By Julian Hill translated by Thomas G. Guo
A new set of Hull Clauses has been issued in London, whilst at the same time the existing Institute Time Clauses – Hulls remain available and in use in the market. The purpose behind the introduction of these new Clauses is unclear from the nature of the changes that have been made. There are however a number of these which have raised serious issues as to their meaning and effect. I have considered these in a number of articles. This one deals with the changes to the main named perils coverage clause, and in particular latent defect.
Introduction and Background.
The new International Hull Clauses (01/11/02) have retained the named perils format of the Institute Time Clauses Hulls (1983 and 1995). They are however considerably lengthened and by including clauses which may or may not be agreed as part of the policy cumbersome to use.
In terms of coverage what was Clause 6 of the Institute Time Clauses is now Clause 2 of the new Clauses. Apart from some minor changes the main differences between the sets of Clauses in respect of this coverage clause is in the treatment of bursting of boilers, breakage of shafts and latent defect. In regard to the 1995 Clauses there is one additional difference. This is a change in the due diligence proviso to Clause 6.2 which reads “provided that such loss or damage has not resulted from want of due diligence by the Assured, Owners, Managers or Superintendants or any of their onshore management.” In Clause 2.2 of the International Hull Clauses this proviso is now the same as the 1983 wording, namely “provided that such loss or damage has not resulted from want of due diligence by the Assured, Owners or Managers.” Reference to Superintendants and onshore management has been deleted. Wider duties are however placed on Assured, Owners and Managers under Clause 14 of the International Hull Clauses so that there is not likely to be much additional coverage, if any, under the International Hull Clauses over the 1995 Institute Time Clauses as a result of the change in the proviso wording. Indeed Owners may in certain factual circumstances be in a worse position because Clause 14 applies in respect of casualties resulting from any of the perils set out in Clause 2 and not merely those in Clause 2.2 to which the proviso is limited.
The main change in Clause 2 is as mentioned above in relation to latent defect. In this regard the Institute Time Clauses Hulls wording was
“6.2 This insurance covers loss of or damage to the subject matter insured caused by
6.2.1 bursting of boilers, breakage of shafts or any latent defect in the machinery or hull.”
The general meaning of the Clause and the coverage given by it has been well understood. It is not the burst boiler or broken shaft or latent defect that is covered but loss of the vessel or damage to it that is caused by one of these, that is the consequential loss of or damage to the insured vessel. If there is no such consequential damage, for example a latent defect is discovered and nothing more, then there is no recovery at all under the insurance. If there is some consequential damage it is only the reasonable cost of repairs to that damage which is recoverable, not the part of the cost relating to putting right or repair of the defect itself or the boiler or shaft. Such cost can be covered by buying additional coverage from underwriters under the Additional Perils Clause 1/11/95.
There have been some well known cases in the English Courts that have focused on the issue of whether or not there has been consequential damage to a vessel or whether what has been found has been merely the latent defect becoming patent during normal use and so not covered by the policy. A good example is the case of Scindia Steamships (London) Ltd. v. The London Assurance Co. Ltd. (1936) 56 Ll. L. Rep.136. The vessel involved had traded for a number of years without incident and went into drydock for the purpose of renewing the lower half of the wood lining of the stern bush. For this purpose it was necessary to remove the propellor and draw the tailshaft. Whilst the propellor was being wedged off, the shaft broke owing to a latent defect in it. The propellor and the end of the shaft fell into the drydock and one blade of the propellor was broken. Hull underwriters agreed to pay for the repair to the propellor as being damage caused by the breakage of the shaft or alternatively by the latent defect but refused to pay for a new shaft. The surveyor had found that where the break had taken place there was a deep smooth flaw in the shaft extending down from the top and that about one half of the material was sound and had been newly fractured. The flaw was treated as an old flaw and the shaft was disposed of as scrap. The shipowners made their claim for the new shaft essentially on the basis that they were covered under the “breakage of shafts” peril or, alternatively, under the heading of “latent defect in the machinery”, saying that since the shaft was part of the machinery and its breakage was due to a latent defect there was coverage. The judge rejected the argument based on “breakage of the shafts” saying that the breakage of the shaft itself is not covered, nor is such breakage loss of or damage to the machinery caused by the breakage of the shaft. The only damage caused by the breakage of the shaft was the propellor damage and that had been paid for. Turning to latent defect he found that the same argument applied. The shaft had not been subjected to anything in the shape of a peril, but to an ordinary operation of ship repairing and that operation caused its breakage. The breakage was not damage caused by the latent defect, all that had happened was that the old flaw had gone on developing.
