We have been following the progress of the English and Scottish Law Commissions' review of insurance contract law since 2006. Today the Law Commissions published their third and final joint consultation paper on "The Business Insured's Duty of Disclosure and the Law of Warranties". The paper covers two topics which have been covered previously by the Law Commissions: (1) the business insured's duty of disclosure and (2) warranties. The Law Commissions have taken the unusual step of consulting on these issues again; whilst most of those who responded to their business proposals previously favoured reform, there was disagreement on the way forward. Further, as a result of the consultation responses, the Law Commissions note that they have "significantly altered" their original views. The Law Commissions seek responses by 26 September 2012 with the aim of producing a final report and draft bill by the end of 2013.
Joint Consultation Paper
The Business Insured's Duty of Disclosure
An insured is under a duty to disclose to the insurer all facts material to an insurer's appraisal of the risk which are known or deemed to be known by the insured but are neither known or deemed to be known by the insurer. A fact is material if objectively it would have influenced the judgment of a prudent insurer in fixing the premium or determining whether to take the risk. A failure to disclose material facts may entitle the insurer to avoid the policy if the insurer can show the non-disclosure induced the making of the contract on the relevant terms. If the policy is avoided, it is treated as if it never existed.
The Law Commissions identify two main problems with disclosure: first, the business insured's duty of disclosure is too unclear and, second, the remedy of avoidance is too harsh.
The Law Commissions recognise the difficulties faced by businesses both in understanding the disclosure requirements and in gathering appropriate information – a particular problem within complex organisations. Their proposal is described as an evolutionary approach with the aim of helping clarify how insureds are expected to go about presenting a risk (and what should be covered) and encouraging insurers to assist policyholders in understanding what must be disclosed.
They propose to retain the essential elements of section 18(1) of the Marine Insurance Act 1906:
"These are that the duty to disclose arises before the contract is concluded; that the policyholder must disclose material circumstances; and that the duty is confined to information which the policyholder knows or ought to know. We think, however, that it would be useful to clarify the meaning of "material circumstances" and what an insured knows or ought to know in legislation".
From case law, the Law Commissions identify "material circumstances" as including: (1) any unusual or special circumstances which increase the risk (2) any particular concerns about the risk which led to the insurance being placed and (3) standard information which market participants generally understand should be disclosed. They consider that it would be helpful for insurers and insureds to work together to develop standards and guidance over what a standard presentation of the risk should include. They also consider the statute should specify that, where an insurer has received information which would prompt a reasonably careful insurer to make further enquiries, it does not have a remedy for non-disclosure of any fact which those enquiries would have revealed. It is also intended that the inducement test is included within the statute so that to obtain a remedy for non-disclosure or misrepresentation the insurer must show it would not have entered into the contract at all, or only on different terms.
So far as knowledge of material circumstances is concerned, section 18(1) of the Marine Insurance Act 1906 requires an insured to disclose every material circumstance "…which is known to the assured, and the assured is deemed to know every circumstance which, in the ordinary course of business, ought to be known by him". The Law Commissions propose a "restatement of the law, which will draw on the best principles in the current case law to clarify both whose knowledge is relevant, and what enquiries need to be made". The Law Commissions consider that for a corporate entity knowledge should be attributable to both the directing mind and will of the corporate entity and the staff who placed the insurance in question. Knowledge should include not only actual knowledge but also "blind eye" knowledge. Further, a corporate entity should be under a duty to make reasonable enquiries which are proportionate to the type of insurance and to the size, nature and complexity of the business before placing insurance. Such enquiries are intended to be judged objectively.
Under section 20 of the Marine Insurance Act 1906 the insured must not misrepresent material facts; representations of fact to be true must be "substantially correct" and representations of expectation or belief are treated as true if made in good faith. The Law Commissions propose that the same knowledge test is applied to both sections 18 and 20. Therefore section 20 would be amended to distinguish between matters which the insured knew or ought to know about and other matters (such as expectation or belief) where they must be made in good faith.
Under section 19 of the Marine Insurance Act 1906, where the insured uses a broker or other agent to effect insurance, the agent has an independent duty to disclose information to the insurer. It is proposed to clarify that the duty of disclosure only applies to information received or held by that agent in its capacity as agent for the insured (and not include information given to the broker by other clients in relation to other insurers). Further, the scope of the obligation should include all producing, placing and intermediate brokers.
An insured is not required to disclose matters which the insurer knows, matters of common notoriety or knowledge or matters which an insurer ought to know in the ordinary course of business. It is proposed to clarify what ought to be known by an insurer in the ordinary course of business. Further, that knowledge can be attributed to an insurer if it is known to the directing mind and will of the insurer or to any staff who are asked to make the underwriting decision.
