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10 September 2008

Insurance options for insured parties - "noting" versus "named" insured

Construction contracts often contain terms and conditions requiring one party to obtain insurance which covers other parties such as mortgagees, contractors, lessors, financiers and trustees. In general, the party with the obligation to effect insurance may seek to discharge its obligation in one of the following ways:

  • having the parties to be covered named on the relevant policy as “Named Insureds”,
  • having the parties to be covered protected under the relevant policy as “interested parties” by reason of their inclusion within a class of persons to whom the cover is expressed to extend protection, or
  • having the parties’ interests in the proceeds of the policy “noted”.

This article looks at the legal effect of each of these three approaches and some of the pros and cons associated with each option.

Privity and Named Insureds

The common law principle of privity of contract restricts the ability of a person who is not a party to a contract from enforcing a benefit under it. Assuming a contracting party to an insurance contract was not, in arranging cover:

  • acting as agent for another non contracting party, or
  • entering into the contract as trustee for another non-contracting party,

lack of privity, historically at common law, meant that such a non-contracting party could not enforce the insurer’s obligations under the contract of insurance against the insurer.

Under the law as it now stands, arranging to have a party named in an insurance policy as a Named Insured by agreement with an insurer, gives such a Named Insured the right to seek indemnity under the policy of insurance directly from the insurer. There are possible drawbacks to having a party made a named insured based on the circumstances. These issues are discussed further below.

“Interested parties” as third party beneficiaries

The common law doctrine of privity of contract also historically prevented non-contracting parties named as beneficiaries under an insurance policy from enforcing the terms of the policy, even though the policy clearly contemplated that they should be beneficiaries. That position at common law was changed by the High Court in Trident Insurance v McNiece Bros (1988) 165 CLR 107.

In Trident, a builder, Blue Circle Southern Cement Ltd, took out a contractors all risk policy which was expressed to be for the benefit of all contractors, subcontractors and suppliers. McNiece, one of Blue Circle’s contractors, sought to recover under that policy for its liability to a subcontractor’s injury on site.

The High Court considered the rights of non-contracting parties named as beneficiaries in policies of insurance and found such parties entitled to be indemnified in respect of losses covered by an insurance policy in certain circumstances. The Court held by a majority that the normal principle of privity of contract did not apply to this situation, enabling the non-contracting party to directly enforce against the insurer the benefit provided for under the terms of the policy. Mason CJ and Wilson J considered that it was necessary to change a common law rule that operated unsatisfactorily and unjustly, in circumstances where it was the expressed intention of the insured, and the common intention of the insurer and insured, that a non-contracting party should receive the benefit of the insurance.

The impact of Trident is now largely most relevant to contracts of insurance which are not regulated by the Insurance Contracts Act (Cth) 1984 (ICA) as section 48 of the ICA effectively anticipated the findings in Trident. Section 48 provides that where a person other than a contracting insured is referred to in a policy as someone to whom the benefit of the policy is intended to cover, that person may enforce the policy directly against the insurer even though they are not privy to the contract of insurance.

It is not necessary for the third party beneficiary to be specifically named on the policy for the third party to take advantage of section 48 of the ICA. Rather, the third party may fall within a specified class of persons. For example, the policy may include in its description of the insured, all subcontractors and consultants employed from time to time in relation to the building works. Any person who is a subcontractor or a consultant during the period of the policy will be covered under it and entitled to enforce it directly against the insurer.

Noted as an “interested party”

The question of noting of interests arises in connection with “first party” loss policies, ie policies which respond to “own” loss of the insureds as opposed to liabilities incurred to third parties.

Generally, noting a person’s interest in an insurance policy is not enough to confer any rights on the person at common law or under the ICA. This is except, of course, in circumstances where the insurance policy specifically extends cover to persons who are noted. In that case, those persons are effectively third party beneficiaries and will have the right to recover under the policy pursuant to section 48 of the ICA.

Whilst merely noting a third party’s interest will not be sufficient to extend protection under the policy to that party, in the absence of the third party being a beneficiary or contracting insured, it is useful as a clear statement to the insurer that another party has an interest in the insured property.

In some circumstances, this will have legal consequences, for example, where a property owner takes out a first party insurance policy covering the owner for damage to the building. Where the interests of a bank as a mortgagee are noted on the policy, the insurer is put on notice that the bank has an interest in the building. If the building was destroyed in a fire and the insurer was to pay the entire insurance proceeds to the owner without any reference to the bank, the bank may be able to argue that the insurer was on notice about the bank’s interest and should have ascertained the nature of the bank’s interest before paying the entire insurance proceeds to the owner.

Although the insurance policy does not, upon its actual terms, respond to losses of the noted party, they may in certain circumstances be entitled to receive or recover policy proceeds in respect of the perils that are insured protected under the policy. The bank’s arguments might be based on misleading and deceptive conduct, misrepresentation, estoppel and equity. Whether such arguments will be successful will depend on the facts in each case, and possibly industry practice.

