be restored to use?

The temporal impact of “sudden”

The process of determining applicability

Conclusion

Introduction

 The impaired property exclusion found in liability policies continues to cause a great deal of confusion, in part because the breadth and scope of its application is difficult to understand. A concern voiced by many is that some insurers are seeking to apply this exclusion to situations involving both physical injury to tangible property and also where there is loss of use of tangible property that has not been damaged. While the drafting history of this exclusion confirms that it is not intended to apply in cases when there is physical injury to tangible property, the exclusion's wording states otherwise. However, if one were to trace the evolution of this exclusion, the conclusion would be that the current exclusion—contrary to how it reads in policies—was intended to address solely those situations where there is an absence of physical injury.

 Reference to the term “impaired property”, its accompanying definition and verbiage comprising the exclusion, were introduced into standard commercial general liability forms of the Insurance Services Office (ISO) beginning in 1986; both its definition and exclusion are discussed in more depth in these pages. For the moment, however, it is only necessary to mention that this exclusion is directed at those damages or costs associated with tangible property that cannot be used, or is less useful, when that tangible property (1) incorporates the named insured's product or work, or (2) the named insured fails to fulfill the terms of a contract—and that tangible property can be restored to use by the repair, removal, or replacement of the work or product, or by fulfilling the terms of the contract.

 Tracing the Exclusion's Evolution

 The grandparent of the current impaired property exclusion was referred to as the “design error” exclusion and first appeared in the 1966 CGL forms of the National Bureau of Casualty Underwriters as exclusion (k). This early version of the impaired property exclusion read as follows: This insurance does not apply to: . . . property damage resulting from the failure of the named insured's products or work completed by or on behalf of the named insured to perform the function or serve the purpose intended by the named insured, if such failure is due to mistake or deficiency in any design, formula, plan, specifications, advertising material or printed instructions prepared or developed by any insured; but this exclusion does not apply to . . . property damage resulting from the active malfunctioning of such products or work.

 According to its1966 explanatory memorandum, ISO stated that the exclusion's purpose was to reinforce the premise that no coverage was intended for the business risk of a manufacturer or contractor whose product or work failed to perform the function or service. Two points are important here.

 The first is that the exclusion was aimed at the business risk of a failure of the insured's product or work. Briefly, a business risk is a risk that is deemed to be solely under the control of the insured and, thus, not insurable. This is because insuring damage to the named insured's own work or product, or as in the case with this exclusion, the inability of the work or product to perform as intended, would eliminate or diminish incentive for the named insured to exercise caution and quality control in the process of manufacturing its product or performing its work.

 The second point here is that the exclusion purports to apply to property damage. This term was first defined in 1941 with the official introduction of the standard liability forms to mean injury to or destruction of property. (It did not require physical injury or tangible property.) At the time the design error was introduced in 1966, the definition of property damage was redefined to mean injury to or destruction of tangible property. The 1966 definition of property damage was broader than subsequent definitions in that it was not limited to physical injury and, therefore, could have applied to any type of impairment, including loss of use in the absence of physical injury. As such, the design error exclusion could arguably have also been said to apply broadly to physical injury or simply where there is a loss of use of tangible property.

 In fact, the drafters of the design error exclusion confirmed as much in explaining the application of this 1966 exclusion. As it turned out, exclusion (k), which attempted to distinguish between injury or damage by employees versus management errors, was too difficult to understand and was replaced in 1973 by a new exclusion (m) labeled as the “failure to perform” exclusion.

 At the same time of this business risk exclusion in 1973, ISO also introduced a revised definition of property damage, meaning physical injury to or destruction of tangible property. To respond to concerns that earlier policies were not clear on whether coverage applied to loss of use of tangible property not physically injured, ISO also introduced an expanded version of property damage consisting of two parts. Part (a) of the definition addressed physical injury to tangible property, including all resulting loss of use. Part (b), on the other hand, applied solely to those situations where there was loss of use of tangible property in the absence of physical injury or destruction.

 Parenthetically, ISO stated that its expanded version of the property damage definition was a clarification always intended. Given that the 1966 and earlier editions of liability forms referred solely to injury without the physical modifier, coverage accordingly should have applied to loss of use of property, even in the absence of physical injury. If that were the case, the design error exclusion also could have applied accordingly, which historically was not the case.

 In any event, when the definition of property damage was again redefined in 1973, along with the introduction of the failure to perform exclusion (m), ISO stated in its explanatory memorandum that this new exclusion no longer applied to physical injury to or destruction of tangible property, including the loss of use of such physically injured property. Instead, the exclusion repeated below, was meant to be limited solely to loss of use of tangible property which has not been physically injured.

 This insurance does not apply to: Loss of use of tangible property which has not been physically injured or destroyed resulting from a delay or lack of performance by or on behalf of the named insured of any contract or agreement; or the failure of the named insured's products or work performed by or on behalf of the named insured to meet the level of performance, quality, fitness, or durability as warranted or represented by the named insured.

But this exclusion does not apply to loss of use of other tangible property resulting from the sudden and accidental physical injury or destruction of the named insured's products or work performed by or on behalf of the named insured after such products or work have been put to use by any person or organization other than an insured.

 While the intent of this exclusion was made clearer, the wording used was not without its problems. Sub-part (2), for example, has been viewed by some courts as applying only to situations involving breach of contract, an issue ISO sought to address in the wording of the current impaired property exclusion.

 When it introduced the latest impaired property exclusion in 1986, ISO indicated that the coverage provided under this exclusion would result in substantially the same coverage as existed under the 1973 version. (Exclusions do not grant coverage. Traditionally, the method in determining coverage of liability policies is to infer from exclusions what is excepted and therefore, covered.) The wording of the impaired property exclusion, however, does not clearly limit its application to situations involving loss of use of tangible property not physically injured, as did the 1973 wording. The current impaired property exclusion reads: