The document discusses various types of defect exclusions commonly found in CAR/EAR insurance policies for offshore contractors. It describes the different LEG clauses - LEG1/96 contains an outright defects exclusion, LEG2/96 excludes costs to repair defects but covers consequential damage, and LEG3/96 covers damage from defects but excludes additional costs to improve the original design. It also discusses exclusions in WELCAR 2001 policies and differences between defining defects versus damage. The key points are that defect exclusions aim to balance coverage for damage from defects while excluding coverage to repair defects themselves, and interpretation depends on how parts and damage are defined.

1. DEFECT EXCLUSIONS
November 2012
Angela Haylett

2. Introduction
Offshore contractors and employers routinely purchase CAR/EAR policies and should
be aware that these policies (and indeed operational policies) commonly contain
defect exclusions. The type of exclusion that a policy contains may affect how their
insurance will respond to a claim.
Common clauses are the London Engineering Group (LEG) clauses:
LEG1/96 – outright defects exclusion
LEG2/96 – consequences defect exclusion
LEG3/96 – improvements defects exclusion
LEG3/06 – amended improvements defects exclusion
WELCAR 2001 Section I contains the “Defective Parts” exclusion clause with the
possibility of the part exclusion buy-back.
The 1995 Design Exclusion Clauses 1 to 5 largely overlap with the various LEG
clauses (with some subtle differences). DE1 to DE5 are not addressed in this
presentation.

3. Interpretation of the Exclusions
Application of exclusions depends how you define:
• Defect
• Damage
• Insured Property
• Part

4. Basic All Risks Cover
In Gaunt’s Case (1921) the House of Lords stated that:
“All risk insurance covers a risk not a certainty; it is something
which happens to the subject matter from without not a natural behaviour of
that subject matter being what it is…”
In practice, this rule = too narrow and unworkable. Defects can result in very serious
consequences such as catastrophic failure or explosion.
Insureds and insurers have sought to strike a balance between:
Cover for damage Guaranteeing
from defects the work

5. LEG1/96
“The Insurer(s) shall not be liable for
Loss or damage due to defects of material workmanship design plan or
specification.”
• Very broad - outright defects exclusion.
• In respect of loss or damage due to defects – even wider than proximately
caused by defects.
• Used by underwriters where the risk of loss is very high eg prototypical
constructions.

6. LEG2/96
“The Insurer(s) shall not be liable for
All costs rendered necessary by defects of material workmanship
design plan 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 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.”

7. LEG2/96
• Puts the insured in the position it would have been in prior to the
damage occurring - broadly excludes everything except
consequential damage.
• By conceptually setting aside any consequential damage, the
clause excludes the cost of repairing the defects cost of replacing
other non-defective damaged property may be excluded if it would
have had to be removed and replaced in order to repair the defects
in any event eg to gain access.
• Advantage = no need to distinguish between the defective
property/part and other property.

8. LEG3/96
“The Insurer(s) shall not be liable for
All costs rendered necessary by defects of material workmanship
design plan 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
incurred to improve the original material workmanship design plan or
specification.
For the purpose of this 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.”

9. LEG3/96
• Cover for the damage to defective property due to defects within it (and
consequential damage)
BUT
Excludes any additional cost incurred relating to an improvement so as to
avoid the damage occurring again.
• Question = when does the defect become damage – defect alone is
insufficient for cover under LEG3.

10. LEG3/06
“The Insurer(s) shall not be liable for
All costs rendered necessary by defects of material workmanship design
plan or specification and should damage (which for the purposes of this
exclusion shall include any patent detrimental change in the physical
condition of the Insured Property) 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 incurred to improve 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”.

11. LEG3/06
•The amendment to this clause (shown in bold) arose out of uncertainty
arising from the Skanska v Eggar case - Court of Appeal held that a latent
defect becoming patent did not constitute damage.
• Expansion of cover? Not really:
– not all latent defects throughout the property simultaneously become
patent; and
– the amendment largely reflects the way a court would approach the
definition of “damage” in an insurance context in any event – see
“NUKILA”.

12. Faulty Design Inclusion Clause (Builder’s
Risk)
“It is understood and agreed that physical loss and/or physical damage to the subject
matter insured during the period of the Policy caused by faulty design, faulty or
defective materials, faulty or defective workmanship (including welding), including
physical loss and/or defect and/or damage to the faulty part shall be covered
hereunder, even though the fault in design and/or defect may have occurred prior to
the attachment date of this Policy.
Including the cost of repairing, replacing or renewing any defective part or parts
condemned solely in consequence of the discovery therein during the period of
this policy of latent defect.
Notwithstanding the foregoing it is understood and agreed that coverage in respect of
faulty or defective materials and/or faulty and defective workmanship, including
welding, does not apply in respect of any loss solely by reason of the item failing to
meet its design specifications or unfit for its intended purpose.”