Section 49 of the ICA also may benefit a third party whose interest in property is noted in a policy. Section 49 applies where:

  • Loss occurs in respect of property where the insured and the third party both have an interest in the risk, and
  • The insurer has not notified the insured in writing that the policy will not provide cover for interests other than the insured’s before the contract of insurance was entered into.

If the third party’s interests are noted, the insurer may be viewed as having agreed to cover the third party even if the notice referred to above has been provided. If section 49 applies, the insurer will be required to pay the insured an amount to cover his or her loss in the first instance. Where the sum insured exceeds the insured’s interest, the insurer will then be required to satisfy (to the limit of the sum insured) proportionally the claims of third parties who notify it of their interests within 3 months of the date on which the loss occurred.

Section 49 has particular relevance to financiers, however, it may also be relevant to owners of property where a structure is being built and the builder has insurance in its own name covering damage to the structure. In the case of the builder’s insurance, the builder may only have a 10% interest in the structure (although it is insured for 100% of its value). As the insurer would only be obliged to indemnify the builder to the extent of the builder’s interest (by virtue of the indemnity principle, the builder can only recover its loss and cannot profit from the insurance policy), the owner of the building may be able to rely on section 49 to recover the remaining 90% of the value of the structure, subject to available limits under the insurance policy.

Pros and cons of being a Named Insured or a third party beneficiary

Contractual obligations of Named Insureds

A drawback to being a Named Insured is that an entity so named is then bound by all the duties and obligations of the other Named Insureds under the insurance contract upon its terms. There may be obligations peculiar to a particular Named Insured in the insurance policy, however, a Named Insured is generally subject to duties of utmost good faith and other obligations and provisions of the policy, such as obligations in respect of the giving of notices in relation to claims and circumstances that might give rise to a claim.

Pre-contractual Duties

Whether or not a contracting insured’s pre-contractual duty of disclosure applies to persons who are named as Insureds will depend on whether such Named Insureds are “party” to the insurance contract. The point is this: only a contracting insured owes a duty of disclosure. Being a Named Insured under an insurance contract does not of itself make that person a contracting insured any more than not being a Named Insured means that a person is not a contracting insured. Whether or not a person is a party to an insurance contract is a question of fact and law.

It is clear, however, that whenever named as an Insured, or a beneficiary under section 48, anything which compromises the existence of the policy or its terms of coverage, such as the right to avoid or reduce liability for pre-contractual mis-representations or non-disclosures, will affect the rights of subsequent Named Insureds or section 48 beneficiaries. In Commonwealth Bank of Australia v Baltica General Insurance Co Ltd 28 NSWLR 579, for example, the insurer sought to rely on non-disclosure by an insured against a third party beneficiary (mortgagee). Giles, J. upheld the defence on the grounds that section 48 was not intended to put a third party beneficiary in a better position than an insured party to the contract in relation to non-disclosure.

Insured v Insured exclusions

A common provision in liability policies that is relevant to Named Insureds and potentially to other insureds is the exclusion for claims made by one insured upon another insured. An “Insured v Insured” exclusion means that a Named Insured may not seek to be indemnified for liabilities incurred to another Named Insured. Whether or not the exclusion has any work to do in relation to third party beneficiaries also protected by the policy will depend on whether those beneficiaries come within the nexus of the term “Insured” under the policy and (thereby within the ambit of any insuring clauses as such) and how the “Insured v Insured” exclusion is drawn.

Section 48 does not per se deem a third party beneficiary an insured but simply confers on such a party the right to recover directly against an insurer notwithstanding the absence of privity of contract and the fact that consideration may not have moved from the beneficiary. A third party beneficiary may come within the nexus of the notion of insured for the purposes of a policy depending on how that term is defined in the policy. For example the term “Insured” may, upon its terms, include in its ambit subcontractors. Such persons may not even be ascertained until after the insurance contract is formed. As such they should not be contracting insureds. They will in this case be third party beneficiaries and for the purposes of the policy and its terms and conditions they are “Insureds” if that term is defined so as to include subcontractors.

If the exclusion is drawn so as to only have work to do in relation to Named Insureds and the insuring clauses respond upon their terms to both Named Insureds and beneficiaries within a class - such as contractors and subcontractors - then being a Named Insured has distinct disadvantages in respect of the operation of this exclusion - at least as regards claims from other Named Insureds. If, on the other hand, the exclusion operates in relation to anyone coming within the nexus of the notion of insured and, for the purposes of the insuring clauses, that term encompasses both Named Insureds and beneficiaries then being named as an Insured or as a beneficiary is neutral as regards the attachment of this exclusion.

Claims and duties of beneficiaries

The ICA provides that a third party beneficiary owes the same obligations to the insurer in relation to a claim as the person would have if they were the insured (ie meaning a contracting insured). These obligations may include the duty of utmost good faith. The obligation to act with good faith towards the insurer may attach in relation to all matters arising under or in connection with the contract of insurance pursuant to sections 13 and 14 of the ICA. Curiously, the insurer may not have a corresponding duty of good faith to the third party under the ICA, although such an obligation may exist at common law.

