This article considers the impact of underinsurance by the insured under property and business interruption insurance policies. Such policies will commonly include an average clause permitting the insurer proportionately to reduce the value of the claim for underinsurance. The Insurance Act 2015 provides the insurer with proportionate remedies for breach of the duty of fair presentation, including a right to reduce claims proportionately if it would have charged more premium. So what remedies would an insurer have under the Act in the event of underinsurance: could it avoid the policy, apply average or even 'double dip' by applying average and then proportionately reducing the claim again under the Act?
1. The current law
Avoidance for material non-disclosure or misrepresentation
Under the Marine Insurance Act 1906, an insurance policy is a contract of the utmost good faith. The insurer may avoid a non-consumer insurance policy if the insured fails to disclose all material circumstances or makes material misrepresentations before the policy is concluded. A circumstance or representation is material if it would influence the judgement of a prudent insurer in fixing the premium, or determining whether to take the risk. If the insurer avoids the policy, it is treated as if the policy had never existed and all previous successful claims under that policy must be repaid by the insured.
Under the current law, avoidance is the sole remedy for breach of the duty of disclosure in respect of non- consumer insurance policies. This is often perceived as unbalanced given the draconian nature of the remedy and the lack of any alternative remedy that may reflect a fair outcome in the circumstances. The potentially unjust nature of the remedy of avoidance was recently described by the High Court as “a blot on English insurance law”.1
Application of average
Average is a mechanism which reduces policy claims proportionately in the case of underinsurance or undervaluation. It applies automatically in marine insurance (but not in non-marine insurance). Section 81 of the
Marine Insurance Act 1906 provides that: "Where the assured is insured for an amount less than the insurable value or, in the case of a valued policy, for an amount less than the policy valuation, he is deemed to be his own insurer in respect of the uninsured balance".
Average clauses are now common in non-marine insurance, particularly commercial property and business interruption insurance (unless the policy is on a declaration linked basis). They apply to reduce the policy claim in the ratio that the insured value, based on the declared values for property and/or gross profit, bears to the actual value at the time of loss. Thus, if the insured value is only 50% of the actual value, the insured will only be able to claim 50% of any loss under the policy. This mechanism encourages the insured to make correct and accurate statements of value before concluding the policy.
The challenge of accurately declaring insured values is one of the major issues faced by insurance and risk managers. Under-declarations can leave insureds seriously underinsured in the event of a major loss and, on top of that, result in a proportionate reduction of the claim through the application of average. The insurer loses out too: if values are being under-declared, then it is not receiving full premium income for the risk.
In contrast, some business interruption policies are written on a declaration linked basis with no proportionate reduction (average clause) in the case of underinsurance. Under a declaration linked policy, the insured declares at the outset of the policy its estimated gross profit for the policy period. The premium is calculated based on this initial estimate but is subject to adjustment (upwards or downwards) at the end of the policy based on a second declaration by the insured of its actual gross profit for the policy period. The insurer's liability will usually be limited to 133.3% of the estimated gross profit figure. Thus, if, for example, an insured estimates its gross profit at £1 million whereas its actual gross profit transpires to be £2 million, the insurer will be due an additional amount of premium and, in the event of a claim, its liability will be capped at £1.33 million but it will not be entitled to apply average for underinsurance. In practice, however, declarations of actual gross profit are very often not made and no premium adjustment is made.
Remedy for underinsurance
Where the policy contains no average clause and is not on a declaration-linked basis, the insurer is protected against underinsurance by having the right to avoid the policy for material non-disclosure or misrepresentation. On the face of it, any under-declaration that impacts the premium charged may in principle be material.
There is some uncertainty as to whether, and if so in what circumstances, the insurer may avoid a policy containing an average clause for material non-disclosure or misrepresentation in relation to underinsurance. There is a vacuum of authority on this point.
In Economides v Commercial Assurance Co Plc  3 WLR 1066, the insured’s flat was burgled and property worth around £31,000 was stolen, whereas under the insured's household policy the sum insured for contents was only £16,000. The insurer sought to avoid the policy. The insured disputed the insurer's right to avoid the policy but conceded that these facts were material. The Court of Appeal found, however, that the insurer could not avoid the policy because the insured’s relevant representation, namely that he believed the particulars given were true, had been made honestly, which was all that was required. Simon Brown LJ commented obiter that certain aspects of the insured's concession as to materiality made him uneasy:
"Ordinarily, therefore, it appears, under-insurance, so far from being regarded as material non-disclosure justifying the avoidance of the policy, results instead in averaging, or indeed in full recovery without penalty. Why then should the position be so very different in the present case, not least given that the policy itself expressly envisages at least some degree of under-insurance… And that leads me to the second point. Just how substantial must be the extent of under-insurance… before it is said that, assuming always that the insured had knowledge of these facts, that the policy can be avoided on the grounds of non- disclosure?"
MacGillivray on Insurance Law (13th edition) submits that the contrary argument to the above is that "the value of the property is important in calculating the applicable premium, and the presence of a number of articles of disproportionately high value might have a bearing on the risk of theft" (paragraph 17-072).
The generally perceived wisdom in the industry likewise appears to be that a serious under-declaration may entitle insurers to avoid the policy. For example, the Chartered Institute of Loss Adjusters has commented in relation to business interruption insurance that in its view:
"A very significant under-declaration may constitute a failure to adequately disclose the nature of the risk presented, which might support avoidance of the policy. Notwithstanding this view … such an approach may be seen as a heavy-handed response, particularly where the BI element of a claim in a specific instance may not be large."2
In short, it is unclear in what circumstances (if at all) an insurer may avoid a non-consumer insurance policy containing an average clause for material non-disclosure or misrepresentation of insured values. The answer to this question is unlikely to be black-and-white but rather to turn on the facts in each case. In our view, in serious cases of underinsurance, the insurer would likely to be entitled to avoid the policy. An example of this may be a deliberately false declaration of insured values.
