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The English and Scottish Law Commissions are continuing their work
on the reform of insurance contract law. Sarah Turpin assesses the
likely impact of their latest proposals.
CONTRACT LAW
THE LATEST
T
he law governing insurance contracts is
outdated, complex and does not always
favour the policyholder. The interests of the
policyholder, which to date have received
little attention from the legislature, are finally getting the attention they deserve.
The English and Scottish Law Commissions are
undertaking a detailed review of insurance contract
law. In July, they published a joint consultation
paper setting out their provisional proposals for
reform in three specific areas:
1. misrepresentation and non-disclosure by the
insured before the insurance contract is made
2. warranties and similar terms
3. cases where an intermediary or broker was
wholly or partly responsible for pre-contract misrepresentations or non-disclosures.
The aim behind the proposals is to ensure that
the law ‘balances the interests of insured and
insurer, reflects the needs of modern insurance
practice and allows both insured and insurer to
know their rights and obligations’. If this aim is to
be achieved, there needs to be some further shifting
of the scales in favour of the policyholder.
Need for reform
The current law derives many of its principles from
the Marine Insurance Act 1906 which, despite its
name, is generally understood to apply to all types
of insurance. The Commissions have concluded that
some of these principles do not meet ‘policyholders’
reasonable expectations’ and no longer suit a
modern insurance market.
This is not the first time such a conclusion has
been reached. It has long been recognised that certain areas produce unexpected and unjust results
for policyholders. As a result the current law has
been adapted, particularly where consumers are
concerned, by the introduction of non-binding
statements of practice, FSA rules and the Financial
Ombudsman Service (FOS) which applies a ‘fair and
reasonableness’ approach to determine coverage
disputes involving consumers.
The problem is that there is no real consistency in
approach, which results in unpredictability, particularly where consumers are concerned. Most busi-
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nesses are forced to rely upon the strict law, which,
while in some respects more predictable, is heavily
weighted in favour of the insurer.
The proposed reforms will apply to all classes of
insurance (and reinsurance) but deal separately with
businesses and consumers. For consumers, a
mandatory regime is proposed, based largely on the
existing FOS guidelines. For businesses, the proposal is for a ‘default’ regime based on ‘accepted
good practice’, which would apply in the absence of
agreement to the contrary. There would also be protective measures for businesses which deal on the
insurers’ standard terms.
Misrepresentation & non disclosure
The current law imposes a strict duty on the
insured to disclose all material facts, and to avoid
any material misrepresentations, prior to the inception of the policy.
Most brokers are careful to highlight the disclosure obligation to their clients, and many insurers
include warnings on their standard policy wordings.
The problem is that, even if the insured is aware of
the duty, the question of what is ‘material’ is determined with reference to what would influence the
‘prudent insurer’ when assessing the risk. How is
the insured to predict what the ‘prudent insurer’
would regard as material?
The other problem is that the remedy for breach
of the duty is draconian. If the insurer can demonstrate that, if the information had been disclosed or
not misrepresented, then it would not have written
the policy (or would not have done so on the same
claims had all relevant information been provided.
The main feature of the mandatory proposals for
consumer policyholders is abolition of their duty to
volunteer information. The insurer would be under
an obligation to ask questions to extract the
required information and would not be entitled to
avoid the policy for non-disclosure if the relevant
question had not been asked.
The duty on consumers would be to answer questions honestly and to take all reasonable care to
answer questions accurately and completely. An
insurer would have a remedy where it could show
that the consumer made a misrepresentation which
induced the insurer to enter into the contract
(which is the requirement under the existing law),
but the misrepresentation would have to be one
which ‘a reasonable person in the circumstances’
would not have made. This shifts the test of materiality from that of the ‘prudent insurer’ to that of the
‘reasonable insured’.
The remedy available to the insurer would
depend upon the nature of the misrepresentation. If
the misrepresentation was reasonable (or what is
currently termed innocent) then there would be no
remedy and the policyholder would be protected. If
the misrepresentation was negligent (because the
consumer should have known it was inaccurate and
relevant) then the insurer would be granted a compensatory remedy. This would be designed to put
the insurer in the position it would have been in had
it known the true facts. If the misrepresentation was
deliberate or reckless (because the consumer must
have known it was inaccurate and that it mattered
to the insurer) then the
insurer would be entitled
to avoid the policy.
The proposal for business insureds is that the
duty of disclosure should be maintained but modified. The proposed modification relates to the test
of materiality. Business insureds would no longer be
required to disclose what a ‘prudent insurer’ would
want to know but only information that a ‘reasonable insured’ would recognise in the circumstances
to be relevant. This is the default rule which would
apply unless the parties agreed otherwise.
