MarIus

5.2.1 The Concept of Damage

For a loss caused by faulty material or error in design to be covered under Cl. 12-4, the perils must cause a “damage”. Thus, if the assured changes or rectifies parts of the vessel before a damage has occurred, the costs are for his account.

There are especially two elements that put losses caused by error in design and faulty material in a special position when it comes to the concept of damage. Firstly, the peril itself is a defect. This means that it may be difficult to separate a damage from the defect, as the defect might appear as a damage. Secondly, the latent defect is present from the moment the vessel is delivered or repaired.

These elements may cause a complicated borderline between the peril, the casualty and the actual damage. The rules in the Nordic Marine Insurance Plan clearly states that the insurer is only liable for the costs of repairing the damage. Consequently, a mere rectification of the faulty material or error in design cannot be considered a recoverable loss, even though it is a defect to the vessel – the defect must cause a casualty and a damage.

This important borderline is also demonstrated through the countervailing considerations of Cl. 12-4. The insurance should not be used as a measure to carry out improvements to the vessel. The purpose of the insurance is to restore the vessel to the condition it was in prior an unexpected damage. Hence, the assured should not be compensated if he rectifies an inherent defect. Due to this fundamental principle of insurance law, it is important to draw a clear line between the defect, being the peril, and the damage. Furthermore, as it is a prerequisite that the peril results in a casualty, it is important to establish how faulty material and error in design affects this principle.

For most losses covered under the hull insurance, the casualty will often be a distinct event, where the casualty and the damage coincides in time.(1) T. Falkanger, H. Bull, & L. Brautaset, Scandinavian Maritime Law, 2017, pp. 628–629 with further references to ND 1995.335 NCA Dino 1 This will often also be the case for defects in the form of faulty material or error in design. The defect may be present for a longer period, before resulting in a casualty and causing immediate damage. In these cases, the general rule in Cl. 2-11 sub-clause 1 is easily applicable, as the peril clearly strikes the vessel and causes a loss.

There are, however, situations where an unknown defect, such as error in design or faulty material, results in a gradually developing damage. In these situations, it may be difficult to establish when the peril actually strikes, as the damage is the result of a gradual process influenced by the peril. The Nordic Marine Insurance Plan regulates these matters in Cl. 2-11 sub-clause 2, which states that if an unknown peril results in a damage, the casualty “shall be deemed to be a marine peril that strikes the interest insured at the time the damage starts to develop”.(2) The rule in also known as the Anti-Hektor rule, cf. T. Wilhelmsen & H. Bull, Handbook in Hull Insurance, 2017, pp.134–135 with further references to ND 1950.458 NSC Hektor Thus, the casualty shall be considered to have occurred when the damage first starts to develop. Consequently, one must establish when a damage caused by faulty material or error in design first starts to develop.

As a starting point, the general rule that a “damage” is an identifiable change must apply also to losses caused by error in design and faulty material. This means that a defect cannot qualify as a damage when it has been present in the same form since the part was installed – the defect must undergo an actual change to manifest as a damage.

The physical change will be somewhat different for losses caused by faulty material and subjective errors in design compared to objective errors in design. Objective errors in design are difficult to objectively measure and test. They will rather be discovered when it becomes clear that the design is not adequate. This will often appear as a sudden casualty, where the design causes damage to the part itself or adjacent parts.

Faulty material and subjective errors in design will, on the other hand, be measurable from the moment the defect is present. The Commentary indicates that measurable cracks are sufficient to qualify as a damage.(3) Commentary, p. 293If the material is faulty by way of cracks from the moment the part is delivered, the remarks in the Commentary may indicate that the defect itself may qualify as a damage without requiring a causality to occur.(4) Previous versions of the Nordic Marine Insurance Plan and Commentary were more imprecise regarding this issue. Reference is made to Wilhelmsen, Hull Insurance of “Latent defects, 2004, p. 268 for further discussions about this topic based on the earlier version of the contract.However, Cl. 12-4 states that “damage is a result of ... faulty material”, which clearly distinguish the terms “damage” and “faulty material”.(5) Wilhelmsen, Hull Insurance of “Latent defects”, 2004, p. 267