This case as well as the other well known cases dealing with latent defect in the context of hull insurance was considered much more recently by the Court of Appeal in The Nukila (1997) 2 Lloyd’s Rep. 146. The Nukila case involved very different facts. The policy was on a mobile accommodation platform. The coverage was on the Institute Time Clauses Hulls and the Institute Additional Perils Clause- Hulls. The importance of having the Additional Perils cover was that if it could be shown by the assured that there had been damage to the platform caused by a latent defect, then all of the repair costs, including those costs actually incurred in putting right the latent defect itself, would be recoverable. If there was no damage there would be no recovery. It followed that the court only had to decide if there was damage and that precisely defining as a matter of fact what was the damage and what was the defect was not necessary. The facts were that due to defective welds on one of the legs of the platform there was extensive fatigue cracking which extended into other areas of the structure and previously sound steelwork. The extensive cracking meant that that the platform was in danger of collapse at the time the cracking was discovered. However at the time of inception of the policy the exercise of due diligence by the owners would not have discovered the defect in the weld nor the minute cracking that existed at that time. The extensive cracking and fracturing of steel was accordingly the result of a latent defect in existence at the inception of the policy. The underwriters denied liability saying that there had been no damage. If there was a latent defect in the hull, then this was a defective part and no consequential damage had occurred. A latent defect had developed in ordinary use and had become patent.
Whether or not there was damage, was a matter of fact for the decision of the Court and not a matter of law. And the Court of Appeal had no difficulty in deciding that on any common sense view of the facts there was damage. This was sufficient to decide the case. In setting out the principles involved, Lord Justice Hobhouse said
“If a latent defect has existed at the commencement of the period (covered by the policy) and all that has happened is that the assured has discovered the existence of that latent defect then there has been no loss under the policy. The vessel is in the same condition as it was at the commencement of the period. Therefore, in any claim under the Inchmaree clause or any similar clause, the assured has to prove some change in the physical state of the vessel. If he cannot do so, he cannot show any loss under a policy on hull. …. If, however, damage has occurred, that does involve a physical change in the condition of the vessel and can be the subject of a claim under the policy.”
The Court went on to consider the earlier case authorities and rejected underwriters suggestion that the dividing line between a defect and damage was whether there was consequential damage to another distinct part of the vessel. The principle was whether there was consequential damage and in the Courts’ view the notion of a part, which is a word that can be used in a variety of ways and with a variety of meanings, did not assist with the assessment of whether there was or was not damage.
As regards the Scindia Steamships case, which I have referred to above and was a judgment of Mr Justice Branson , there was there an old flaw which led to the fracturing of the rest of the shaft. Lord Justice Hobhouse said
“ Mr Justice Branson was clearly justified in reaching the conclusion which he did. No loss by a peril insured against had been proved. The shaft was already in a condition which required it to be condemned and its value was already no more than scrap value. The breakage of the shaft was simply the breakage of a part that was already without value and required to be replaced. There was no insured loss. This is what is reflected by the language which Mr Justice Branson used when asking whether there was something different from the damage involved in the latent defect itself…The loss which the shipowner had suffered was a financial loss arising from the discovery of the latent defect not from the latent defect having caused any damage.”
There are still certainly difficult factual situations where it would be difficult to apply these principles One such area is where the defect has developed prior to the commencement of the policy and continues to do so and the issue arises as to when damage occurred and what was the cause of the continuing damage. However in considering a claim under the Institute Time Clauses Hulls these are the principles to apply.
The New Clauses
Clause 2.2 of the new clauses reads as follows:
2.2 This insurance covers loss of or damage to the subject-matter insured caused by…
2.2.2. any latent defect in the machinery or hull, but only to the extent that the cost of repairing the loss or damage caused thereby exceeds the cost that would have been incurred to correct the latent defect. (my underlining)
The change from the previous wording is the addition of that new underlined limitation. It is worth noting the contrasting change to Clause 2.2.1, where the wording is now “bursting of boilers or breakage of shafts but excludes the cost of repairing the boiler which bursts or the shaft which breaks.” Here the reference is to the actual cost whereas with latent defect it is the cost “that would have been incurred”.
The Reasons for Change.
