UK: Law Commissions’ Proposals - Update

The English and Scottish Law Commissions’ plans to review insurance contract law were announced in January 2006. Recommendations will be published in 2007. Prior to that, a series of issues papers are being published to promote debate at open seminars organised by the Commissions. Papers on non-disclosure/misrepresentation (September 2006) and warranties (November 2006) have now been published.

All insurance contracts are based on the duty of utmost good faith. The applicability of the principle as regards disclosure of material circumstances and the making of material misrepresentations is set out in the Marine Insurance Act 1906.

A circumstance is deemed to be "material" if it is one that would affect the judgment of the (re)insurer in assessing the risk even if, ultimately, it would not have a decisive effect on the (re)insurer’s acceptance of the risk or on the amount of premium charged.

The remedy for breach of the duty is avoidance of the contract, irrespective of whether the breach was made innocently, negligently or fraudulently. However, before a (re)insurer can avoid, it must be shown that the non-disclosure/ misrepresentation actually induced the underwriter to accept the contract on the relevant terms.

Proposed reform - consumer contracts

The most significant proposal is that the test of materiality be re-defined. In addition to proving actual inducement, the insurer should be required to demonstrate that:

1. the insured appreciated that the fact in question would be relevant to the insurer (in the sense that it would have an effect on the insurer’s mind in assessing the risk); or, if not,
2. a reasonable insured in the circumstances would have appreciated that the fact would be relevant to the insurer.

It is also proposed that the applicable remedy should depend on the proposer’s state of mind. Where he has acted fraudulently, the insurer should be entitled to avoid; where negligently, both parties should be put into the position they would have been in had the insurer known the true facts; where innocently, he should not be penalised.

The Commissions suggest that the duty of disclosure should continue to apply to business insurance contracts but that the "reasonable insured" test, set out above, should apply.

They also propose that the same remedies as are proposed in the consumer context should apply for fraudulent and innocent non-disclosure/misrepresentation. In the case of negligence, they query whether the insured should be required to demonstrate that it did not know what a person in its position would be expected to know, or that it would not know why an inaccurate response to a clear question was material.

The Commissions’ proposals raise numerous questions: who is the reasonable insured? How can this be determined when insureds vary so dramatically in terms of size, resources and familiarity with the product in question? How would the test work in the context of reinsurance?

However, in their warranties issues paper, they have revised the approach to business contracts, recommending that any new rules on misrepresentation/non-disclosure should be compulsory for business as well as consumer contracts.

The rationale for this change was that if (re)insurers could treat statements of fact as misrepresentations rather than warranties and stipulate in the policy the remedies available for misrepresentation, this would enable them to side-step the Commissions’ proposed new rules on warranties. Whilst this makes sense from a legal perspective, it increases the potential significance of the Commissions’ proposals on misrepresentation/non-disclosure for the market.

There are two broad categories of warranty in (re)insurance contracts - warranties about past or present facts at the time when the contract is entered into and warranties about the insured’s future conduct during the contract period. It is a question of interpretation whether or not any particular term is a warranty.

It is well established that a breach of warranty, however minor, automatically discharges the (re)insurer from any further liability under the policy as from the time of the breach - regardless of whether the (re)insured acted fraudulently, negligently or innocently, and regardless of whether or not the breach was subsequently remedied.

The Law Commissions believe that because of the strict consequences which flow from a breach of warranty, the current law has potential to cause considerable unfairness to policyholders, particularly in the consumer market, where policyholders are unlikely to understand the significance of warranties. Few policyholders would expect (re)insurers to be entitled to reject a claim because of a breach of warranty which has no causal connection with the claim.

Their tentative proposals distinguish between warranties as to past or existing facts, and warranties as to future conduct.

The Commissions recommend that, for consumer contracts, all statements of existing fact should be treated as representations rather than warranties and should be subject to the proposed new rules on misrepresentation. In relation to business contracts, they propose either that the position should be the same as for consumer contracts, or that (re)insurers should only be entitled to rely on a breach of warranty as a defence to a claim if: (a) the warranty has been set out clearly in a written statement provided to the (re)insured; and (b) the claim is causally connected with the breach.

The Commissions propose that (re)insurers should only be entitled to refuse a claim for breach of warranty if: (a) the warranty is set out in writing and included or referred to in the policy and, for consumer contracts, if the insurer has taken sufficient steps to bring it to the policyholder’s attention; and (b) the breach caused or contributed to the loss. The Commissions ask whether (re)insurers should be entitled to contract out of the causal connection rule for business contracts, and whether the same rules should apply not only to warranties, but to any term which purports to exclude or limit a (re)insurer’s liability for matters which increase the risk of loss (for example clauses limiting the scope of cover, or excluding certain activities from cover).

The Commissions also recommend that for both consumer and business contracts, a breach of warranty should no longer automatically discharge a (re)insurer from liability under the policy. Instead, they suggest that (re)insurers should be entitled to terminate cover for the future against pro rata refund of premium, but should remain on risk unless and until they have given notice of termination to the (re)insured.

In a ‘basis of the contract’ clause, the applicant warrants the accuracy of the answers given in the proposal form and usually agrees that those answers form the basis of the contract. Their effect is to elevate statements in proposal forms into contractual warranties. There has been widespread criticism of such clauses because of the potential severity of the consequence of giving an inaccurate answer in a proposal form. In their latest proposals, the Commissions have renewed the call for these clauses to be abolished.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.