Design Clauses in Engineering Contracts Industry Standard Wordings in Comparison In large-scale engineering projects, millions of dollars in potential losses hinge on the integrity of each and every constituent part. When a loss event arises from defective design, materials, or workmanship, the design clause determines what is covered and what is not. A clear definition of these clauses is obviously critical, yet the standard wordings found in the marketplace are often confusing and misleading. An analysis of the two industry standard wordings - the London Market Defect Exclusion (DE) and Munich Re wordings - goes a long way toward sorting out the confusion. The First Standard - London Market Design Clauses The London Market design clauses offer five distinct levels of coverage against defects in design, materials, and workmanship. Taken individually, each level of coverage seems to explain itself, yet each clause differs subtly from the next. The five clauses, in order of increasing coverage, run as follows: DE 1: Outright Defect Exclusion. Excludes any and all damages due to property in a defective condition. DE 2: Extended Defective Condition Exclusion. Excludes damages to (a) property that is in a defective condition, or (b) property that relies on (a) for support. Consequential damage to any other property free of defective conditions, however, is covered. DE 3: Limited Defective Condition Exclusion. Excludes damages to property that is in a defective condition, in whole or in part; covers consequential damage to any other property free of defective conditions. DE 4: Defective Part Exclusion. Excludes damages to only that constituent part of the property that is deemed defective (the "faulty part"); covers consequential damage to any other property free of defective condition. DE 5: Design Improvement Exclusion. Covers all damages excluding only the additional costs of improvements to the original design, materials, etc. For each of these clauses: "Defective condition" is defined as "a defect in design, plant, specifications, materials, or workmanship." Here, "workmanship" means the manufacture of the property itself, not the on-site construction or erection of the property, which is always covered; property lost or damaged to enable the repair of the defect is not covered (e.g., if you tear down a wall to gain access to repair the property, the wall is not covered); and design, materials, etc., are not considered "damaged" merely by the presence of a defect. To trigger the cover, the defect must result in a sudden and unforeseen physical loss event. Case Study A marble column fails because its inner steel supporting rod (the faulty part) is defective in design or material. The roof collapses, causing extensive damage to an expensive tile floor. Under these circumstances: DE 1 covers nothing. DE 2 covers the floor, but doesn't cover the roof or the column. DE 3 covers the floor and the roof, but doesn't cover the column. DE 4 covers the floor, the roof, and the column, but doesn't cover the supporting rod itself, DE 5 covers everything, but doesn't cover a different type of supporting rod to be used in repairs. DE 1 and DE 5, which cover one end of the spectrum each, are relatively easy to apply: DE 1 excludes everything, while DE 5 covers everything, minus improvement expenses. DE 2 is also relatively unambiguous. The difference between DE 3 and DE 4, however, isn't immediately obvious: DE 3 literally excludes "loss of or damage to and the cost necessary to replace, repair or rectify property insured which is in a Cổng thông tin Bảo hiểm Việt Nam Page 1
defective condition due to a defect... of such property insured or any part thereof". In this case, the entire column including the supporting rod isn't covered. DE 4, meanwhile, excludes "loss of or damage to and the cost necessary to replace, repair or rectify any component part or individual item of the Property Insured which is defective..." In this case, the supporting rod alone isn't covered. Often, the distinctions aren't as easy to determine as in this case: If a faulty winding causes a fire in a USD10-million transformer and results in a total loss, DE 3 coverage wouldn't pay for anything. DE 4 coverage would pay for everything except the directly affected winding or "faulty part," which may have cost only a few dollars. Moreover, it may be almost impossible to determine the source of the defect. In such cases, the insured, the insurer and a loss adjuster must thoroughly examine the damaged property and find the source of the damage to attach liability. The process is much like searching through the wreckage of a plane for the all-important black box. Proper identification of risks and appropriate covers are critical in writing contracts for such eventualities: If a million-dollar gas turbine is at risk from a defective two-dollar rivet, DE3 could have catastrophic results for the insured, while DE4 might result in extensive payments from the insurer. The Second Standard - Munich Re Design Clauses Although they are an industry standard, the Munich Re clauses can be needlessly complicated. However, a brief survey of each cover yields a handful of simple and basic principles. Munich Re CAR (Contractor's All-Risks) Policy The CAR policy distinguishes clearly between faulty design and