Legal Blog

Fire

Mortgagors carry insurance on the mortgaged property, as all good mortgagors should do. The insurance policy contains the standard mortgage clause and notes the interest of the mortgagee in the policy. The property burns, the mortgagee applies for the insurance proceeds, and the insurer pays. Right? Not necessarily, says the Ontario Court of Appeal in a 2004 decision in Royal Bank of Canada v. State Farm Fire and Casualty Company.

Background 

Mortgagors insured a property with a homeowners’ policy through State Farm. The interest of the first mortgagee was noted on the policy. The mortgagors then defaulted on their mortgage to the Bank and the Bank initiated foreclosure proceedings. The mortgagors moved out of the property on November 19, 1999. The Bank, who had hired a property manager to make weekly checks on the property, took possession of the property on November 20, 1999. It changed the locks, drained the plumbing, and emptied the hot water tank. In short, it did everything a good mortgagee would do to secure the property. Or did it?

During the enforcement proceedings, a fire destroyed the property. State Farm refused to pay the Bank the insurance proceeds because the Bank had not notified it that the property was vacant, contrary, it alleged, to the insurance policy.

Contract 

The outcome of the case depended almost entirely on the interpretation of the insurance contract. It had three important clauses:

1.   The vacancy exclusion. This clause excluded State Farm’s liability to pay if the property was vacant for more than 30 days.

2.   Statutory Condition No 4 (“Stat 4”). By virtue of the Insurance Act, this condition is deemed to be part of every contract of fire insurance and states, “any change material to the risk and within the control and knowledge of the insured voids the contract … unless the change is properly notified in writing to the insurer.” Once notified, the insurer may then cancel the policy or increase the premium.

3.   The mortgage clause. This clause insulated the mortgagee from improper actions of the mortgagor. However, the protection was subject to the proviso that “The mortgagee shall notify forthwith the insurer … of any vacancy … extending beyond 30 consecutive days … that shall come to his knowledge.”

The mortgage clause is a saving clause. It trumps the other clauses in the insurance policy if they differ from the mortgage clause. Accordingly, the court had to determine whether the vacancy exclusion or Stat 4 was inconsistent with the mortgage clause and therefore of no effect. If either the vacancy clause or Stat 4 did apply, was the applicable clause breached?

Vacancy Exclusion 

The Court had little problem deciding that the vacancy exclusion was inconsistent with the terms of the mortgage clause. Under the vacancy exclusion, the policy was automatically voided 30 days after vacancy. Notice was irrelevant; the knowledge of the mortgagee was irrelevant. The provisions of the mortgage clause that were inserted to benefit the mortgagee were made irrelevant. The Court held that while the vacancy clause affected the rights of the mortgagor, it was ineffective to negate the claim of the mortgagee.

Statutory Condition No. 4

Unlike the vacancy exclusion, Stat 4 and the mortgage clause can co-exist quite nicely. While the mortgage clause protects the mortgagee from the misdeeds of the mortgagor, Stat 4 makes the mortgagee, who is also an “insured”, responsible for increases in risk within the mortgagee’s own knowledge and control.

The Court held that “the mortgage clause is concerned with the conduct of the mortgagor and the mortgagee’s obligations if and when that conduct comes to the attention of the mortgagee. Statutory Condition No. 4 is concerned with the conduct of insured, including insured who are mortgagees. It addresses the consequences of the mortgagee’s actions which materially affect the insured risk.”

Both the motions judge and the Court of Appeal agreed that a material change in risk occurred when the mortgagor vacated the premises. The difference between the analyses of the motions judge and the Court of Appeal related to their interpretations of the duties of the mortgagee. The motions judge noted that Stat 4 necessitated notice only when the mortgagee had knowledge and control. He then held that the mortgagee had no control to enable it to reverse the change in risk until after foreclosure when it took title to the property and, therefore, the Bank did not have to give notice until then.

The Court of Appeal disagreed. It felt that Stat 4 did not refer to a mortgagee’s ability to undo the additional risk that the mortgagor’s conduct created; rather, one had to determine whether the risk from the date of the insurance policy had increased in all the circumstances and whether at some point the mortgagee obtained knowledge and control of that increase in risk. The Court noted that the Bank had gone into possession to protect the property and, in doing so, acted prudently. However, the “continued vacancy after November 20 and the effective possession and control of the property by the mortgagees after that date were ‘within the control and knowledge’ of the mortgagees and materially increased the risk when compared to the risk that State Farm had agreed to insure.”

Since the Bank chose not to give notice when it took possession, it voided the insurance contract.

Future

In light of this decision, if a mortgagee takes possession of property, it must notify the insurer that the property is vacant and either pay increased premiums or arrange its own insurance.

In Royal Bank, the Court indicated that control did not occur until the mortgagee took possession of the property. This seems to be reasonable. However, we foresee an insurer attempting to stretch the limits of this case by claiming that a mortgagee ought to give notice when the mortgagee is capable of taking control and has knowledge of the vacancy, regardless of whether the mortgagee actually takes possession.