The distinction is well demonstrated in Statement of Particular Average 3045 issued in Gothenburg on 25 March 2002 in matter 2001-10:

“The case concerned the coverage for faulty material in SHC 87 § 8.1.b) no. 2, which as mentioned is similar to NM1P § 12-4. The question was whether or not the insurer was obliged to pay compensation for cracks in the crown wheel in two so-called Azimuth thrusters in a vessel. The parties agreed that the cracks existed already at the delivery of the ship from the building yard, and it was accepted that the cracks were produced in connection with the case-hardening process of the wheels in 1984. The adjuster therefore held that the crown wheels had to be considered as faulty material. It was clear that the relevant parts were approved by the classification society. The assured claimed that errors during the hardening process of the crown wheel constituted the peril, and that this peril had caused the damage in the form of cracks. The insurer, on the other hand, claimed that the cracks were the faulty material per se, and that there was no damage that was covered by the conditions. This was accepted by the adjuster, who held that there were no «indications in the documentation that the cracks have propagated during service or that the defects have developed since the wheels were hardened». Thus, coverage was not granted.”(6) As cited in Wilhelmsen, Hull Insurance of “Latent defects”, 2004, p. 268

To summarize, it appears that the decisive point is that the defect must undergo some kind of change in order to qualify as a damage. This coincides with the opinion that that the peril must change from a dormant to an active state when it causes a casualty.(7) Wilhelmsen, The distinction between one and more than one insured event, 2003, Ch. 4.1 This solution also shows a consistency between Cl. 2-11 sub-clause 1 and 2. In accordance with sub-clause 1, the casualty occurs when the peril strikes, and there will be causality between the casualty and the damage. If, however, the peril does not strike in a clear manner, the casualty will be deemed to have occurred when the damage starts to develop, which will be the earliest time a causal link between the peril and the damage may be established.

5.2.2 The Term “Part” and the Connection to the Classification Societies

The partial exclusion in Cl. 12-4 is closely connected with the term “part”. The term is used twice in the clause. Firstly, it is used in order to limit the scope of the exclusion, as the exclusion only applies to the “part or parts of the hull, machinery or equipment which were not in proper condition”. Hence, it is only the damage to the defective part that is excluded from cover. Secondly, the term “part” is used as a measure to exclude the exclusion if “the part or parts in question had been approved by the classification society”.

The term “part” implies that an entity may be technically or logically separated or defined as a fraction of a whole. Based on a wide interpretation, it must be assumed that every part of the machinery or equipment can be broken down to the smallest possible parts, such as bolts and nails. A more lenient understanding of the term would favor a technical interpretation where a part is understood to mean a self-contained component of a larger entity.

Due to the magnitude of parts onboard a vessel, it is impossible to give an objective definition of the term “part” that includes every component onboard. The term must rather be interpreted on a case to case basis. However, the Nordic Marine Insurance Plan seems to work with two different definitions of the term “part” within Cl. 12-4.

The first definition is related to the term “part” as used in order to limit the insurer’s liability and refers to the “part or parts of the hull, machinery or equipment which were not in proper condition”. The Commentary suggests on page 294 that it is a question of identifying the “natural unit of repair” for the damage in question. For this definition of a “part”, the technical and economic aspects of the case will be in the center of the evaluation,(8) T. Falkanger, H. Bull, & L. Brautaset, Scandinavian Maritime Law, 2017, p. 661 and the key element is the “natural unit of repair”, as stated in the Commentary. This implies that a “part” is the unit that may be repaired or replaced.(9) T. Wilhelmsen & H. Bull, Handbook in Hull Insurance, 2017, p. 297 Thus, if the cause of damage is faulty material in a bolt, this bolt will be considered a “part” if it is possible to repair or exchange this particular bolt. Similarly, if parts of a steel plate is corroded due to error in design, the entire steel plate must be considered to be the “part”, if it is natural to remove the entire plate and not only the corroded part.(10) T. Falkanger, H. Bull, & L. Brautaset, Scandinavian Maritime Law, 2017, p 661

The second definition is related to the term ”part” used as a measure to remove the exclusion, if “the part or parts in question had been approved by the classification society”. The wording implies that the damaged part must be subject to class approval. It also implies that the term “part” should be interpreted in accordance with the first definition.

