Case notes

Author Charlie Weston-Simons

In most cases where an indemnity is claimed under a property insurance policy which requires the insured to reinstate, the cost of reinstatement is the insured’s loss. However, over the years, there have been occasional examples of a different measure of indemnity being adopted. In this case, an unusual difficulty had arisen because the value of the insured property had substantially increased as a result of a fire. As a result, the insurer argued that the insured had suffered no loss but that, in any event, the insured had no intention to reinstate (and therefore no entitlement to the cost of reinstatement). The Court of Appeal confirmed that the insured was entitled to a reinstatement indemnity if there was a clear intention to reinstate that was ‘genuine’ as well as ‘fixed and settled’. However, in this case, the necessary intention would have to be demonstrated by the insured proceeding with the reinstatement hence the appropriate remedy was a declaration that the insured would be indemnified if the works were undertaken.

Background

The insured was the manager of a Grade II listed former factory (the ‘Property’) owned by the insured’s director and principal shareholder, Mr Singh. In 2012, the Property was destroyed by fire. At the time of the fire, the Property was derelict and could not be profitably developed due to its listed building status. Though of limited value in its pre-fire condition, the Property was insured against (amongst other matters) fire damage for £2.1 million, which was the likely cost to reinstate, and the indemnity was conditional on the insured incurring the cost of reinstatement. After the fire, the Property’s listed building status was removed, significantly enhancing its development potential, and therefore its value. However, no steps were taken to reinstate. As a result, no payment was made under the policy, and the insured subsequently commenced proceedings seeking damages or a declaration ‘in respect of the losses it has suffered’.

The first instance decision

At first instance, the insurer argued that the insured’s claim failed due to lack of insurable interest, material misrepresentation/non-disclosure and breach of warranty. However, the Mercantile Court rejected these defences and granted the declaration sought by the insured.

The Court of Appeal’s decision

The insurer accepted the Mercantile Court’s decision in relation to insurable interest, material misrepresentation/non-disclosure and breach of warranty.

However, the insurer was granted leave to appeal on two grounds:

• First, the insurer argued that the declaration was pointless because the insured had not suffered a loss (because the value of the Property had increased as a result of the fire) and would not suffer a loss (because the Property would not be reinstated).
• Second, the insurer argued that the Mercantile Court had wrongly decided that where the insurer repudiates the policy, it cannot rely on a condition that the costs of reinstatement will only be repaid once they have been incurred.

On the first issue, the Court of Appeal agreed that the declaration was flawed because it referred to ‘losses’ and none had been suffered. However, it remained the case that the insured was contractually entitled to the cost of reinstatement. Accordingly, the issue was not whether the Property had gone up or down in value as a result of the fire. Rather, it was whether the insured had a genuine intention to reinstate that was ‘fixed and settled’. If the insured has this intention, it was entitled to the cost of reinstatement. However, if the court considered there was a realistic prospect that the reinstatement would not happen, it could decline to award damages and either order a declaration or postpone deciding the issue until the position became clearer.

In this case, the Court of Appeal decided the insured’s intention would only be apparent when the reinstatement works started. On that basis, the appropriate remedy was a declaration that the insured would be indemnified if and when that happened.

On the second issue, the Court of Appeal held the Mercantile Court had actually decided (correctly) that, in a policy such as this one, the insured’s obligation to reinstate does not arise until the insurer confirms it will indemnify.

Comment

The Court of Appeal’s decision confirms that, in most cases where the policy requires the insured to reinstate the damaged property, the right to an indemnity is contingent on the insured showing a clear intention to reinstate. In cases such as this where there is a real possibility that the property will not be reinstated, that threshold will only be met when the works takes place. However, until the insured positively decides not to proceed, an indemnity for the cost of reinstatement should still be available unless the policy indicates otherwise.

On November 25 the Supreme Court of Canada rendered its decision in Lizotte v Aviva Insurance Company of Canada, 2016 SCC 52.

In this case, the professional order supervising claims adjusters in Quebec was investigating the conduct of a claims adjuster. In the context of its investigation, it asked an insurer for a copy of its claim file pertaining to one of its insureds.

