Australia: Perched on Mount Ararat – Insurers and insureds in the aftermath of the flood

insurance update
Last Updated: 14 February 2011
Article by Greg Moss

And the heavens opened...

Recent weather volatility, primarily storms and flooding in Queensland and Victoria (including tropical cyclone Yasi), has resulted in thousands of insurance claims placing stress on insurers and insureds alike.

Many insurers may take a tough line with commercial policy flood claims and there may be significant differences depending on whether the affected property was domestic/residential or commercial/industrial.  The policies are very different and divergent legal and factual disputes are likely to arise.

Much ink has already been spilt on the various implications for insurers, insureds and their advisors.  Issues include event definition (whether damage was caused by flood or not), aggregation (number of insured events), loss calculation and business interruption - particularly in the absence of 'physical damage'.

In this update we will focus on business interruption as it is likely to become contentious as various claims are assessed.  We will address a range of other flood related issues at our upcoming Hot Topics seminar.

Major business enterprises, for example mining operations, may be significantly affected by a loss of access and/or inability to operate by the mere presence of excess water even if not strictly resulting in physical damage to insured property.  The policy wording will prove to be the key and we address how far policies extend in respect of damage to insured commercial/industrial property in the case of a deluge.

And the waters subsided...

In the aftermath of the recent Queensland natural disasters, in the context of consumer home and contents insurance policies, claims disputes are likely to revolve around how a policy's Product Disclosure Statement explained that the policy did not cover flood (if it did not, as many policies included flood cover), how the policy defined 'flood' and whether this was properly explained to the consumer at the time they bought the policy.

However, in the case of commercial, mining and industrial property, the debate is more likely to centre on whether there was actual physical damage to the Insured's property or the property of one of their suppliers or customers.  If flood was excluded, an issue may also arise as to the extent to which water causing damage was in fact 'flood' water.  The ensuing debate will then revolve around how the policy entitlements (if any) are to be calculated.

And Noah reviewed the surface of the ground...

The majority of business insureds in Australia are covered by property damage and business interruption insurance based upon the National Insurance Brokers Association's (NIBA) Mark IV or V Industrial Special Risks (ISR) wording as a template.[1]

Although both Mark IV and Mark V standard policy wordings exclude flood, with exclusions distinguishing between water which escapes from a natural water course and other forms of deluge, many businesses have had these exclusions removed[2].  Further, all ISR insurance requires that 'physical loss or damage' to insured property has occurred in order for any consequent business interruption loss to be covered.

This is often extended to provide cover if damage that occurs to the property of a supplier of services (including utilities) to the Insured, or even in some cases of a customer of the Insured, would have been covered had it happened to the Insured's property.[3]  Prevention of access and loss of attraction causing business interruption may also be covered by extension.

Adding to the complexity of the policy wording landscape are the variety of bespoke coverage terms that can be based upon standard template wordings and the use of policies provided by overseas-based insurers with often verbose wordings (US wordings are often the worst offenders).

Despite these limitations, some businesses may still have hope of cover.  Flood exclusions only apply to damage directly caused by the flood water itself.  If a flood causes the occurrence of another peril which is covered under the Policy and that insured peril actually damages the business before the flood does, the damage and resulting business interruption should be covered.

It is also common for Australian policies to leave the phrase 'physical loss or damage' undefined. Ordinarily, where a policy of insurance does not define a phrase, the phrase is to be construed according to the plain and ordinary meaning of its words.  However, if the phrase has a settled meaning, it is to be attributed that meaning.[4]  Further, the phrase is to be construed by reference to the context in which it appears and the commercial object of the policy.  Relevantly, if the ordinary or settled meaning of the phrase produces a result that is contrary to the commercial object of the policy, the phrase must be construed (or read down) in a way which avoids such a result.[5]

There are a number of domestic cases concerning the meaning of damage in the context of a policy of insurance.  A number of cases support the proposition that damage includes an alteration in the condition of property insured that impairs its usefulness (ie impaired utility)[6]

In 1998, the Victorian Court of Appeal considered a policy that provided cover against accidental damage to property insured and found that damage extended to: ... damage that rendered [the property insured] less useful and effective for the purpose for which it had been acquired.[7]  The NSW Court of Appeal also considered a policy that provided cover against physical damage to property insured and found that damage extended to: ...physical alteration or change that impairs the value or usefulness of the thing said to have been damaged.[8]  In Queensland, the Court of Appeal considered a policy that provided cover against physical damage to property insured and found that damage extended to: ...physical alteration or change, not necessarily permanent or irreparable, which impairs the value or usefulness of the thing said to have been damaged.[9]

United States case law supports the proposition that damage includes an alteration in the condition of property insured that impairs its usefulness.  For example, a Court considered a policy that provided cover against physical damage to property insured and found that damage extended to:  ...loss of use of tangible property.[10]  Similarly, in another case, a court considered a policy that provided cover against physical damage to property insured and found that damage extended to: ...loss of access, loss of use and loss of functionality: [11]

To date, authorities in the United Kingdom have not in themselves been determinative of these issues, however, in English law, 'damage' usually refers to a changed physical state. Therefore, for the purposes of indemnity it is normally necessary to demonstrate that a physical change has occurred to the property damaged.[12]

The Australian authority of arguably the greatest relevance to the issue is that of the NSW Court of Appeal in Transfield Constructions Pty Ltd v GIO Australia Holdings Pty Ltd.[13]  In that case, the insured had contracted to build grain silos, and the insurer had insured the works against 'physical loss or damage'.  Owing to a defect in screens installed within them, fumigation pipes in each of the silos became blocked by grain.  It was necessary for the insured to remove the grain in order to carry out rectification works on the screens.  The question for the Court's determination was whether this blockage constituted 'physical loss or damage'.  Meagher JA, with whom Clarke and Sheller JJA concurred, held that it did not, saying:

Loss of usefulness might in some contexts amount to damage, though even that is not beyond dispute, but in my view it cannot amount to physical damage. Functional inutility is different from physical damage.