Claims and defences available to insurers against beneficiaries

Section 48(3) allows an insurer to avail of the same defences in an action by a third party beneficiary as it would use in an action by an insured (ie meaning a contracting insured). However, there is some dispute about whether a third party beneficiary’s claim for indemnity may be prejudiced by the wrongful conduct of the insured (meaning contracting insured) and much depends on the circumstances of each case.

In V.L Credits Pty. Ltd v Switzerland General Insurance Co [1990] V.R. 938, for example, the insurers argued that because the lessee (a contracting insured) had fraudulently caused the damage, the plaintiffs (who were outside the contractual nexus) as co-insured could not make a claim under the policy. However, Tadgell J held that “there is no logical reason either, in my opinion, why the fraud of one co-insured should affect a claim by the another, if …the two persons’ interests are not inseparably connected so that a loss or gain necessarily affects them both”.

It appears that in circumstances where the interests of an insured and a beneficial third party are severable ie the insurance cover is composite as opposed to “joint” (such as insurance of a husband and wife joint interests in a matrimonial home), the beneficial third party may still be covered notwithstanding the insured’s post contractual wrongdoing. That is, section 48 is to be construed to mean that the insurer may raise the same “types” of defences against a beneficiary as it may raise against a contracting insured but cannot raise against a beneficiary under a “true” composite insurance contract, post contractual vitiating conduct of a contracting insured which entitles the insurer to deny coverage to that contracting insured in respect of the same occurrence. So, for example, an innocent mortgagee may still (depending on the policy terms and conditions) recover upon an insurance contract insuring property where the mortgagor has engaged in vitiating conduct - for example, arson - which prevents the mortgagor from recovering.

Proposed amendments to the ICA may clarify whether the wrongful conduct of an insured can be used to defend a claim by a third party beneficiary, regardless of whether the insured’s conduct occurs before or after the contract is entered into. Such amendments have been the subject of discussion since 2001 and it is not clear when or if they will become law. If passed, the legislative changes are unlikely to come into force before the second half of 2009.

Ameliorating measures

Although there are drawbacks to a party becoming a Named Insured or a section 48 third party beneficiary, negotiating the terms of the policy or ensuring a contractor negotiates such terms with an insurer may remove some of the risks associated with being an “innocent” Named Insured or third party beneficiary. Some terms that might assist are:

  • Protection for innocent insureds clause – this is a clause that prevents an insurer from relying on the breaches of duty or obligation or other acts or knowledge of one insured against insureds without such knowledge or involvement in the breach or acts.
  • Severability clause – although only one proposal form is submitted in relation to the insurance policy, this clause construes separate proposal forms for each insured so that no statement or omission in the proposal form which contains actionable non-disclosure or misstatement can be relied upon against insureds who had no such knowledge or information. This clause should be included in conjunction with a non-imputation clause which states that the knowledge or state of mind or information possessed by an insured shall not be imputed to any other insured for the purposes of determining coverage under the policy or the availability of a remedy for the insured.
  • Cross liability clause – such a clause obligates an insurer to protect each unrelated insured separately. In the event of liabilities arising between Named Insureds, the policy will operate as though a separate contract of insurance in the same terms had been issued to each of them (without increasing the limit of liability). For example, in Transfield Pty Limited v National Vulcan Engineering Insurance Group Limited & Ors; Connell Wagner Pty Ltd v National Vulcan Engineering Insurance Group Ltd & Ors [2002] NSWSC 830, the plaintiffs each sought indemnity under a policy of insurance held by Transfield which covered Transfield, all of its subsidiaries and their subcontractors for any liability for (among other things) loss of, damage to or destruction of property. The insurers denied indemnity, relying on an exclusion for liability for damage to property owned by “the insured”. The insurers argued that the expression “the insured” means all parties insured under the policy. Accordingly, property owned by “the insured” means property owned by any one or more of the insured entities, including property owned by any of the subcontractors. The plaintiffs argued that the exclusion did not apply, as the expression “the insured” referred not to any insured entity but to the particular entity bringing the claim. It was argued that the exclusion must be interpreted in this way in light of a cross-liability clause in the policy, which stated that “each of the persons comprising the Insured considered as a separate and distinct unit and the words “the Insured” shall be considered as applying to the same manner as if a separate policy had been issued to each...”
  • Justice McClellan concluded that, informed by the cross-liability clause, the phrase “the insured” in the exclusion was a reference to the particular party making a claim under the policy on the basis that the purpose of the policy was plainly to provide insurance to all parties as though separate policies had been issued.

The best approach?

The “correct” approach to be taken to discharge an obligation to obtain insurance cover for parties to a construction contract very much depends on the circumstances in each case. The precise requirements under the construction agreement, what is sought to be achieved, the commercial imperatives, the type of insurance policy and terms involved and the possible duties placed under the insurance policy are but some of the issues to be considered.