Court clarifies correct approach to interpretation of exclusion clauses in insurance contracts
22 Nov 2022
The recent decision of the Court of Appeal in Napier City Council v Local Government Mutual Funds Trustee Limited(1) provides useful clarity regarding the correct approach to interpretation of exclusion clauses in insurance contracts. The decision is particularly relevant to situations where a third-party claim involves a mixture of liabilities, only some of which are the subject of an exclusion clause.
The Court of Appeal's decision also provides the first appellate level guidance on the application of the test for admission of extrinsic evidence in contract interpretation disputes outlined by the Supreme Court in Bathurst Resources Ltd v L & M Coal Holdings Ltd.(2)
The appeal centred on the interpretation of a weathertightness exclusion in a professional indemnity insurance policy issued by Riskpool (the policy). It arose from an underlying building defect proceeding against Napier City Council (NCC) by the owners of the Waterfront Apartments, a multi-unit apartment complex, alleging a mixture of weathertightness defects and non-weathertightness defects (such as structural and fire safety failings) (the Waterfront proceeding).
NCC notified Riskpool and sought indemnification for non-weathertightness liability arising from the Waterfront proceeding. Riskpool relied on a weathertightness exclusion in the policy to decline cover entirely. The exclusion provided that the policy did not cover "liability for Claims alleging or arising directly or indirectly out of, or in respect of" the failure of any building or structure to meet the weathertightness requirements of the building code (the weathertightness exclusion). In denying coverage for the non-weathertightness defects, Riskpool argued that the entire Waterfront proceeding was one claim and that, because the claim included allegations of weathertightness defects, the exclusion applied to the claim in its entirety.
Following the declinature, NCC defended the Waterfront proceeding, which concluded with a confidential settlement at mediation. The settlement provided for payment of a global settlement sum, without apportionment between the weathertightness and non-weathertightness liabilities. NCC then brought proceedings against Riskpool seeking indemnification for the proportion of the settlement sum that related to non-weathertightness defects (and defence costs).
The central issues were therefore:
- whether the weathertightness exclusion, properly interpreted, excluded cover for non-weathertightness defects alleged in the same underlying proceeding; and
- if indemnification was available, how the global settlement sum should be apportioned between weathertightness and non-weathertightness defects.
In the High Court, NCC argued that, when the words of the weathertightness exclusion were read as a whole, the natural and ordinary meaning of the exclusion was that it excluded only liability arising from weathertightness defects, not that which had no causal connection to weathertightness defects. The exclusion referred solely to weathertightness failings without mention of building failures due to other causes. Interpreting the weathertightness exclusion to exclude cover for non-weathertightness defects would produce extreme and perverse results (eg, liability for very substantial and indemnifiable building defect claims would be uninsured if a plaintiff also made a very minor weathertightness allegation). If the policy drafter had intended to exclude building defect liability more generally, it should have said so explicitly.
In the High Court, Judge Grice accepted Riskpool's interpretation of the weathertightness exclusion, seeing the meaning of the word "claim" as critical to the scope of the weathertightness exclusion. Grice J approached its interpretation by inserting the definition of the policy definition of "claim" into the text of the weathertightness exclusion, which she regarded as an accepted approach to the proper construction of an operative provision in a commercial instrument. As the policy defined "claim" as a "demand for compensation" and the introductory phrase to the exclusion clause provided that the policy "does not cover liability for claims" alleging weathertightness defects, the High Court held that the application of the weathertightness exclusion was governed by the "liability for Claims" alleging weathertightness defects, rather than the "liability" for weathertightness defects. It followed that, where a demand for compensation was made that included allegations of weathertightness defects, "any other failures or building defects within that Claim have been tainted by the weathertight complaint".(3)
In reaching her conclusion, Grice J placed significant weight on background materials extrinsic to the contract, devoting 120 paragraphs of the judgment to extrinsic evidence that canvassed the evolution of the policy wording over previous policy years, the commentary provided in Riskpool's renewal correspondence and in annual reports, and correspondence from Riskpool in 2012 when it declined a claim with some similarities to the Waterfront proceeding.
Grice J considered that the extrinsic evidence supported the preferred interpretation for the weathertightness exclusion, as it would have conveyed to the notional reasonable person that the weathertightness exclusion was intended to cover non-weathertightness defects in a weathertightness claim.(4) The High Court's approach to the 2012 declinature was particularly notable, as it treated NCC's failure to actively dispute Riskpool's declinature before renewing its cover for subsequent policy years as a breach of its good faith obligation,(5) apparently extending an insured's duty of disclosure to require disclosure on renewal of disagreement with a contractual interpretation earlier asserted by an insurer.
NCC's submission regarding the extreme and perverse consequences of adopting the insurer's interpretation was met by implying a de minimis threshold into the policy, either as a general principle or by way of an implied term, with the determination of the threshold for de minimis being assessed objectively.(6) This aspect of the High Court decision was novel, as the first instance of de minimis being applied to an issue of contractual construction.
As the High Court held that the policy excluded cover for the entire Waterfront proceeding, the issues of apportionment were addressed only briefly but NCC's position – that the correct assessment was whether the insured had acted reasonably in settling the third-party claims, with the apportionment exercise then based on the global settlement sum and the evidence available at the time of settlement – was endorsed.
