Australian decision takes opposite view to the English court on whether depreciation amounts to a saving in Business Interruption calculation

An Australian state Court of Appeal decision has expressly rejected the reasoning of Mr Justice Flaux (as he then was) in the English High Court case of Synergy Health (UK) Ltd v CGU Insurance Plc [2010] EWHC 2583 (Comm), finding that depreciation is not to be deducted as a "saving" when quantifying loss of Gross Profit under a business interruption policy.

Background

A warehouse owned by the policyholder (Mobis Australia) collapsed during a severe storm, causing damage to plant and equipment. The policyholder claimed indemnity for losses arising from the collapse under its property damage and business interruption insurance policy: Mobis Parts Australia Pty Ltd v XL Insurance Company SE [2018] NSWCA 342.

Under the policy, the policyholder was covered for loss of "Gross Profit" as a result of business interruption consequential upon loss of or damage to insured property. The policy provided for the assessment of loss of Gross Profit on the following basis:

"The insurance under this chapter is limited to loss of Gross Profit due to (a) Reduction in Turnover and (b) Increase in Costs of Working, and the amount payable as indemnity under this Policy shall be:

(a)   in respect of the reduction in Turnover: the sum produced by applying the Rate of Gross Profit to the amount by which the Turnover during the Indemnity Period shall in consequence of the Damage fall short of the Standard Turnover

…

less any sum saved during the Indemnity Period in consequence of the Damage in respect of such of the charges and expenses of the Business payable out of Gross Profit".

(emphasis added)

The parties agreed that, in the 12 month period after the damage to the warehouse had occurred, the policyholder would have, but did not, make provisions totalling $1,449,509 for depreciation of plant and equipment destroyed in the collapse.

Decision

One of the issues in the case was whether a reduction on non-cash costs such as depreciation following insured damage amounts to a "saving" to the policyholder which is to be deducted from insured Gross Profit when calculating business interruption losses.

At first instance, the trial judge followed the decision of Flaux J in Synergy Health in the English High Court (in relation to a policy which had terms indistinguishable from those under consideration in this case), finding that the depreciation expense which was no longer recorded in the policyholder's financial records because the assets in question were destroyed was an "expense…payable out of Gross Profit" which had been "saved" for the purpose of quantifying the indemnity under the policy. This meant that the depreciation expense was to be offset against any indemnity.

The NSW Court of Appeal unanimously reversed the trial judge's decision and expressly rejected the reasoning of Flaux J in Synergy Health. The NSW Court of Appeal defined depreciation as:

"the systematic allocation of a tangible asset's cost (less its anticipated scrap value) as a series of expenses over its expected useful life…Each depreciation expense appears in the income statement as an expense deducted from gross profit for the purpose of calculating net profit…but the process of depreciation has no direct impact on cash flows".

The NSW Court of Appeal concluded that the use of the word "payable" in the phrase "payable out of Gross Profit" as opposed to the word "deducted" suggested the exclusion of charges and expenses that are not liable to be paid away, such as depreciation.

The different conclusions reached by the English High Court in Synergy Health (as followed by the trial judge) and the NSW Court of Appeal largely turned on a difference of opinion as to the weight to be placed on the indemnity principle of insurance in the face of the language of the policy contract.

Flaux J in Synergy Health found that the policyholder would "recover an indemnity for more than its actual loss in respect of business interruption" if depreciation was not deducted from Gross Profit and concluded that such an outcome should not be reached "unless no other conclusion is possible". The result, as he has admitted, somewhat stretched the language in the policy. In effect, the English High Court determined that the indemnity principle coloured the meaning of the language of the provisions for the assessment of loss.

In contrast, the NSW Court of Appeal placed greater weight on the importance of upholding the bargain that was struck between the contracting parties, as expressed by the words of the insurance contract. It concluded that the formula for the assessment of insured loss of Gross Profit qualified the application of the indemnity principle insofar as it might be said to depart from perfect indemnification. The NSW Court of Appeal favourably cited Greer J in Henry Booth & Sons v The Commercial Union Assurance Co Ltd (1923) 14 Lloyds LR 114, stating:

"It is common practice in policies of this sort, in order to prevent lengthy disputes, that there should be an agreed method of ascertaining the loss. Sometimes the assessment of the loss is in favour of the assurance company and sometimes the assured…"

The NSW Court of Appeal also hinted at the fallacy of the assumption that, if depreciation was deducted as a saving, perfect indemnification would necessarily be achieved. For example, it noted that depreciation charges are often overstated in the early years of an asset's life, meaning that if the equipment is destroyed during this period the "saving" on depreciation that is charged in the accounts of the business may not reflect the actual cost of depreciation. Similarly, although the policyholder may in one sense be over-indemnified if replacement property is in better condition than the destroyed property at the time of damage, this benefit may be offset by adjusted depreciation costs into the future.

As the NSW Court of Appeal highlighted, inquiries as to whether a policyholder has been over or under indemnified (which could easily manifest in a dispute), are intended to be prevented by the application of a formula for the assessment of the loss.

Comment

The decision of the NSW Court of Appeal which appears based on sound reasoning may well open up the debate again about the treatment of depreciation charges in business interruption policies and in particular whether "charges and expenses of the Business" that are "payable out of Gross Profit" mean only cash reductions or include all expenses in the accounts deducted from gross profit for the purpose of calculating the net profit of the business.

The Insurance Institue of London in collaboration with the Chartered Institute of Loss Adjusters published a report in October 2012 titled 'Business Interruption Policy Wordings - Challenges Highlighted by the Claims Experience'. On the topic of depreciation savings, the report recommended that insurers revised policy wordings to make it clear whether savings were inclusive or exclusive of depreciation. Clarity in the policy wording would enable insurers to charge a premium that properly reflected the risk assumed, while brokers and policyholders would gain clarity on the scope of cover. Despite the report's recommendation and the publicity this topic has received in recent years, the majority of policies remain silent on the issue. We are only anecdotally aware of a handful of policies that explicitly state that depreciation is not a saving.