Contract risk insurance – when must an insurer pay more than the actual loss, and can I settle the claim without the insurer’s agreement?

The recent decision of the Queensland Court of Appeal in Royal and Sun Alliance Insurance Plc v DMS Maritime Pty Limited¹ raises two important issues for investors, trading businesses, and insurers:

• Where an insurer issues a policy to cover an obligation to “replace or otherwise make good” a valuable asset, what does this mean in practical terms if it is not feasible to carry out a like-for-like replacement?
• If a policy holder settles a major claim against it without the permission of its insurer, what must it prove to claim the amount of the settlement from the insurer?

Background

DMS Maritime Pty Ltd (DMS) is an Australian company providing port services to the Australian Defence Force and Australian Customs Service.  In 2003, DMS entered into a contract with the Commonwealth of Australia for the design, manufacture and supply of Armidale class patrol boats (the supply and maintenance contract or SM contract).  One of the boats constructed under the SM contract was HMAS Bundaberg.

On 11 August 2014, the HMAS Bundaberg was in dry dock in the possession of DMS, for routine repairs and maintenance.  An employee of one of DMS’s subcontractors caused a fire which destroyed the vessel.

It was common ground at trial that the circumstance of that loss meant DMS became liable to indemnify the Commonwealth against “any loss or damage” to the vessel (clause 6.8.1.1 of the SM contract) and, further, that DMS became liable to the Commonwealth to “promptly replace or otherwise make good any loss of” the vessel (clause 8.3.1 of the SM contract).

DMS held a current ship repairer’s insurance policy, which relevantly provided that the insurer would “indemnify [DMS] for all sums which [DMS] shall become liable to pay by reason of the legal liability of [DMS] as shiprepairers for … (i) Loss of or damage to any vessel or craft upon which is the care, custody or control of [DMS] for the purpose of being worked upon …”.

Insurance dispute – partially settled

The insurers at first disputed liability under the policy, but then entered into a Deed of Settlement whereby they agreed that the insurance policy would respond to DMS’ claim, but that DMS was obliged to prove the amount of the loss.  DMS then proceeded to negotiate with the Commonwealth.

DMS settles with the Commonwealth

On 10 June 2016, the DMS settled the claim against it by agreeing to pay $31.5 million to the Commonwealth.  This amount was based on the assumption that the loss of HMAS Bundaberg required its replacement by a new Cape Class Patrol Boat.  The expert evidence was that at the date of the loss the market value of the HMAS Bundaberg was nil.   DMS then claimed on its insurers to reimburse it for the cost of the settlement.

DMS sues the insurers

The insurers were unhappy at having to meet the cost of effectively replacing HMS Bundaberg with a new boat of a better class.  They refused to pay. Legal action ensued, first before a single judge in the Supreme Court of Queensland, who found in favour of DMS.  The insurers appealed to the Queensland Court of Appeal, but lost again.

Two issues particular are illustrated by this case:

1. The insurers argued that DMS was not obliged to provide a new boat to the Commonwealth, but only to pay for a lease of a replacement boat for a period of a few years. However, the Court of Appeal pointed out that:
   1. Under the SM contract, the Commonwealth was to receive not only the use of an Armidale class patrol boat for the life of the contract, but would also have possession of the boat at the end of the contract life. Whilst the boat by then would be old and perhaps obsolete, merely paying a lease of an equivalent boat during a fixed period did not fulfil the obligation to “promptly replace or otherwise make good” the loss.  The Commonwealth had to be given possession of a replacement boat, or its equivalent value.
   2. The parties knew when they entered into the contract that the only Armidale class patrol boats were those contracted by the Commonwealth – no orders had been received from overseas parties. It followed that the parties contemplated that, if DMS were required to replace a boat, this would probably require it to procure a boat of a different class, and quite possibly one that was better than the Armidale class boats.
2. The insurers also argued that DMS had not proved that its settlement with the Commonwealth was reasonable. The Court of Appeal also rejected this argument but without resolving a conflict in the judicial authorities on this issue:
   1. This was a case where the insurer has not declined liability under the policy, but where it had not agreed to the settlement either. The insurers relied on a line of judicial authority² which holds that in such cases a settlement is not binding on the insurer unless the policy holder (i.e. DMS) can demonstrate that the settlement amount is less than it would have achieved had it litigated the claim.  In other words, the onus of proof is on the insured to prove what the likely result would have been in hypothetical litigation – not an easy thing to do.
   2. However, the Queensland Court of Appeal has previously decided differently to the foregoing authorities.  In Hurlock v Council of the Shire of Johnstone [2002] QCA 256, it held that the onus lies on the insurer to demonstrate that the settlement was unreasonable or that it has some other defence. DMS naturally relied on this line of authority.
   3. The NSW Court of Appeal has previously noted that there is a conflict among the authorities on this point.³
   4. In this case, the court sidestepped the conflict in the authorities by holding that DMS had proved that the settlement was better than it would have achieved in litigation, since the $31.5 million settlement figure was only for the bare cost of the replacement vessel and did not include the cost of modifications to make the replacement vessel functionally equivalent to an Armidale class boat. This finding by the court thus raises a new issue that goes beyond Hurlock, i.e. that if a compromise or settlement is less than the full amount that could have been achieved, it could ipso facto fulfil the onus of proving that the settlement was reasonable.

Recommendations

• When insuring against an obligation to “promptly replace or otherwise make good” the loss of an expensive asset, both business owners and insurers should consider the likely and possible exposures under that clause. In this case the fact that both parties to the SM contract knew that there would be no more Armidale class boats built acted as an indicator that their contract could require replacement in a greater amount than the market value of the boat.Such clauses are common in ship repairers liability policies, but can be found in many other types of policy also.

• In a situation where a policy holder settles a claim against it by another party and where the insurer has not denied liability but has not formally agreed to the settlement either, there is a conflict in the applicable law, which this case has not resolved. According to the Queensland Court of Appeal in Hurlock, the onus of impugning the settlement lies on the insurer – it must reimburse the policy holder for the settlement amount unless it can prove that the settlement was unreasonable (or it some other defence).  Whereas a number of other decisions in Australia and overseas indicate that the onus lies on the policy holder – it must prove that the settlement was less than it would achieve in litigation.

1 [2019] QCA 264 (22 November 2019) per Fraser and McMurdo JJA and Boddice J

2 Sources cited by the Court of Appeal included Colinvaux’s Law of Insurance, 11^th edition at 21-107; Drayton v Martin (1996) 67 FCR 1 at 14-15; Enterprise Oil Ltd v Strand Insurance Co Ltd [2000] EWHC 58 (Comm) at [167] and CGU Insurance Ltd v AMP Financial Planning Pty Ltd (2007) 235 CLR 1

3 Vero Insurance Ltd v Baycorp Advantage Ltd (2005) ANZ Ins. Cas 61-630]