Smoke and Mirrors

Where there’s smoke, there’s fire – and usually an insurance claim. But what happens if a policyholder fails to notify an insurer of a “change material to the risk?” A recent Supreme Court of Canada decision, Marche v. The Halifax Insurance Company, reveals a layer of uncertainty when it comes to fire insurance policies. Some are concerned courts may take on a wider ability to interpret policy conditions, even statutory conditions, if they are deemed “unjust or unreasonable.”

THE TRIAL

“Full disclosure” has become a catch phrase for insurance companies and brokers in light of the commission controversy that has rocked the insurance industry over the past two years. But what is the responsibility of the consumer to disclose fully any changes “material to the risk?” Given that the principle of Uberimma Fides (“the utmost good faith”) is the foundation of insurance contracts, many think full disclosure should also apply to policyholders.

Utmost good faith is a principle that binds both insurer and insured to the terms of a contract, within statutory conditions laid out in provincial insurance legislation. But when does a statutory condition apply to a material change in risk? The courts looked at this question when a Nova Scotia property owner suffered a fire loss, and her insurance company subsequently denied the insurance claim. The case, Marche v. The Halifax Insurance Company, eventually made its way to the Supreme Court of Canada, which found in favour of the policyholder.

The insured and the lead plaintiff in the case Theresa Marche had purchased a house in Sydney, Nova Scotia. She converted the house into a two-apartment rental unit and subsequently left the province to find work in British Columbia, leaving the home vacant for a period of several months. A tenant moved into the house, which was eventually destroyed by fire in February 1999. The Halifax Insurance Company denied Marche’s claim, saying the insured had failed to inform them of the earlier vacancy – a material change to the risk.

In denying the claim, the insurer relied on Statutory Condition 4 of the Fire Insurance provisions of the Nova Scotia Insurance Act. This condition is similar in language to insurance acts of all common law provinces in Canada. It states: “Any change material to the risk and within the control and knowledge of the insured shall avoid the contract . . . unless the change is promptly notified in writing to the insurer.”

Marche filed a lawsuit against The Halifax, contending that even if Statutory Condition 4 was breached, she should still be relieved from the consequence of that breach under section 171 of the Insurance Act, also known as the “saving provision.” This section states that a policy condition is not binding on the policyholder if a court holds it to be “unjust or unreasonable.” The trial judge originally found in favour of Marche.

THE APPEALS

The Halifax Insurance Company appealed to the Nova Scotia Court of Appeal, which heard the case in 2003. The appellate court reversed the lower court decision on the grounds that s. 171 does not apply to statutory conditions, but only to conditions in the policy. In particular, the Nova Scotia Court of Appeal noted that statutory conditions are created by the legislature, not underwriters. Their inclusion in every fire insurance policy is mandatory. The Appeal Court held the statutory conditions must therefore be presumed to be just and reasonable, and beyond the scope of judicial review under the “saving provision.”

“It is suggested that the real issue is whether a material change that existed at one time, but is no longer there at the time of a loss, can still void an insurance contract,” David Hendricks, a lawyer and associate with Gowlings, says. “There is a reasonably solid body of law in favour of insurers on that question. It would appear the appellants (Marche), by arguing that Statutory Condition 4 ought to be suspended on the grounds that is unjust and unreasonable, are simply trying to do an ‘end run’ around well-established law that historical material changes in the risk can and do void contracts.”

However, the Supreme Court of Canada saw things differently. It granted leave to appeal and issued its judgment in 2005, a 5-2 decision in favour of the insured. In its decision, Supreme Court of Canada Chief Justice Beverley McLachlin, writing for the majority, noted the question was whether the saving provision of section 171 applies to statutory conditions, which the court said it did.

The court also said s. 171 applies “not only to delete conditions that are unreasonable on their face . . . but also to relieve against the results of applying conditions that, in the particular circumstances of the case, are unreasonable in their application or draconian in their consequences.” In other words, it may not be a policy condition itself that is unjust or unreasonable, but the application of the condition in a given circumstance.

As lawyer Nigel Kent of Clark Wilson LLP observes: “In the Marche case, because Section 171 of the Act did indeed apply to statutory conditions, and because the unreported vacancy had been cured before the actual loss, the court affirmed that voiding the policy in such circumstances would be an unreasonable application of the policy condition and therefore refused a denial of coverage.”

THE AFTERMATH

Invariably, many disagree with the decision, arguing that subjective saving provisions should not easily sweep aside statutory conditions. Supreme Court of Canada Justice Michel Bastarache wrote a lengthy dissenting judgment, arguing this very point. Bastarache wrote: “It would be unreasonable and incongruous for the same statute to dictate, on the one hand, that statutory conditions are mandatory to assure fairness to both parties, but, on the other hand, to allow that these same conditions can be avoided because they are unreasonable or unjust by virtue of section 171.”

Some contend the decision is a distinct move away from years of case law supporting insurers on material change to risk. “In Marche, the Supreme Court of Canada has seemingly departed from the ‘settled’ authority that for decades has guided our courts and the insurance industry,” notes lawyer Michael Bailey of Miller Thomson LLP. “The concept that the justness or reasonableness of an exclusion or limitation of coverage should be tested by evaluating the balancing of risk and reward during the underwriting process has now, apparently, been abandoned. The test of whether the ‘saving provision’ will apply to the breach of any condition – statutory or otherwise – will now turn on factual issues of causation after a loss has occurred.”

