Wisconsin Supreme Court Overrules Pharmacal and Rejects “Other Property” Requirement for Initial Grant of CGL Coverage
Joseph M. Mirabella, Simpson & Deardorff, S.C., Doug Raines, Husch Blackwell LLP,
and Henry E. Koltz, Crivello, Nichols & Hall, S.C

In 5 Walworth LLC v. Engerman Contracting,[1] the Wisconsin Supreme Court recently decided that for the purposes of determining whether an initial grant of coverage exists under a commercial general liability policy, the definition of “property damage” does not require “other property” damage—i.e., that there be damage to the work or product of someone other than the insured.

Wisconsin law has long held that faulty workmanship or a defective product alone is not enough to constitute an “occurrence” under the policy,[2] but there had been some degree of uncertainty as to whether there could be “property damage” if there was an accident that resulted in the need for only repair or replacement of the work or product of the insured.

Less than ten years ago, in Wisconsin Pharmacal Co., LLC v. Nebraska Cultures of California, Inc.,[3] the Wisconsin Supreme Court decided that the definition of “property damage” implicitly meant damage to property other than the work or product of the insured, and it adopted the “integrated system” test, which is derived from the economic loss doctrine, to aid in that analysis.[4] The integrated system test asks whether the damaged property is part of an integrated whole, such that any damage by one component to another constitutes damage only to the product itself, rather than to “other property.”[5] If the only damage was to components of an integrated system, then there was no “property damage” and therefore no initial grant of coverage.

In Pharmacal, the product at issue was a probiotic pill with a defective ingredient, and the court held that “combining a defective ingredient with other ingredients and incorporating them into supplement tablets, formed an integrated system.”[6] And because damage by one component of that integrated system to another component could not constitute damage to “other property,” there was no initial grant of coverage under the policy issued to the defective ingredient supplier and others.[7] 

In 5 Walworth, the court was asked to apply those rules to a high-end residential pool complex, which allegedly cracked and leaked and had to be replaced along with the surrounding contiguous deck, plumbing, electrical, and a retaining wall.[8] The insurers for the general contractor who built the pool structure and a subcontractor that supplied concrete for the pool bowls argued that the entire pool structure was an integrated system such that damage to any of its components must be treated as damage to the work or product of the insureds. Consequently, the insurers argued that there was no initial grant of coverage because any damage caused by the leaking pool to the surrounding components of the pool complex did not constitute “property damage.”

The Wisconsin Supreme Court rejected the insurers’ arguments. In doing so, the court reversed course and abandoned the rule that “property damage” requires damage to other property, and overruled Pharmacal insofar as it adopted the integrated system test to analyze whether an initial grant of coverage exists. The court decided that its “analysis in Pharmacal went wayward in two respects,”[9] with those being that it strayed too far from the language of the insurance policy, which does not explicitly require damage to other property, and that it should not have borrowed from the economic loss doctrine and adopted the integrated system test to evaluate the initial grant of coverage.

5 Walworth characterized its holding as maintaining fidelity to the well-settled three-step coverage analysis spelled out in other cases that predated Pharmacal.[10] Under that three-step coverage analysis, courts must “first examine if the policy makes an initial grant of coverage, then analyze if any exclusions preclude coverage, and finally, review if any exceptions to a particular exclusion reinstate coverage.”[11] By inserting an “other property” requirement into the initial grant of coverage step, Pharmacal had conflated the first and second steps in the same way that some past decisions had imprecisely discussed them together in finding no coverage for damage to the insured’s work or product.[12]

The court explained that 5 Walworth “illustrates inconsistencies that cannot be reconciled,” forcing it to “choose whether to remain consistent with our prior cases, or follow the new course charted by Pharmacal.”[13] And while the court was “reluctant to reject the holding of a case so recently decided,” it concluded that it “must bring consistency and clarity to this area of law” that was “muddled by Pharmacal’s missteps.”[14] 

With the “other property” requirement eliminated from the initial grant of coverage analysis, 5 Walworth held that there were factual issues that precluded a no-coverage declaration in favor of the insurers.[15] The pool had allegedly cracked and leaked, destabilizing the surrounding soil, which could be an “occurrence” even if the only things damaged were other parts of the pool complex.[16] From there, coverage for damage to the insured’s own work or product could still be limited by the policy’s exclusions, but, again, there were issues of fact that precluded summary judgment on those issues.[17] Accordingly, the matter was remanded for additional discovery and litigation on coverage and the merits.