The abolition of 'basis of contract'
clauses is a welcome development
terms), it is entitled to avoid the policy from inception. This is the case regardless of whether the nondisclosure or misrepresentation was fraudulent,
negligent, or entirely innocent. It also makes no difference if the facts not disclosed or misrepresented
have no relevance to, or connection, with any
claims that have been made. The insurer is entitled
to refuse all claims even if it would have paid such
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INSURANCE
The time has come to introduce
a more level playing field
addressing their mind to that of the ‘prudent
insurer’. The fact is that, whatever the test, the
insurer is clearly in the best place to determine what
information is relevant to their assessment of the
risk. There should therefore be greater onus on the
insurer to ask the relevant questions required to
extract that information, whether in the business or
the consumer context.
The Commissions clearly recognise that the
remedy of avoidance has the effect of ‘over-compensating’ the insurer for the loss suffered. In the light
of this, there seems to be no real justification for
retaining avoidance as the default remedy where the
non-disclosure or misrepresentation is merely negligent. It seems that some insurers have been arguing
that the remedy should be retained on the basis that
strong incentives are required to encourage businesses to act carefully with regard to their disclosure obligations. The same might of course be said
of insurers ie that they should be given strong
incentives to ask the right questions of their
insureds to ensure that they extract all relevant
information.
Insurers have for too long had the comfort of
knowing that, if they fail to extract all relevant
information, they may have the option of avoiding
the policy. The time has come to introduce a more
level playing field. The avoidance remedy, given its
harsh consequences, should be limited to circumstances where the non-disclosure/misrepresentation
was deliberate or reckless.
Warranties
With regard to misrepresentations, the proposal
is for a default regime similar to the scheme outlined above for consumers. The insurer would need
to show that the business made a misrepresentation
which induced the insurer to enter into the contract
and which a ‘reasonable person’ in the circumstances would not have made. In other words, a
business insured which acted honestly and reasonably should be protected from policy avoidance,
unless of course the insurance contract provides
otherwise.
In terms of remedies, the Commissions invite
views on whether the remedy of avoidance should
be reserved for dishonest conduct, with a compensatory remedy being provided for negligent misrepresentation or non-disclosure, or whether the avoidance remedy should also be retained for the latter.
The proposed modification of the test of materiality sounds good in principle but does it really
solve the problem? In practice, the abolition of the
‘prudent insurer’ test should remove the need for
expert evidence from an insurer, but how would the
issue of what a ‘reasonable insured’ would regard as
material be determined? Some critics have suggested that the only way a ‘reasonable insured’
would determine what was material would be by
Warranties are promises of past, present or future
facts. Under the current law, if a statement which is
‘warranted’ proves to be incorrect, the insurer is discharged from all liability under the policy and is
entitled to reject all claims from the date of breach.
This is the case regardless of materiality and regardless of whether the statement induced the insurer to
enter into the contract. Where an insured gives a
warranty as to future actions, such as the maintenance of a burglar alarm, any breach will discharge
the insurer from liability, even for a claim which has
no connection to the breach.
Many insurers have adopted the practice of con-
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There should be greater onus on the
insurer to ask the relevant questions
verting statements in the proposal form into warranties by means of a ‘basis of contract’ clause. This
provides that any statements in the proposal form
(and in any documents supplied with it) are incorporated into and form the basis of the contract. The
legal effect of this apparently innocuous wording is
to convert any statements in the proposal into warranties, breach of which discharges the insurer from
all further liability. In the business context, this
might include any statements in the financial
accounts, copies of which are often provided to
insurers with the proposal form. Few policyholders
(whether consumer or business) understand the
implications of these types of clause which, despite
heavy criticism, are still in regular use.
Proposals for warranties
The proposal for consumers is that any statement of
past or current fact should be treated as a representation rather than a warranty. Basis of contract
clauses would also be abolished in the consumer
context. This would mean that, if the consumer
made an incorrect statement in the proposal form,
the insurer would not be discharged from liability.
The remedy available would depend upon whether
the incorrect statement was made innocently, negligently or recklessly.
For business insureds, warranties of past or present fact would still be permitted and liability would
remain strict. In other words, it would not matter
that the insured was unaware that the warranty was
incorrect at the time it was given. The remedy for
breach of these types of warranty would, however,
be modified. The insurer would only be entitled to
refuse any claims on the grounds of breach of warranty where it could be shown that the breach was
material and had some connection to the loss. This
would be the default regime and it would be open to
the parties to agree other consequences if they
wished. The parties would not, however, be entitled
to convert all statements in the proposal form into
warranties by means of a basis of contract clause.
