Interpreting Exclusion

In O’Byrne v. Farmers’ Mutual Insurance Co., a ruling issued by the Court of Appeal for Ontario this past July, the court held that a property insurer could not rely on the failure to deliver a proof of loss, or the mechanical breakdown or pollution exclusions to support its refusal to indemnify its insureds.

In the course of the court’s reasoning, it made some interesting observations on how interpretation of the pollution exclusion might differ between liability and property policies. It also had some helpful comments on how to address multi-causal losses.

BACKGROUND FACTS

The appellant, Farmers’ Mutual Insurance Co., insured the respondent’s two-storey, multi-use commercial building in accordance with an “all-risks” insurance policy. Two residential apartments, one of which contained an oil-fired furnace, existed on the second floor of the building.

On March 11 or 12, 2005, a tenant of the apartment with the furnace placed a piece of cardboard into its main control in the middle of two sets of contacts. This was apparently done in an effort to bypass the thermostat and to keep the furnace in “hot” operation while the tenant was away.

While the tenant was away from the unit on March 13, 2005, a major spill occurred of heating oil from the furnace. The cause of the spill was determined to be the tenant’s actions with respect to the placement of the cardboard.

The oil spilled onto the floor of the unit, leaked through the floorboards and into the main floor beam of the property’s lower commercial units. By bypassing the thermostat, the furnace temperature would not fall below 200 degrees.

The furnace technician who testified at trial opined that making the furnace almost continually run at such a high temperature would result in the failure of the ignition component. When this happened the oil continued to pump out, but because the oil was not burned, it overflowed.

The furnace had been maintained annually and the trial judge found that the damage was a result of the tenant’s actions.

The respondents reported the damage to the insurer the day that it was discovered, but did not deliver a proof of loss. The insurer, for its part, had appointed an independent adjuster to deal with the claim.

The insureds were informed by the adjuster in a letter dated March 28, 2005 that their loss was not covered due to a pollution exclusion in the policy. The adjuster’s letter implied that a proof of loss form would not be required.

At no later point did the insurer advise to the contrary.

ISSUES

The insurer argued three grounds on the appeal. First, it contended the trial judge erred in refusing to dismiss the action on the basis that the insureds did not deliver a proof of loss; second, the insurer argued that the trial judge made a mistake in failing to apply the “mechanical breakdown or derangement” exclusion to the policy; and third, it submitted that the trial judge erred in not applying the pollution exclusion.

Failure to provide a proof of loss

The insureds stated in their claim that they did not file a proof of loss form because they were not asked to do so.

Of note, the insurer’s original defence made no reference to the insureds’ failure to file this form. In an amended defence, the insurer did argue the insureds were prohibited from bringing their claim due to this failure.

The Court of Appeal agreed with the trial judge’s finding that the adjuster’s letter stating it was unnecessary for the respondents to deliver a proof of loss was binding on the appellant so the pre-condition of filing a proof of loss was not necessary. This was supported by evidence of the fact that the appellant did not disavow this letter, and even referred to it specifically when conversing with counsel for the respondent.

The appeal court found that under Rule 26 of the Rules of Civil Procedure, there is nothing that prohibits a court from granting leave to amend pleadings on its own volition. Emphasis was given to substance over form, with the court refusing to accept the insurer’s argument that the waiver issue should not have been entertained as the insureds did not request leave to amend their pleading.

As further support for its ruling on this issue, the court relied on Section 129 of Ontario’s Insurance Act, which permits the court to grant relief from forfeiture where an insured imperfectly complies with a statutory condition regarding the provision of a proof of loss.

Failure to apply the “mechanical breakdown or derangement” exclusion to the policy

The insurer submitted the mechanical breakdown exclusion should apply because the damage caused by the oil spill “was caused indirectly,” “resulted from,” “was contributed to” or “was aggravated by” the ignition failing to reignite. The insurer argued this failure was one in the operation of the furnace as a result of a mechanical defect or derangement.

The insurer relied on Derksen v. 539938 Ontario Ltd., a 2001 decision by the Supreme Court of Canada, in support of the argument that an exclusion may be worded to apply to a loss resulting from multiple causes even if only one of the causes is considered by the exclusion.

