Canadian Underwriter

Appeal court quashes ruling that ‘resulting physical damage’ can mean ‘loss of use’

September 13, 2021   by Greg Meckbach

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Your commercial client could get business interruption coverage if they can no longer “use” their property, but only if the policy wording actually says so, a Court of Appeal for Ontario panel suggests.

MDS Inc. v. Factory Mutual Insurance Company, released Sept. 3., means Rhode Island-based commercial insurer FM Global no longer has to pay out on a $25-million claim by medical materials vendor MDS.

In MDS, Ontario’s appeal court overturned a 2020 Ontario Superior Court of Justice ruling against FM Global.

Many Canadian, British and American courts have concluded that “resulting physical damage” does not extend to loss of use, Justice Julie Thorburn wrote for the Court of Appeal for Ontario in its unanimous ruling against MDS.

“On the contrary, they have held that where loss of use is to be included as resulting physical damage, this must be made clear in the policy.”

The coverage dispute – between MDS and FM Global – began in 2009, when the Canadian Nuclear Safety Commission ordered the shutdown of Atomic Energy of Canada Ltd.’s reactor in Chalk River. At that time, AECL was using its reactor to make a number of materials – among them Molybdenum 99 – which MDS sells to healthcare facilities. Those radioactive products are used for cardiac imaging, cancer treatment and sterilization of medical products.

Chalk River is roughly half way between Ottawa and North Bay. The reactor was shut down so AECL could inspect and repair a leak. This resulted in critical shortages of radioactive material for MDS products. Had the shutdown resulted from an insured peril, FM Global’s policy would have covered loss of income.

The main result, of the Court of Appeal for Ontario’s Sept. 3 ruling, is that MDS is not covered because of the corrosion exclusion in the FM Global policy.

Originally in 2020, Justice Janet Wilson of the Ontario Superior Court of Justice ruled that neither the corrosion nor the nuclear material exclusions applied. Furthermore, Justice Wilson ruled that even if the corrosion exclusion did apply, the exception for resulting damage also applied.

The contract of insurance reads in part:

This Policy excludes the following, but, if physical damage not excluded by this Policy

results, then only that resulting damage is insured: …

3) deterioration, depletion, rust, corrosion or erosion, wear and tear, inherent vice or latent

The Chalk River reactor has a calandria, where the radioactive activity takes place. Inside is a J-rod annulus, which is a 10-centimetre compartmentalized space running the entire height and circumference of the calandria. There is also an outer layer known as a reflector. The J-rod annulus is not supposed to contain water. Nonetheless, water was leaking from the reflector into the J-rod annulus before the reactor was ordered shut down.

In her original 2020 ruling, Justice Wilson found that the leak did not damage the interior of the J-rod annulus and there was no physical damage beyond the corrosion in the calandria wall.

Still, she found that loss of use should be considered “physical damage” because in her view, the term “physical damage” was ambiguous.

The Court of Appeal for Ontario disagreed, citing several decisions including MRI Healthcare Center of Glendale Inc. v. State Farm General Ins. Co., released by the California Court of Appeal in 2010.

That coverage dispute with State Farm, leading to the 2010 California court ruling, began in 2005. That was when MRI Healthcare Center had to shut down an MRI machine. After a storm, MHC’s landlord had to repair its roof. Those repairs could not be undertaken unless the MRI machine was demagnetized. This was because that machine had to be kept in a room shielded with copper to keep out electrical or radio wave interference.  Once the roof was repaired, MHC was unable to ramp the machine back up.

State Farm denied MHC’s business interruption claim, arguing there was no accidental direct physical loss to MHC property. MHC took State Farm to Superior Court of Los Angeles County, which ruled in favour of State Farm. That ruling was upheld on appeal.

“In effect, the machine was turned off and could not be turned back on. This does not constitute a compensable ‘direct physical loss’ under the policy,” Judge Madeliene Flier wrote for the California Court of Appeal. “The failure of the MRI machine to satisfactorily ‘ramp up’ emanated from the inherent nature of the machine itself rather than actual physical ‘damage.’ As State Farm suggests, the MRI machine was not ‘damaged’ in the ordinary meaning of the word.”

In MRI Healthcare, the California state appeal court “concluded that there is no resulting physical damage to be covered where the detrimental impact is ‘unaccompanied by a distinct, demonstrable, physical alteration of the property,’” Justice Thorburn wrote for the Court of Appeal for Ontario in MDS.

“As such, although the leak resulted in the [Chalk River nuclear reactor] shutdown, the shutdown itself is not resulting physical damage. To read in coverage for ‘loss of use’ distorts the plain language of the Policy and is out of step with the … case law.”

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