Advisories & Insights

A fire damages part of a restaurant. The fire marshal's post-loss inspection reveals fire code violations in areas unaffected by the fire. The marshal orders the owner to correct fire code violations in the entire building. An apartment building suffers water damage. The post-loss inspection by the building department reveals code violations in areas unaffected by the water. In each instance the building owner is ordered to correct all code violations, including those in unaffected areas. May the owner collect the cost of code compliance in the unaffected portions from its insurer under an "increased cost of construction" provision?

Courts are divided, according to the relatively few cases addressing the issue. Some courts say "yes," reasoning that the proximate cause of the inspection and subsequent order was the insured peril of fire or water. Other courts say "no," concluding the public agency's action was the proximate cause.

Coverage Granted
In Davidson Hotel Company v. St. Paul Fire and Marine Insurance Company, 136 F.Supp.2d 901 (W.D.Tenn. March 12, 2001), the insured premises sustained water damage due to a sprinkler malfunction. A post-loss inspection revealed building code violations requiring necessary upgrades. The policy included a "Demolition and Increased Costs of Construction" provision obligating the insurer for the "increased cost of repair or reconstruction of the damaged and undamaged property on the same or another site intended for the same occupancy, and limited to the costs that would have incurred in order to comply with the minim requirements of such law or ordinance regulating the repair or reconstruction of the damaged property on the same site…"

In the court's view, the policy language was clear and not limited by any reference to "grandfathered" or existing code violations. The court held the inspection revealing the violations occurred "only because" of the insured peril; therefore, the insured peril was the proximate cause of the inspection and resulting code upgrade requirements. In so holding, the court rejected the insurer's argument that coverage for code upgrades would violate public policy. The insurer reasoned that policyholders would have incentive to refrain from necessary code upgrades because if a loss caused by a covered peril occurred, the cost of the upgrades would be insurable. The court disagreed: "if [the insurer] wished to avoid liability, it could have done so through the language of the contract."

Decisions consistent with Davidson Hotel Company have been reached in Commonwealth Ins. Co. v. Benihana of Tokyo, Inc., 1997 WL 361617 (N.D.Tex.), and Commonwealth Ins. Co. v. Grays Harbor County, 120 Wash.App.232 (February 18, 2004).

Coverage Denied
In contrast, in Chattanooga Bank Associates v. Fidelity and Deposit Company of Maryland, 301 F.Supp.2d 774 (January 21, 2004), the Eastern District Court of Tennessee held that a fire did not "cause" building code enforcement. The Chattanooga Bank building suffered a fire on its second floor, and post-fire inspection revealed building code violations. The insured sought to hold its insurer liable for all such code violations irrespective of their relation to the fire. The court declined, however, to follow the rationale of Davidson Hotel Company, supra, and Benihana of Tokyo, supra. Instead, relying on St. Paul Fire and Marine Ins. Co. v. Darlak Motor Inns, Inc., 1999 WL 33755848 (M.D.Pa.), the court held that the code violations existed independently of the fire, and the fire did not "cause" the post-loss code enforcement. Accordingly, the court concluded that the cost of the code upgrades was not covered.

In sum, reasonable arguments exist both for and against coverage for increased costs of code upgrades in undamaged portions of insured premises, and the courts have yet to develop a consensus view. Fortunately, a long-term solution may exist, by way of ISO Building and Personal Property coverage form CP 00 10 04 02. In contrast to the policy language in Davidson Hotel, form CP 00 10 04 02 clarifies that coverage for the costs of code compliance is limited to costs associated with the reconstruction or repair of only the damaged portion of the property.