Risk Management

Software developers/consultants and liability exclusions

Property damage requirement remains a formidable obstacle to coverage

By Donald S. Malecki, CPCU

Years ago, one of the examples commonly used by producers attempting to sell a commercial general liability policy having to do with premises exposures was slip and fall accidents due to a stairway or sidewalk that was in disrepair. For off-premises exposures, the common example was an insured accidentally poking someone with an umbrella.

Although the hazards of businesses have grown complicated over the decades, producers can still fall back on citing the foregoing, particularly with businesses where liability insurance covers little else than those types of events.

Many different businesses fall into this category. Some that come to mind are those that develop and/or design software, as well as consultants. If the product sold or recommended does not work, the end result will likely be passive retention. This is a risk management term that describes a situation where, instead of being able to transfer the risk of loss to an insurer, the insured has to assume it, often as a surprise.

The reason for this consequence is that there has to be property damage to tangible property of others, and when tangible property of others cannot be used or is less useful, the obstacles to obtaining coverage are extremely difficult to overcome.

A recent case

A case in point is Kenray Association, Inc. a/k/a Kenray, Inc., et al. v. Hoosier Insurance Company, 874 N.E. 2d 406 (Ct. App. IN 2007). Kenray Association [hereinafter, the consultant] was a computer software and consulting business that sold and installed computer software, including software it also developed. After purchasing software developed by this consultant, three customers found that the software did not function properly. As a result, all three customers filed suits against the consultant alleging that the software did not function properly and caused problems with their computer systems.

At the time of these suits, the consultant maintained both primary and umbrella liability policies from one insurer. When the consultant sought defense, it was denied by the insurer. This prompted a declaratory judgment action by the consultant, which ended in favor of the insurer.

The essence of the argument between the parties on appeal was whether the two liability policies covered the claims made against the consultant software developer. The consultant’s downfall was the Damage to Impaired Property Exclusion.

This Impaired Property Exclusion states in part that insurance does not apply to “‘property damage’ to ‘impaired property’ or property that has not been physically injured arising out of (1) A defect, deficiency, inadequacy or dangerous conditions in ‘your product’ or ‘your work’ or (2) A delay or failure by the named insured or anyone acting on its behalf to perform a contract or agreement in accordance with its terms.”

“Impaired property” is defined to mean tangible property, other than “your product” or “your work,” that cannot be used or is less useful because: (a) It incorporates “your product” or “your work” that is known or thought to be defective, deficient, inadequate or dangerous; or (b) You have failed to fulfill the terms of the contract or agreement; if such property can be restored to use by: (a) The repair, replacement, adjustment or removal of “your product” or “your work”; or (b) Your fulfilling the terms of the contract.

Since the three customers alleged that the consultant’s software did not function properly and caused problems with their computer systems, the appeals court held that the customers’ computer systems fell neatly within the definition of “impaired property.”

Clarifying that holding, the court stated that: (1) the computer systems were tangible property, which could not be used or were less useful because these systems incorporated the named insured’s [consultant’s] product, which was alleged to be defective, deficient, inadequate or dangerous; (2) the customers’ computer systems were alleged to be unusable or less useful because the named insured’s [consultant’s] product failed to fulfill the terms of the warranties allegedly made to the customers; and (3) the computer systems could be restored to use by the repair, replacement, adjustment or removal of the named insured’s [consultant’s] software, or by the named insured’s [consultant’s] fulfilling the warranties allegedly made.

The worth of litigating these issues

Whether it is worth litigating these issues should largely depend on the facts, how the liability policy is prepared and, considering the cost of litigation, the amount at stake.

On its face, the Impaired Property Exclusion appeared to be a slam-dunk insofar as the above Kenray Association case was concerned. Not all cases, however, fit neatly into the Impaired Property Exclusion.

It is also important to point out that the Impaired Property Exclusion has had somewhat of a controversial history since it was first “officially” introduced in 1966. It was so difficult to understand then that it was completely revamped with the 1973 comprehensive general liability changes. Although this version was somewhat more understandable, it was again amended with the 1986 changes that currently apply.

Although clearer than its predecessors, the current Impaired Property Exclusion is too often relied on by insurance claims people, sometimes even in desperation when there is physical injury to or destruction of tangible property! The result is a tarnished track record of court cases for insurers.

Considering this exclusion’s length, understanding it can sometimes work to the disadvantage of the insurer. In fact, in the case of Computer Corner, Inc. v. Fireman’s Fund Insurance Company, 46 P. 3d 1264 (N.M. Ct. App. 2002), relied on by the consultant in the above Kenray Association case, the court held that a similarly worded Impaired Property Exclusion was unintelligible. (The Kenray court disagreed.)

This case, briefly, involved a family-owned business engaged in the sale and service of personal computers. In the process of repairing a computer, the hard drive was reformatted without backing up the data. Although the data could have been retrieved through certain procedures, the computer owner was told that the data no longer existed. As a result, the computer owner over-wrote the existing files, permanently destroying them.

Insurers’ reliance on the Impaired Property Exclusion has always been a good idea from the perspective of many courts. Of course, with current standard ISO-type commercial general liability policies subject to an Electronic Data Exclusion, insurers have yet another tool on which rely in denying coverage.

Although a subject for a future article, the Electronic Data Exclusion (p) is particularly important because it excludes “[d]amages arising out of the loss of, loss of use of, damage to, corruption of, inability to access, or inability to manipulate electronic data.” Since damages is not a defined term, it could include both injury and damage to tangible property—which, when one considers its parameters—is a very broad and all-encompassing exclusion.

Another coverage possibility

Surprisingly, the Kenray Association case did not mention anything about the insurer’s reliance on a professional liability or errors and omissions exclusion. Such an exclusion might have been issued and overlooked in this matter, or simply not issued.

Some of the possible endorsements might have been CG 22 75 Professional Liability Exclusion—Computer Software; CG 22 88 Professional Liability Exclusion—Electronic Data Processing Services and Computer Consulting or Programming Services; or CG 22 89 Exclusion—Property Damage to Electronic Data (Computer Software Manufacturer).

If one of these or some other exclusionary endorsement is issued, it should produce a red flag for producers, who could then suggest the purchase of a separate policy for the exposure—if the prospective insured had not already inquired about it. However, it is not likely that producers can obtain a professional liability policy. It might be referred to as that, but it usually is an errors and omissions policy limited to negligent acts, errors or omissions.

The problem with these special policies is that they commonly exclude bodily injury and property damage. With commercial general liability policies also excluding bodily injury and property damage, there is no alternative but to hope that what happens as a result of a named insured’s negligent act, error or omission amounts to damages that are not considered to be bodily injury or property damage.

The result in the Kenray Association case might have been the “saving grace” for the named insured confronted with a hopeless situation of being forced to assume the damages sought against it.

Of course, not everything is lost here. For those who purchase commercial general liability insurance, coverage will still likely be provided for trips and falls and poking others with an umbrella—unless the act is expected or intended. Producers may wish to point out these coverage possibilities, to the extent they are queried about what these liability policies can do.

One final point is that there is a wide array of businesses that could be confronted with the same situation as the consultant in the Kenray Association case. The best way to determine prospects here is to ponder whether the service, product or work a business provides can impair property of others, without damaging it. It may be like searching for a needle in a haystack, but it is a start. *

The author
Donald S. Malecki, CPCU, has spent 48 years in the insurance and risk management consulting business. During his career he was a supervising casualty underwriter for a large Eastern insurer, as well as a broker. He currently is a principal of Malecki Deimling Nielander & Associates L.L.C., an insurance, risk and management consulting business headquartered in Erlanger, Kentucky.