Supreme Court of Texas Declines to Adopt Incorporation Theory: But Destructive Repairs are Covered

Ruling on certified questions from the Fifth Circuit Court of Appeals, the Supreme Court of Texas has positioned the state as another jurisdiction to refuse to characterize mere incorporation of a defective component into a product or system as “physical injury” to property that would trigger coverage under a standard form CGL policy. The court also refused to narrowly apply the “impaired property” exclusion by rejecting the insured’s argument that the exclusion should be limited to those situations where the property is restored to use by the replacement of the defective product without affecting or altering the property in the process. The court did find, however, that the “impaired property” exclusion would not exclude coverage for any part of the property that is destroyed in the restoration process. In this case, the insured, a refinery parts manufacturer, filed suit in federal district court against its liability carrier to recover costs paid to settle an underlying liability action. The insured had provided custom component parts to a refinery for incorporation into machinery. As part of this installation, the refinery had to weld each of the insured’s flanges to machinery pipes and then cover the finished network with high temperature coating and insulation. After investigating leaks discovered in initial testing of the machinery, the refinery determined that the flanges were defective. To avoid the danger of potential explosion, the refinery, quite prudently, replaced all of the defective flanges before they were placed into operation, effectively delaying the operation of the units at the refineries for several weeks. The refinery sued the insured to recover the costs of replacing the faulty flanges, which necessitated labor-intensive destruction of the thermal coating, insulation, weldings and gaskets. It also sought loss of use damages for the machinery downtime. The insured settled with the refinery and sought indemnity from its carrier. The policy covered losses incurred because of “property damage,” defined as “physical injury to tangible property, including all resulting loss of use of that property” and “loss of use of tangible property that is not physically injured.” The policy then excluded “property damage” to “your product” and “property damage” to “impaired property” that arises out of the defect in your product. “Impaired property” was defined as tangible property that cannot be used or is less useful because of your product but that can be “restored to use by the repair, replacement, adjustment or removal of ‘your product.’” The insured argued the policy covered all repair and loss of use damages, because the machinery could not be used with the faulty flanges installed. It further argued the “impaired property” exclusion did not apply because the machinery could not be restored to use without the destructive process of replacing the flanges. The district court granted summary judgment to the carrier, and the insured appealed. The Fifth Circuit Court of Appeals, without Texas precedent on the matter, certified questions to the Supreme Court of Texas on essentially two issues: (1) is property “physically injured” by the mere incorporation of the faulty component, absent some tangible damage; and (2) is property “restored to use” by replacing the faulty component if the property must be damaged in the replacement process. The insured wanted the Supreme Court of Texas to adopt the incorporation theory of “physical injury” for CGL policy coverage that holds that merely incorporating a defective component into something constitutes a “physical injury” even if the product has not actually failed or produced tangible damage. Siding with the majority of jurisdictions that have considered the issue, the court declined to adopt the incorporation theory as a general rule. In refusing to do so, the court first concluded that without some manifest, physical harm, the mere presence of the faulty component part or resultant diminution in value of the property caused by the inclusion of the defective component does not trigger coverage under the policy because there is no “physical injury to tangible property,” which is necessary for coverage. The court noted that the “policy’s limitation of coverage to damages from physical injury necessarily implies that there can be non-physical, non-covered injuries….” Otherwise, the policy’s use of the term “physical” in this respect would be “superfluous.” While the court barred coverage for the replacement of defective components that did not cause physical injury, the court held that the replacement process did physically injure the machinery. Therefore, the insured was entitled to indemnification for damages, unless the “impaired property” exclusion applied. The court stated that this exclusion precluded recovery of damages for repair costs and loss of use because the machinery was successfully restored to use by the replacement of the defective flanges, thereby falling within the policy definition for “impaired property.” The court rejected the insured’s argument that the definition of “impaired property” should be limited to “property restored to use by the replacement of the flanges without affecting or altering the property in the process,” holding that such a limitation cannot be fairly inferred from the policy language. The insurer, however, was not entirely absolved from responsibility for the claim, because the court found that the costs incurred for replacement of the thermal coating, insulation, and gaskets feel outside the exclusion. Those parts were not “restored” to use, but were completely destroyed in the replacement process.

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