The request of the order was based on Section 337 of the Act respecting the distribution of financial products and services, which provides the order with the right to obtain ‘any document’ that is relevant to its inquiry.

According to the order, the law did not allow it to require the disclosure of documents protected by solicitor-client privilege. However, the same protection was not afforded to documents falling under litigation privilege.

The order argued that the protection afforded by litigation privilege had been expressly set aside by the wording of section 337 of the Act respecting the distribution of financial products and services.

In a unanimous decision, the Supreme Court rejected the order’s arguments on the grounds that a legislative provision that simply refers to the communication of ‘any document’ is not sufficiently explicit to set aside litigation privilege.

In doing so, the Supreme Court confirmed the possibility that an insurer might invoke litigation privilege in respect of communications with a claims adjuster. This question had been previously discussed at court of appeal level, but never by the Supreme Court.

For example, in Union canadienne (L’), compagnie d’assurance c. St-Pierre, 2012 QCCA 433, the insured asked for a copy of the investigation report prepared by the claims adjuster at the request of the insurer. The Quebec Court of Appeal dismissed the demand of the insured on the grounds that the report was protected by litigation privilege.

In Lizotte v Aviva Insurance Company of Canada, the Supreme Court of Canada confirmed the possibility for the insurer to invoke litigation privilege, not only against the insured, but also against the professional order supervising claims adjusters.

The Supreme Court of Canada has provided important guidance in Ledcor Construction Ltd. v Northbridge Indemnity Insurance Co., 2016 SCC 37 on interpreting insurance policies, particularly in the context of construction projects.

Background

The source of this litigation was the construction of a 28-storey office building in downtown Edmonton, Alberta, Canada. As one of the final steps in the project, the general contractor retained a sub-contractor to clean the tower’s exterior windows for C$45,000. Unfortunately, the subcontractor used improper tools and methods and ended up scratching the tower’s windows to the point where they had to be replaced at a cost of C$2.5 million.

The general contractor and subcontractor made a claim under the project’s builder’s risk policy for the cost of replacing the scratched windows. The policy covered all risks of direct physical loss or damage to the property undergoing construction, subject to certain exclusions. The insurer denied the claim on the basis that it fell under the following exclusion for the ‘cost of making good faulty workmanship’:

This policy section does not insure … [t]he cost of making good faulty workmanship, construction materials or design unless physical damage not otherwise excluded by this policy results, in which event this policy shall insure such resulting damage.

Trial judge and Alberta Court of Appeal

At trial, the insureds argued that the exclusion for the ‘cost of making good’ only referred to the cost of redoing the cleaning work, while the insurer argued it also included the cost of replacing the scratched windows. The trial judge found that the exclusion clause was ambiguous because the interpretations of the insureds and insurer were equally plausible. The trial judge accordingly found that the policy covered the cost of replacing the windows because any ambiguity in an insurance policy in Canada will always be resolved to the benefit of the insured.

The Alberta Court of Appeal reversed the trial judge’s decision. The court developed a new ‘physical or systemic connectedness test’ to determine whether the scratched windows were the result of ‘faulty workmanship’ (excluded) or ‘resulting damage’ (covered). Under this novel test, the court found that damage to the windows was the result of ‘faulty workmanship’ because it occurred during the intentional scraping and wiping of windows. The court accordingly found that the policy excluded the replacement cost of the windows.

Supreme Court of Canada

The Supreme Court of Canada granted the insured’s appeal and found that the policy covered the cost of replacing the windows. In coming to this decision, the court provided important guidance on interpreting insurance policies:

• The court found that the decision of a trial judge on the interpretation of an insurance policy is not typically owed any deference on appeal. The court noted that the use of the correctness standard of review for insurance policies and other standard form contracts was an exception to the general rule the court had recently affirmed in Sattva Capital Corp. v Creston Moly Corp., 2014 SCC 53 that appellate courts should review the interpretation of contracts using the palpable and overriding error standard of review. A palpable error is one that is plainly seen. An appellate court should only apply this more deferential standard of review to insurance policies in exceptional cases where, for instance, the parties actually negotiated the terms of the policy¹.
• The court rejected the Alberta Court of Appeal’s new ‘physical or systemic connectedness test’ as unnecessary and affirmed that trial courts should rely on the general rules of interpretation for insurance policies that the Supreme Court had established in prior cases. In short:
  • The insured has the onus of establishing that the damage falls within the initial grant of coverage. The insurer then has the onus to establish that one of the exclusions to coverage applies, with the onus then shifting back to the insured to apply any exception to the exclusion.
  • If the policy’s language is ambiguous, the court may consider the reasonable expectations of the parties, as long as that interpretation is supported by the language of the policy, does not give rise to results that are commercially unrealistic, and is consistent with the interpretations of similar insurance policies.

On the claim before it, the court agreed with the trial judge that the exclusion clause was ambiguous and accordingly turned to the reasonable expectations of the parties.

The court found that the purpose of a builder’s risk policy is to provide broad coverage for construction projects, providing ‘certainty, stability, and peace of mind’ in exchange for ‘relatively high premiums.’ In this context, the court found that the insureds would be deprived of the very thing they had contracted for if the exclusion clause removed coverage for the cost of replacing the windows merely because the windows were the part of the project on which the sub-contractor had worked. The court accordingly found that while the policy would not cover the cost of redoing the subcontractor’s work, it did cover the cost of replacing the scratched windows.

Conclusion

This decision provides guidance to Canadian lower courts on the proper interpretation of insurance contracts in Canada by removing the temptation to come up with novel ways of resolving coverage disputes. This should lead to greater certainty for insureds and insurers on the interpretation of insurance policies. However, it could also increase the temptation to appeal lower court decisions since appeal courts will generally consider the matter anew.

This decision could also cause an increase in claims under builder’s risk policies as insureds latch on to the Supreme Court of Canada’s generous interpretation of the reasonable expectation of parties involved in construction projects. All insurers that write builder’s risk policies in Canada need to review their policy wording to ensure any exclusionary language is free from the ambiguity found in Ledcor Construction.

Footnote

1. Justice Cromwell concurred with the result but found that there was no reason to depart from the general rule in Sattva for the interpretation of standard form contracts.

Plaintiff John Sebo bought a house in Florida in April 2005. Defendant American Home Assurance Company (AHAC) provided homeowners insurance from the time of purchase. The AHAC policy (the ‘Policy’) provided over US$8 million in coverage for damage to the home and other permanent structures on the premises. It also provided coverage for loss of use of the home. The Policy excluded losses caused by defective construction.

Extensive roof leaks were reported as early as May 2005, and Hurricane Wilma exacerbated the damage in October 2005. Sebo reported water intrusion to AHAC in December 2005. AHAC investigated but denied coverage for most of the claimed losses in April 2006. AHAC tendered its US$50,000 limit for mold damage, but took the position that ‘damages to the house, including any window, door, and other repairs, is not covered’ as defective construction contributed to the loss.

The residence could not be repaired and was demolished. In January 2007, Sebo filed suit against the home’s previous owners, architect, and builder. In November 2009, Sebo amended his complaint, adding AHAC as a defendant and seeking coverage under the Policy. A jury eventually found in Sebo’s favour, and the trial court entered judgment against AHAC.

On appeal, Florida’s Second District Court of Appeals noted the lack of any dispute ‘that there was more than one cause of loss, including defective construction, rain, and wind.’ The Second District then disagreed with the trial court’s application of Florida’s concurrent causation doctrine in a ‘case involving multiple perils and a first-party insurance policy.’ The Second District therefore reversed and remanded for a new trial ‘in which the causation of Sebo’s loss is examined under the efficient proximate cause theory.’

Efficient proximate cause or concurrent cause?

As the Florida Supreme Court put it, “[w]e are confronted with determining the appropriate theory of recovery to apply when two or more perils converge to cause a loss and at least one of the perils is excluded from an insurance policy.” The Court described the competing theories as follows:

[Efficient Proximate Cause or EPC theory] provides that where there is a concurrence of different perils, the efficient cause—the one that set the other in motion—is the cause to which the loss is attributable.

...