faulty materials and workmanship. Since the policy covers mainly civil engineering projects - such as roads, bridges, buildings, pipelines, airports, dams and water supply systems - the materials and components are standardized to quite some extent. Consequently, materials and components don't present a high risk. The risks lie largely in the design. Especially in new projects, the design is likely to be untested and unproven. Therefore, materials and workmanship are automatically covered in the basic policy, but design needs to be covered by an endorsement. This basic CAR policy provides the equivalent of DE 1 with respect to faulty design. It excludes all design-related loss or damage. For defective materials or workmanship, however, this policy provides much broader cover - that is, the equivalent of DE 4 (full cover except for the "faulty part"). Munich Re CAR (Contractor's All-Risks) Policy with Endorsement 115 The so-called END 115 "Designer's Risk" endorsement increases the coverage for faulty design to the equivalent of DE 4. Faulty design, design materials, and workmanship are all covered equally. Adding the Designer's Risk endorsement compels both the insured and the insurer to identify the design risks properly and to select the appropriate cover. Evidently, Designer's Risk cover commands additional premium. Applied to our first case study, the Munich Re CAR policy covers everything except the supporting rod (faulty part), if the defect in the column is due to faulty material or workmanship - whether the endorsement has been added or not. If the defect is due to faulty design, however, the basic policy pays for nothing, whereas the policy with the endorsement pays for everything except the supporting rod itself. Munich Re EAR (Erection All-Risks) Policy The EAR policy deals with the erection of industrial facilities and heavy machinery - power stations, petrochemical refineries, ore processing plants, paper mills, electrical transmission networks - which often use materials and components that are newly developed and possibly inadequately tested. Therefore, the materials pose just as great a risk as the design that holds them together. Taking this Cổng thông tin Bảo hiểm Việt Nam Page 2
into account, the policy addresses faulty design, materials, and workmanship equally. It is also important to note that the EAR policy covers testing and commissioning - a major difference between a CAR risk and an EAR risk - and it is during this period when loss or damage owing to a defect in design, materials, or workmanship is most likely to occur. Munich Re EAR (Erection All-Risks) Policy with Endorsement 200 The basic policy provides the equivalent of DE 1 with respect to defective design, materials, and workmanship. An endorsement (END 200 Manufacturer's Risk) increases the coverage for consequential damage to the equivalent of DE 4 (consequential damage to any property free of defective conditions). END 200 differs from DE 4 in an important respect that is often overlooked: The last clause of the endorsement excludes all costs "which the insured would have incurred for rectifying the original fault had such fault been discovered before the loss occurred." These "costs" can make the difference between little or no coverage and a major loss, as the following case study shows: Case Study If a single blade of a gas turbine breaks because of a defect in its design or material, and it causes extensive damage to the blades around it, the basic EAR policy does not attach. With END 200, the consequential damage to the surrounding blades is covered in its entirety. However, in these circumstances there are considerable costs (from USD 500,000 to USD 1 million) associated with the disassembly and the reassembly of the turbine before repairs can be carried out. Had the defective blade been discovered and mended before the loss occurred, these costs would also have arisen. Therefore, the costs for disassembly and reassembly are not covered under END 200. By comparison, DE 4, which does not contain this exception, would cover all costs (including disassembly and reassembly) with the exception of the faulty blade itself. A clear task Clouded in needlessly confusing language, the concepts underlying the London Market and Munich Re design clauses are intuitive and easy to grasp. Insurers face a clear task: Identify the risks associated with insuring against defects and, working with the insured, select the appropriate degree of cover. In addition to understanding the design clause wordings, the insurer must also know when to refuse cover based on sound engineering judgment. Given the evolving nature of high-tech engineering, the rules, and the risks, are constantly changing. When applying design clauses, every project will inevitably present its own challenges and complications, but a thorough knowledge of these basic principles is an excellent place to start. Appendix: London Market Design Clauses DE 1 Outright Defect Exclusion This policy excludes loss of or damage to the Property Insured due to defective design, plan, specification, materials, or workmanship. DE 2 Extended Defective Condition Exclusion This policy excludes loss of or damage to and the cost necessary to replace, repair or rectify a. Property Insured which is in a defective condition due to a defect in design, plan, specification, Cổng thông tin Bảo hiểm Việt Nam Page 3
