The Law Commissions’ second consultation on the duty of disclosure in business insurance law adopts an "evolutionary approach" based on principles developed within current case law.
But its also proposes a default regime of proportionate remedies which would apply to all breaches of the duty - unless the insured acted dishonestly, when the insurer would still be entitled to avoid the insurance contract.
This note looks at the Law Commissions’ proposals to clarify the pre-contract duty of disclosure in business insurance and reform the remedies for breach. The same paper also includes proposed changes to the law on warranties for both business and consumer insurance. These are considered separately in Reforming insurance law: warranties.
Non-disclosure and misrepresentation
Under English law, an insured is under a duty of utmost good faith. When someone applies for insurance he must volunteer material information, whether or not the insurer asks about it. If he fails to disclose (or he misrepresents) a material fact that induces the insurer to enter into the contract on the agreed terms, the insurer is entitled to avoid the policy entirely, which means treating it as if it never existed.
What is material is judged from the viewpoint of a prudent insurer, not the insured. No distinction is made between innocent, negligent or dishonest behaviour, and avoidance is the only remedy available. So, although in theory, the duty of good faith applies both to insured and insurer, in reality it is one-sided, as the only remedy operates against the insured.
The duty is set out in section 18 of the Marine Insurance Act 1906, although its principles have been developed and refined by case law.
For consumers, who may have little knowledge of insurance law, the rules have been softened over the years by voluntary industry codes, the regulatory regime and the Financial Ombudsman Service (FOS) which applies a “fair and reasonable” test to complaints brought by consumers and small businesses.
In January 2006, the Law Commissions of England and Scotland began a review of insurance contract law and, in 2009, put forward proposals to bring consumer insurance law more into line with current industry and FOS practice. In March 2012, Royal Assent was given to The Consumer Insurance (Disclosure and Representations) Act, which closely follows the recommendations made in the 2009 report.
The Act (which is not yet in force) removes a consumer insured’s duty to volunteer information, replacing it with a duty to take reasonable care not to make a misrepresentation to the insurer before the contract is entered into or varied.
If this duty is breached, the new law introduces a range of proportionate remedies based on what the insurer would have done had there been no breach, such as charging a higher premium or adding an exclusion. Insurers would still be able to avoid the policy if the insured’s misrepresentation was deliberate or reckless.
For business insurance, in their first consultation paper in 2007, the Law Commissions proposed to retain the insured's duty voluntarily to disclose and not misrepresent material information. But a new test for materiality would replace the "prudent insurer" with a "reasonable insured".
Instead of asking whether the information was something that would influence the judgment of a prudent insurer, the question would be whether it was something a reasonable insured in the circumstances would have appreciated the insurer would want to know about. Unless the insured acted dishonestly, insurers’ remedies for breach would be proportionate, but, since this would be a default regime, the parties could agree more stringent terms if they wished.
These proposals proved more controversial than those for consumer insurance, prompting a major rethink and – most unusually – a second consultation.
Rather than introduce major changes into the law of disclosure, in their 2012 consultation paper, the Law Commissions have opted for a more "evolutionary" approach, based on principles developed by current case law, and in some cases clarifying those principles.
"The duty is unclear and sometimes poorly understood while the consequence of breach is too harsh", the paper states. "There is evidence that the duty does not work well in practice. Our proposals aim to clarify how policyholders are expected to comply with the duty when presenting a risk to insurers and to encourage insurers to assist them in that task."
The Commissions have, however, retained the original proposal to introduce a default regime of proportionate remedies where the insured has not acted dishonestly.
From an early stage in the insurance law project, the Law Commissions considered providing additional protections for smaller businesses ("micro-businesses") on the basis that such businesses would have no greater understanding of insurance law than consumers.
Initially they suggested placing controls on insurers’ written standard terms to prevent insurers giving themselves greater rights to avoid claims than under the business insurance default regime, if this would defeat the insured's "reasonable expectations of cover".
