The "Impaired Property" General Liability Exclusion; Manufacturers Need for Errors & Omissions Insurance

When you think of manufacturer's exposure to risk, the first thing that comes to mind is the potential for bodily injury and property damage caused by products, and for good reason.  Bodily injury and property damage claims arising out of manufactured products are well documented, as evidenced by highly publicized court cases with sizable damage awards.  But what if a product doesn’t cause bodily injury or property damage, but fails in its warranted capacity and causes financial loss to a customer?   Many manufacturers are exposed to this very risk, but the problem is that general liability/products liability will not cover it.  The insuring agreement in standard ISO general liability forms agrees to pay sums that an insured becomes “legally obligated to pay as damages because of bodily injury or property damage”, so the door closes there.  Further, the “Damage to Impaired Property Exclusion” found within most general liability coverage forms nails the door shut, creating a potentially significant impact on a manufacturer’s overall risk exposure.

The “Damage to Impaired Property”, aka “Property Not Physically Injured” exclusion basically removes coverage for your product or your work that fails to perform its intended or warranted function, but subsequently does not cause any bodily injury or property damage.  The exclusion does not apply if there is a “sudden and accidental physical injury” to your product once it is put to its intended use. The exclusion centers on the definition of “impaired property”, which is: any tangible product other than your product that incorporates your product that is or could be defective, deficient, inadequate, or dangerous; or you have failed to fulfill the terms of a contract;  the “impaired property” can be restored to use by the repair, replacement or removal of “your product”; or the fulfillment of the terms of the contract.  

Put simply, if your product is a component in the product of a third party, and the end product cannot function because your product is faulty, there is no coverage for any resulting financial loss to the third party.  The litmus test is whether or not the repair, removal, or replacement of your component fixes the problem.  If it does, the exclusion stands.  If it doesn’t, the exclusion is inapplicable. For example, your product is a chemical additive in the batch of a third party, and it is later found that your chemical additive was not accurately produced.  Your chemical cannot simply be removed from the compound of the batch, so the exclusion would be inapplicable.  The incorrect additive would have rendered the batch useless, essentially causing property damage, which would be covered under the standard general liability insuring agreement. 

Manufacturers Errors & Omissions Insurance (E & O) is designed to cover these gaps in products liability coverage.  It is a non-standard and highly customizable insurance coverage, and as such, policy forms will vary among the insurance carriers that offer it.  In general, it covers an insured for legal obligation to pay financial damages arising out of covered products and/or services.  Premiums for E & O coverage are based on such criteria as the nature of the product or service, company & professional experience, financial stability, limits and retentions, and annual revenues.  

The possible claim scenarios for E & O exposures are numerous and distinct, and are the basis for any manufacturer to consider purchasing E & O insurance.

Consider the following examples:

• Your product is a component in a customer’s finished product.  A short time after installation, it is discovered that the product isn’t working correctly because your component is faulty.  Your customer has to recall their product to remove and replace your faulty component. Further, many customers are unhappy and do not want replacements. Your customer suffers unforeseen expenses and lost profits as a result, and they sue you to recoup their financial loss.

• Your product is a device that regulates portion control within the automated production line of one of your customers.  Your device was not calibrated correctly, and it is several weeks before it is discovered that their product was being portioned at a higher volume than it was supposed to be.  As a result, your customer's profit margin suffers on the affected batches, they incur extra expense to correct the problem, and lose revenue due to the down time. Your customer sues you to recoup their financial loss.

• Your machine shop fabricates a part for a customer with a tight contract deadline in order to ship a product.  After your customer receives your parts and starts installing them, they realize that the parts are not to their exact specs and cannot be used.  Since there isn’t enough time to re-fabricate the parts, your customer cannot ship their end product in time and as a result they miss the deadline and lose out on the contract.  Your customer sues you to recoup their financial loss.

Manufacturers should take the time to consider the potential scope of how an error or omission in the production of their product(s) could cause a customer financial harm.  In most cases, the customer would exercise their rights and seek to recoup their financial loss from the manufacturer.  Leaving this distinct E & O gap uncovered would mean that the manufacturer would end up paying for the loss out of pocket.  Errors & Omissions insurance can be the solution, deflecting potential impact that could have severe financial ramifications on a manufacturer.