Court of Appeal
On appeal, the Court of Appeal overturned the High Court's decision, providing guidance on the construction of exclusion clauses in insurance contracts, and issues of quantification and apportionment where a third-party claim involves a mixture of insured and uninsured liabilities which were the subject of settlement following a wrongful declinature by the insurer.
Interpretation of weathertightness exclusion
On the key issue of contractual interpretation, the Court of Appeal held that the weathertightness exclusion only excluded cover for alleged liabilities that had a causal link to weathertightness defects. Cover remained for aspects of the claim wholly unrelated to weathertightness defects.
The Court of Appeal did not regard the meaning of the word "claim" as critical. While accepting the insurer's argument that each plaintiff in the Waterfront proceeding had brought one "claim" against NCC, they were held to be "mixed claims" in the sense that the Waterfront proceedings involved a mixture of liabilities which were not co-extensive, with some insured and some excluded.(7)
For insurance cover purposes, a "claim" may be either aggregated or divided. The weathertightness exclusion contemplated divisibility, as it was aimed solely at excluding cover for liability arising out of weathertightness defects. This was because the introductory wording of the exclusion required a causal connection between a weathertightness defect and the council's liability to pay the compensation demanded. By utilising "language of causation",(8) the weathertightness exclusion contemplated an inquiry into the "real nature" of the council's liability. A mixed claim was only excluded to the extent that weathertightness defects were an indirect cause of losses claimed, so a division between insured and excluded liabilities was contemplated.
Considerations of commercial purpose supported the conclusion that the weathertightness exclusion only excluded "claims" to the extent they were causally attributable to weathertightness defects, noting that it was orthodox practice for a court to inquire into the underlying causes of loss to decide whether and the extent to which an exclusion applies.(9)
The Court of Appeal rejected the High Court's implication of a de minimis threshold into the policy, to ameliorate the extreme consequences of the insurer's preferred interpretation. De minimis is a legal concept appliable to issues of loss or departure from a specified standard, with no reported prior application to an issue of contractual interpretation. The Court of Appeal's view was that it would be impossible to define a de minimis threshold with the level of precision required for contractual certainty.
Use of extrinsic material
On appeal, the insurer sought to support the High Court's use of the correspondence surrounding the previous declinature of a similar claim by reference to the Supreme Court's recent Bathurst decision.
Bathurst held that extrinsic evidence will be admissible if it is relevant and probative, in terms of sections 7 and 8 of the Evidence Act 2006. The Court of Appeal observed that, if read in isolation, that might be taken as casting "a wide net" for admission of a great deal of extrinsic evidence.(10) However, the Supreme Court in Bathurst explicitly affirmed the objective approach to contract interpretation (as outlined in the earlier Supreme Court decision of Firm PI 1 Ltd v Zurich Australian Insurance Ltd). As a result, the language of the document retains primacy, with extrinsic evidence confined to what a "reasonable person" would consider relevant. For extrinsic evidence to be admissible, it must be reasonably capable of altering the ordinary meaning of the words used in the documents.(11)
On the facts, the previous declinature was neither relevant nor probative. As the correspondence was unilateral conduct by Riskpool, it was relevant only to its subjective views on an unrelated claim. Noting that other member councils were insured under the same Riskpool policy wording, the Court of Appeal considered that it would be a remarkable outcome for extrinsic evidence to result in the same insurance policy wording having different meanings for different councils, or different meanings across different policy years.(12)
On issues of quantification and apportionment, the Court of Appeal confirmed the High Court decision. It held that, where an insurer had wrongfully declined cover, a reasonable settlement of the third-party claim crystalised the loss for which the insured is entitled to indemnity. Therefore, in a subsequent claim for indemnity, the insured is only required to prove that the settlement was reasonable. Where the settlement involved a mixture of insured and excluded liabilities, the insured is also required to prove the allocation of the part of the settlement that came within the cover.(13)
The insurer's argument, that the insured ought instead to be required to prove what its "at-trial" liability to the third party would have been, was rejected, with the Court of Appeal applying two of its previous decisions which had treated wrongful declinature by an insurer as a form of repudiation.(14)
On the evidence, the Court of Appeal was satisfied both that the settlement was reasonable and that all aspects of the Waterfront proceeding were reasonably included within the settlement. The proceeding was remitted to the High Court for final assessment of an appropriate apportionment.
The decision has important implications for the liability insurance industry. It confirms that exclusion clauses must be read in the context of the policy as a whole, to ascertain the peril which the clause is directed at excluding. The conclusion that claims may be "mixed" and involve divisible losses is also potentially significant.
Riskpool has since applied for leave to appeal to the Supreme Court, with the leave decision pending.
(1)  NZCA 422.
(2)  NZSC 85.
(3) Napier City Council v Local Government Mutual Funds Trustee Ltd  NZHC 1477 (High Court judgment) at .
(4) High Court judgment at .
(5) High Court judgment at .
(6) High Court judgment at .
(7) Court of Appeal judgment at .
(8) Court of Appeal judgment at .
(9) Court of Appeal judgment at  citing Body Corporate 326421 v Auckland Council (Nautilus) at .
(10) Court of Appeal judgment at .
(11) Court of Appeal judgment at .
(12) Court of Appeal judgment at .
(13) Court of Appeal judgment at .
(14) Court of Appeal judgment at  citing Royal Insurance Fire & General (NZ) Ltd v Mainfreight Transport Ltd (1993) 7 ANZ Ins Cas 77,972 (CA) and D A Constable Syndicate 386 v Auckland District Law Society Inc  3 NZLR 23.