The Southern District of Texas has issued its latest ruling in U.S. Metals, Inc. v. Liberty Insurance Corp., 2017 WL 830398 (S.D. Tex. Feb. 27, 2017), a complex and longstanding coverage litigation concerning the interpretation of the “your product” and “impaired property” exclusions. U.S. Metals sold Exxon 350 flanges used to remove sulphur from diesel fuel at Exxon refineries. The flanges did not meet industry standards, and several began leaking. Because the flanges were welded onto diesel units, they had to be cut out while the refineries were closed for several weeks.  Items connected to the flanges such as gaskets and insulation also had to be cut out as part of the removal process.

Exxon sued U.S. Metals for $6 million in replacement costs and for $17 million as damages for the lost use of the diesel units. The parties eventually settled their dispute for $2.2 million. U.S. Metals tendered the claim to its general liability insurer, Liberty Insurance Corp, which disclaimed coverage based on the “your product” and “impaired property” exclusions.

In the ensuing coverage litigation, the Southern District of Texas granted summary judgment in favor of Liberty. The Southern District concluded the cost of replacing the flanges and the connected property was excluded under the your product and impaired property exclusions. The court also determined the loss of use damages were excluded by the impaired property exclusion. The insured appealed to the Fifth Circuit, which certified questions of law to the Texas Supreme Court.

The Texas Supreme Court was asked to determine whether the installation of faulty flanges physically injured the diesel units themselves. The Texas Supreme Court answered “no.” In doing so, it rejected the “incorporation theory,” in which a product is considered physically damaged when its value is lessened by a faulty component. Instead, the court embraced an “actual harm theory,” whereby physical injury requires tangible, manifest harm that does not merely result from the installation of a defective component. The Texas Supreme Court therefore concluded Exxon’s diesel units were not physically injured merely by installation of the flanges. However, the court also held that gaskets and insulation destroyed in the replacement of the flanges were replaced rather than restored to use. Therefore, the court concluded the gaskets and insulation were not impaired property, meaning the cost of replacing them was covered by the policy.

After receiving guidance from the Texas Supreme Court, the Fifth Circuit remanded the case back to the Southern District of Texas. Applying the “actual harm theory” rather than the “incorporation theory,” the court concluded the insurer was not entitled to summary judgment. Instead, it determined that tangible property that was destroyed as a result of the flange removal process was covered by the policy. The court therefore concluded Liberty had a duty to indemnify its insured for these costs.

The court also determined Liberty had a duty to defend, holding Liberty was liable for 18% interest based on the Texas Insurance Code’s Prompt Payment Statute. However, the court rejected the insured’s claims for bad faith and extra-contractual damages. The court reasoned that at the time of its coverage determination, Liberty arguably had a reasonable basis to deny or delay payment of the claim, especially based on the novel questions of Texas law.

There is considerable variance across jurisdictions concerning how property damage claims are treated in connection with general liability insurance. It is important for insurers to understand the nuances of each jurisdiction’s rules when evaluating their duties to defend and indemnify insureds in claims arising from such losses.