In September 2006, the English and Scottish Law Commissions published a discussion paper which touched on the concepts of misrepresentation and non-disclosure in insurance contract law in England and Scotland. (This was followed by an amended paper in November 2006.) Susan Dingwall and James Noble summarise the law to which those issues relate, where they involve the duty of utmost good faith and its application to business insurance contracts at the pre-contractual stage, and comment on the main reforms proposed by the Commissions.
The duty of utmost good faith imposes reciprocal obligations on the parties to the contract (although we are focusing here on its application to the conduct of the insured).
Breach by the insured
Should the insured commit a breach of its pre-contractual duty, the insurer may then be entitled to avoid the policy, on the basis that it is void from the very beginning (assuming that the right is exercised within a reasonable period after the breach has been discovered).
The entitlement to avoid the policy exists irrespective of whether the breach was committed innocently, negligently or fraudulently. To understand whether the insured may have committed such a breach, it helps to examine the law governing two related concepts: misrepresentation and non-disclosure.
The law on misrepresentation
The parties to an insurance contract must not misrepresent material facts. A material fact is a fact which would affect the judgment of a prudent insurer in evaluating and accepting the risk. (See the House of Lords' judgment in Pan Atlantic Insurance Co Ltd v Pine Top Insurance Co Ltd  AC 501.)
For an insurance contract to be avoided on this ground, the insurer must be able to demonstrate that it was induced to enter into the policy as a result of the misrepresentation.
The law on non-disclosure
Subject to some exceptions, the common law duty of utmost good faith requires the parties to disclose all material facts relevant to the policy of insurance. That duty extends to information about which the insured has not been asked, provided that it constitutes a material fact. A failure to comply with this duty may entitle the insurer to avoid the contract.
Proposals for reform
A ‘reasonable insured’ test
The Commissions proposed that the duty of disclosure in business insurance be amended so that it would only cover matters which a ‘reasonable insured’ would understand to be material to the insurer. (They recommended a similar test for claims of misrepresentation.) In the Commissions’ view, such a test would give the courts more flexibility to accommodate the many situations in which insurance is used.
The Commissions proposed that the test be mandatory so that the parties are unable to exclude its application contractually.
This proposal would allow the courts to take into account whether the insured had received professional advice from a third party in considering whether circumstances were material to the underwriter.
On the other hand, the proposal may create uncertainty about the rights of the parties by inviting the court to substitute its own opinion for that of the industry as to what was reasonable for the insured. At the moment, an insurer will ordinarily adduce expert evidence, that is, from an underwriter, to support its avoidance claim. Quite what evidence will be required, and from whom, to support the “reasonable insured” test is unclear. For example, in demonstrating whether the insured acted reasonably, would the expert be required to give evidence that the insured’s conduct was in accordance with the practices of a number of industry participants? Would it suffice if only one other organisation is shown to have adopted the same practice?
There are clearly some difficulties with this proposal which must be overcome in order to give the parties greater certainty about their rights and liabilities.
A fresh look at innocence
The Commissions recommended a discussion of the remedies available to an insurer depending upon whether the misrepresentation or non-disclosure was innocent, negligent or fraudulent.
They suggested that, where a business insured has acted without negligence (or fraud) in making an inaccurate statement, the insurer should have no entitlement to avoid the policy or to refuse to pay a claim on that basis. (The insurer would be entitled to recover the relevant portion of any extra premium payable and rely upon any additional terms that it would have otherwise imposed.)
The Commissions recommended that the proposal be mandatory so that the insurer would be unable to exclude contractually its application.
The Commissions considered that the burden of disproving negligence (or fraud) should rest with the insured (as laid down in the Misrepresentation Act of 1967).
Whilst the Commissions recognised that a reform of this kind is likely to cause an increase in business insurance premiums, they considered that the augmentation would be minor and that most insureds would be willing to bear that cost in return for protection against avoidance of the policy based on an innocent misrepresentation (or non-disclosure).
A proportionate remedy for negligence
The Commissions did not form any firm view on what ought to be the consequence of a negligent misrepresentation.
However, they opened for discussion the concept of a proportionate remedy, whereby the insurer is put into the position that it would have been in had it known the true circumstances: that is, it would have an entitlement to avoid the policy where it can prove that it would have declined the risk, but for the negligent act.
The advantage to an insured of a reform of this kind is that it prevents an insurer from avoiding the policy based on a technical breach. The Commissions presumably believe that this approach would not unfairly prejudice the insurer in accepting the risk, nor unjustly punish the insured where it has not acted fraudulently. In the Commissions’ view, the reform appears to adequately balance the competing interests of the parties.
Re-assessing the burden of proof in fraud
The Commissions acknowledged that it is often difficult to prove that an insured has engaged in fraud. They suggested the adoption of a test similar to that prescribed under the Marine Insurance Act of 1906: the Act states that the insured is “...deemed to know every circumstance which, in the ordinary course of business, ought to be known by him” (section 18(1)). They proposed that – unlike the provisions of the Marine Insurance Act – this would be a rebuttable presumption. The insured would be entitled to adduce evidence that it was not aware of the relevant facts, even though it ought to have been. Therefore, the burden of proof would rest with the insured.
The notion of lessening the burden of proof in fraud is a topic which should be explored. However, the Commissions’ proposal will almost certainly not find favour with insureds, as it disproportionately reduces the evidentiary threshold which the insurer is required to meet. On the basis that a finding of fraud is significant for the insured (as it could lead to criminal sanctions in other proceedings), the Commissions may seek some middle ground between the current position and the test they have proposed.
The Law Commission is expected to publish further consultation papers before the summer. A final report and draft bill is expected around 2010.