[Concurrent Cause Doctrine or] CCD provides that coverage may exist where an insured risk constitutes a concurrent cause of the loss even when it is not the prime or efficient cause.

The Court illustrated its understanding of efficient proximate cause doctrine with a prior case deciding coverage under an all-loss fire policy that excluded loss caused by an explosion. The Court there distinguished between a fire causing an explosion which causes a loss—a covered loss—and an explosion causing a fire which causes a loss—a non-covered loss.

In contrast, the Court illustrated its understanding of concurrent cause doctrine with the case followed by the trial court, Wallach v. Rosenberg, 527 So.2d 1386 (Flo. 3d DCA 1988) . There, the Rosenbergs’ sea wall partially crumbled due to a combination of the neighbour’s sea-wall collapsing and a storm. The Rosenbergs sought coverage under their homeowner’s policy. Their insurer denied the claim on the basis of an exclusion for loss caused by earth movement or water damage (i.e. the storm), even though it was undisputed that the neighbour failed to properly maintain his sea wall, and that the neighbour’s failure contributed to the Rosenbergs’ loss. Florida’s Third District Court of Appeals there held that “[w]here weather perils combine with human negligence to cause a loss, it seems logical and reasonable to find the loss covered by an all-risk policy even if one of the causes is excluded from coverage.”

The Sebo holding: concurrent cause doctrine applies in favour of coverage when no efficient proximate cause can be determined

The Florida Supreme Court granted review based on the conflict between Wallach and the Second District’s decision, which explicitly rejected Wallach. Before handing down its decision, the Court noted the parties’ agreement “that the rainwater and hurricane winds combined with the defective construction to cause the damage to Sebo’s property.” The Court noted further that “there is no reasonable way to distinguish the proximate cause of Sebo’s property loss—the rain and construction defects acted in concert to create the destruction of Sebo’s home.”

The Court then held that “it would not be feasible to apply [efficient proximate cause] doctrine because no efficient cause can be determined.” The Court then opined that because nothing in the Policy undermined application of concurrent cause doctrine and no efficient proximate cause could be determined, concurrent cause doctrine applied in favour of coverage for the loss. Thus, under Florida law, a loss is generally covered under a first-party policy if: (1) no efficient proximate cause can be determined; (2) covered and excluded causes jointly cause a loss; and (3) the policy does not contain an applicable anti-concurrent cause provision.

This approach stands in contrast to some other states, like Texas. Texas follows its own, more insurer-friendly, variation of concurrent cause doctrine: “when covered and non-covered perils combine to cause a loss, the insured is entitled to recover only that portion of the damage caused solely by the covered peril.” See, e.g., Travelers Indemnity Co. v McKillip, 469 S.W.2d 160, 162 (Tex. 1971). In other words, the insured bears the burden of segregating covered damage (i.e. damage due to a covered cause) and non-covered damage (i.e. damage due to a non-covered or excluded cause).

What’s next?—and how insurers can protect themselves

Sebo is in some ways unsurprising. The loss fell within the Policy’s insuring agreement, and “it w[as] not feasible to apply [efficient proximate cause] doctrine because no efficient cause c[ould] be determined.” Accordingly, AHAC could not prove that an excluded cause was the proximate cause of the loss, and the insuring agreement’s broad grant of coverage therefore governed.

What Sebo leaves open, however, is the issue of what happens when an excluded cause precedes and gives rise to a covered cause, and both later cause a loss. If a case with those facts reaches the Court, the Court may well carve out an exception from concurrent cause doctrine in favour of efficient proximate cause doctrine such that the loss would be excluded from coverage.

We also note in closing the Court’s implicit approval of insurance policies’ use of anti-concurrent cause language to avoid application of concurrent cause doctrine and thereby narrow the scope of coverage. In “disagree[ing] with the Second District’s statement that [concurrent cause doctrine] nullifies all exclusionary language,” the Court “not[ed] that AHAC explicitly wrote other sections of [the] [P]olicy to avoid applying [concurrent cause doctrine].” Thus, the Court held, “[b] ecause AHAC did not explicitly avoid applying [concurrent cause doctrine], we find that the plain language of the [P]olicy does not preclude recovery in this case.” Accordingly, an insurer seeking to avoid AHAC’s fate in Sebo would do well to include anti-concurrent cause provisions in its first-party policies.

