On 17 July 2007, the English and Scottish Law Commissions (the Commissions) published a joint consultation paper on insurance contract law. The paper sets out wide-ranging proposals for the reform of the current law, which, if enacted, will have significant repercussions for both insurers and policyholders. The proposed reforms shift the balance in favour of policyholders, and insurers will want to carefully consider whether the proposals sufficiently respect their own legitimate interests.
Background to the current proposals
The Commissions first announced their intended review of insurance contract law in January 2006 and this has been followed by the publication of three issues papers setting out provisional proposals for reform. Following industry responses to those papers, the Commissions have modified a number of proposals for inclusion in their consultation paper.
The Commissions believe that statutory reform is necessary for three principal reasons.
The current law does not produce results that are in line with the reasonable expectations of policyholders. The Commissions believe that principles embodied in the Marine Insurance Act 1906 are ‘no longer appropriate to a modern insurance market’, and that some aspects of the current law are ‘unjust’ and ‘defy logic’.
Over the past 20 years, the current law, particularly on consumer insurance, has been tempered by the 2007introduction of non-binding Statements of Practice, the FSA Rules, and the creation of the Financial Ombudsman Service (the FOS), which has applied a ‘fair and reasonable’ approach to consumer-related insurance disputes. The result is a patchwork of rules and guidelines that are ‘incoherent, unclear, and inaccessible’, and in need of reformulation.
Many other common law countries have already reformed their insurance law provisions along the lines of the Commissions’ proposals, serving to re-emphasise the possibility that English (and Scottish) law may be out of step with market practice.
The Commissions intend their proposals to apply to all classes of insurance and reinsurance.
Misrepresentation and non-disclosure
Current insurance law imposes strict duties on the insured to disclose all material facts to the insurer, and to avoid making any material misrepresentations. Any breach of these duties enables the insurer to avoid the policy ab initio – in practice this means that the policy is treated as if it never existed, and the insured will usually only be entitled to the return of his premium.
There are several reasons why it is commonly argued that the law as it stands operates harshly on insureds. A fact is considered material if it would influence the judgement of the hypothetical ‘prudent insurer’ in assessing the risk. However, the fact need not have had a decisive effect on the mind of that insurer. Despite this, the insurer is entitled to avoid the policy, and therefore refuse to pay claims that it arguably would have paid had the fact been disclosed. Many policyholders, particularly consumers, may not realise that they have a duty to disclose information about which the insurer has not asked them any questions. They may also not appreciate what would influence the judgement of a prudent insurer. There is no differentiation between a misrepresentation that is fraudulent, negligent, or entirely innocent. The Commissions believe that a policyholder may be denied claims even when they have acted honestly and reasonably. To address these issues, the Commissions propose to alter the test for materiality, and introduce the concept of proportionality to determine the remedies available to the insurer. There are separate proposals for consumer and business insurance, but both are based on the general principle that an insured who was honest and careful in giving pre-contract information should not have his claim refused.
Proposals for consumer insureds
For consumer insurance, the Commissions propose a mandatory regime based principally on existing FOS guidelines. The main features of this would be as follows.
The consumer’s duty to volunteer information would be abolished. The onus would be on the insurer to ask questions covering the information it required. The insurer would have no remedy in respect of information about which it had not asked a question.
The consumer’s duty would be to act honestly and to take reasonable care to answer questions accurately and completely. Breach of that duty would only give rise to a remedy if the insurer could show that: it would not have entered into the contract on the same terms (or at all) had it been aware of the full facts (this restates the existing requirement for inducement); and a reasonable insured in the circumstances would have appreciated that the fact in question was one that the insurer would have wanted to know about (or, alternatively, that this particular insured did actually know that the insurer wanted to know the fact). This is the new test of materiality, and would represent the end for the hypothetical ‘prudent insurer’.
The insurer’s remedy for breach of the duty would depend on the consumer’s degree of fault, which the Commissions define by reference to three categories of misrepresentation. If the consumer acted dishonestly and made a ‘deliberate or reckless’ misrepresentation, the insurer would be entitled to avoid the policy.
If the consumer made a negligent misrepresentation, the insurer would be granted a compensatory remedy – ie one that aims to put the insurer in the position it would have been in had it known the true facts. For example, if the insurer would have increased the price of cover, then the claim should be reduced in proportion to the under-payment of premium. If the insurer would have refused to write the cover at all, it should be entitled to avoid the policy.
If the consumer made a misrepresentation that was neither dishonest nor negligent (which the Commissions refer to as a ‘reasonable misrepresentation’) then the insurer would have no remedy, and would be obligated to pay the claim in full.
Proposals for business insureds
For business insurance, the Commissions propose a regime based on current accepted good practice. Unlike in consumer insurance, it is important to note that the parties would be free to contract out of the regime by express agreement in the policy. The main features of the regime would be as follows.
The insured’s duty of disclosure should be retained, but the current test of materiality should be narrowed. The duty would be limited to those facts that a reasonable insured in the circumstances would have appreciated the insurer would want to know about. For misrepresentations, the materiality test would be the same as that for consumers. An insurer would need to demonstrate that a misrepresentation had been made that had induced the insurer to enter into the contract and that a reasonable insured in the circumstances would not have made it.
In terms of remedies for the insurer, the Commissions seek views on whether it is appropriate to distinguish between dishonest and negligent conduct in a business context. They ask whether the remedy of avoidance should be reserved for dishonest conduct, with only a compensatory remedy available for negligent misrepresentation or non-disclosure. However, as there are concerns that it might be difficult to prove that a corporate organisation acted dishonestly, it has been argued that avoidance should be retained as the default remedy for negligent misrepresentation and non-disclosures.
