This Student Companion by Les Arthur appeared in the March 2015 edition of the New Zealand Law Journal  NZLJ 73.
STUDENT COMPANION: INSURANCE
Tower Insurance Limited v Skyward Aviation 2008 Limited  NZEmpC 110 CRC 16/13
This litigation concerned the interpretation of policy conditions relating to a 110-year-old residential Christchurch property which had sustained unrepairable earthquake damage. The Court of Appeal ( NZCA 76) overruled the judgment of the High Court ( NZHC 1856) which had found in favour of Tower’s interpretation of the policy conditions. In the Court of Appeal, Skyward successfully argued that the policy enabled the insured to elect the settlement option from the four alternatives provided, and that the amount payable by Tower, if the insured elected to purchase another house, was calculated on the replacement rather than indemnity value of the damaged house. The outcome of Tower’s appeal to the Supreme Court turned entirely on the wording of the policy. While the Supreme Court largely accepted the interpretation favoured by the Court of Appeal it also considered the interpretation issue in the general context of the difference between indemnity and replacement policies and the policy conditions relied on by insurers to mitigate the increased moral hazard posed by replacement value policies.
The house was insured under a replacement value policy. The renewal certificate stated:
SUM INSURED FULL REPLACEMENT based on Area sq. Meters 210.
Year Built 1900.
The policy defined “full replacement value” as:
…the costs actually incurred to rebuild, replace or repair your house to the same condition and extent as when new and up to the same area as shown in the certificate of insurance…
Clearly replacement value contemplates replacement or repair of the damaged house on a new for old basis, enabling the insured to replace or rebuild the damaged building using new materials and in compliance with current building standards. Payment of the insured’s claim calculated on replacement value is contrary to the indemnity principle which is a core feature of insurance law: Castellain v Preston (1883) 11 QBD 380 (CA) per Brett LJ . Unlike replacement value policies, indemnity value policies limit the amount payable by the insurer to repair or replace the damaged building to its present day or market value. As illustrated by the facts in Tower the difference between replacement value and indemnity value can be considerable. The insured property had been purchased in 2009 for $450,000 and had a pre-earthquake market value of $492,000. Settlement on Skyward’s interpretation of the policy conditions allowed the insured to recover around $1,1000,000 in respect of its damaged building. As the Supreme Court observed, at , it was not surprising that the cost of rebuilding a house that was approximately 110 years old considerably exceeded the indemnity value of the house immediately before the earthquakes. Departure from the indemnity principle therefore entitled Skyward to profit from its earthquake damaged building. In this context the legitimate concern of insurers is to manage the increased moral risk which flows from the primary obligation to replace damaged buildings. Moral risk refers to the risk that an insured will make a fraudulent claim. The incentive for an insured to make a fraudulent claim is heightened to the extent that the insured is able to profit from the occurrence of an insured peril. As insurers rely on policy conditions to minimise the incentive for fraudulent claims the Court analysed the available settlement options and preconditions on the ability of the insured to achieve replacement value, in the context of the insurer’s purpose of minimising the moral hazard (at ).
Tower’s policy imposed a number of preconditions before it was required to settle the claim on a replacement value basis. First, and obviously, the claim had to be accepted by the insurer. Acceptance of Tower’s liability to pay the claim was not in issue; the house had been damaged by earthquakes. Second, the settlement options of rebuilding on another site or buying another house were limited to circumstances where the insured house was damaged beyond economic repair. Being in the Red Zone, repair of the house was not a realistic option in the foreseeable future. Third, the insurer’s obligation to settle the claim on a replacement value basis, rather than the present day value, was subject to the insured actually incurring the cost of replacement or repair. Fourth, and of particular importance on the present facts, the policy limited the insurer’s obligation to pay the claim on a replacement value to circumstances where the insured chooses to rebuild or buy another house. As noted above, one of the questions submitted by the parties for determination was the basis for the limit of Tower’s liability if Skyward chooses to buy another house.
As noted by the Court at , replacement value policies which include strict preconditions, intended to minimise the risk of a dishonest or careless insured making a profit, can be irksome to honest insureds seeking flexibility in achieving settlement calculated on a replacement value basis. Although minimising the moral hazard, policy clauses predicating the insurer’s payment of replacement value on the rebuilding or repair of the damaged property may not be palatable to some insureds. Market forces may, therefore, encourage insurers to enable insureds to achieve replacement value without replicating what had been lost on a ‘like for like’ replacement of the insured house.
In this context the Court concluded, at , that the payment option which expressly referred to the cost of buying another house limited to the cost of rebuilding the house at the original site, was for the benefit of Skyward. Within this framework, the Court upheld the Court of Appeal’s decision that the policy enabled Skyward, not Tower, to choose whether the claim could be settled by Tower paying the cost of another house. If the payment option, which included four alternatives, was Tower’s choice the insurer could have elected to pay the present day value. The interpretation would clearly have defeated Tower’s primary full replacement value obligation. This express obligation would also be compromised to the extent that Tower’s payment to Skyward for the cost of purchasing another house fell short of the amount payable if the house was rebuilt at the original site.
The Supreme Court’s interpretation of the policy conditions gave effect to Tower’s obligation as stated in the renewal certificate and was consistent with the policy conditions which were intended to minimise the moral risk. Insurers may consider reviewing their replacement value policy conditions in light of the Court’s approach in Tower.
The full March 2015 edition of the New Zealand Law Journal is available on the LexisNexis research database.