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WORKSHOP M5

Monday, November 7
10:30 a.m.–11:45 a.m.

BUILDERS RISK AND THE IMPACT OF LEG‐3

Presented by

Lori Montoya
National Construction Property Director
Zurich North America

Workshop M5
London-based builders risk policies have long included a LEG-3 defects exclusion,
which removes coverage for costs incurred to improve defects of material,
workmanship, design, plan, or specification. Although LEG-3 endorsements are still
rarely used in the United States, they are becoming more common in policies covering
large construction projects. In this session, contractors and their insurance advisers
will learn the key differences in LEG exclusions, how they affect coverage, and issues
that prevent clarity around the intended scope of the exclusion.

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Lori Montoya
National Construction Property Director
Zurich North America

Ms. Montoya is the national construction property director for Zurich North America’s Construc-
tion Industry Segment. In her current role, she is responsible for overseeing the strategy and prof-
itability of the National Construction Property team, including Canada. Previously, she served as
the West Region construction property manager and a large property underwriter. Prior to joining
Zurich, Ms. Montoya held positions of increasing responsibility at Fireman’s Fund, Marsh, and The
St. Paul Companies. She graduated from the University of Denver with a BS/BA degree in business
management and real estate.

Workshop M5

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Notes

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Builder’s Risk and the Impact of LEG 3

Lori Montoya, Property Practice Lead


Zurich North America

Education | Connection | Opportunity

Workshop M5
Key principles of a builder’s risk policy

• The goal of insurance is to make the insured “whole” after sustaining a covered loss,
which does not include betterment
• It is a first-party cover
• Coverage is provided for all perils, unless excluded
• Losses must be fortuitous in nature, happening by accident or chance, not by design
• Physical damage must occur for coverage to be triggered under a builder’s risk policy

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Key principles of a builder’s risk policy

Business Risk Liability Insurance Property Insurance


Project not built as agreed Professional Indemnity (architects, All risks of physical damage
Rectifying defects engineers, etc.)
Natural Catastrophe / Fire
Not fit for purpose Performance Bond
Resultant damage from defects
Wear and tear/deterioration etc. Manufacturer’s Warranty
Delay CGL – PD or Bodily Injury (incl.
Insolvency following defects)
Workers’ Compensation

Traditional US approach to defective cover

• Traditionally, builder’s risk policies have only covered “ensuing loss” from defect by:
• Exclusion stating policy that does not cover the cost of making good a defect or loss or
damage caused by or resulting from a defect
• Exception outlining said exclusion shall not apply to physical loss or damage resulting
from such fault, defect, etc.; commonly known as the ensuing loss provision and
basically restores coverage for losses arising from the excluded peril (i.e., defect) if
caused by a separate and independent peril
• Manifestation of a defect or damage to the defective part specifically not covered
• Losses wholly separate from the defective materials themselves specifically covered

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Traditional US written defect exclusion interpretations

Welding failure Buckling of material Foundation with Wall collapse


defective concrete Cracking in piles
• Court held there was no • No coverage for loss from • Where wall collapsed as a
peril separate from and in buckling of marble facade • Finding cracking in piles of
• Costs to repair building result of faulty
addition to the initial that was caused by wear a building during
foundation constructed workmanship, repair costs
excluded peril of the and tear; the non- construction was excluded
with defective concrete were not covered; In order
welding failure and kettle excluded causes grew out by virtue of the policy’s
were excluded by the for ensuing loss provision
rupture because the of and were directly faulty workmanship and
“faulty or defective to be operative, there had
spillage of molten zinc related to the excluded cracking exclusions and
workmanship or material” to be “collateral or
was part of the loss causes alleged resulting material
exclusion where no subsequent damage or loss
directly caused by the impairment of structural
separate physical loss or as a result of the collapse
excluded peril, not a new integrity to the building
damage ensued of the wall”
hazard or phenomenon was not an ensuing loss

Workshop M5
History of LEG coverage

Exclusionary wording used in a builder’s risk policy to progressively provide coverage for a traditionally excluded peril
(defect in design, materials or workmanship) in a builder’s risk policy; generally focuses on defect vs. damage

LEG = London Engineering Group


Established in London market as a consultative group for insurers and reinsurers active in the “Engineering Market”
(i.e., energy, operational power)

1990’s: LEG crafted 3 variations of defects exclusions that allowed for varying degrees of coverage for use within
infrastructure projects
These defect exclusions were initially adopted by European insurance markets; now finding their way into the US marketplace