Although it has been argued that the current law in this area is capable of producing harsh results, particularly on consumer insureds, it does have the advantage of being certain. Critics of the introduction of a ‘reasonable insured’ test point to the inherent uncertainty in that formulation. Who is the reasonable insured? How can this be determined when insureds vary so dramatically in size, sophistication, and familiarity with the insurance market? By including reference to the circumstances of the insured, the Commissions are suggesting a hybrid objective/subjective test, of the kind used in Australia. A court would therefore be able to take into account matters such as, for example, whether that particular insured had access to independent professional advice. There is a risk therefore that the proposals exchange one set of uncertainties for another.
On the compensatory remedy for negligent misrepresentation, insurers should note that the Commissions seek views on whether the courts should be afforded an overriding discretion to refuse the remedy of avoidance in certain circumstances. They suggest this may be appropriate where the policyholder’s fault was ‘minor’, and the insurer could be ‘adequately compensated by a reduction in the claim’. In circumstances where the insurer has shown that it would have declined the risk had it known the true facts, it is questionable whether the existence of such a discretion would be consistent with the principle of proportionality. In addition, the proposals do not expressly deal with circumstances in which the insurer would have covered the risk, but its premium would have been so high that the cover would be rendered uncompetitive, and the insured would likely not have taken it up. The outcome of such an argument by insurers may depend on the precise proportionality wording that is chosen for any statute.
Certain statements in insurance contracts as to past, present or future fact are known as ‘warranties’. Under the existing law, an insurer can refuse to pay any claims that arise after the date of a breach of warranty, regardless of whether that breach is subsequently remedied or had any connection to the loss in question. In contrast to the position on misrepresentation, there is no requirement that the warranted statement be material to the risk or that it induced the insurer to enter into the contract. A statement on a proposal form that the answers given form the ‘basis of the contract’ has the effect of converting all of the insured’s answers into warranties.
The Commissions believe that reform is needed in this area primarily to prevent insurers relying on technical breaches that have no connection with the claim. Their principal proposals on warranties regarding future conduct are as follows. There should be a causal connection test to link the breach of warranty to a particular loss. The insurer must pay the claim if the insured can demonstrate on the balance of probabilities that the breach did not contribute to the loss.
The causal connection rule would be mandatory for consumer insurance. For business insurance, the parties would be able to agree other consequences for breach of warranty if they wished, subject to special controls where the parties contract on the insurer’s standard terms. The Commissions propose that the insurer would not be able to rely on a warranty contained in the standard terms if it would render the cover substantially different from what the insured ‘reasonably expected’ in the circumstances. A breach of warranty would not automatically discharge the insurer from all future liability under the policy. It would instead give it the right to terminate the contract, but only if the breach has sufficiently serious consequences. Warranties should be set out in writing, and in consumer cases the insurer should take specific steps to bring the warranty to the insured’s attention.
On warranties of past or present fact, the Commissions propose the following.
In consumer insurance, all statements of past or present fact would be treated as representations rather than warranties. In business insurance, specific warranties of past or present fact would be permitted, but the insurer could only refuse to pay a claim if the breach of warranty was material, and had some connection to the loss.
For all types of insurance, ‘basis of the contract’ clauses should be abolished. The Commissions describe them as ‘using obscure words that most policyholders will not understand’. Any warranty must be specifically identified.
Intermediaries and the law of agency
Under the present law, an insurance intermediary such as a broker is usually regarded as acting on behalf of the insured, rather than the insurer. There has long been debate, both academically and in the insurance market, as to whether this is appropriate. The question is one of real practical significance.
Legally, the actions of an agent are attributed to those for whom they act. In practice, this means that if the intermediary is at fault in providing the insurer with incorrect information prior to or at inception (whether negligently or deliberately) then that fault is imputed to the insured. This enables the insurer to avoid the cover, regardless of whether the insured provided correct information to the intermediary, against whom the insured is then left to pursue a remedy.
The Commissions believe that insureds may reasonably expect not to be held responsible for an intermediary’s errors. The issue is complicated by the fact that the intermediary may potentially be regarded as agent of the insurer in certain circumstances, eg an appointed representative of one insurance company. This may not be clear to prospective insureds (particularly consumers), and adds to the complexity of disputes involving alleged fault by intermediaries.
To address these issues, the Commissions:
- propose that an intermediary should be regarded as acting for the insurer unless they are clearly independent and acting on the insured’s behalf;
- seek views on whether the independence of an intermediary should be determined by reference to whether he conducts ‘a fair analysis’ of the market, as defined in the Insurance Mediation Directive; and
- propose to abolish the rule that an insurer’s agent may temporarily become agent of the insured when completing the proposal form (originating from the much-criticised Newsholme v. RTG Insurance case).
In business insurance, the agency question has tended to raise separate issues, centred around whether the current law of agency is consistent with the commission payments received by brokers. The Commissions recognise that their proposed intermediary reforms, while significant for consumers, are likely to have less effect on business insurance, where the intermediary is likely to continue to be regarded as agent of the insured. This recognition will be welcomed by business policyholders, for whom the broker often fulfils a vital role in negotiating the best terms of cover on their behalf. It will not, however, address criticisms of the practice whereby brokers who are supposedly the agent of the insured, are in fact remunerated by the insurer.
The future of the proposals
The Commissions seek responses to their proposals by 16 November 2007. A separate consultation paper will be published in 2008 dealing with post-contractual good faith, insurable interest and damages for the late payment of claims. Given the complex patchwork of law, regulation, and guidelines that presently govern an insured’s rights and obligations, it seems likely that these proposals will result in reform (in contrast to the proposals of the English Law Commission in 1980 and its predecessor in 1954). Insurers now need to engage fully in the consultation process to ensure that their interests are sufficiently reflected.