From a historical perspective, this decision constituted a rather remarkable reversal for a court that only seven years earlier had broadly adopted the integrated system test to evaluate insurance coverage and that had expansively interpreted the economic loss doctrine. This article will examine the court’s stated reasoning for its reversal of course and then analyze the extent to which the integrated system test may continue to be utilized in evaluating insurance coverage. 

Adoption of “Other Property” Requirement for Initial Grant of Coverage was the Result of Imprecise Discussion in Past Cases 

Generally speaking, CGL policies provide an initial grant of coverage for “property damage” caused by an “occurrence.” The term “occurrence” is typically defined to mean an “accident,” and the term accident has been interpreted to mean “an event or condition occurring by chance or one that arises from unknown causes and is unforeseen and unintended.”[18] The term “property damage” is typically defined in pertinent part to mean “physical injury to tangible property, including all resulting loss of use of that property.”

CGL policies also typically contain a number of so-called business risk exclusions, and included among those exclusions are a set of provisions designed to eliminate coverage for damage to the work or product of the insured. The sum of these parts is a CGL policy that generally provides coverage for accidents that cause damage to property other than the work or product of the insured but does not cover the repair or replacement of the insured’s own defective work or product.

Because CGL policies generally do not cover the repair or replacement of the insured’s own work or product, it is generally understood that there is no coverage where the only claim is for repair or replacement of the insured’s work or product. But the precise analytical path to that conclusion had arguably been left unclear by Wisconsin appellate decisions that predated Pharmacal. Specifically, the question in that situation was whether the policy does not provide an initial grant of coverage in the first place or if that initial grant of coverage is extended and then eliminated by the application of the business risk exclusions.

Wisconsin appellate courts have repeatedly emphasized that faulty workmanship or product that merely required replacement, without more, does not constitute an “occurrence.”[19] The lessons of those cases are that “while faulty workmanship is not an ‘occurrence,’ faulty workmanship may cause an ‘occurrence.’[20] Stated otherwise, ‘faulty workmanship may cause an unintended event … and that event—the “occurrence”—may result in harm to other property.’”[21]

That reference to “other property” damage at the very least implied that such damage is necessary to distinguish “property damage” caused by an “occurrence,” for which there is an initial grant of coverage, from simply a claim for faulty workmanship or product that had to be repaired or replaced, for which there is no initial grant of coverage. And indeed, that is exactly what Pharmacal explicitly decided. “The insured risk (i.e., physical injury to tangible property) applies to physical injury to tangible property other than, but which is caused by, a defect in the product or work the insured supplied.”[22]

Accordingly, Phamacal held that “an integrated system analysis is necessary when evaluating coverage under a CGL policy,” because courts “must decide whether the product is to be treated as a unified whole or whether a defective component can be separated out such that the claimed damage constitutes damage to property other than the defective component itself.”[23] In situations where the only thing alleged to be damaged is a structure in which the insured’s product is a component, the integrated system analysis is dispositive of whether there can be “property damage” caused by an “occurrence” or merely defective work or product that results in no more than the need to repair or replace that product.[24]  

In 5 Walworth, the court rejected that interpretation it had so recently endorsed and decided instead that Pharmacal had relied on a misapprehension of the underlying precedent. The passages from Wisconsin Label and Vogel upon which Pharmacal had relied “were not in the initial grant of coverage discussions; they were general comments on the purpose of a CGL policy.”[25] And while it remains true “that the risk insured in a CGL policy includes damage to property other than to the product or completed work itself … this is true because of the business risk exclusions, not the initial coverage determination.”[26] 

Despite Obvious Analytical Similarities, the Court Overruled Pharmacal’s Adoption of the Integrated System Test to Analyze Insurance Coverage 

Pharmacal borrowed from the economic loss doctrine when it adopted the integrated system test. “The economic loss doctrine is a judicially created doctrine under which a purchaser of a product cannot recover from a manufacturer on a tort theory for damages that are solely economic.”[27] The economic loss doctrine exists to serve three primary functions: “(1) to maintain the fundamental distinction between tort law and contract law; (2) to protect commercial parties’ freedom to allocate economic risk by contract; and (3) to encourage the party best situated to assess the risk of economic loss, the commercial purchaser, to assume, allocate, or insure against that risk.”[28]