However, the Commentary clearly states on page 292 that the term should be interpreted more leniently, and that it is enough that the part “forms part of a larger unit or assembly for which accept criteria have been specified”.

Hence, it appears that the requirement of class approval uses a broader interpretation of the term “part” than the one discussed above. The more lenient interpretation in the Commentary should be seen in connection with how the classification societies approve vessels.(11) T. Wilhelmsen & H. Bull, Handbook in Hull Insurance, 2017, p. 305 The class will not approve every small part or component on a vessel. They will instead approve systems that are central for the safety of the vessel, and their objective is to:

“verify the structural strength and integrity of essential parts of the ship’s hull and its appendages, and the reliability and function of the propulsion and steering systems, power generation and those other features and auxiliary systems which have been built into the ship in order to maintain essential services on board”.(12)http://www.iacs.org.uk/media/3784/iacs-class-key-role.pdf

Consequently, the classification societies do not classify every minor part of the vessel, but carries out a control of vital parts and systems. Hence, the insurer cannot require that the assured gets every part approved by class, as this would place a disproportionate burden on the assured.

Still, the class approval is used as a safety measure for the insurer.(13) T. Wilhelmsen & H. Bull, Handbook in Hull Insurance, 2017, p. 305 If the classification society deems a part to be safe, the risk of damage due to untested design may decrease significantly. Hence, the insurer must be able to require a more specified class approval, rather than a general approval of the vessel all-together. This leaves the question of how the term “part” should be interpreted in connection to the requirement of class approval in order to balance insurer’s need for a safety measure with how the classification societies actually carry out their approvals.

The classification societies control the essential systems of the vessel, which implies that the interpretation of a “part” should be seen in connection with the system it forms a part of, as for example the steering and propulsion system, and the auxiliary system. The different parts in a system may have different functionalities, but the system should have the same purpose.

It could be argued that the definitions in Cl. 12-4 provides a low degree of foreseeability for both the assured and the insurer, and that it allows for unnecessary conflicts between the parties. The solution might have worked better when the systems and machinery in the industry were less complex. However, neither of the definitions seem to have taken into account the complexity of newer designs and the emerging technology within the business. The importance of the two definitions are crucial for the totality of the insurance cover. Firstly, it will decide which part or parts that are excluded from cover. Secondly, it will decide whether those parts might be recoverable after all. Consequently, it may have a great effect on the settlement amount, which further increases the need for a clear rule.

On the other hand, it could be argued that it is the complexity of the new technology that makes it impossible to create absolute and objective rules. Furthermore, it could be argued that as the costs of renewing the defect part are often low, the total effect on the settlement amount will be minor. However, with this line of reasoning, it brings the question of whether the rule is superfluous, as the monetary effect might be low compared to the possible conflicts it may create.

Still, the rule concerning error in design and faulty material has remained relatively unaltered since the 1964 version.(14) See § 175 in the 1964 version. Still, the Commentary has undergone several changes This long tradition indicates that the rule works well in practice. Furthermore, the contract is negotiated with all relevant parties in the industry, which indicates that the result is balanced and benefits all parties equally. This presumed balance is a very good reason to trust that the wording provides a fair and reasonable result.(15) T. Wilhelmsen, Flexibility, foreseeability and reasonableness in relation to the Nordic Marine Insurance Plan 2013, 2013, p. 64

5.2.3 The Economic Extent of Cover

The Nordic Marine Insurance Plan operates with a distinction between the primary and consequential damage. The primary damage is considered to be the direct consequence of the peril, whilst any other damage emerging due to the primary damage is considered to be consequential damage. Wilhelmsen describes the primary damage as the part that “was the first that was struck and consequently triggered the casualty”, whilst it is a consequential damage when “the casualty can be traced back to another factor, where the part concerned was struck as a result of this factor”.(16) T. Wilhelmsen, The Norwegian Marine Insurance Plan and Substandard ships, 2000, p. 236

The distinction is also used within other types of non-marine insurances, and Nygaard describes the consequential damage as

“… consequent upon the factual/historical development of the damage. (…) Thus in this instance it is a question of a chain of causation leading from the primary damage to the subsequent development of the damage or secondary damage”.(17) N. Nygaard, Placing the Burden of Proof of a Hypothetical Cause, 2001, p. 441

In Cl. 12-4 the distinction between the primary and consequential damage is demonstrated in the wording “the insurer is not liable for the costs of renewing or repairing the part or parts of the hull, machinery or equipment which were not in proper condition”. Thus, the clause only excludes cover for the primary damage – the part which was damaged due to faulty material or error in design.(18) Provided that the part was not approved by a classification society The exclusion does not apply to the losses occurring as a consequence of the primary damage.