Similarly, there is a dearth of authority on underinsurance in declaration linked policies. A declaration of estimated gross profit is likely to be construed as a representation of expectation or belief rather than a statement of fact. It would therefore be treated as true if it were made in good faith such that the insurer would only have a right to avoid the policy for underinsurance if the under-declaration of estimated gross profit were made dishonestly. That may be the case where the insured has deliberately under-declared, knowing that there is a 133.33% uplift applying to the estimated gross profit figure. In these circumstances, where the insurer does not benefit from an average clause, it may well have grounds to avoid the policy for material misrepresentation.
Overall, however, the lack of case law and commentary on these issues is an indicator of the practical reality that, broadly speaking, insurers prefer to eschew the 'nuclear' option of ultimately seeking to avoid the policy – whether on a sum insured or declaration linked basis – and instead to adjust claims by applying average (and relying upon the liability cap in declaration linked policies) in cases of under-insurance.
2. The Insurance Act 2015
Duty of fair presentation and new regime of proportionate remedies
The Insurance Act 2015 (the Act) applies to all insurance (and reinsurance/retrocession) policies and variations to existing policies made on or after 12 August 2016.
Under the Act, the insured under a non-consumer insurance contract must make a "fair presentation of the risk" to the insurer. This duty replaces the existing duty relating to disclosure and representations although it retains many key aspects of the existing duty.
Unlike the current law, where the insurer's only remedy for breach of the duty of disclosure is avoidance of the policy, the Act provides for a range of proportionate remedies if the insured breaches the duty of fair presentation. If the breach is deliberate or reckless, the remedy of avoidance will still be available and the insurer may keep the premium. For all other breaches, the onus is on the insurer to show what it would have done had it received a fair presentation of the risk:
- The insurer will still be entitled to avoid the policy (but must return the premium) if it can show that it would not have entered into the contract;
- If the insurer shows that it would have entered into the contract but on different terms, then it may treat the policy as having included those terms from the outset; and
- If the insurer would have entered into the contract but only at a higher premium, the insurer may reduce the amount to be paid on the claim proportionately. Thus, if it would have charged double the premium, it is only liable to pay 50% of the amount of the claim.
It is open to the parties to contract out of these provisions of the Act subject to the 'transparency' requirements, meaning essentially that the 'disadvantageous term' must be brought to the insured's attention and be clear and unambiguous as to its effect.
What remedies may the insurer have for underinsurance?
If the insured makes an under-declaration that amounts to a material non-disclosure or misrepresentation, the insurer's remedy depends upon what it would have done had it received a fair presentation of the risk.
That raises the interesting issue of whether, if the policy contains an average clause and the insurer can also show that it would have charged more premium had it received a fair presentation, the insurer has two potential remedies, namely to apply the average clause and/or to reduce the amount to be paid on the claim proportionately to the higher premium it would have charged. There is no commentary dealing with this and the Act is self-evidently yet to be tested before the courts or in practice.
At first blush, this is a tricky question. It may be argued that the parties intended the average clause and any proportionate remedy based on an increase in premium to work together, such that the insurer can elect which remedy to apply. But could the insurer take this further and 'double-dip'? The proportionate remedy based on an increase in premium is applied against what "the insurer would otherwise have been under an obligation to pay under the terms of the contract" and it may be suggested that the amount the insurer would have been required to pay under the contract is the amount for which the insurer is liable after application of the average clause. However, it must be highly unlikely that a court would permit an insurer to apply both remedies cumulatively in this way. That is a deeply unattractive argument, and is unlikely as a matter of commercial common sense to be found to have reflected the intention of the parties in agreeing to the average clause.
The answer as to what remedies the insurer may have available in these circumstances is probably far more straightforward. The better view is probably that the remedies operate in different circumstances. Ordinarily an under-declaration of insured values (whether under the current law or the Act) is unlikely to give rise to a breach of the duty of fair presentation and the insurer's remedy will be in application of the average clause. Only in circumstances where the under-declaration is made deliberately or recklessly, or is otherwise extreme, is it likely to be considered material such as to constitute a breach of the duty of fair representation. In this case the insurer is more likely, in fact, to be able to show that it would not have entered into the contract had it known the actual value at risk entitling it to avoid the policy rather than have to rely upon the new regime of proportionate remedies under the Act.
Similarly in the case of declaration linked policies, if the declaration of estimated gross profit is properly construed as a representation as to a matter of expectation or belief, and that representation were not made in good faith, then the insurer's remedy would be avoidance for a deliberate (or reckless) breach of the duty of fair presentation. If, on the other hand, the declaration were properly constructed as a representation as to a matter of fact, and was made otherwise than deliberately or recklessly, the position may be more complicated. It may well be that a significant under-declaration would be considered material absent the insurer being protected by an average clause. If the insurer would have written the risk but charged a higher premium, then at first blush it would be entitled to reduce the claim proportionately – thus effectively introducing a remedy akin to average into declaration linked policies. However, there is fertile scope for debate in these circumstances about whether the regime for proportionate remedies under the Act has been varied as regards terms relating to premium given that declaration linked policies already contain a premium-adjustment mechanism.
In summary, the Act presents tricky questions to which there may be simple answers. But these are untested waters and the approach the courts may take remains to be seen.