Interestingly, the insurer argued that the mechanical breakdown exclusion should apply because while the loss was caused in part by the tenant’s conduct (not considered by this exclusion), it was also caused, in part, by the furnace’s ignition failure (which was considered by this exclusion). Thus, the insurer argued that the exclusion should apply and coverage should be denied.

The Court of Appeal disagreed with the insurer’s reliance on Derksen in the case at bar. Namely, it was incorrect for the appellant to try to characterize the loss as a multi-causal one.

The court held that what happened was a chain of events set in motion by the tenant’s actions with respect to the placement of the cardboard. What the tenant did resulted in bypassing the thermostat, leading the furnace to run at too high a temperature, which led to the ignition failure and the oil being pumped without being burned.

In this analysis, the court relied on the 2008 Court of Appeal for Ontario ruling, Caneast Foods Ltd. v. Lombard General Insurance Co. of Canada, and how the court there considered a “mechanical breakdown or derangement” to refer to a problem or defect in the equipment internally.

The court pointed out that a failure of a component of the furnace to operate is not sufficient to engage application of the mechanical breakdown exclusion, explaining that it is not enough to determine that some type of mechanical or electrical breakdown or derangement occurred. The cause of that happening must also be considered.

In the case at bar, Ontario’s appeal court held that the failure of the mechanical element of the furnace was not an additional cause of the loss, but merely something that happened only after the tenant interfered with the usual operation of the furnace. The loss resulted from an external interference, the tenant’s actions, and not an actual defect in the furnace.

The court indicated that for the mechanical breakdown exclusion to apply, there must be a problem or defect internal to the machine.

Failure to apply the pollution exclusion to the policy

The court agreed with the trial judge’s finding that the pollution exclusion did not apply to exclude the insureds’ claims, but for different reasons.

The court then proceeded to provide some useful guidance as to how the pollution exclusion is to be interpreted. First, the court held the exclusion is to be read in light of the policy as a whole.

In the case at bar, the policy was an “all-risks” prop
erty insurance policy. Usually these policies insure against any loss or damage resulting from any event except ones that are excluded. Second, the court determined that each of the words in the pollution exclusion are to be considered.

In this case, the first part of the policy was worded broadly and the policy defined a “pollutant” to include any liquid contaminant. There was then an exception to the exclusion, stating that the exclusion does not apply “if the discharge… of pollutants is the direct result of a peril not otherwise excluded under this policy.”

Through the application of a plain reading of the policy, the court interpreted the policy as requiring another operative exclusion to apply before the application of the pollution exclusion.

The court noted that counsel for the insurer acknowledged the pollution exclusion would apply here only if the mechanical breakdown exclusion also applies.

As the court had previously ruled out the application of the mechanical breakdown exclusion earlier in its decision, there was nothing left to support the application of the pollution exclusion.

Offering further guidance for future legal interpretation, the court pointed out that the pollution exclusion in the case at bar related to an “all risks” property insurance policy.

This is different than the policy up for interpretation in Zurich v. 686234 Ontario Ltd., a 2002 decision by Ontario’s appeal court, which was a standard absolute pollution exclusion in a comprehensive general liability policy, and which the trial judge had relied on to find the exclusion did not apply.

The Court of Appeal for Ontario referred with approval to Corbould v. BCAA Insurance Corp., released by the Superior Court of British Columbia in 2010. In that case, the court noted that there was a “material distinction” between the two policies.

As a result, the court did not consider the principles set out in Zurich as being directly relevant to interpreting the pollution exclusion here. The court held that, logically, the extent to which the insurance policy provides coverage for pollution damage is dependent on the pollution exclusion itself being read together with the indemnity and exclusion provisions.

COMMENT

This decision is significant both for how it addresses what constitutes a multi-causal loss and how the pollution exclusion in a property policy should be interpreted.

On the latter point, insurers will wish to take note that depending on how the pollution exclusion in a property policy is worded, it may have little or no effect where, as here, the peril is covered and another exclusion does not apply.

Many thanks to Ashley Peacock, student-at-law in Hughes Amys LLP’s Toronto office, for her excellent assistance in the preparation of this article.

Hughes Amys is a member of The ARC Group of Canada, a network of independent insurance law firms across Canada.