The Law Commissions propose a new system of proportionate remedies based upon the insured's conduct and, in particular, whether its conduct is dishonest or not. The Law Commissions seek responses on how dishonest conduct should be defined. For example, should the statute simply refer to fraudulent conduct and leave it to the courts to define in accordance with the existing law or should a new statutory definition of "deliberate" or "reckless" behaviour be provided.
It is proposed that where the insured's conduct is dishonest then the insurer will be entitled to avoid the contract, refuse all claims and retain any premium. It is presently not settled law (in non-marine insurance) whether insurers are entitled to retain premiums where there has been fraudulent non-disclosure or misrepresentation and this would clarify the position.
For conduct which is not dishonest, the remedy will turn on the contract which the insurer would have entered into with the insured if the insured had complied fully with its duty of disclosure or not misrepresented information: "If there would not have been any contract at all, then the insurer may avoid the contract, and simply return any premiums paid. If the insurer would have written other terms into the contract, then the contract is treated as if it contained those terms. If the insurer would have charged a higher premium, then the amount of the claim is reduced proportionately. This is the default position; it will be open to the parties to contract out of what is proposed and make alternative provision for the consequences of breach of the duty to disclose".
So far as reinsurance is concerned, the Law Commissions consider that, where reinsurance is written "back to back" with the direct insurance, proportionate remedies should not be problematic. However they note that, in theory, if not written on a back to back basis there may be many ways in which the reinsurer would be entitled to refuse claims (albeit they say that, in practice, the market copes with these issues now). Responses are sought on whether the effect of proportionate remedies on reinsurance can be left to freedom of contract.
In 2007, the Law Commissions proposed that micro-businesses (less than 10 employees) should be given special protection on the assumption that they would experience the greatest compliance problems. The Law Commissions discovered there was no simple definition of a micro-business and also found little evidence that the current law causes particular problems for small businesses. They therefore do not treat smaller businesses any differently to large businesses in their proposals.
Duty of good faith
The Law Commissions propose to retain the duty of good faith as an interpretative principle but breach will not, in itself, give an insured or insurer a cause of action.
In the insurance context, a warranty is a pre-contractual promise by the insured that a given fact is true or that a given fact will remain true, or that the insured will refrain from behaving in a particular way. Warranties must be complied with strictly - breach automatically discharges the insurer from liability under the policy from the date of breach irrespective of whether the breach is material to any loss or claim. Later remedy of the breach by the insured does not restore cover. Warranties are commonly created through "basis of the contract" clauses. These are provisions set out in a proposal form to the effect that all or any answers to the questions in the proposal shall form the basis of the subsequent contract of insurance. By signing a proposal containing such a clause the insured warrants the truth of the answers set out in the proposal.
The Law Commissions note that for many years the courts have attempted to mitigate the draconian effects of breach of warranty through the use of interpretative principles: "The problem is that where the outcome of a case is dependent on the courts' interpretation, inconsistencies creep in". The Law Commissions set out three proposals for reform which we deal with in turn below. In consumer insurance the reform would be mandatory whereas in business insurance the parties will be able to contract out.
- Abolishing basis of the contract clauses
Basis of the contract clauses have already been abolished in consumer insurance through the Consumer Insurance (Disclosure and Representations) Act 2012. The Law Commissions propose that they should also be abolished for business insurance so that any such terms or statements seeking to convert the answers on a proposal form into warranties would be of no effect. Warranties of past or present fact would have to be included specifically in the policy.
- Suspension of liability for the duration of the breach
The Law Commissions propose that breach of warranty should suspend insurers' liability under the contract (as opposed to discharging it). If the breach is remedied before the loss, insurers must pay the claim. It is, of course, accepted by The Law Commissions that not all breaches will be capable of remedy. Further, section 34(3) of the Marine Insurance Act 1906 will be retained so that a breach of warranty may be waived.
- Suspension of liability for terms which reduce particular risks
The Law Commissions propose to introduce special rules for terms (not just warranties) designed to reduce the risk of a particular type of loss or the risk of loss at a particular time or location such that breach would suspend liability only in respect of that type of loss: "A failure to employ a night watchman should suspend the insurer's liability for losses at night, but not for losses during the day".
As the Law Commissions rightly point out in their paper, the law in these areas is of major concern to both insurers and insureds: "It is crucial that any reform is based on a practical understanding of how change would work in practice". It seems to us to be of real benefit that the Law Commissions have taken the step of revising their proposals and consulting again on the topics. The new proposals represent a sensible step back from the very significant reform which was proposed initially and instead (rightly in our view) look to building and improving upon familiar insurance case law principles.
David Hertzell, Law Commissioner, said today at the BILA conference on the reforms: "This exercise is as much about policy as about the law. Whether or not you are a lawyer we want your views on these proposals". Responses to the consultation are sought by 26 September 2012 and policyholders, brokers and (re)insurers are urged to do so.