The reason for the first change has been said to be to reinstate a distinction between the defect and its consequential damage to what, it is said, it was understood to be prior to the Court of Appeal decision in the “Nukila” (1997), but to do so without referring to ‘part’. However, the first difficulty with this explanation is that the “Nukila” decision turned on a finding of fact that there had clearly been damage. This, under a policy which also contained the Institute Additional Perils Clause, meant that the cost of repairing the defect was in fact covered anyway. Furthermore no previous authorities were overruled in the “Nukila” judgments. As to the relevance or meaning of ‘part’ in the context of latent defects, where the defect is in a continuous structure such as a hull there never has been consensus as to what constitutes a part. That is a difficult but often purely factual area. In the “Nukila” underwriters had put their case very high, accepting in their argument that the hull of a ship would be a single part so that no system of fatigue cracking short of total loss (however extensive and whether or not leading to shearing or other tensile failures) could (they argued) amount to damage to the hull for the purposes of the Inchmaree Clause. One wonders if the desire to resurrect this argument is part of the reason for the change referred to above.
It can be said that the new wording does in one sense refer back to the ‘Nukila’. There Lord Justice Hobhouse , as he then was, said “Correcting latent defects is, as a matter of principle, an expense to be borne by the shipowners and not the underwriters.” This statement would seem to me to be the foundation for the introduction of a threshold of the cost that would have been incurred to correct the latent defect.
The New Clause – In Operation.
However, to see what is covered one must look at the whole of the new clause. It is then clear that the basic coverage for latent defect claims is exactly the same as with previous Institute Time Clauses i.e. loss of or damage to the subject matter insured caused by latent defect in the machinery or hull.
In the case of damage, if it is repaired, it is the reasonable costs of repairing that consequential damage after allowing for any deductible, that is claimable. Any claim should therefore initially be adjusted in exactly the same way under all three sets of Clauses (1983, 1995 and 2002). Then, in the case of the new clauses, there is the novel restriction on coverage to be considered - do the actual costs so adjusted of repairing the consequential damage exceed the costs that would have been incurred to correct the latent defect? To the extent that they do, the assured may recover.
There is no room in this article to debate at length the exact nature of this provision This does matter since it would determine which of the parties, assured or underwriters, has to prove what the costs would have been. In short, it would seem to be a claims provision affecting the measure of indemnity rather than a coverage provision, even though it has, rather confusingly, been placed in the Perils clause as a limited exception to coverage. As such, the onus of proof of the new excess probably therefore rests on the assured rather than on underwriters. The costs that would have been incurred in repairing the latent defect will thus have to be separately proved by the assured.
It has, however, been argued that where, for example, an engine is damaged as a result of a latent defect and has to be stripped down for repair and the same costs of stripping down would need to have been incurred to correct the latent defect if that had been done without the presence of any consequential damage, then, in calculating the cost of correction that would have been incurred, these stripping-out costs should also be apportioned (as with common charges where owners’ and underwriters’ work is being undertaken at the same time). Unhappily, even in the case where these costs were exactly the same, that suggestion does not seem (in my view) to accord with the new wording.
The first requirement under this wording seems to me to be to establish the reasonable cost of repairs of the damage caused by the latent defect. These are the actual costs incurred and the cost of repairing the defect and any actual common costs for owners’ and underwriters’ accounts will already have been taken account of in reaching this figure. These costs can hardly be what is being referred to in the new additional wording since if they were, the introduction of this new limitation would be a meaningless complication and one would in reality merely work out the claim exactly as before. The different wording of Clause 2.2.1 is to be compared in this respect.
The second requirement under Clause 2.2.2 must surely be to work out what it would have cost to repair the defect alone? What would it have cost the shipowner to correct it by stripping down, and all? None of that is recoverable on the clause as drafted.
Unfortunately (in what is from the point of view of clarity a singularly unhelpful omission from the new wording) no time is mentioned for working out the theoretical expense of correction. Is it at inception, casualty, damage, repair, immediately before any of these, or at some other time? Depending on the situation of the ship at the relevant time and the nature of the defect, the time (which will also govern the place) at which the calculation is to be made could have a large impact on the size of the theoretical costs. It has been suggested at various seminars in which underwriters and their representatives have taken part that it should be at commencement of the policy. Whether that is correct or not, it emphasizes that this is all Owners’ work and that one is asking the question – what would the reasonable cost to owners have been of repairing the defect had they done so at that time? As such, no common costs enter into this part of the calculation.
The effect of the new words would appear to be a significant reduction in coverage over that available under either prior set of Institute Time Clauses which an assured would need to consider carefully before accepting insurance under them rather than the Institute Time Clauses.
Effect of Additional Perils cover?