DE = Defects Exclusion Clauses:


These are another set of 5 clauses used to address defects in European markets that are not used and/or referenced in the US

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Three levels of coverage provided by LEG exclusions

A model “outright” defects exclusion


LEG 1/96 • “The insurer(s) shall not be liable for: Loss or damage due to defects of material workmanship design plan or specification”

A model “consequences” defects exclusion


• “The Insurer(s) shall not be liable for: All costs rendered necessary by defects of material workmanship design plan or specification and should damage occur to any
portion of the Insured Property containing any of the said defects the cost of replacement or rectification which is hereby excluded is that cost which would have
been incurred if replacement or rectification of the Insured Property had been put in hand immediately prior to the said damage. For the purpose of this policy and
LEG 2/96 not merely this exclusion it is understood and agreed that any portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of
any defect of material workmanship design plan or specification” .
• The measure is to subtract the hypothetical costs of fixing a defect immediately before the damage occurred.

A model “improvement” defects exclusion


• “The Insurer(s) shall not be liable for: All costs rendered necessary by defects of material workmanship design plan or specification and should damage occur to any
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portion of the Insured Property containing any of the said defects the cost of replacement or rectification which is hereby excluded is that cost incurred to improve
LEG 3/96 the original material workmanship design plan or specification. For the purpose of the policy and not merely this exclusion it is understood and agreed that any
portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship design plan or
specification”
NOTE: “damage” in this version of wording has been qualified so as to include “any patent detrimental change in the physical condition of the insured property”. A change made to the original LEG
3/96 clause in response to observations made in a case relating to a dispute under a building contract and not an insurance policy (Skanska Construction Ltd vs. Egger (Barony) Ltd.).
• The measure is subtracting the actual costs of making the property “better” from all covered damage.
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Comparison of costs covered by each level of LEG wording
LEG 1 LEG 2 LEG 3

Costs to remedy defects where no damage has occurred

Costs to remedy resultant damage due to defects

Costs to remedy resultant damage to property supported by


Typically Excluded
defective property
Possible - Depends on
Costs to remedy defective property Circumstance of Loss
Costs to remedy defective part, portion or item Typically Covered

Loss, damage or costs incurred to access defective part

Costs to improve original design, plan, specification,


workmanship or material

Workshop M5
Practical application of defective loss
Example 1: defective roof structure
• Several steel framed industrial units under construction at one site
• Designers have miscalculated stress on the bolts that secure the roof beams together
• Bolts fail as the final roofing panels are being fitted to one unit, which collapses and
damages another unit on site
• Costs are incurred for:
• Replacing bolts that failed
• Replacing the roof structure that was damaged when it collapsed
• Making good damage to the supporting wall
• Repair of damage to the other unit on site
• Redesign costs for defective bolts (a defect of design)
• Replacement of the bolts already fitted in the other units
What costs would have been incurred if LEG 2 What costs would have been incurred if LEG 3
exclusionary wording applied? exclusionary wording applied?
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Practical application of defective loss
Example 2: Kansas City Hyatt Regency Atrium Walkway Collapse
• Loss: Two of three suspended walkways inside a hotel atrium collapsed during a public event
being held in the hotel’s lobby. The falling walkways killed 114 and injured 216.
The two-level walkway was suspended over the hotel atrium with the use of threaded steel rods
supported from the atrium celling. The hanger rods connected to welded, steel box-beams that
were part of the walkway support framing.
• Design Change: A modification of the original design occurred during construction because the
contractor on site found the installation of the continuous support rods too complex, difficult to
fabricate, and time consuming. They proposed using two hanger rods in lieu of a single rod,
offset at the upper walkway support connection. The Design Firm was allegedly called and a
change discussed. The Designer approved the shop drawings reflecting the modification. Later,
it was determined this was done without any re-calculation of loads and stresses which
ultimately doubled the load on the connection between the upper walkway support beams and
the hanger rods carrying the weight of both walkways.

