Canada: The Supreme Court Of Canada Narrows The Faulty Design Exclusion In All-Risk Property And Builders Risk Policies

Canadian National Railway Co. v. Royal and Sun Alliance Insurance Co. of Canada 2008 SCC 66

A recent decision of the Supreme Court of Canada has narrowed the "faulty or improper design" exclusion found in many all-risk property and builders risk insurance policies. The decision is relevant to all claims where insurers deny coverage because the loss arose from the failure of a design. In CNR, the Supreme Court of Canada created a new standard for insurers who seek to rely on the exclusion. The new standard is more favourable to insured parties than either of two standards that Canadian courts had previously applied.

In a typical all-risk property policy, all risks of direct physical loss or damage to insured property are covered, except where that loss falls within one of the specific exclusions listed in the policy. One such exclusion, known as the faulty design exclusion, excludes coverage for "the cost of making good faulty or improper design." Where a policy contains a faulty design exclusion, an insurer may deny coverage on the basis that the claimed loss is attributable to a faulty or improper design.

Before the Supreme Court of Canada's decision in CNR, Canadian courts had been inconsistent in their interpretation of "faulty or improper design." Two competing standards had emerged. In one line of cases, a design was considered faulty if it simply failed to work for its intended purpose. In a second line of cases, a design was considered faulty if it failed to provide for, and withstand, all foreseeable risks.

In CNR, the Supreme Court of Canada rejected both standards as overly broad. To rely on a faulty design exclusion, an insurer must now establish that a design fell below a "realistic" standard. Such a standard can require no more than that the design comply with the "state of the art."

State of the art is defined as "the current stage of development of a practical or technological subject; frequently implying the use of the latest techniques in a product or activity." This does not require a design to be perfect. The Supreme Court of Canada recognized that there is an inevitable gap between the current state of engineering knowledge and omniscience. The fact that an unseen risk is later made visible with the benefit of hindsight does not render a design faulty or improper. An industry standard, however, will not necessarily meet the state of the art. Citing Vancouver's leaky condo epidemic as an example, the Supreme Court of Canada recognized that the industry standard may be affected by contractors and designers cutting corners to save costs.

The facts of the CNR case can be stated simply. In the early 1990s, CNR commissioned the design of the largest customized tunnel boring machine of its kind in the world to facilitate the building of an underwater railway tunnel between Ontario and Michigan. In designing the machine, CNR engineers anticipated that it would have to withstand 6,000 metric tonnes of pressure from the weight of soil and water above it. The machine was designed to accommodate those pressures according to the "state of the art" at the time. Nevertheless, the machine failed when dirt entered its internal chambers. CNR lost more than $20 million as a result of repair costs and project delays. CNR claimed its losses under its all-risks insurance policy but was denied coverage on the basis of the faulty design exclusion.

The Supreme Court of Canada found that CNR's losses were not caused by faulty or improper design. The tunnel boring machine had been designed to state of the art specifications at the time. The failure to address a risk that only became known with the benefit of hindsight did not render the design faulty. The damages caused by the design failure were, therefore, properly covered by the insurance policy.

The CNR decision affects all policy holders who suffer a loss which the insurer attributes to a failed design. In such cases, the insurer will invariably deny coverage on the basis of the faulty design exclusion. The law is now clear that a design will not be considered faulty simply because it failed to work for its intended purpose or because it failed to withstand all foreseeable risks. A design will only be considered faulty if it did not meet the standard set by the state of the art at the time.

Policy holders should be aware that many all-risk property policies contain an exception to the faulty design exclusion, called the "resultant damage" or "ensuing loss" exception. Under the exception, even if an insurer is able to establish that a design is faulty, coverage may still be available for losses to insured property that can be characterized as separate and distinct from the "thing" that was faultily designed.

The scope of coverage available under any policy is determined by the specific language in the contract, as negotiated between you and your insurance company. Not all policies are written in the same manner. Although court decisions, such as CNR, are helpful in interpreting the limits of similarly worded policy provisions, coverage under each policy should be considered on a case-by-case basis. In addition, policy holders should keep in mind that future insurance contracts may be adjusted in reaction to court decisions, such as CNR, or to any other changes in the law as they occur.

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.