The contract would need to specify which facts
were to be given warranty status.
Warranties as to future facts, where consumers
are concerned, should be enforced in accordance
with existing FOS guidelines. These stipulate that an
insurer may only refuse to pay a claim for breach of
warranty if it has taken sufficient steps to bring the
requirement to the consumer’s attention. If the consumer can prove on the balance of probabilities that
the event or circumstance constituting the breach
did not contribute to the loss then the consumer
should be entitled to recover.
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For business insureds, the proposal is similar to
that for consumers. If the business can prove that
the event or circumstance constituting the breach
did not contribute to the loss then the business
should be entitled to recover. Unlike for consumer
insurance, however, this would be the default rule
and it would be open to the parties to agree other
consequences. The remedy for a breach of warranty
would be to enable the insurer to terminate cover
for the future but the insurer would not be automatically discharged from liability.
For standard term contracts, which are used in
the business context but are not subject to negotiation, the insurer should not be permitted to rely
upon a warranty if this would render the cover ‘substantially different’ from what the insured ‘reasonably expected’. This will depend in practice on how
the insurer presented the policy to the insured.
The abolition of ‘basis of contract’ clauses is a
welcome development. The concern is, however,
that insurers will rely heavily on their ability to contract out of the default regime, with the result that
the proposed reforms will have limited benefit for
business insureds. In practice, many business risks
are placed on the basis of standard policy wordings
drafted by insurers (with input from their lawyers),
often with a view to taking full advantage of the
legal remedies available to them. This is reflected in
the fact that most standard policy wordings include
a basis of contract clause.
While the proposal is that standard policy wordings should be subject to ‘specific controls’, this will
not actually prevent insurers from imposing warranties, nor from contracting out of the default
regime, in their standard wordings. It will be up to
the business insured to demonstrate that the insurer
cannot rely upon such terms, in the event that a
claim is rejected, on the basis that it would defeat
their ‘reasonable expectations’ of cover. If the
insurer can demonstrate that the insured knew
about the term, and its implications, then the term
would be upheld, even if the insured could demonstrate that it had no option other than to accept it.
This is rather unsatisfactory from the point of view
of the policyholder.
Pre-contract information and
intermediaries
Under the current law, an insurance intermediary or
broker is generally regarded as the agent of the
insured rather than the insurer. This has important
implications as, if the broker fails to disclose or misrepresents any facts prior to inception, that non-disclosure or misrepresentation will be attributed to
the insured. This means that the insurer will be entitled to avoid the policy regardless of whether the
insured provided the broker with the incorrect
information. Thus, the insured bears responsibility
for any mistakes made by the broker in relation to
the presentation of the risk.
The current proposal is that this should remain
the position, for both consumer and business insurance, where the intermediary is clearly independent
of the insurer and acting on the insured’s behalf. In
other cases, the proposal is that an intermediary
should be treated as acting for the insurer. This is
more likely to apply in the consumer context and
will not affect businesses who use brokers to search
the market for them nor where the insured pays the
broker a fee or commission.
In the business context, these proposals are
unlikely to have much impact, given that most large
businesses instruct brokers to act as their own
agents to search the market and negotiate the best
cover available. The issue which is not addressed by
the reforms, and which has recently aroused controversy, is the practice whereby brokers (despite
being agents of the insured) are paid by the insurer.
The next steps
The Commissions are seeking responses to the provisional proposals by 16 November 2007. A separate consultation paper will be published in 2008
dealing with the remaining topics: post-contractual
good faith, insurable interest and damages for late
payment of claims. When the scope of the reforms
has been decided, the Commissions will then consider how they should be implemented (whether by
means of amendments to the 1906 Act or an
entirely new Insurance Act) and whether there is a
need to codify insurance law more generally.
Sarah Turpin is associate in the insurance coverage practice
group at Kirkpatrick & Lockhart Preston Gates Ellis LLP,
Tel: 0207 360 8285, E-mail: sarah.turpin@klgates.com
K&L Gates will be submitting responses on behalf of policyholders and would welcome comments for inclusion.
BACKGROUND
In early 2006, the Commissions published a scoping paper which set out possible areas for reform
(see earlier article Is the Tide Turning?,
StrategicRISK June 2006). The Commissions have
since produced several issues papers seeking further views which have led them to modify their
proposals.