An insurer faced with a fraudulent claim should no longer be able to avoid the insurance contract as if it had never existed, according to proposals put forward in a new Law Commission consultation paper on reforming post-contract duties in insurance law.
The paper concludes the law should reflect current court decisions that the fraudulent claim should be forfeited, but that this should not affect previous, valid claims made under the same policy. The insurer would, however, be discharged from any future liabilities.
In certain circumstances, an insured who makes a fraudulent claim may also be liable to pay the insurer's reasonable and legitimate costs incurred in investigating the fraud.
The proposals are set out in a second consultation paper on insurance law reform, published in December 2011 by the Law Commissions of England and Scotland. The consultation, which also covers damages for late payment of insurance claims and insurable interest, closes on 20th March 2012.
Research carried out in 2009 by the Association of British Insurers found that fraudulent insurance claims worth over £730 million were detected during 2008. But the estimated value of undetected fraud is much greater at £1.9 billion a year.
Criminal prosecutions for insurance fraud, however, are relatively rare, so the burden of providing an effective deterrent lies with the civil law. The problem, however, is that there is a discrepancy between the way in which courts in the UK approach fraudulent claims and the law as set out in the Marine Insurance Act 1906.
Under section 17 of the Act (which applies to all forms of insurance), the parties to an insurance contract owe each other a duty of utmost good faith, both before and after the contract is entered into.
Before the contract, utmost good faith mainly comprises the insured's duty to disclose and not misrepresent all material facts to the insurer. Post-contract, it means the insured must act honestly when making any claim under the policy.
If one party breaches the duty of utmost good faith, the only remedy under the Act is for the other party to avoid the contract in its entirety - i.e. treat the policy as if it never existed. In the context of a fraudulent claim, this means that, in addition to not paying the claim in question, the insurer is entitled to avoid any liability (and recoup any payment made) for any previous, genuine claims under that policy.
The courts, however, see avoidance of the whole policy as disproportionate. Instead, they have applied a special common law rule, so that the fraudulent claim is forfeited but the policy is not. Valid claims made before the fraud are unaffected.
In their consultation paper, the Law Commissions favour this approach rather than the all-or-nothing remedy of avoidance.
"It is common for commercial insurance policies to cover many different goods, or many different risks," the paper states. "Small businesses are increasingly using combined policies, covering vehicles, property and liability. In these circumstances, the difference between forfeiting the claim and avoiding the whole policy may be significant.
"Moreover, it is particularly important that the law in this area is clearly articulated and understood. The more confused the rules, the less they will deter fraud."
Consequently, the Law Commissions propose a new statutory provision that will clearly set out the remedies for fraudulent claims.
An insured who commits a fraud in relation to a claim would forfeit the whole claim to which the fraud relates. Any interim payments made on the claim would have to be repaid. Any claim arising after the date of the fraud would also be forfeited, whether or not the insurer had taken action to terminate the contract. But any previous, valid claim, where the loss arose before the fraud took place, would be unaffected.
The consultation paper, however, warns that, on discovering a fraud, the insurer must take some action to communicate the finding to the insured and terminate the cover. Otherwise, it may be taken to have waived its defence to a subsequent claim.
The Law Commissions do not consider any statutory reform is required in relation to exaggerated claims or claims presented in a dishonest way.
Under the current law, where a claim is partly genuine, partly fraudulent, the whole claim will be forfeit as long as the fraudulent element is "more than minimal". Judges have resisted applying a hard and fast rule to what is more than minimal and will look at the fraud on its own and in the context of the claim as a whole. The Law Commissions are satisfied to leave this to the courts.
Utmost good faith
The effect of the changes and other proposals on remedies for misrepresentation, non-disclosure and the late payment of insurance claims will require a radical re-modelling of section 17 of the Marine Insurance Act, which states that a contract of insurance is "based upon the utmost good faith" and that the only remedy for breach is avoidance of the contract, as if it had never existed.
The Law Commissions' view is that the duty of good faith "is best seen as a shield rather than a sword."
"It is a general interpretative principle," they state in the consultation paper, "and it may be used to prevent a party from relying on a contractual provision to justify actions taken in bad faith. It becomes problematic, however, when it is used as a cause of action in its own right, especially as it only specifies one remedy, namely avoidance.