But after acknowledging this would introduce too much uncertainty over what constituted standard terms, they suggested removing micro-businesses from the business regime altogether and treating them in the same way as consumers for the purposes of giving pre-contract information.
This plan, too, has now been rejected. Not only was there the difficulty of clearly defining a micro-business, but insurers would have to re-programme their systems to differentiate between micro-businesses and enterprises that fell outside the definition, incurring additional cost. More significantly, however, the 2012 paper concludes: "There was little real evidence of a problem".
"In cases of hardship, the FOS is already able to provide protection to micro-businesses. We have therefore concluded that while there might appear to be a logical case to distinguish small businesses, there is insufficient evidence of a systemic problem in practice to justify imposing a third regime for micro-businesses."
The proposals put forward in the 2012 consultation, therefore, apply to all businesses buying insurance, whatever their size. This also includes large risks, marine insurance and reinsurance.
The paper retains all the essential elements of the duty of disclosure as set out in the 1906 Act and developed in case law.
Business insureds would still have a pre-contract duty voluntarily to disclose material circumstances that the insured knows or ought to know so as to make a fair presentation of the risk. Where the duty is breached, the insurer would have to show inducement – in other words, that without the non-disclosure or misrepresentation, it would not have entered into the contact at all, or only on different terms.
The Law Commissions, however, think it would be helpful to clarify in the legislation what "material circumstances" and "knowledge" mean.
Material circumstances would include: "any unusual or special circumstances which increase the risk; any particular concerns about the risk which led to the insurance being sought; and standard information which market participants generally understand should be disclosed."
The consultation paper continues: "We also think that it would be helpful to specify that where the insurer receives information which would prompt a reasonably careful insurer to make further enquiries, then, if the insurer fails to make appropriate enquiries, it does not have a remedy for non-disclosure of any fact which those enquires would have revealed.
"We think that this is such an important doctrine that it needs to be specifically mentioned in statute, rather than simply seen as part of a more general doctrine of waiver."
The statute would also confirm that an insured need not disclose matters of common knowledge or information relating to the practices and risks of the trade which a well-informed insurer writing that particular class of business ought to know and it would set out what is meant by "known to the insurer".
A definition of what a business insured "knows or ought to know" would also be included in the legislation. This would be a restatement of the best principles of current case law and make it clear whose knowledge is relevant.
Those deemed to have relevant knowledge would be the directors or partners of the organisation and those employees whose business it is to arrange insurance for it. Knowledge would include actual knowledge and "blind eye" knowledge, meaning any information which the directors or partners and insurance buyer deliberately avoided acquiring because they preferred not to know.
The Law Commissions also want to specify the duty of a corporation to make reasonable enquiries before placing insurance. These should be proportionate to the type of cover and the size and nature of the business:
"We think it is appropriate for the legislation to set out a general test which can then be clarified by industry guidance and by agreements between businesses and insurers," the paper states. "The insurer should have a remedy against a policyholder who fails to disclose information which would have been discovered by those enquiries.
"On the other hand, there would be no requirement to disclose information which would not be revealed by reasonable enquiries, such as the fact that some staff or agents are defrauding the company. The test should accept that not all companies are perfectly run."
The Law Commissions hope that the new Act will be backed up by industry guidance developed by insurers and insurance buyers.
"We see our proposals as providing a framework of principles," the consultation paper states. "In order to provide the industry with transparency as to what is required, however, insurers and businesses need to work together to provide further guidance, protocols and understandings on how businesses should prepare presentations. The guidance needs to cover both procedural issues (how a business should set about preparing a presentation) and substantive issues (what must be included)."
The paper cites as an example the "Disclosure of Material Facts and Information in Business Insurance" published by the risks managers’ association Airmic in 2011.
Airmic represents insurance buyers and risk managers for the largest companies, including around three-quarters of the UK FTSE 100 group of companies.