Tort law exists “to protect people from misfortunes which are unexpected and overwhelming,” and, accordingly, imposes liability on manufacturers for injury or damage caused by defective products.[29] Contract law and remedies, by contrast, hold the parties to the benefit of their bargain, which may include the obligation to repair or replace a product that does not perform as intended.[30] So when a product fails in its intended use and injures only itself, thereby causing only economic damages to the purchaser, “the reasons for imposing a tort duty are weak and those for leaving the party to its contractual remedies are strong.”[31]                                         

In keeping with those principles, the economic loss doctrine distinguishes between “economic losses” and damage to “other property.”[32] “Economic losses” are those damages “arising because the product does not perform as expected, including damage to the product itself or monetary losses caused by the product.”[33] “Other property” damages are “claims based on personal injury or damage to property other than the product, or economic loss claims that are alleged in combination with noneconomic losses.”[34] 

“Distinguishing between economic loss and physical harm to property other than the product itself is often a difficult task.”[35] Accordingly, Wisconsin adopted the integrated system test to assist in that line-drawing exercise in the context of the economic loss doctrine. Wausau Tile endorsed the Restatement explanation of the integrated system rule:

A product that nondangerously fails to function due to a product defect has clearly caused harm only to itself. A product that fails to function and causes harm to surrounding property has clearly caused harm to other property. However, when a component part of a machine or a system destroys the rest of the machine or system, the characterization process becomes more difficult. When the product or system is deemed to be an integrated whole, courts treat such damage as harm to the product itself.[36] 

The underlying reasoning is pragmatic and intuitive. “Since all but the very simplest of machines have component parts, a holding that a component of a machine was ‘other property’ would require a finding of ‘property damage’ in virtually every case where a product damages itself.”[37]  

The integrated system test has been repeatedly and expansively endorsed by Wisconsin courts applying the economic loss doctrine over the last few decades. Among the cases where the court did so were ones involves such products as a tail rotor drive system in a helicopter,[38] windows in a new construction home,[39] an entire new construction home,[40] a comprehensive renovation of a commercial building,[41] and adhesive in aftermarket vehicle lights.[42] These cases broadly stand for the proposition that an integrated system is not simply components of a whole that are literally, technically indivisible, but rather “integral parts of a greater whole [that] did not serve an independent purpose.”[43] 

Given that CGL policies also are intended to and generally[44] do provide a grant of coverage for the insured’s tort liability arising from unforeseen accidents causing physical damage to others, but not for the insured’s contractual liability to repair or replace its own defective work or product that did not live up to expectations, Pharmacal borrowed from economic loss doctrine jurisprudence, in particular the integrated system test, to aid in the insurance coverage analysis.

However, 5 Walworth held that doing so strayed too far from the policy language.[45] “Pharmacal painted with a broad brush and seemed to incorporate the integrated systems analysis into all determinations of whether ‘property damage’ has occurred under the terms of a CGL policy.”[46] But that “runs headlong into the fundamental principle running through our insurance cases that policy interpretation should focus on the language of the insurance policy,” and do so “without resort to tort principles such as the economic loss doctrine, and by implication, the integrated systems analysis used to assess its application.”[47]

5 Walworth acknowledged that the insurers were simply asking the court to “enforce what [the court] said in Pharmacal—that the integrated systems test is ‘necessary when evaluating coverage under a CGL policy.’”[48] But because the court decided that doing so—at least at the initial grant of coverage stage—would be “importing language that does not exist into a policy,” the supreme court decided that Pharmacal must be overruled to that extent.[49]

Integrated System Test Applicable to Business Risk Exclusions?