13. WELCAR 2001 Section I
“Terms and Conditions
(Section I Only)
7. Defective Parts
The insurance afforded by Section I covers physical loss and/or physical damage to the property
insured herein occurring during the Policy Period and resulting from a Defective Part, faulty
design, faulty materials, faulty or defective workmanship, or latent defect even thought the fault in
design may have occurred prior to the attachment date of the Policy.
Section I, however, does not provide coverage for loss or damage to (including the cost of
modifying, replacing or repairing) and Defective Part itself, unless all of the following are satisfied:
(a) such Defective Part has suffered physical loss or physical damage during the Policy Period
(b) such physical loss or physical damage was caused by an insured peril external to that part;
and
(c) the defect did not cause or contribute to the physical loss or physical damage.
In no case shall Section I provide coverage for any cost or expense incurred by reason of
betterment or alterations in design… “
• Shows that insurers intend to cover for physical loss/damage arising from defects but exclude
loss/damage to a Defective Part unless it is damaged by an independent cause.

14. WELCAR 2001 Section I
“…7. Defective Parts (cont)
…In the event of the total physical loss or total physical destruction of one or more of the items
listed in the Schedule “B” attached to the Policy, then this exclusion shall only apply to an
identifiable part or parts of such scheduled item or items.
For the purposes of this clause a “Defective Part” shall mean any part of the subject matter
insured which is or becomes defective and/or unfit or unsuitable for its actual purpose, whether by
reason of faulty design, fault workmanship, a combination of one or more thereof or any other
reason whatsoever. The term “Defective Part” shall also include such ancillary components,
which are not themselves faulty, but which would normally be removed and replaced by new
components when the component that is faulty is rectified.
This clause shall prevail in the event of any conflict or inconsistency with any other clause forming
part of the Policy. The terms of this clause are not intended and shall not be construed as
providing coverage not otherwise provided under the Policy.”
• Must distinguish “part” from remainder of the property insured  notoriously difficult!

15. WELCAR 2001 Section I - buyback
“Defective Part Exclusion Buyback
Notwithstanding the provisions of the Defective Part Clause in Section I of the attached Policy,
this insurance will pay for the cost of repair or replacement of defective parts which have suffered
physical loss and or physical damage during the Policy Period, but the recovery
of such costs is subject to:
deductible $_______ each part, each accident or Occurrence; and
a total aggregate limit of $_______ for all losses during the Policy Period, including the
Maintenance Period; and
the provisions of the Basis of Recovery Clauses in Section I of the Policy; and
an additional premium $_______ being paid in full.
However, it is specifically understood and agreed that this endorsement will not provide recovery
for cancellation charges, stand-by costs or consequential costs or expenses that would not be
recoverable under the terms and conditions of the Policy in the absence of this clause.”
• Buyback only provided by insurers on a selective basis.
• Does not remove the issue of identifying the “defective part” because separate deductible is
applied in respect of each part, each accident or occurrence.

16. Damage vs Defect and Definition of Part
 Crucial to the interpretation of defect exclusion clauses:
– Have any defects become damage?
– Which part(s) is or are defective?
– Has the defect and/or damage in that/those part(s) caused damage to
other parts of the insured property?
 Very limited case law - rulings on each case would be too fact specific.

17. Defect vs Damage and Definition of Part
Arnould: Marine Insurance defines defect as:
“A condition causing premature failure which is present in the relevant part…
when it is constructed or installed…or which comes into existence as a result
of the way in which the relevant part was designed, constructed or installed.”
Traditional distinction:
– “Defect” = state of affairs
– “Damage” requires some sort of occurrence.
But modern technology (eg MPI and UT)  can identify molecular changes
in structures and predict premature failures. Has damaged occurred by
reason of these changes?

18. Defect vs Damage and Definition of Part
Not much directly applicable English case law on these questions but see
Pilkington Glass and “NUKILA” cases (plus others).
Avoid metaphysical argument;
Matter of fact and degree
Imminence of loss is not the same as damage.
Resounding impression = English court adopts a common-sense approach
in asking what a part is, whether it is damaged or simply defective and
whether it has caused damage to other insured property.
Tip:
When interpreting and applying the defects exclusion clauses: Take a step
back and ask whether a lay person would see the alleged “part” as a
separate part, whether that same person would think it is damaged or
defective and whether that same person would thinit is has damaged other
insured property.

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