The rule of consequential losses may result in random coverage of losses for the assured.(19) S. Brækhus & A. Rein Håndbok i kaskoforsikring, 1993, p. 112 If the assured notices or becomes aware of the error in design or faulty material before it manifests in a damage, the entire rectification will be for the assured’s account, even if the chance of a damage occurring is imminent. If, on the other hand, the assured becomes aware of the defect because of the damage, all consequential losses will be covered as a minimum.

The rules concerning primary and consequential damage allows the insurer to exclude the costs related to renewing the part that was defective prior to the damage, provided that the part was not class approved. Hence, it is a measure that seeks to balance the countervailing considerations of losses caused by faulty material and error in design. The exclusion of the costs of repairing the defective part places the risk of a poor business risk with the assured. At the same time, the assured will be compensated for the larger extent of the loss, the consequential damage, which will to a higher degree be unforeseeable.

Another aspect of the economic extent of cover is the general principle that the assured should not benefit from an insurance claim. When a defect results in a damage, the repairs will include both damage repairs and rectification of the defect. Cl. 12-4 only excludes costs related to the primary damage, also provided that the part was not approved by class. Thus, any other costs related to rectifying the defect will not be included in the exclusion. To ensure that the assured does not gain from the insurance settlement, Cl. 12-4 must be seen in connection with Cl. 12-1. It is stated in Cl. 12-1 sub-clause 1 that:

“If the vessel has been damaged without the rules relating to total loss being applicable, the insurer is liable for the costs of repairing the damage in such a manner that the vessel is restored to the condition it was in prior to the occurrence of the damage.”

The principle of betterments is further specified in Cl. 12-1 sub-clause 3:

“If the repairs have resulted in special advantages for the assured because the vessel has been strengthened or the equipment improved, a deduction from the compensation shall be made limited to the additional costs caused by the strengthening or the improvement.”(20) The content of Cl. 12-1 sub-clause 3 is only a clarification of sub-clause 1, and is to some extent superfluous, cf. Commentary p. 280

The starting point in Cl. 12-1 is that the assured shall be compensated for all costs in connection with the repairs, and thus be put in the same economic situation as before the damage occurred. Hence, Cl. 12-1 directly addresses the principle that the assured should not benefit from the casualty.

The connection between the Cl. 12-1 and Cl. 12-4 is emphasized in the Commentary on page 294:

“…the principles in Cl. 12-1 apply and the insurer is not liable for any additional costs that are incurred for the purpose of rectifying the original error. The insurer’s obligation under Cl. 12-1 is to pay for the cost of restoring the vessel to the same condition it had before the casualty. The extra costs of any improvements must be for the account of the assured.”

Consequently, Cl. 12-4 is supplemented by Cl. 12-1. As a result, the assured will not get compensated for the costs of rectifying and improving the faulty material or error in design, even if the defective part was approved by the classification society. However, the deduction is “subject to the condition that the strengthening or the improvement has made the repairs more expensive”.(21) Commentary, p. 280

To summarize, the economic extent of cover in Cl. 12-4 will to some extent work as a measure to ensure that risk connected to faulty material and error in design is placed for the assured’s account. At det same time, the consequential losses, which will be more unforeseeable, are covered by the insurance. Consequently, Cl. 12-4 balances the countervailing considerations and principles that apply for losses caused by error in design and faulty material. The clause does not, however, exclude all expenses related to improvement of the defective material or design. The consolidated structure of the Nordic Marine Insurance Plan ensures that the general principles in Cl. 12-1 supplements Cl. 12-4. This way, compensation is limited to the actual costs of restoring the vessel and thus ensures that the assured does not benefit from the damage.