Pharmacal recognized that “a CGL policy’s sole purpose is to cover the risk that the insured’s goods, products, or work will cause bodily injury or damage to property other than the product or the completed work of the insured,” so it was necessary to determine whether damage to the tablet via the incorporation of the defective ingredient constituted physical injury to tangible property other than the insured’s product.[50] Consequently, Pharmacal stated that “to answer the question of what constitutes other property that has suffered physical injury, we analyze whether a supplement tablet is an integrated system because if it is, damage to the system has been defined as damage to the product itself, not damage to other property.”[51] Although 5 Walworth was clear that the integrated system test was improperly applied at the first step of the coverage analysis to determine whether there was “property damage,” it conspicuously left open the possibility that such “an ‘other property’ analysis … may be relevant to the policy’s business exclusions (stage two).”[52] 

That makes sense intuitively, because the issue of where the insured’s work or product ends and “other property” begins must still be reckoned with in order to apply the business risk exclusions. In other words, it remains true that “since all but the very simplest of machines have component parts,” a holding that damage by one component of it that was the insured’s work or product to another component of it that was not the insured’s work or product would lead to a finding of covered property damage that falls outside the scope of the business risk exclusions “in virtually every case where a product damages itself.”[53] 

Importantly, the scope of the business risk exclusions—specifically, but not necessarily limited to, the “your work” exclusion—has been interpreted to apply to the insured’s work or product and damages directly related to the repair and replacement of the allegedly defective product.[54] Jacob involved defective masonry that caused water infiltration into a home, and the court of appeals held that the scope of the “your work” exclusion[55] extended to damages for costs associated with investigating the cause of the damage, assessing the extent of the needed repairs, and repairing or replacing the defective work,” because those things were “directly related to the repair and replacement of the defective work.”[56]

Jacob contrasted those excluded damages with other categories of damages “such as relocation costs, temporary repairs, loss of use and enjoyment of the residence, and repair of the interior of the residence are not directly the consequence of repairing or replacing [the insured]’s defective work,” but instead were “collateral damage to the [plaintiff’s] ‘other property’ (the interior of the residence) and the costs associated with addressing and correcting that situation.” There was coverage for those damages.[57]

This interpretation of the “your work” exclusion is analogous to the application of the integrated system test. Each recognizes that it is infeasible to look myopically at solely the work or product of the insured when applying the business risk exclusions, and that in order to serve the purpose of a CGL policy, the scope of the coverage must necessarily exclude unavoidable costs incurred to repair or replace the insured’s uncovered work or product. 

The integrated system test would accomplish that by eliminating coverage for other components of an integrated system that are damaged because the insured’s work or product was defective. “A product that fails to function and causes harm to surrounding property has clearly caused harm to other property. However, when a component part of a machine or a system destroys the rest of the machine or system [that] is deemed to be an integrated whole, courts treat such damage as harm to the product itself.”[58] 

Jacob was decided twenty-five years ago and while its interpretation was later endorsed by the Wisconsin Supreme Court,[59] no subsequent Wisconsin case has endeavored to more precisely define the boundaries of the “your work” (or “your product”) exclusion.[60] Perhaps the supreme court’s dicta in 5 Walworth is an invitation to do just that.  

Author Biographies:

Joseph M. Mirabella is a shareholder at Simpson & Deardorff, S.C. in Milwaukee. He earned his bachelor’s degree from the University of Wisconsin-Milwaukee in 2007 and his law degree from the Marquette University Law School in 2011. In addition to the WDC, Joseph is a member of the Milwaukee Bar Association and the Defense Research Institute. He is admitted to practice in all Wisconsin state courts, as well as both Wisconsin district courts and the United States Court of Appeals for the Seventh Circuit.

Doug Raines is Senior Counsel at Husch Blackwell LLP in Milwaukee. Doug draws on more than 15 years as a litigator and has represented clients in a variety of general commercial cases, including breach of contract, tort, statutory claims and shareholder disputes. He also has an extensive insurance coverage practice and has represented insurers in both first-party and third-party actions. Doug earned his bachelor’s degree from Miami University and his law degree from the Marquette University Law School. Doug is the author or co-author of multiple law review articles. His work on affirmative action jurisprudence, New Federalism and Wisconsin’s risk contribution doctrine has been published in the Marquette Law Review, Boston University Law Review and Pace Environmental Law Review, respectively.

Henry E. Koltz is a Shareholder at Crivello, Nichols & Hall, who joined the firm through a merger in September of 2022. He has over 20 years of experience defending contractors, motorists, and insurance companies across Wisconsin. He has handled numerous jury trials, appeals, and argued at the Wisconsin Supreme Court, at Wisconsin’s Federal Courts, in the United States Court of Appeals for the Seventh Circuit, and in the United States Court of Federal Claims in Washington, DC. He has served as an arbitrator and mediator.