The impaired property exclusion: finding a path through the morass.

• Author: Brady, Michael J.

RECENTLY a Silicon Valley newspaper reported that a computer chip manufacturer had found a flaw in its computer motherboards. The defective controller chip in the motherboard was not made by the chip manufacturer but was purchased by it from an outside supplier. Fortunately for customers who had purchased the faulty hardware, the manufacturer had developed a software program or "patch" that can correct the error.

But what did this faulty product mean to the chip manufacturer and the supplier? If the manufacturer sued the supplier, bringing a myriad of allegations--for examples, breach of contract, breach of warranties, loss of use, consequential damages to create and distribute the software patch. negligent representation of the product, etc.--could the supplier turn to its insurer for defense and indemnification?

Assume the supplier had a standard Insurance Services Office (ISO) 1986 commercial general liability policy, which promises to indemnify for damages as a result of "bodily injury" or "property damage." The policy defines bodily injury as "bodily injury, sickness or disease resulting from any of these at any time." Property damages is defined as "a. Physical injury to tangible property, including all resulting loss of use of that property; or b. Loss of use of tangible property that is not physically injured." If the supplier claims that its coverage has been triggered by a "property damage" claim from the manufacturer, will its insurer defend and indemnify for this loss?

Once an insured has tendered a claim, its insurer either must accept the tender or provide a basis for denying the claim. Let's assume that the supplier's insurer will deny the claim and base its denial of coverage solely on Exclusion m of the CGL policy. This provision, also known as the "impaired property" exclusion, was among the exclusions designed by the insurance industry to "exclude coverage for the business risk of the insured."(1) The theory behind these exclusions is that an insured should remain liable for losses that are within its control, such as the quality and conformity of its product.

Liability insurance policies are not intended to cover damage to the insured's product or work itself. The risk insured is the possibility that the product or work of the insured, once relinquished or completed, will cause bodily injury or damage to property other than to the product or work itself, and for which the insured may be found liable. A product manufacturer may be liable as a matter of contract law to make good on products that are defective or otherwise unsuitable because they are lacking in some capacity. The obligation of the product manufacturer may extend even to complete replacement of the product.

Such liability is not insured against. General liability insurance coverage is designed to cover tort liability arising from the unforeseen and accidental losses to others and not for contractual liability of the insured for economic loss because the product or work is not that for which the damaged person bargained.(2) Such tort liability is largely outside the insured's control, such as when the insured's product injures a consumer.

The impaired property exclusion upholds this theory. Nevertheless. although the theory behind the exclusion remains clear, the insurance industry hats experienced great difficulty encapsulating a comprehensive exclusion that effectively implements this theory and withstands judicial scrutiny.(3)

For example. the 1973 standard CGL policy provided that

This insurance does not apply . . . [Exclusion!

(m) to loss of use of tangible property which has

not been physically injured or destroyed resulting

from . . . (2) the failure of the named insured's

products or work performed by . . . the named

insured to meet the level of performance, quality,

fitness or durability warranted or represented by

the named insured....

The 1973 language led to battles over what constituted physical and non-physical injury and what was the insured's "work" or "product" versus "other property." Additionally, basing their decisions on the warranty language, some courts held that subpart (2) applied only to breach of contract cases and not to actions alleging tort or negligence.

In 1986, the ISO reformulated Exclusion m in order to "eliminate some defects in the prior exclusion that allowed coverage in cases where none was intended.... [The 1986 exclusion] makes no mention of warranties or representations of the named insured. The absence of such terminology should avoid the types of court decisions that have held the failure to perform exclusion to apply only to claims based on contractual grounds and not to claims alleging negligence."(4)

Will this reformulation be effective? To answer, one must begin with the language itself. The exclusion and the corresponding definitions are:

Exclusion m:

m. "Property Damage" to "impaired property"

or property that has not been physically injured,

arising out of:

(1) A defect. deficiency, inadequacy. or

dangerous condition in "your product" or "your

work;" or

(2) A delay or failure by you or anyone

acting on your behalf to perform a contact or

agreement in accordance with its terms.

This exclusion does not apply to the loss of use

of other property arising out of sudden and accidental

physical injury to your product or "your

work" after it has been put to its intended use.

* * *

Definitions:

"Impaired property" means tangible property,

other than "your product" or "your work" that

cannot be used or is less useful because:

a. It incorporates "your product" or "your

work;" that is known or thought to be defective.

deficient, inadequate or dangerous; or

b. You have failed to fulfill the terms of a contract

or agreement;

if such property can be restored to use by:

a. The repair, replacement, adjustment or removal

of "your product" or "your work;" or

b. Your fulfilling the terms of the contract or

agreement.

* * *

12. "Property Damage" means:

    a. Physical injury to tangible property, including

    all resulting loss of use of that property; or

    b. Loss of use of tangible property that is not

    physically injured.

    * * *

14. "Your product" means:

    a. Any goods or products. other than real property,

    manufactured, sold, handled, distributed or

    disposed of by: (1) You; (2) Others trading under

    your name; or (3) A person or organization whose

    business or assets you have acquired; and

    b. Containers (other than vehicles), materials,

    parts or equipment furnished in connection with

    such goods or products.

    "Your product" includes warranties or representations

    made at any time with respect to the fitness,

    quality...