A recent judgment by the Supreme Court of Canada (“SCC”) has clarified the standard necessary for the “faulty or improper design” insurance exclusion to apply. Typically, this exclusion would relieve an insurer from providing indemnity for a loss resulting from design problems that led to the claim. This SCC judgment has profound implications for all insurers and insureds whose policies include this kind of exclusion.

In Canadian National Railway v. Royal and Sun Alliance Insurance Co. of Canada (“CN Railway”), the SCC addressed the issue of “faulty or improper design” in an insurance contract. Prior to CN Railway, some authorities suggested that a design was faulty if it did not work for its intended purpose, while another line of authorities suggested that a faulty design was one that could not cope with all foreseeable risks. In CN Railway, the SCC rejected both of those approaches and paved its own way.

Canadian National Railway sought to build a railway tunnel under the St. Clair River, between Sarnia, Ontario and Port Huron, Michigan. This required the construction of a large tunnel boring machine (“TBM”) nearly 10 metres in diameter and 83 metres in length. In order to keep rock and dirt contaminants out of the mechanism that drove the TBM forward, a complicated system of 26 seals was used. It was thought that the TBM would only be stopped if all 26 seals failed, but that the redundancy built into the system would make this failure very unlikely. However, approximately 14% of the way through the project, dirt was found to have bypassed the elaborate seal system entering the main bearing chamber. During design, the engineers appreciated that if differential deflection between key components exceeded ±3 mm, dirt could penetrate and bypass the seals. Based on detailed computer analysis of the design, the engineers were satisfied that differential deflection could be kept within the ±3 mm range. In operation, this proved not to be the case. Consequently, the project had to be paused, modifications made to the boring machine, and the project subsequently restarted. Construction was delayed 229 days at a total cost of approximately $30M.

Canadian National Railway sought indemnification for this cost from its insurers under its “all risks” insurance policy. The insurers rejected the claim, relying on an exclusion to the insurance policy that provided, in part, that the insurance policy did not insure the cost of making good “faulty or improper design” (the “Exclusion”).

The key question for the Court to address was whether the failure of the design to withstand the foreseeable and, indeed, foreseen risk that differential deflection could exceed ±3 mm was itself sufficient to establish that the design was “faulty or improper.”

At the SCC, the majority found that an engineering design cannot be said to be faulty if it conforms to the state-of-the-art and that a simple failure does not discharge the onus of establishing a “faulty or improper design.” That is, the Court found that failure alone was not sufficient evidence of inadequate design. An insurer is entitled to the benefit of an exemption such as the Exclusion “unless the design met the very highest of standards of the day and failure occurred simply because engineering knowledge was inadequate to the task at hand.” The majority said quite clearly that where the risk is broadly defined and the design addresses that risk with state-of-the-art diligence and expertise, an insurer is not entitled to benefit from the Exclusion simply because the state of the art falls short of perfection and omniscience.

The decision in CN Railway, while a win for the insureds in the specific case, should also be seen as a win for the broader insurance industry.

While the SCC stated quite clearly that a standard of omniscient perfection is too high a standard, it determined that the state-of-the-art is the appropriate standard rather than a lesser standard such as “industry practice.” Insurers seeking to rely on a “faulty or improper design” exclusion must show that existing scientific/technical knowledge could have predicted the risk of damage and provided a design that would avoid the problem.

Future insureds claiming under insurance policies that have “faulty or improper design” exclusions will certainly be required to demonstrate that their design met the state-of-the-art standard. The problem that insurers will face will be proving that innovative and novel equipment is not state-of-the-art, particularly when technology is proprietary or it is otherwise difficult to locate witnesses willing and able to testify that a design is not state-of-the-art.

However, in practical terms, policies with a “faulty or improper design” exclusion, as in CN Railway, will only be appropriate for unique, high-priced goods. Indeed, some products occupy a segment of the market that are intentionally of lower quality and lower price, and therefore more accessible to a wider swath of consumers, yet producers of such goods may still desire liability coverage. A policy with a “faulty or improper design” exclusion, in light of CN Railway, would not provide any protection with respect to such goods, and producers should seriously consider saving the cost of their premium, unless the exclusion is redrafted.

Further, even some unique goods, such as manufacturing plants, are intentionally designed and built to a standard less than that of the “state of the art” and more reflective of a standard that is cost-effective under the circumstances. In light of the holding of the SCC that a design below that of the state-of-the-art would not be covered by a policy with a “faulty or improper design” exclusion, such owners are again left with the choice of saving the premium or negotiating a more appropriate policy.

Insurance is a contract for the reallocation of risk. A “faulty or improper design” exclusion allocates to the insurer only the risk that despite the best efforts of the designer to eliminate all risk, some risk may remain. If the design is intended to avoid eliminating all possible risk, on the basis that the cost of eliminating the residual risk is not considered to be worth the cost, then a policy which accepts this additional risk is essential, and a policy with a “faulty or improper design” exclusion is a waste of money. If the premium for a policy which assumes the additional risk is prohibitive, then the designer’s evaluation of the risk needs to be considered.

With this new guidance from the SCC, insurers and policy-holders are advised to:

  • Review their general insurance policies, paying particular attention to the wording of any exclusions, specifically those relating to “faulty or improper” design or use;
  • Ensure that, to the greatest extent possible, their design of products approaches the state-of-the-art standard and that it has the documentary record necessary to demonstrate that this is so;
  • Discuss with their legal counsel, their insurance broker and their insurer ways to bring their practice up to the state-of-the-art; and
  • Consult with legal counsel when reviewing current insurance policies or when considering entering into new policies that may have exclusions for “faulty or improper design.”