The new clauses also contain a new Additional Perils Clause in Clause 44. Somewhat bizarrely, cover is not there given for the actual costs incurred in repairing the latent defect but as follows
“44.1 If the Underwriters have expressly agreed in writing, this insurance
covers…
44.1.2 the cost that would have been incurred to correct the latent defect where such latent defect has caused loss of or damage to the subject-matter insured covered by Clause 2.2.2”…
Nor is the actual cost a limit. Capricious results could follow from this new approach. Suppose, as an example and disregarding any deductible, repair costs of a latent defect and consequential damage are £40,000. £20,000 of this is for owners’ account as being the costs attributable to repairing the latent defect rather than the damage caused by it. The amount recoverable under Clause 2.2.2 would be the amount by which the £20,000 cost to repair the consequential damage exceeded the cost that would have been incurred to correct the latent defect ( that is the calculated cost not the actual costs incurred). If, say, that figure were £15,000, £5,000 would be recoverable under Clause 2.2.2 plus the £15,000 under the new Additional Perils Clause, leaving owners out of pocket in the amount of £20,000. That is exactly the same position as they would have been in under the 1983 or 1995 Institute Time Clauses without Additional Perils coverage at all.
If the cost that would have been incurred to correct the latent defect was not £15,000 but was, say, £25,000, then nothing would be recoverable under Clause 2.2.2 but the whole £25,000 would be recoverable under the new Additional Perils Clause. However the Owner would still be out of pocket and £15,000 worse off than under the previous Institute Time Clauses with the Institute Additional Perils Clause added.
A third possibility, which is less likely but feasible in certain circumstances, is where the cost that would have been incurred to correct the latent defect is more than the total actual repair costs, say in the above example £45,000. The Owner would recover nothing under Clause 2.2.2 but £45,000 under the new Additional Perils Clause, thereby getting a windfall of £5,000 over the actual costs incurred.
Unrepaired Damage
Two other points can be shortly considered: unrepaired damage claims and Constructive Total Loss. All of the above comments have assumed the damage is repaired. What if it is unrepaired? The wording in Clause 20.1 of the new clauses in this respect is unchanged from the Institute Time Clauses. The measure of indemnity under that Clause for an unrepaired damage claim is the reasonable depreciation in the market value arising from such unrepaired damage but not exceeding the reasonable cost of repairs. However, no reference is made to how the new words in Clause 2.2.2 are to be applied in this context, if at all. Is the recovery limited to the reasonable cost of repairs of the damage caused by the latent defect as implied by Clause 20.1? Or only to the extent by which these costs exceed those that would have been incurred to correct the latent defect as referred to in Clause 2.2.2.? That question is not answered in the Clauses. The answer obviously makes a difference to the monetary amount of any such claim but could also make a difference as to whether an Owner repairs or not. Similarly the position should the owner have Additional Perils Coverage under Clause 44 is neither explained nor clear. It would seem that Clause 44.1.2 ought to entitle the owner to the cost that would have been incurred to correct the latent defect regardless of the question of depreciation in market value or what the actual costs of repair would have been.
Constructive Total Loss
A similar point arises in relation to Constructive Total Loss, now dealt with in Clause 21 of the new clauses. This provides that no claim for constructive total loss of the vessel based upon the cost of recovery and/or repair of the vessel shall be recoverable unless such cost would exceed 80% of the insured value of the vessel. In the case of latent defect what is the cost for the purposes of s.60 (2) (ii) of the Marine Insurance Act, that is the cost of recovery and/or repair, which is to be compared to 80% of the insured value of the vessel under Clause 21.1 in order to establish whether or not there is a constructive total loss claim? Nothing is mentioned in the Clauses and again the issue is unclear.
If the owner has Additional Perils Coverage under Clause 44.1.2 how is that coverage meant to apply in the case of a constructive total loss claim? It would seem to be clearly arguable here also that applying this new Additional Perils wording gives the assured an additional recovery on top of the insured value for constructive total loss?
In Conclusion
I have concentrated in this particular article on one issue, the coverage for latent defect and its implications. It can be seen that in my view there is more restricted coverage under the new Clauses and that there are many questions which arise and remain unanswered under them. Clearer drafting would be desirable to provide the answers and it would not be satisfactory to attempt to introduce change through claims practices which may or may not be known to or indeed agreed by all market participants. Furthermore the new extended format of these Clauses whereby the Additional Perils Clause now appears as Clause 44 of the main Clauses and not as a separate Clause to be added to the policy means that problems with that particular Clause cannot be dealt with by the simple expedient of withdrawing that Clause on its own and reissuing it with any amendments that might be thought necessary.
JULIAN HILL
© Julian Hill, February 2003 |
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