This decision arguably creates a tension between NSW and authorities in other Australia states.

If physical damage, for the purposes of the commercial policy, extends to impaired utility or functionality, then commercial property that cannot be utilised due to inundation of the premises by water could (arguably) result in a valid claim.  The reason is because the presence of water could amount to a change in the condition of the property that impaired its usefulness. 

It will be interesting to see if such issues arise out of the current crop of natural disasters.

And two by two the employees left the ark...

Upon becoming aware that the flood waters were rising, many commercial businesses in the vicinity acknowledged the threat posed and followed generally accepted practices by evacuating all employees.  The action of securing and evacuating the insured properties consequently impaired the business's commercial utility and functionality.  Accordingly, as an extrapolated argument similar to the above, it could be contended that such impairment similarly constituted damage.  Many policies provide some cover for steps taken for the protection and preservation of property.

Although it is generally accepted that compliance with an order of an authoritative body may result in cover for the purpose of relevant extensions, further debate is likely if insurers deny indemnity causally related to compliance with the requirements of a mere 'announcement' by a civil servant (mayor or politician).  Consideration will likely be given to whether or not a mere public service announcement is deemed to be an order of a civil authority requiring compliance, at law.[14]

And Noah heard their voice...

The trend of Anglo-Australian authority suggests that as a general rule:

  • some form of physical alteration of property is required before it will be regarded as having suffered 'physical damage' for property insurance purposes;
  • loss of utility, unaccompanied by any physical change, may in some circumstances amount to 'damage'; but
  • mere loss of utility will not amount to 'physical damage'.

However, these issues are not free from doubt.

And there was a rainbow...

In conclusion, commercial business insurance polices are complex and require thorough analysis in the case of disputed claims.  Australian insurers routinely exclude cover for 'flood' in their policies while retaining cover for storm damage or other similar concepts.  As a result, there has been considerable debate and case law developed over the years (across State lines) in respect of the interpretation and ambiguity in policy wording. 

According to federal Assistant Treasurer Mr Bill Shorten, Australia's insurance industry has agreed to establish a standard definition for flood insurance and to write policies in simpler language.[15]

Suggestions of a flood reinsurance pool along similar lines to that already in place in respect of Terrorism cover have been met with mixed support.  All stakeholders will continue to monitor developments closely and it is hoped that some good will result in the form of enhanced protection and certainty for all involved.

[1] However, there exist myriad variations of individually negotiated coverage terms that can be written on those wordings as well as foreign developed/drafted alternative policy wordings available in Australia.

[2] Anecdotal evidence suggests approximately 50%.

[3] The combined operation of such extensions can be problematic given arguably unintended drafting issues in the Mk IV wording.  See Cat Media Pty Ltd v Allianz Australian Insurance Ltd [2006] 14 ANZ Ins Cas 61-700

[4] Australian Casualty Co Ltd v Federico (1986) 160 CLR 513.

[5] McCann v Switzerland Insurance Australia Limited (2000) 203 CLR 579; Wilkie v Gordian Runoff Ltd (2005) 79 ALJR 872.

[6] See: Ranicar v Frigmobile Pty Ltd (1983) 2 ANZ Ins Cas 60-525 and Graham Evans & Co (Qld) Pty Ltd v Vanguard Insurance Co Ltd [1986] 4 ANZ Ins Cas 60-689.

[7] Switzerland Insurance Australia Ltd v Dundean Distributors Pty Ltd [1998] 4. V.R. 692 per Ormiston JA at 74,102.

[8] AXA Global Risks (UK) Ltd v Haskins Contractors Pty Ltd [2004] 13 ANZ Ins Cas 77401 per Mason P at [41].

[9] Prime Infrastructure (DBCT) Management Pty Ltd v Vero Insurance Ltd [2005]. QCA 369  per McMurdo P at [31]. 

[10] Lassen Canyon Nursery v Royal Insurance Co, Inc [1983] 720 F.2d 1016

[11] Southwest Mental Health Ctr, Inc v Pac Ins Co, Inc [2006] 439 F.Supp. 2d 831

[12] Pilkington UK Ltd v CGU Insurance Plc [2005] All E.R (Comm) 283

[13]  [1997] 9 ANZ Ins Cas 61-336

[14] See Cat Media Pty Ltd v Allianz Australian Insurance Ltd and Allstate Exploration NL v QBE Insurance (Australia) Ltd [1998] VSCA 148.

[15] Sydney Morning Herald, Standard definition for flood insurance: Shorten , 3 February 2011

For more information, please contact:


Ray Giblett

t (02) 9931 4833


Wendy Blacker

t (02) 9931 4922


The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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