This article was written by Scott Watson and Aisling Scott.
In an interesting set of facts, the Queensland Court of Appeal in Royal and Sun Alliance Insurance Plc v DMS Maritime Pty Limited  QCA 264 has recently considered the extent of an insurer’s obligation to indemnify an insured where a “reasonable compromise of a legal proceeding” has occurred absent the insurer’s consent. At issue was the appropriate measure of the loss, being the cost to replace a specialised navy vessel in circumstances where the insured property had little to no market value and limited remaining operational life at the time it was destroyed.
As part of the compromise negotiated by the insured with its contractual counter-party (being the Commonwealth Government), a replacement vessel of some similarity had been leased for an interim period, together with a cash payment being made to the Commonwealth.
The Court dismissed the insurer’s contention on appeal that the insurer was only required to indemnify the insured in respect of the cost of the leased vessels for the remainder of the effective life of the destroyed vessel. The Court did not agree that such payment was sufficient to “otherwise make good” the loss and damage suffered by the Commonwealth, who would no longer have a vessel at the expiry of the lease.
The Court found that the policy required the insurer to pay for the replacement of the vessel, or payment of an amount that would allow the purchase of a replacement vessel. The Court found that, in these particular circumstances, the settlement amount paid by the insured for the cost of a replacement vessel was reasonable and that the insurer was obliged to indemnify the insured in respect of that amount.
The decision comes as a reminder of the Courts’ realistic and pragmatic approach to construing the extent of an insurer’s obligation to make good damaged insured property. The decision also recognises that some element of improvement or betterment can nearly always be expected when a party is required to reinstate or replace property if it is lost or destroyed many years after it was originally purchased or procured, but that such improvement or betterment alone is not a proper basis for discount or reduction by an insurer. The reasoning of the Court may also be of interest to underwriters, as the Court examines the meaning of certain words of loss commonly used in insurance policies.
DMS Maritime Pty Limited (DMS) and the Commonwealth Government entered into a contract for the design, manufacture, supply and provide support services for a fleet of Armidale Class Patrol Boats. One of the boats was destroyed by fire while in DMS’ possession for servicing. Under the contract with the Commonwealth, DMS was obliged to “promptly replace or otherwise make good any loss”. DMS and the Commonwealth reached a settlement, whereby DMS would pay the Commonwealth $31.5million (Settlement Sum).
Royal and Sun Alliance Insurance Plc (Royal) was one of DMS’ insurers. Under a policy of insurance, Royal indemnified DMS in respect of “all sums which [DMS] shall become liable to pay by reason of the legal liability of [DMS]”. Relevantly this included coverage for loss or damage of a vessel in DMS’ care, custody or control.
A dispute arose between Royal and DMS concerning the quantum for which Royal was liable under the policy. Having proceeded to achieve a compromise with the Commonwealth, in these proceedings, DMS sought a declaration that Royal was obliged to indemnify DMS in the amount of the Settlement Sum.
There was no dispute that Royal was liable to indemnify DMS for the loss of the vessel; the dispute turned on the proper measure of that loss. Royal’s position was that an amount lower than the Settlement Sum was appropriate, as if the dispute had been litigated rather than settled, the proper measure of the loss would have been limited to the cost of leasing a similar vessel for the balance of the contractual term between DMS and the Commonwealth.
At first instance, Bond J held that Royal was obliged to indemnify DMS for the Settlement Sum if the amount was “reasonable”. His Honour found that the Settlement Sum was reasonable in the circumstances.
In so finding, His Honour found that the obligation to “otherwise make good” in the contract between DMS and the Commonwealth required DMS to do one of the following:
- provide the Commonwealth with ownership of a substitute Armidale Class Patrol Boat;
- provide the Commonwealth with ownership of some other vessel with functionality and characteristics equivalent to the lost Armidale Class Patrol Boat; or
- compensate the Commonwealth for the loss of the vessel (ie by paying sufficient money to enable the Commonwealth to obtain a replacement vessel, and to compensate the Commonwealth for the vessel having been destroyed).
Royal appealed the decision.
On appeal, Royal submitted that the relevant contractual obligation on DMS related to the availability of the vessels to perform their patrol functions during their service life.
Royal further submitted that DMS was not obliged to pay the Commonwealth a sum greater than its “actual loss” or “actual expenditure”. As the market value of the HMAS Bundaberg was practically nil (the vessel was approaching the end of its operational life), Royal submitted that the Commonwealth’s actual expenditure or loss was the cost of leasing two similar vessels for a three year period. Royal’s position was that, as that was how the Commonwealth actually made good the loss, or mitigated its loss, that loss represented Royal’s maximum liability to DMS under the insurance policy.
The Court of Appeal did not accept Royal’s position, finding that:
- the contract between DMS and the Commonwealth was not only for the delivery of patrol boats and services for a 15 year term, the contract also required that those patrol boats be capable “of performing specified functional and operational requirements for an average service life in excess of 20 years from the date they were commissioned.”
- at the end of the contractual term, “the Commonwealth would still own the patrol boats”.
- the word “otherwise” suggested a link between the concepts of “replace” and “make good” such that DMS was required to either provide a substitute equivalent vessel or pay compensation to the Commonwealth for an equivalent amount.
- a replacement vessel (or payment of an equivalent amount) may result in conferring a benefit on the Commonwealth in the form of betterment.
- betterment alone does not render the construction advanced by DMS untenable as reasonable business people, understanding the context of the agreement, would interpret the obligation to “otherwise make good” in this way.
- DMS’s obligation to otherwise make good (and Royal’s liability to indemnify DMS for that liability) could not be met by only replacing ownership of a vessel with a leased vessel which would not be owned by the Commonwealth at the expiration of the term of the lease.
The Court concluded that Bond J’s conclusion as to the reasonableness of the Settlement Sum was correct and confirmed that a reasonable compromise of a legal proceeding could trigger an obligation to indemnify.