Texas Supreme Court Addresses Impaired Property Exclusion

In U.S. Metals Inc. v. Liberty Mut. Ins. Group, Inc., 2015 Tex. LEXIS 1081 (Tex. Dec. 4, 2015), the Texas Supreme Court had occasion to consider whether the mere incorporation of a defective component into a larger product constitutes “property damage” in the absence of tangible, manifest harm to the larger product.

U.S. Metals sold ExxonMobile Corp. (“Exxon”) 350 flanges for use in its refineries in Texas and Louisiana.  The flanges were welded to piping in diesel units in the refineries and covered with coating and insulation.  The flanges began leaking when they were first tested, and Exxon decided to replace the flanges.  The replacement process required Exxon to strip the coating and insulation, cut the flange out of the pipe, remove the gaskets (which were destroyed in the process), grind the pipe surfaces for re-welding, replace the flanges and gaskets, weld the new flange to the pipe and replace the coating and insulation.  The replacement process delayed the operation of the refineries for several weeks.

Exxon sued U.S. Metals for $6,345,824 representing the cost of replacing the flanges and $16,656,000 for damages for the lost use of the refineries during the process. U.S. Metals settled with Exxon for $2.2 million and sought indemnification from Liberty Mutual under a commercial general liability policy.  Liberty Mutual denied coverage and U.S. Metals initiated suit in federal court to recover the cost of the settlement.  The district court granted summary judgment to Liberty Mutual and Exxon appealed to the U.S. Circuit Court of Appeals for the 5th Circuit.  The 5th Circuit certified four questions to the Texas Supreme Court relating to whether covered “property damage” was alleged and the application of the “impaired property exclusion.” 

The Texas Supreme Court held that damages to the flanges themselves were not covered under the “your product” exclusion of the policy, which barred coverage for “‘property damage’ to ‘your product’ arising out of it or any part of it.”

The Court then addressed the application of the “impaired property” exclusion, which precludes coverage for property damage if the property was not physically injured or if it was restored to use by replacement of the flanges.  U.S. Metals argued that the exclusion could not apply because Exxon’s property was physically injured by the mere installation of the faulty flanges and also during the replacement process. Alternatively, U.S. Metals argued that the refineries could not be restored to use simply by replacing the flanges because welds, gaskets, insulation, and coating were destroyed in the process and had to be replaced as well.

The Court rejected U.S. Metals’ first argument, holding that “the best reading of the standard-form CGL policy text is that physical injury requires tangible, manifest harm and does not result merely upon the installation of a defective component in a product or system.”  Because Exxon replaced the flanges before they caused any such injury, the diesel units in the refineries did not suffer property damage by the mere installation of the defective component – i.e. the flanges.

Turning to U.S. Metals’ second argument, the court acknowledged that some physical injury did occur when the original welds, coating, insulation and gaskets were destroyed during the replacement of the flanges.  Therefore, the repair costs and damages associated with the downtime at the refinery were covered “property damage” unless the “impaired property” exclusion barred coverage.  The policy defined “impaired property” as property that could be “restored to use by the … replacement” of the faulty flanges.  U.S. Metals argued that because the flanges could not simply be replaced, but instead required damage to other property, the exclusion could not apply.  The Supreme Court rejected that argument, holding that the application of the exclusion does not depend on whether incidental damage was caused in the process of replacing the flanges.  Rather, the diesel units were restored to use by replacement of the flanges and therefore the units constituted “impaired property” for which coverage is excluded.  The Court found that coverage was only owed for the insulation and gaskets that were destroyed during the process of replacing the flanges.