"Be careful what you wish for": Managing the laws of fate

“Should I support the Law Commission’s proposals for reform as to the ‘Business Insured’s Duty of Disclosure’?” is something which lawyers, risk managers, compliance officers and others at insurance purchasers, intermediaries and risk-carriers will be considering during the 3-month consultation period in relation to the joint consultation paper with the Scottish Law Commission (the “Consultation”).

It might intuitively seem unreasonable to question any proposal for a change to the business insurance market’s mechanisms and structures given the evidence and assertions put forward by the Law Commission and others.

However, insurers, brokers and insureds would be well advised to consider what the practical effects of reform could be in the light of the London insurance market’s longstanding operations, and the forthcoming ‘Solvency 2’ Directive (2009/138/EC) (“S2”).

In particular, it is possible that the very problems which the Consultation seeks to eliminate or mitigate are actually made worse. There are two ancient and fundamental laws to consider in this regard: “the Law of Unintended Consequences” and “Sod’s Law”!

The Consultation

A key feature of the Consultation is, in short, the proposal that the current statutory remedy available to insurers of avoiding (in other words, rescinding or repudiating) insurance policies entered into as a result of any material misrepresentation or a failure to disclose information should be replaced by a range of remedies “proportionate” to the nature of the insured’s, or its broker’s, infraction.

In particular, where misrepresentation or non-disclosure is “negligent”, as opposed to deliberate or fraudulent, the Consultation proposes that the default statutory position – subject to contractual agreement otherwise – should be that the insurer is required to undertake a re-formulation of its underwriting process on the basis of what would have happened had it known the truth of the matter which was the subject of the negligent misrepresentation or non-disclosure.

The outcomes envisaged by the Consultation include a Court’s decision that an insurer would have:

  • increased the premium, pro rata to which adjustment the insured’s claim would be reduced,
  • added to the policy terms an exclusion which might or might not have the effect of reducing or removing cover for the claim in issue, ord
  • eclined to write the risk – this outcome being in effect the same as the remedy of avoidance which currently exists.  

We refer below to such outcomes as the “Re-underwriting Process”.

Risk Identification

The Re-underwriting Process gives rise to various areas of risk for insurers, insureds and brokers. The Commission acknowledges the practical potential outcome that premiums will have to increase, but there are other practical considerations, especially in respect of S2. Depending on the issues in a case, and the nature of the risk insured, the Reunderwriting Process might undermine an insurer’s risk and capital management assumptions, processes and decisions – and even appetite or profile – in respect of individual risks or claims, or wider books.

The ‘downside’ for an insurer of the Re-underwriting Process is not just the ‘legal risk’ that a contract or dispute does not have the outcome intended, but could easily engender other risks –

  • especially ‘compliance risk’ (in short, sanctions, financial loss, or loss of reputation from a failure to comply with regulatory rules), but also
  • ‘business risk’ (in short, unexpected changes to the legal conditions to which insurers are subject); and even,‘
  • strategic risk’ (in short, the inability to address or adapt to changes in the  

Insurers’ response to such risks may not simply be limited increasing premiums in order to provide additional capital pursuant to a model. This is because the Re-underwriting Process contains a significant threat to expose publically the commercial processes and skills of insurers and individual underwriters to criticism.

Clams worth fighting over

In order to defend their systems, controls, personnel and reputations, insurers may be compelled to establish precedent findings as to their underwriting methodologies. On the other hand, corporate insureds with extensive insurance programmes and exposures, as well as claimant lawyers, may well have an interest in obtaining such findings in order to exert pressure in relation to other claims. It is easy to imagine the US plaintiff bar taking a particular interest.

Re-assessing how a risk would have been written may prove to be more complex and involved than deciding that one component part of an insurance contract (eg the premium or deductible, or an exclusion) would be altered in some way without any consequences for any other part of the contract. A placement negotiation as to contractual terms and policy limits does not take place in a vacuum, and it may be necessary to introduce into the Re-underwriting Process witness or expert evidence on circumstances surrounding the negotiation of a particular risk – such as broader market conditions and the state of an underwriter’s book and broker relationships – in order to tackle questions on whether, for instance, the underwriter might have been able to –

  • impose certain terms at a particular time, or
  • decline a risk (in the face of say, the need to achieve certain premium income targets at certain times).

Challenging and seeking to re-formulate insurers’ approach to underwriting – and not just challenging whether a matter was material and would have resulted in a different approach to the risk, as is currently the case – could therefore well result in trials which require more evidence, and are therefore longer and more expensive.

Brokers and a sting in the tail

There is a further point, which relates to the phenomenon that an insured’s claim which results in cover being avoided often results in a negligence claim by the insured against its broker. It seems logical to assume that if there were no, or materially fewer, actions in which insurers sought to avoid cover, then there should be fewer actions – or perhaps as many or more actions, but for lower quantum – against brokers, who may, via the Re-underwriting Process, be able to have a ‘second bite of the cherry’ on placing the risk.

Having said that, a detailed re-examination of the placement process has the potential to give rise to allegations and findings adverse to a broker, especially if an insurer and an insured were to disagree over whether the insurer would have been able to impose a particular exclusion or premium. Recent publications by Mactavish have expressed substantial doubts as to the broker’s efficacy in placing appropriate cover, and it could well be that the operational methodologies of both broking houses and individual brokers could become subject to as much criticism as the methodologies of insurers and individual underwriters.