If the High Court’s signal in Highway Hauliers was not clear enough, the Full Court of the Federal Court has further affirmed the pervasive remedial nature of section 54 of the Australian Insurance Contracts Act 1984 (ICA).

Watkins Syndicate v Pantaenius concerned an appeal from a decision handed down in January this year. In dismissing the appeal, the Full Court reaffirmed the general position that s 54 may apply provided that a restriction or limitation is not inherent in the claim and observed that this requires an analysis of the essential character of the policy.

A claim on the rocks

Watkins concerned a luxury yacht which sank off the coast of Cape Talbot, WA, while returning to its home port following completion of the Fremantle to Bali yacht rally.

The yacht was insured under two policies. The first was held with, Pantaenius Australia Pty Ltd (Pantaenius Policy). The second was underwritten by the Appellant, Nautilus Marine Agency Pty Ltd (Nautilus Policy).

The Pantaenius Policy responded to the loss, but the Nautilus Policy excluded losses occurring outside a defined geographical zone, being 250 nautical miles off the Australian mainland or Tasmania. Under this exclusion, coverage was suspended from the time the yacht cleared Australian Customs on its outward voyage until it cleared Customs on its return.

At the time the yacht sank it was within 250 nautical miles of the Australian mainland but had not cleared Australian Customs following its return from Bali.

Pantaenius made a claim for contribution on Nautilus, arguing s 54(1) nullified Nautilus’ exclusion clause. Justice Foster, at first instance upheld the application and ordered contribution.

Was s 54 engaged?

On appeal, the first issue was determination of whether s 54 was engaged. Following a close examination of the relevant High Court authorities, the Full Court concluded this task involves identifying the nature and limits of the risks that are intended to be accepted, paid for, and covered under the policy. The Full Court observed:

“The process of understanding what are the restrictions or limitations that are inherent in the claim is one that involves the construction of the policy, not merely as to what its constituent words mean, but in a broad sense so as to characterise as a matter of substance what is the essential character of the policy. Once that essential character is decided upon, the restrictions or limitations that necessarily inhere in any claim under such a policy (to which s 54 does not apply) and the restrictions or limitations that do not necessarily inhere in any claim under such a policy (to which s 54 may apply) can be ascertained.”

Perhaps unsurprisingly, their Honours held that the essential character of the Nautilus Policy was to provide coverage for damage occurring while the yacht was within 250 nautical miles of mainland Australia or Tasmania. As the insured’s yacht was within this geographical limit at the time it sunk, the insured’s claim necessarily incorporated a physical dimension that was part of the essential character of the policy. The suspensory limitation created by the particular wording of the exclusion clause (i.e. the requirement to clear and re-clear Australian Customs) was therefore a qualification on, or collateral to, the policy’s essential character. As such, s 54 was engaged.

Did s 54 prevent refusal of the claim?

Having determined that s 54 was engaged, the Full Court found that cover was suspended due to an “act” of the insured (either the insured’s act of clearing Australian Customs on the outward journey or the omission of not having cleared customs upon return from Bali). Therefore, as the relevant “act” did not cause or contribute to the loss suffered, Nautilus could not refuse Pantaenius’ claim.

Can an insurer rely on the remedial benefit of s 54?

Finally, the Full Court confirmed that an insurer can rely on s 54 and the remedial benefit of s 54 is not reserved solely for insureds. Nautilus’ argument that s 54’s use of the word “claim” referred only to claims made by the insured was rejected.

Going forward

As the Full Court noted, the approach taken in Watkins represents the gradual distillation of jurisprudence on s 54 over nearly 20 years of litigation. This high-water mark in judicial interpretation, in what has previously been a difficult area to navigate, sends a clear signal to insurers. Close and careful attention must be paid to defining the limits of a policy to ensure that the scope accurately reflects the risk intended to be covered. Undue reliance should not be placed on technical exclusion or limitation clauses to remedy what is otherwise a broad or vaguely defined policy.