The guidance suggests disclosure procedures should be proportionate to the size, nature and complexity of the business. For many companies, the process will be relatively simple, involving the completion of a proposal form by an authorised person. Larger, more complex businesses, however, will require more formal procedures.
These should include allocating (and documenting) clear roles and responsibilities within the company to establish who will be making the enquiries, who will compile the material information and who will sign it off as full and accurate. Ideally these roles should be agreed with the insurer.
The Law Commissions would like to see more guidance of this sort, with insurers and policyholders working together to develop protocols over what a standard presentation of a risk should include. Different protocols could cover different types of insurance.
"We think that a test based on established market understanding would encourage initiatives of this type. Where an insurer could show that it had not been told information which the guidance specifically stated should be included, the insurer would find it easy to show that the risk had not been fairly presented."
Under the Law Commissions’ proposals, no distinction is made between "innocent" and "negligent" breaches of the duty of disclosure in business insurance. The insurer is entitled to a proportionate remedy in either case.
This is a significant difference from consumer insurance, where, under The Consumer Insurance Act 2012 (when it comes into force), the insurer will have no remedy if the insured acted honestly and reasonably.
As in the Consumer Insurance Act, however, proportionate remedies are based on what the insurer would have done had it known the true facts. Where it would have declined the risk altogether, the policy can be avoided, the claim refused and the premiums returned. Where the insurer would have accepted the risk but included another contract term, the contract should be treated as if it included that term. Where the insurer would have charged a higher premium, the claim should be reduced proportionately.
The Law Commissions acknowledge that in some cases it may be difficult to establish exactly what an insurer would have done: "The court will need to hear the evidence and subject it to scrutiny. The courts are already used to deciding issues of inducement.
"We accept that in some cases, the result will be imprecise, but we think it is better to aim imprecisely at the right target than precisely at the wrong target. Proportionate remedies are the neutral solution to compensating the insurer for its loss; such remedies are therefore the most appropriate default regime."
Since this would be a default regime, however, parties would be free to contract out and agree different remedies for breach. Any terms changing the default regime must be written into the contract in clear unambiguous terms and specifically brought to the attention of the other party.
The paper asks for views on whether the statute needs to provide a specific statutory right to cancel future cover where the insurer has been induced to enter into a contract as a result of non-disclosure or misrepresentation - and whether the insured should have the right to cancel on reasonable notice where they discover that the insurance will not provide them with the cover they expected because the insurer intends to apply a proportionate remedy.
Where the insured has acted dishonestly (deliberately or recklessly), the insurer would be entitled to avoid the contract altogether. The statute will clarify that the insurer need not return any premiums paid.
The paper asks whether a definition of dishonest conduct is required in business insurance. The Consumer Insurance Act provides a standalone definition of "deliberate or reckless" conduct. A misrepresentation is deliberate or reckless if the consumer knew it was untrue or misleading (or did not care either way) and knew (or did not care) that the matter to which it related was relevant to the insurer.
The duty of good faith
Where do these changes leave the duty of utmost good faith? Section 17 of the Marine Insurance Act 1906 states that a contract of insurance is "based upon the utmost good faith" and that the only remedy for breach is to avoid the contract, as if it had never existed. The duty applies to both the insurer and the insured, both before and after the contract has been formed.
The Law Commissions have already indicated in recent issues papers on fraudulent claims and late payment of claims that the duty should be a shield rather than a sword:
"We think that the duty of good faith is important as a general interpretative principle but we do not think it should, in itself, give either a policyholder or an insurer a cause of action. Any remedies which are required, such as remedies for non-disclosure, misrepresentation or fraudulent claims, should be specified directly in the legislation."
The paper also asks whether a revised section 17 should refer to "utmost good faith" or simply "good faith".
The consultation closes on 26th September 2012. The Law Commissions plan to publish their final report and a draft Bill by the end of 2013. This will cover pre-contract duties of disclosure in business insurance, warranties, damages for late payment, insurers’ remedies for fraudulent claims, insurable interest, and policies and premiums in marine insurance.