In the context of Property insurance, this article considers:

1. the indemnity principle;
2. replacement cost insurance; and
3. the reasonable despatch requirement.

While the article focusses on the Australian Industrial Special Risk (ISR) policy, it is relevant to Property and Material Damage Business Interruption (MDBI) policies generally.

What is the indemnity principle?

The indemnity principle means that the insured is restored to their position prior to the loss. Where an insurance policy covers real property, the insured can only be restored to their pre-loss by reinstatement (i.e. repair, rebuilding or replacement) of that property.

If the insured was to be indemnified purely on an indemnity basis, the amount of the indemnity would be the cost of reinstatement less an allowance for betterment. Here, betterment is the amount by which the reinstated property (containing new and/or improved materials) is more useful or valuable than the pre-loss property. As Campbell and Stewart explain:

“A deduction for betterment is a necessary corollary of the indemnity principle: the deduction ensures that an insured is not put in a better position, post-indemnity, than he or she was in prior to the loss.”[1]

Replacement cost insurance

Contrary to the indemnity principle, under “replacement cost” insurance:

1. the insured is indemnified on a “new-for-old” basis;
2. there is no deduction for betterment; and
3. the parties effectively “contract out” of the indemnity principle.

The Australian Industrial Special Risk (ISR) insurance policy is an example of “replacement cost” insurance, and many Property insurance policies operate on this basis. For buildings, machinery, plant and other property and contents, the “Reinstatement or Replacement” memorandum in the Mk.IV ISR provides that “[T]he basis upon which the amount payable is to be calculated shall be the cost of reinstatement of the damaged property insured at the time of its reinstatement, subject to the following Provisions…”

Conditions applying to replacement cost insurance

In the Mk.IV ISR’s “Reinstatement or Replacement” memorandum, the following conditions (among others) apply to its replacement cost indemnity:

1. the reinstated property is not to be better or more extensive that the condition of the original property when it was new. This condition (and condition 4), below) seek to counter the moral hazard that arises in replacement cost insurance;
2. reinstatement must be commenced and carried out with reasonable despatch. This condition seeks to contain reinstatement costs which could reasonably be expected to increase if reinstatement is not effected promptly. If property were not reinstated promptly, it would increase insurance premiums for insureds generally. Beyond this, reasonable despatch provides contract certainty since, without it, the insured’s responsibilities for effecting reinstatement are unclear (i.e. when is reinstatement to occur?);
3. co-insurance (also known as average or underinsurance). This condition is vital to ensure that insureds accurately declare reinstatement costs and the premium can be calculated accordingly; and
4. no payment beyond indemnity value is payable until the cost of reinstatement has been incurred. In the ISR, the however, this condition is tempered by the “Progress Payments” condition.

These conditions are fundamental to replacement cost insurance, and the rest of this article will focus on reasonable despatch.

Reasonable despatch in the Mk.IV ISR

In the Mk.IV ISR, the reasonable despatch requirement in the “Reinstatement or Replacement” memorandum is as follows:

“The work of rebuilding, replacing, repairing or restoring as the case may be (which may be carried out upon any other site(s) and in any manner suitable to the requirements of the Insured, but subject to the liability of the Insurer(s) not being thereby increased), must be commenced and carried out with reasonable dispatch, failing which the Insurer(s) shall not be liable to make any payment greater than the indemnity value of the damaged property at the time of the happening of the damage.”

Reasonable despatch in Australia: CIC Insurance and Brescia

In Australia, the “reasonable despatch” requirement has come under scrutiny as a result of the judgments in CIC Insurance Ltd v Bankstown Football Club (1997) CLR 384 and Brescia Furniture Pty Ltd v QBE Insurance (Australia) Limited & anor [2007] NSWSC 598.

In CIC Insurance Ltd,

1. six months after the insured lodged its claim, the insurer declined the claim, alleging that it was a fraudulent claim, and cancelled the policy;
2. the insured’s financial position was such that it could not reinstate and replace property unless it was indemnified under the policy;
3. a majority of the High Court held that the failure of the insured to commence reinstatement with reasonable despatch meant that the insurer was only liable to pay the indemnity value of the property;
4. the majority held that reasonable despatch should be measured without consideration of the insurer’s wrongful declinature (at 403).
5. the majority indicated that the insured’s position would have been better had it accepted the insurer’s repudiation and sought damages for breach of contract. If the insured proved that rebuilding would have occurred had the insurer admitted liability, damages would be calculated on the basis of the cost of reinstatement.

Gaudron J dissented, stating that:

“It is not reasonable, in my view, to require an insured person to commence and carry out rebuilding and repairs in circumstances where the insurer is wrongfully denying liability under a policy of insurance of the kind involved in this case” (at 412).

In Brescia Furniture Pty Ltd v QBE Insurance, the facts were similar, i.e. the insurer declined the claim and the insured could not reinstate and replace property unless it was indemnified under the policy. Hammerschlag J considered that he was bound by the decision in CIC Insurance, such that Brescia was only entitled to indemnity value, and not the cost of reinstatement. Per Hammerschlag J (at 464):

“An outcome in accordance with the reasoning of Gaudron J is in my view a fair and reasonable one but I am bound to follow the majority view. But for that, I would have followed the approach of Gaudron J.”

Campbell and Stewart concur with Gaudron J and Hammerschlag J[2]:

“Where an insurer under a replacement cost policy wrongfully declines a claim, few would disagree that it is unfair of an insurer to argue that its liability under the policy should be limited because of the insured’s non-fulfilment of conditions. This would be to allow the insurer to take advantage of its own wrong.”

Furthermore, other jurisdictions support the views of Gaudron J, Hammerschlag J, and Campbell and Stewart:

• In an obiter passage in City Realties (Holdings) Ltd v National Insurance Co of New Zealand Ltd (1986) 4 ANZ Insurance Cases 60-695, 74, at 140, the insurer’s wrongful declinature was regarded as relevant to reasonable despatch; and
• In British Columbia, it has long been held that for so long as the insurer wrongfully declines the claim, it is not reasonable to expect the insured to rebuild. See, for example, see Omega Inn Ltd v Continental Insurance Co (1987) 37 DLR (4^th) 573, at 574.

Reasonable despatch and Unfair Contract Terms (UCT) laws

As explained, reasonable despatch is a fundamental condition for replacement cost insurance. However, the decision in CIC Insurance (in 1997) should have been a wake-up call for the insurance industry to ensure that the reasonable despatch requirement operates fairly. And the decision in Brescia Furniture (in 2007) should have been a reminder. Yet it seems that the vast majority of ISR policies were not amended in light of these decisions.

However, Unfair Contract Terms (UCT) laws came into effect in Australia on 5 April 2021, applying to standard form contracts, consumer contracts and small business contracts. As a result, many Property insurance policies (including ISR policies) have been amended to qualify the reasonable despatch requirement so that it would not apply where a delay was due to circumstances beyond the insured’s control – this would appear to include an insurer’s declinature. But not all Property insurance policies have made this transition and, for those that haven’t, reasonable despatch may be an elusive concept. I hope that this article provides some guidance.

[1] Campbell, N., and Stewart B., Prevention of Performance in Replacement Cost Insurance – Preventing a Fictional Response, Otago Law Review (2002) 5 229, at 231.

[2] Campbell, N., and Stewart B., Prevention of Performance in Replacement Cost Insurance – Preventing a Fictional Response, Otago Law Review (2002) 5 229, at 249.