"In our next consultation paper, on the pre-contract duty of disclosure in business insurance, we will return to the issue of whether avoidance is always the appropriate remedy for non-disclosure or misrepresentation.
"At the same time, we will make proposals to reform section 17. Our current thinking is that the duty of good faith should remain as a general principle, but that it should not, in itself, provide any specific remedies. Instead the appropriate remedies for late payment, fraudulent claims, non-disclosure and misrepresentation should be specifically set out in legislation."
Under the Law Commissions' proposals, insurers would, for the first time, be able to claim damages for the reasonable costs incurred in investigating a fraudulent claim.
The insurer would need to show that the policyholder committed a fraud and be able to prove the actual costs incurred in investigating it. It would also have to demonstrate those costs were reasonable and proportionate in the circumstances and could not be offset by any saving from legitimate, forfeited claims.
The consultation paper gives an example of an insured suffering a genuine loss of £1,000 and using a fraudulent device to claim a further £100. The insurer forfeits the entire claim of £1,100, incurring £500 costs investigating the fraud. In these circumstances, it would not be entitled to any damages as it has effectively "saved" £1,000 in not having to pay out for the genuine loss.
"We do not think such a right would be used often, but it would be an important sanction against major fraud, where the whole claim has been fabricated," the consultation paper states.
Public policy prevents a party from including a term in an insurance policy that excludes or limits liability for its own fraud.
Many policies, however, include specific fraud clauses that set out the insurer's remedies for fraud. The courts will uphold these if they are clearly expressed.
In consumer insurance, such terms must also satisfy the Unfair Terms in Consumer Contracts Regulations, which means they must be drafted in plain, intelligible language and be fair. A clause which is unexpectedly harsh might be considered unfair if it is not brought to the insured's attention.
In their consultation paper, the Law Commissions provisionally propose that, in commercial contracts, an express clause extending the insurer's remedies for fraud should be upheld, but only if it is written in clear, unambiguous terms and specifically brought to the attention of the other party.
The same would apply to a clause that modified or limited the insurer's remedies, for instance by forfeiting the claim to which the fraud relates but not any subsequent claim.
In consumer insurance, however, any term which purported to give the insurer greater rights in relation to fraudulent claims would have no effect.
The Law Commissions make no proposals in respect of clauses purporting to exclude an agent's liability for fraud. "Given that such clauses are so rare, the courts would seem to be best placed to resolve any issues," the consultation paper concludes. The wording of the clause would have to be very clear for it to be upheld.
A particular problem can arise where two or more people have identical interests insured under the same policy (known as joint insurance) and one of them submits a fraudulent claim. A common example is where husband and wife own and insure their home together. If one party commits a fraud, the other will lose any claim under the policy, even if they were wholly innocent.
In their July 2010 issues paper, the Law Commissions tentatively suggested that, in this situation, there should be a presumption that the fraud was committed on behalf of them both, but that the innocent party should be able to rebut that presumption.
Since then, however, the Commissions have not found evidence that fraudulent claims in joint insurance are a problem in practice. They suspect that, in this situation, many insurers already pay the innocent party’s claim without relying on their strict legal rights.
In other cases, the court may be able to construe the insurance as a composite policy, under which the parties have different and separate interests, so that fraud by one of them will not affect the other.
"Our current view on the basis that there appears to be no evidence of a significant issue, is that legislative intervention is not necessary," the consultation paper concludes. "If however, there is significant evidence to the contrary we may reconsider the position."
The Law Commissions also consider group insurance schemes, where, typically, a policy is taken out by an employer for the benefit of employees.
They propose that the new legislation give insurers the same remedies against a group member as they would have against a policyholder. This means that a group member who acts fraudulently would forfeit their whole benefit, and any subsequent benefit, and would be liable to pay the insurer’s reasonable costs of investigating the fraud. But fraud by one member would not affect the benefits of other members.
The consultation, which also covers late payment of insurance claims and insurable interest, closes on 20th March 2012. The Commissions plan to make their final recommendations to Parliament in 2013.
Their third Consultation paper, due in 2012, will cover pre-contract nondisclosure and representations in business insurance and the law of warranties in business and consumer insurance.