Faulty design exclusion sinks claim for policy indemnity

The recent Federal Court decision in Sheehan v Lloyds Names Munich Re Syndicate Ltd [2017] FCA 1340 illustrates the importance of obtaining clear evidence as to the cause of damage which is the subject of a claim under a policy and also acts as a reminder of the high standard of proof required to satisfy a court that an insured has “courted the risk”.

Mr Sheehan made a claim for indemnity under an insurance policy underwritten by the Munich Re Syndicate at Lloyd’s in respect of the cost of replacing the starboard engine on his motor yacht. The engine suffered significant damage while he was operating the vessel in September 2015.

Underwriters denied indemnity on the following grounds:

  1. The damage to the engine was not accidental loss or damage within the meaning of the policy;
  2. Mr Sheehan had “courted the risk” by continuing to operate the engine despite warning alarms on the vessel activating; and
  3. A policy exclusion for damage due to faulty design.
Referee’s determination

Because of the integral technical questions in the case, the parties agreed to these issues being referred to a referee. The referee concluded that:

  1. The mechanical breakdown of the yacht was caused by lack of lube oil pressure;
  2. The oil cooler gasket was defective from faulty design as the fit of the gasket to the oil cooler and engine block was mismatched;
  3. Mr Sheehan had not complied with the operating manual and did not switch off the engine as indicated in the manual; and
  4. The damage to the engine would have been avoided if the engine had been stopped immediately when the alarm activated.
Was the loss or damage accidental?

The policy defined “Accident/Accidental” as “an event that you did not expect or intend to happen”.

In his evidence Mr Sheehan conceded that:

  • He had not read the operation manual of the yacht prior to 17 September 2015 and did not know it existed;
  • He did not habitually look at any particular analogue gauge while operating the yacht;
  • He did not check the alarm screen and gauges to determine why the alarm was activated;
  • Did not think there would be a problem as the engine was serviced the day before or the day of the incident;
  • He thought that since the yacht was in “limp mode” (whereby the engines default from the usual speed when activated by a critical alarm such as low lube oil pressure), this operated to protect the engine from damage; and
  • If he knew the engine had low oil pressure he would have stopped the engine.

Underwriters argued that the damage to the engine was not accidental loss or damage within the meaning of the policy as it could not be considered unexpected from the perspective of a reasonable person in the circumstances. A reasonable person would have read the manual, known about the operation of the alarms, recognised their significance and turned off the engine when an alarm activated.

Alternatively, underwriters argued that Mr Sheehan “courted the risk” as he knew of the risk of damage and deliberately chose to take it. Underwriters also contended that the exclusion clause present in the policy was operative to exclude liability for faulty design.

Allsop CJ held that the relevant test in determining whether the damage was accidental was whether a reasonable operator of the yacht with the knowledge of Mr Sheehan would have expected the damage to the starboard engine to have occurred in the circumstances.

With regard to the argument that Mr Sheehan had “courted the risk”, Allsop CJ noted the high standard of proof required for a court to conclude that an insured had “courted the risk”.

Allsop CJ acknowledged that Mr Sheehan’s conduct was undoubtedly an example of poor seamanship that bordered on negligence, as a reasonable operator of the vessel would have read the manual, checked the analogue gauges and scrolled through the list of alarms. However, this was insufficient to lead to a conclusion that he had “courted the risk”.

Accordingly, the Court found that the damage to the starboard engine was accidental loss or damage within the meaning of the policy.

Did the faulty design exclusion apply?

Mr Sheehan argued that the proximate cause of the damage was his failure to turn off the engine once the alarm sounded.

Allsop CJ accepted the referee’s finding and concluded that the sole proximate cause of the damage was the defective design of the oil cooler gasket.

Accordingly, the policy’s faulty design exclusion applied and the Court held that Mr Sheehan was not entitled to indemnity under the policy.

Key takeaways

The decision illustrates the importance of obtaining relevant expert evidence to assess whether the damage which is the subject of a claim falls within the scope of the policy or is excluded.

Secondly, the decision is a reminder to insurers of the high standard of proof required to persuade a court that an insured has “courted the risk”. The insurer must demonstrate that the insured has knowingly accepted the risk. Mere inadvertence or carelessness is insufficient to deny an insured cover under a policy.

This article was written by Khym Weldon, Law Graduate, James McIntyre, Special Counsel and David Muir, Partner.

Important Disclaimer: The material contained in this publication is of a general nature only and is based on the law as of the date of publication. It is not, nor is intended to be legal advice. If you wish to take any action based on the content of this publication we recommend that you seek professional advice.