Addressing Consequential Damages in the Property Policy

Property insurance policy drafters have long attempted to address how excluded perils, such as faulty workmanship, latent defects, design defects, wear and tear, corrosion, or erosion, affect coverage.

Approaches have included:

• “Resulting loss or damage” carve-backs
• “Cost of making good” faulty workmanship
• London Engineering Group (LEG 1, 2 and 3) defect clauses

It is helpful to examine the background and application of these approaches to separate excluded perils and covered property damage.

Resulting loss or damage

Markets recognized the distinction between economic loss (cost to remedy a defect) and separate physical damage caused by that defect. Policies generally take one of two approaches: exclude only the cost to correct the defect while preserving coverage for resulting physical damage, or they exclude both the defect and any resulting damage unless a specific carve-back restores coverage.

Courts commonly apply a two‑step test: They identify whether the claim is for rectification (economic loss) or for separate physical damage—often allowing recovery for the latter where policies preserve “resulting” damage.

Cost of making good rectification exclusions

Insurers historically resisted acting as guarantors for contractors. Excluding the “cost of making good” places economic loss on contractors or their Liability insurers. Drafting ranges from narrow wording that excludes only repair of the defective item to broader wording, such as exclusions applying to losses ‘arising out of’ defective workmanship, which may also bar consequential physical damage.

Courts generally apply the economic‑loss principle but often allow coverage for physical damage to other property unless the policy clearly excludes it.

London Engineering Group (LEG) clauses — LEG 1/2/3

LEG model clauses standardize approaches to defect exclusions across a spectrum:

LEG 1: Most restrictive—excludes loss due to defects of material, workmanship, or design. It shifts defect risk away from Property insurers.

LEG 2: Middle ground—excludes cost to make good defects but allows coverage for resulting physical damage. It denies pure economic loss while preserving consequential physical damage cover.

LEG 3: Least restrictive—excludes only “improvement” costs, generally allowing replacement or restoration to original condition without providing a betterment windfall.

Selection among LEG 1/2/3 signals intended risk allocation, and disputes focus on causation and measurement of excluded costs.

Recent Developments

The “resultant loss,” “cost of making good,” and LEG clauses all focus on separating the costs tied to excluded perils, whether one or more excluded perils are involved.

But some newer policy wordings appear to limit the traditional “resulting damage” carve-backs by requiring both resultant physical damage and a separate covered peril before coverage is restored:

“Does not exclude any loss, damage, cost, or expense caused by any ensuing physical loss or damage to covered property from a cause/peril not specifically excluded.

This approach can significantly narrow coverage by limiting recovery where an excluded peril directly causes physical damage, unless a distinct covered peril subsequently occurs.

Historically, this language was used when underwriters wanted to limit coverage erosion while remaining in the business of covering typical physical perils (fire, explosion). That approach is relatively easy to apply in standard property polices, but is it “fit for purpose” for Boiler, Machinery, and Breakdown coverages, where fire and explosion are usually not the main causes of loss.

What further complicates the approach is that certain perils are subject to the “resulting loss or damage” carve-back, while others require a “resulting covered peril.”

Either the version requiring a resulting covered peril or versions incorporating both often result in a “chicken or egg” discussion around what is the excluded peril and what, if any, is the resulting covered peril. What excluded peril caused the loss, and was there a separate covered peril that resulted from it?

Resolving these issues requires a careful investigation into what caused the loss, often with help from engineers and cause-and-origin experts, to determine whether the loss is covered. In practice, even small differences in policy wording can significantly affect whether insurers respond differently to the same loss.

In many complex losses, an exhaustive cause-and-origin analysis may ultimately find that faulty workmanship, wear and tear, corrosion, erosion, or another excluded condition played a role in causing the loss.

What happens when there are multiple possible causes and it’s unclear which one led to the loss? How do you break that stalemate? And how can you prevent an excluded peril from causing the whole loss to be denied?

Some Practical Guidance for Practitioners and Drafters

• When manuscript wording cannot be used, determine if the insurer proposed wording “fit for purpose” for the nature of the risk (i.e., standard fire policy exposure vs boiler and machinery).
• If an insurer proposes the restricted carve-back wording, should there be a discussion of the appropriate premium if coverage is limited to a few perils?
• Use market conditions to leverage more favorable wording (e.g., soft market, insurers chasing premium, and oversubscribed situations).
• Check for “resulting physical damage” carve‑backs: These clauses often determine recoverability.
• Read the exact wording: Small phrasing differences (“arising out of” vs “directly caused by” vs “resulting from”) can change outcomes.
• Compare competing market wordings carefully: Seemingly similar consequential damage provisions may respond very differently depending on how resulting damage and ensuing covered perils are defined.