U.S. District Court of Colorado Interprets Insurance Policy’s Faulty Workmanship Exclusion and Exception for Ensuing Damage

Recently, the United States District Court for the District of Colorado interpreted a faulty workmanship exclusion in a property insurance policy in The Lodge at Mountain Village Owner Association v. Eighteen Certain Underwriters of Lloyd’s of London, 22 U.S Dist. Ct LEXIS 48883*, decided on March 18, 2022.  The Court held that the faulty workmanship exclusion at issue extended to preclude coverage for later ensuing damage that arose from the faulty workmanship, even though the damage was weather related, because faulty workmanship was the primary cause of the ensuing damage.

The claims in The Lodge at Mountain Village arose from maintenance work performed on log siding at three multi-unit condominium buildings in Telluride.  The maintenance work to the log siding included staining, finishing, and chinking repairs to joints between the logs.  About a year after completion of the work, The Lodge at Mountain Village Owners Association (“The Lodge”) notified the maintenance contractor that logs were extremely weathered and that its work was defective.  The Lodge retained an expert who prepared a report stating that the log finish and underlying wood was deteriorating because of the contractor’s work and that some areas were not properly protected from exposure to snow, rain, and brine from ice-melting salt.  The Lodge pursued and settled its claims against the contractor.

A year after filing suit against the contractor, but before settling those claims, The Lodge filed an insurance claim with its first-party property insurance carrier.  The insurance policy provided coverage for “All Risks of Direct Physical Loss or Damage except as hereinafter excluded.”  With respect to applicable exclusions, the policy stated that it did not insure against “the cost of making good defective design or specifications, faulty material, or faulty workmanship, unless physical loss or damage by a peril not excluded ensues and then this policy shall only cover for such ensuing loss or damage . . .”  The policy also excluded “ordinary wear and tear” and “gradual deterioration,” with the same language that “unless physical loss or damage by a peril not excluded ensues and then this policy shall only cover for such ensuing loss or damage.”  The insurance carrier denied the loss pursuant to the exclusions for faulty material, faulty workmanship, gradual deterioration, and ordinary wear and tear.  The Lodge then had its expert provide an additional report, which described damage that was due to the failed chinking sealant and that areas with failed chinking had increased moisture due to rain and melting snow events.  The Lodge provided this letter report to its insurance carrier and asked that it reopen the claim, describing the loss as damage that resulted from faulty workmanship, but noting that the damage ensued after the faulty workmanship.  The insurance carrier denied the claim a second time.

The Lodge then filed suit against its insurance carrier and the independent insurance adjuster that investigated the claim, asserting claims of breach of contract, statutory bad faith, and common law bad faith.  The parties agreed that the damage arose from faulty workmanship.  The question addressed by the Court was whether the ensuing damage was covered by the insurance policy.  The Lodge’s argument was essentially that the contractor did not cause the damage itself, but that it was caused by later moisture intrusion from rain and snow.  The Court noted that, though courts around the country have reached mixed results regarding ensuing damage caused by excluded perils, they all agree with the principle that “the exception cannot be allowed to swallow the exclusion.”  Therefore, the Court found that the cause of the damage claimed by The Lodge was the construction defect, not a later covered peril.  There was no dispute that the damage to the logs was caused by the contractor’s failure to properly seal the logs, which led to water penetrating behind them, which the Court found to have unambiguously fallen within the exclusion for faulty workmanship.  The court noted that, to read the policy as The Lodge requested, would have resulted in coverage for the very damage caused by the construction defect, which was excluded under the policy.  In other words, it would allow the exception to swallow the exclusion.

The Court went on to analyze whether the damage would similarly be excluded by the ordinary wear and tear and gradual deterioration exclusions.  The Lodge argued that the damage was due to moisture from rain and snow.  The Lodge had described such damage in its complaint and discovery responses as resulting from “slow, hidden, and repeated intrusion of water,” which was “slow and discrete,” and “gradual and progressive.”  Based on this description, the Court found that The Lodge’s argument that the damage was due to later rain and snow intrusion would similarly result in a lack of coverage for the damage because it would fall under the policy’s exclusion for gradual deterioration.

The Court also held that another basis to dismiss The Lodge’s breach of contract claim against the insurer was that The Lodge had failed to notify the insurer of the claim until at least 24 months after it discovered the damage.  The Court held that it was undisputable, as a matter of law, that The Lodge did not notify its insurance carrier of the claim within a reasonable time as required by the insurance policy.  Therefore, the Court dismissed The Lodge’s breach of contract claim for this additional reason.

Since the Court dismissed The Lodge’s breach of contract claim against its insurance carrier, there was no basis for its bad faith claims against the carrier as a matter of law.  This opinion upholds the U.S. District Court’s inclination to interpret insurance policy language strictly, and to not permit an insured to use an exception to an exclusion to serve as a means for the insured to get around an exclusion.  Also, it provides guidance to policyholders that damage arising from defective workmanship will not be covered where there is a faulty workmanship exclusion unless there is a subsequent loss legitimately caused by a covered peril.