materials, or workmanship of such Property Insured or any part thereof b. Property Insured which relies for its support or stability on (a) above c. Property Insured lost or damaged to enable the replacement, repair or rectification of Property Insured excluded by (a) and (b) above Exclusion (a) and (b) above shall not apply to other Property Insured which is free of the defective condition but is damaged in consequence thereof. DE 3 Limited Defective Condition Exclusion This policy excludes loss of or damage to and the cost necessary to replace, repair or rectify a. Property Insured which is in a defective condition due to a defect in design, plan, specification, materials, or workmanship of such Property Insured or any part thereof b. Property Insured lost or damaged to enable the replacement, repair or rectification of Property Insured excluded by (a) above Exclusion (a) above shall not apply to other Property Insured which is free of the defective condition but is damaged in consequence thereof. DE 4 Defective Part Exclusion This policy excludes loss of or damage to and the cost necessary to replace, repair or rectify a. Any component part or individual item of the Property Insured which is defective in design, plant, specification, materials, or workmanship b. Property Insured lost or damaged to enable the replacement, repair or rectification of Property Insured excluded by (a) above Exclusion (a) above shall not apply to other Property Insured which is free of the defective condition but is damaged in consequence thereof. DE 5 Design Improvement Exclusion This policy excludes a. The cost necessary to replace, repair or rectify any Property Insured which is defective in design, plant, specification, materials, or workmanship b. Loss or damage to the Property Insured caused to enable replacement, repair or rectification of such defective Property Insured But should damage to the Property Insured (other than damage as defined in (b) above) result from such a defect, this exclusion shall be limited to the costs of additional work resulting from the additional costs of improvements to the original design, plan, specification, materials, or workmanship. Cổng thông tin Bảo hiểm Việt Nam Page 4
Munich Re Design Clauses Munich Re CAR END 115 Cover for Designer's Risk Base policy wording: Insurers shall not be liable for c) loss or damage due to faulty design d) the cost of replacement, repair or rectification of defective material and/or workmanship, but this exclusion shall be limited to the items immediately affected and shall not be deemed to exclude loss of or damage to correctly executed items resulting from an accident due to such defective material and/or workmanship Wording with endorsement: c) deleted d) the cost of replacement, repair or rectification of loss or damage to items due to defective material and/or workmanship and/or faulty design, but this exclusion shall be limited to the items immediately affected and shall not be deemed to exclude loss of or damage to correctly executed items resulting from an accident due to such defective material and/or workmanship and/or faulty design. Munich Re EAR END 200 Cover of Manufacturer's Risk Replace: Insurers shall not be liable for c) Loss or damage due to faulty design, defective material or casting, bad workmanship other than faults in erection with: c) all costs related to repair and/or replacement of parts and/or items directly affected by faulty design, defective material or casting, bad workmanship other than faults in erection, which the Insured would have incurred for rectifying the original fault had such fault been discovered before the loss occurred This Endorsement does, however, not apply to parts and items of civil engineering sections. The following additional paragraph will be found in ABB/Alstom policies: Costs of dismantling and reassembly incurred in connection with any loss or damage to the insured items recoverable under Section I, shall be included in the cost of repair or replacement and shall be reimbursed. Other Design Clauses Lowndes-Lambert "Negligent" Design Clause This Policy does not cover loss or damage caused by negligent workmanship, negligent construction or negligent design or wear and tear or normal upkeep or normal making good but this Exclusion shall be limited to that Part of the Property Insured immediately affected and shall not apply to any other Part or Parts lost or damaged in consequence thereof. Cổng thông tin Bảo hiểm Việt Nam Page 5
LEG 2/96 Consequences Defect Exclusion The Insurer(s) shall not be liable for All costs rendered necessary by defects of material workmanship design plan or 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. This is Munich Re END 200, i.e., the equivalent of DE 3 or DE 4, depending upon the details of the 'faulty part' and what would have been required to rectify the property prior to the damage. LEG 3/96 Improvement Consequences Defect Wording The Insurer(s) shall not be liable for All costs rendered necessary by defects of material workmanship design plan or 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 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. This is none other than DE 5. Cổng thông tin Bảo hiểm Việt Nam Page 6