The impact of Marche is discussed in a study done for the Insurance Bureau of Canada (IBC) by the University of Western Ontario (UWO) law faculty professors Craig Brown, Jason Neyers and Stephen Pitel. The study says Marche will limit how an insurer can apply conditions – even statutory conditions – to a fire insurance policy. “Now, after Marche, even a condition reasonably connected to the risk undertaken may not be invoked by an insurer unless its breach is connected to the loss in the particular case,” according to the report The Impact of Recent Legal Developments on Liability Insurance. “This narrows the range of defences open to an insurer. This may impact underwriting assumptions.”

For insurance companies, one of the main implications of Marche is uncertainty. Randy Bundus, vice president and general counsel for IBC, says the decision creates an unpredictable environment for underwriters in assessing risk.

“It does add a level of uncertainty as to what actually constitutes a material change to risk,” Bundus says. “Does the fact that a building was vacant at some point during the term of the policy, but occupied at the time of loss, mean there was a material change? I wish I knew the answer to that. I would have thought that a statutory condition would hold, but such is not the case
. It also can create uncertainty in the sense of which statutory condition is next for overruling?”

Vacancy was the key issue in Marche. But what if a property is used for other purposes during the term of a policy and then returned to its former state or condition? How would courts interpret true material changes to risk in any given circumstance? Examples of how a property is used, without notification to insurer, are varied; they extend from storage of hazardous material to marijuana grow-ops and chemical labs.

If uncertainty continues to exist surrounding statutory conditions and fire insurance polices, insurers will have to pay close attention to consumer disclosure and potential material changes in risk. How companies could monitor such changes, however, is an area rife with problems. “It would be very costly to set up the monitoring of each step of whether people are disclosing the true nature of the risk,” Bundus notes. “And then we would have concerns about privacy.”

A mitigating factor in the Marche decision is its application to fire insurance policies only. Bundus says fire policies represent only a small portion of the property insurance sold in Canada: most homeowners are covered by multi-peril contracts. Many fire insurance policies specifically apply to landlord-tenant type agreements.

Still, insurers are concerned that Marche might represent a trend towards a wider scope of judicial interpretation. “The section (171) appears to give judges the power to refuse to apply terms imposing obligations or restrictions on insureds when, according to subjective values, it would seem unfair to do so – even if, objectively, the obligation or restriction is material to the insurance,” according to the IBC study. “Until recently, this apparently wide discretion to intervene has generally been exercised conservatively.”

Marche “has arguably widened the scope of the section,” according to the study, although s. 171 “does not apply to liability insurance (at least not yet).” A major concern for the insurance industry is the introduction of similar provisions to s. 171 into other areas of insurance contracts – especially commercial policies, in which a “change to material risk” can be very significant.

“As an industry, we watch carefully legislative developments to make sure they don’t override the powers of the parties to a contract, without a very good reason, to deal with the reasonable terms of the contract,” Bundus says. “To this point in time, it has been restricted to the fire insurance part of the insurance acts.”

THE APPLICATION

In fact, the IBC is playing very close attention to the upcoming changes to provincial insurance acts in Alberta and British Columbia Two Supreme Court of Canada cases, KP Pacific v. Guardian and Churchland v. Gore Mutual, ruled the fire part of the B.ritish Columbia Insurance Act did not apply to the “modern multi-peril policy.” Bundus notes that both 2003 Supreme Court judgments have established that the provisions of the fire insurance part of the act are not applicable to multi-peril policies.

As Kent asks: “There is a major question that remains unanswered, and which, rather remarkably, the Marche case did not address: Does the ‘unjust condition’ provision of the act even apply to the modern all-risk insurance policy?” Had the Marche case occurred in B.C., Kent says, the provisions would not apply and coverage could have been successfully denied. “It remains to be seen how this argument will be received in other provinces,” he says.

Bundus says Alberta and B.C. are both actively discussing amendments to insurance legislation to deal with ambiguous wordings for fire and multi-peril policies. Alberta anticipates draft legislation as soon as spring 2007.

“We are in the process of working with regulators in Alberta and BC,” Bundus says, noting that the IBC has provided sample legislative wordings written by Craig Brown. “If the government does move forward with statutory conditions, we would request that they put in legislation to make it clear that statutory conditions would not be subject to overruling by a court, such as the provision used in the Marche decision.”

“The Marche decision has influenced what we are doing in Alberta and B.C., and it is something we have in the backs of our minds in discussions,” Bundus adds. “We are saying: ‘Be careful when you reintroduce legislation: if you are going to continue to have statutory conditions, exempt them from a provision from this override rule – if there even needs to be an override rule.'”

In the end, Bundus says, adherence to the fundamental nature of the insurance contract may be the best route to address the uncertainty around material change to risk. “There has to be a reliance on utmost good faith,” he says. “That is an integral concept in insurance, and we feel it has to continue to be a part of the whole insurance system.”