April 2007

Canadian National Railway Company et al v. Royal and Sun Alliance Insurance Company of Canada et al.
Ontario Court of Appeal, Docket C42591, March 26, 2007

When can an insurer rely on an exclusion for faulty or improper design? In Canadian National Railway Company et al v. Royal and Sun Alliance Insurance Company of Canada et al. the Ontario Court of Appeal considered the effect of a faulty design exclusion under an all risks policy.

In the above noted case, C.N. was claiming against its insurers the sum of roughly 30 million dollars. The claim was damages due to delayed construction of a new railway tunnel. In order to dig the tunnel, C.N. had hired a design firm to build a tunnel boring machine ("TBM"). During the course of building the tunnel, the machine broke down which caused damage to the machine and delayed construction.

C.N.'s insurer denied coverage. Insurers claimed that a policy exclusion for the "cost of making good . . . faulty or improper design" was engaged. The court of appeal agreed.

The TBM was a unique and specially designed piece of machinery designed by a large team of individuals. One of the concerns in the creation of the machine was preventing soil from entering the bearing chamber. As luck would have it, although the designers believed that they had adequately dealt with the risk to the bearings, the cause of the machine failure was that it did not "operate as intended to prevent soil or other foreign materials from passing through the seal gap and entering into the bearing chamber thereby creating a risk of damage to the bearing".

C.N.'s insurance policy covered "all risks of direct physical loss or damage, including general average and salvage charges to: (a) all real and personal property of every kind and quality including but not limited to the [TBM]". This coverage excluded "the cost of making good . . . faulty or improper design provided, however, to the extent otherwise insured and not otherwise excluded under this Policy, resultant loss or damage under any Section of this Policy shall be insured".

The main issue in this case was the standard of proof. When is a design deemed faulty or improper so as to exclude coverage? The court rejected the submission that the test should be one of negligence, where a design would be faulty if it failed to account for reasonably foreseeable risks. Rather, "property must be designed so that it accommodates all foreseeable risks, even though such risks may be unlikely and remote". It is not enough to account for a foreseeable risk, risks must further be identified and allowed for in the design.

It was clear that the TBM did not withstand the conditions. However, the court had to consider technical evidence to determine if the conditions were foreseeable. In this case, the evidence showed that the designers were concerned about foreign materials compromising the bearings. The designers knew of the potential danger and investigated the extent of the risk. This was not a case where the problem was not known to the industry. Rather the type of problem was a concern to the designers. After the failure, the TBM was modified to prevent future similar failures. The designers simply believed that the risk had been accommodated, when in fact, it was not.

Further, the appellate court found that the a design will still be faulty if the magnitude of the risk was not foreseen. It was sufficient that the "design of the TBM was inadequate to meet a known risk of possible failure of the TBM . . .". As such, the TBM "was faulty and, consequently. . .the faulty or improper design exclusion applies".

In coming to this conclusion, the court had to consider the interpretation of all risks policies. These policies provide broad coverage for losses and damage to property, but not against all perils. The policy was not meant to be a warranty.

By rejecting the tort test of reasonable foreseeability, the court was requiring a higher standard of designers. Under the negligence test, a design would only be faulty if the designers neglected risks that were reasonably foreseeable. If a risk was determined to be foreseeable, but remote, then a design would not be faulty for failing to account for the risk. In effect, insurers would have greatly increased exposure for design defects, and in effect, would be providing design warranties.

It can be argued that an all risks policy is ill-designed to deal with design defects. When could it be said that a risk is reasonably foreseeable rather than remote? This is a subjective test. An all risks policy is not designed to compensate for shoddy products, or to regulate technical areas such as the design of heavy duty equipment.

C.N. also argued that its losses were coverable under the exception to the exclusion, in that, a portion of the loss was for delay beyond the scheduled start-up date, and delay was a peril insured against under another section. The faulty design exclusion stated "to the extent otherwise insured and not otherwise excluded under this Policy, resultant loss or damage under any Section of this Policy shall be insured". However, the court found that the section that covered delay was also subject to the faulty design exclusion, and that C.N. was covered "for consequential economic loss only to the extent that the economic loss results from insured loss or damage to insured property".

Does this interpretation render the exception to the exclusion nugatory? The court found that there are still situations when this exception would apply. For example, if "the faulty design of the TBM had caused a fire that damaged the TBM and part of the tunnel constructed behind it, the damage to the TBM would be excluded, as would any economic loss from delayed opening due to the damage to the TBM. However, the physical damage to the tunnel itself, which was insured property, would be covered, as would any economic loss from delayed opening attributable to the damage to the tunnel".

This decision affirmed the reasonable expectations of both parties to an all risks insurance contract. Insured's do not expect that they will have coverage for design decisions on complicated machinery. If the test for triggering a design exclusion is that of reasonableness, the issues of cost and strategy would come into play. Would it be sufficient to not plan for a risk that had a low chance of occurring, if the expense to do so was very great? This is a risky game, and not one that insurers want to play under an all-risks policy.

Finally, C.N. argued that it had mitigated its damage and that the sue and labour clause under the policy would oblige the insurer to contribute to reasonable and proper expenses incurred to prevent further damage. The court found that this does not "apply to indemnify the insured for expenses incurred to minimize or mitigate an uninsured loss". Sue and labour clauses simply require insured's to ensure that insured losses are minimized.

Effectively, the court reinforced the expectations of insurers under all-risks policies. Although exclusions must be interpreted strictly, the court must be careful not to extend all-risk policies to technical areas that are beyond the scope of this type of policy.

Cynthia Verconich