(Article from Insurance Law Alert, December 2015)
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Answering questions certified by the Fifth Circuit, the Texas Supreme Court ruled that the installation of defective flanges in diesel units, without more, does not constitute physical injury under a general liability policy. U.S. Metals, Inc. v. Liberty Mut. Grp., Inc., 2015 WL 7792557 (Tex. Dec. 4, 2015).
U.S. Metals sold flanges to ExxonMobil for use in diesel units. After the flanges were installed, ExxonMobil discovered that they were defective. The process of replacing the flanges required the destruction of several components of the diesel units. U.S. Metals agreed to pay ExxonMobil for the costs of replacing the flanges as well as the loss of use of the diesel units during the process, and then sought indemnification from Liberty Mutual under a general liability policy. Liberty Mutual denied coverage. In ensuing litigation, a Texas federal district court ruled in Liberty Mutual’s favor. On appeal, the Fifth Circuit certified four questions relating to interpretation of several policy provisions. The questions presented two central issues: (1) did the mere installation of the faulty flanges cause “physical injury” to the diesel units when the only harm at that point was the risk of leaks?; and (2) is property “restored to use” by replacing a faulty component when the property must be altered, damaged and repaired in the process?
The Texas Supreme Court ruled that physical injury requires harm that is tangible and manifest. Therefore, incorporating a defective component into a larger product is not, in and of itself, physical injury, even though there may be intangible injury, such as diminution in value or increased risk of damage. However, the Court ruled that physical injury occurred when components were cut and destroyed in order to replace the faulty flanges. The Court distinguished between, on the one hand, the units considered as organic wholes, and, on the other hand, the particular components of the units. The Court found that “Exclusion M” of the policy barred coverage for physical injury to the units considered as organic wholes. Exclusion M precludes coverage for impaired property that can be “restored to use.” The Court found that the diesel units were impaired property that could be (and actually were) restored to use. Exclusion M did not apply, however, to those particular components of the units (e.g. the insulation and gaskets) that were not restored to use but destroyed and replaced. The policy therefore covered the cost of replacing such components.
The Court acknowledged the “perverse aspect” of the decision, noting that had ExxonMobil been negligent in failing to test the flanges, and had damage resulted, the policy would have provided coverage. However, the Court emphasized that coverage issues are dictated by policy language, not by “what coverage should be available.”