Source: "Hyatt Regency walkway collapse." Wikipedia. <https://en.wikipedia.org/wiki/Hyatt_Regency_walkway_collapse#cite_note-KCPitch-2>


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Workshop M5
Practical application of defective loss
Example 2: Kansas City Hyatt Regency Atrium Walkway Collapse
• Loss Scenario: Due to the excessive forces transferred through the connection as a result of the fabricator's
change, the box beams split along the weld and the hanger rod nut supporting them slipped through the
resulting gap between two C-channels welded together to form the box beam. Therefore, the revised
hanger rod-to-box beam connection (and unintended redistribution of loads) was the cause of the walkway
collapse (i.e., design defect). Ultimately, an entirely new walkway design was implemented, foregoing the
hanger rod concept and using steel support columns.
• Costs incurred:
• Replacing hanger rods and walkway support steel
• Replacing the lobby damage as a result of the walkways collapsing on top of it
• Making good damage to any supporting property of the walkways
• Repair of damage to surrounding property on various floors
• Redesign costs for the walkway support connection
What costs would have been incurred if LEG 2 What costs would have been incurred if LEG 3
exclusionary wording applied? exclusionary wording applied?
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Practical application of defective loss
Example 2: Kansas City Hyatt Regency Atrium Walkway Collapse
Question: Does LEG 3 always give an insured a better end result?

HYPOTHETICAL COSTS
Replacing steel hangar rod – box beam connections $1,000,000

Replacing the lobby damage as a result of the walkway collapse $15,000,000

Making good damage to any supporting property of the walkways $5,000,000


Repair of damage to surrounding property on various floors $5,000,000

Redesign costs for new walkway support system $100,000


VALUE OF LOSS: $26,100,000

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Workshop M5
Practical application of defective loss
Example 2: Kansas City Hyatt Regency Atrium Walkway Collapse

PRACTICAL APPLICATION: LEG 2 CALCULATION METHOD

The measure is to subtract the hypothetical costs of fixing defect immediately before damage occurred
Total value of loss $26,100,000

Cost of fixing defect prior to loss (assumes simple solution) -$100,000

Cost for betterment (new, more complex support system) -$200,000


LEG 2 deductible -$50,000

Covered Loss $25,750,000

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Practical application of defective loss
Example 2: Kansas City Hyatt Regency Atrium Walkway Collapse

PRACTICAL APPLICATION: LEG 3 CALCULATION METHOD

The measure is taking all covered damage and subtracting actual costs for making the property better
Total value of loss $26,100,000

Cost for betterment (new, more complex support system) -$200,000


LEG 3 deductible -$250,000

Covered Loss $25,650,000

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Practical application of defective loss


Example 3: U.K.’s Eurostar Terminal at Waterloo Station
• Loss Scenario: Specialized glass roof was installed in the new station and later
determined it COULD fail; failing roof would be a danger to the public. It was stated that
“the methods of installation of the glass panels (workmanship) led to a significant
number of defects such as damaged panels, incorrect tolerances, loose, missing,
misaligned and damaged fittings and sealants.”
• Issue: No physical damage to covered property thus far; only a defect. “Damage”
requires an altered state. Argument was whether or not a shortened useful life is
considered “damage”. Courts held this is NOT a LEG 3 covered loss based on the damage
vs. defect argument.

What costs would have been incurred if LEG 2 What costs would have been incurred if LEG 3
exclusionary wording applied? exclusionary wording applied?
Source: Swiss Re Engineering Seminar. Miami, FL. 2016.
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Key takeaways

• Because this is an emerging request in the US, there are fewer experts to speak with
certainty on the topic
• Litigation knowledge is developing, so “standards” are still to be set in many scenarios
• Drawing conclusions from litigation in other countries and among various forms poses
difficulties
• Difficult to determine what risks pose higher exposure when LEG 3 is involved
• Awareness that LEG 3 may not always put an insured in a more favorable financial
position
• Key to understand where insurance coverage is best suited and basic principles of
insurance
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The information in this publication was compiled from sources believed to be reliable for informational
purposes only. All sample policies and procedures herein should serve as a guideline, which you can use
to create your own policies and procedures. We trust that you will customize these samples to reflect
your own operations and believe that these samples may serve as a helpful platform for this endeavor.
Any and all information contained herein is not intended to constitute advice (particularly not legal
advice). Accordingly, persons requiring advice should consult independent advisors when developing
programs and policies. We do not guarantee the accuracy of this information or any results and further
assume no liability in connection with this publication and sample policies and procedures, including any
information, methods or safety suggestions contained herein. We undertake no obligation to publicly
update or revise any of this information, whether to reflect new information, future developments,
events or circumstances or otherwise. Moreover, Zurich reminds you that this cannot be assumed to
contain every acceptable safety and compliance procedure or that additional procedures might not be
appropriate under the circumstances. The subject matter of this publication is not tied to any specific
insurance product nor will adopting these policies and procedures ensure coverage under any insurance
policy.
©2016 Zurich American Insurance Company. All rights reserved.

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