Insurable Interest

SCC Narrows Design Exclusion in All-Risk Property Policies

A 15 year long insurance dispute over equipment repair and project delay costs has come to an end with the Supreme Court of Canada's decision in Canadian National Railway Co. v. Royal and Sun Alliance Co. of Canada. In finding for the insured, the SCC has narrowed the –faulty or improper design– exclusion found in many all-risk property insurance policies.

In the early 1990s, the Canadian National Railway (CNR) established an elaborate and sophisticated process to design and construct the world's largest tunnel boring machine (TBM). CNR needed the TBM to excavate a new railway passage under the St. Clair River between Sarnia, Ontario and Port Huron, Michigan. To work properly, the gap between the 31 foot wide cutting head and the adjoining bulkhead had to remain between a miniscule 3 and 9 millimetres or else dirt would flow in and grease would flow out. The designers addressed the possibility of deflection beyond those parameters by creating a redundant system of 26 seals to keep the dirt and grease apart. Excavation began in 1993 but excessive deflection between the TBM components allowed dirt into the bearings with the tunnel only 14% complete. TBM suffered over $20,000,000 in repair and project delay costs.

At the time of the loss, CNR held a manuscript builders risk insurance policy issued by Royal and Sun Alliance Co. of Canada ("Royal") that insured CNR against "ALL RISKS of direct physical loss or damage…to all real and personal property of every kind and quality including but not limited to the [TBM]". When CNR sought indemnity under the policy, Royal denied coverage, relying on exclusions in the policy that exempted from coverage "the cost of making good… faulty or improper design" and "inherent vice". CNR successfully sued Royal but the trial ruling was overturned on appeal. Those decisions are the subject of an earlier Insurance Bulletin that can be found here: www.cwilson.com/insurance/reviews/insrev131.shtml. CNR then appealed to the SCC.

The SCC decision focused mainly on the "faulty or improper design" exclusion. The key issue was whether a design which specifically addressed but ultimately failed to withstand a foreseeable risk automatically fell within the exclusion. CNR acknowledged it had foreseen the risk of deflection but argued that it took its design to the extent of current engineering knowledge to address the problem. Such a design could not be considered "faulty or improper" even if it failed. Against this, Royal argued that the failure itself was enough to show that the design was faulty.

The SCC did not agree with CNR that the exclusion was ambiguous and should be read narrowly and contra proferentem against Royal. Justice Binnie noted that while the exclusion required interpretation, it was not ambiguous and so contra proferentem did not apply. [Of course it's ironic that the majority and the minority both came to different conclusions on what the supposedly non-ambiguous exclusion meant!]

Binnie J. ruled that the concept of a "faulty or improper" design implies a comparative standard against which the impugned design falls short. The words "faulty or improper" require insurers to establish that the design falls below a "realistic" standard, one that requires no more than that the design comply with the state of the art. Simply meeting any lower "industry standard" may not be enough to escape the exclusion.

The SCC made short work of the "inherent vice" exclusion, upholding the lower court rulings that it did not apply. Royal argued an inference ought to be drawn that, because the TMB failed under normal conditions, there must have been some inherent defect if the failure was not the result of faulty or improper design. The Court adopted a narrow interpretation of the exclusion and the trial judge's ruling there was insufficient evidence to find an inherent vice.

The CNR decision will certainly broaden the scope of property insurance coverage in technical projects involving pioneering design. Since mere failure of design without more is no longer enough to trigger the exclusion, one can expect much coverage litigation in the future about whether the particular design in any given case meets the slightly reduced standard the Supreme Court has now endorsed.