The Insurance Act 2015 – Discussion for Underwriters “failing that”, is “just enough” good enough?

18/02/2015

Having been fast-tracked through Parliament, the time for debating the merits of the Law Commission's Insurance Bill has come to an end. 

The time for planning an underwriting strategy for the new Act is now upon us.

FSW has never been an “academic” law firm, we take the law as a fact and predictability is all we ask for.  We are not lobbyists and we act for underwriters and insureds as the instructions find us.

The introduction of the actual underwriter test in Pan Atlantic Insurance Co. Ltd v Pine Top Insurance Co. Ltd probably marked the point where we concluded that, in all but very clear-cut cases, Judges would not let underwriters avoid in anything but the strongest non-disclosure case.

It is worth briefly summarising the most important changes that are to be made to the law on non-disclosure (changes to the law on warranties and fraudulent claims are outside the scope of this article).  In practice, it is to the remedy that has changed.  Underwriters will no longer be able to avoid ab initio (rescission of the contract from inception) unless the “qualifying breach” of the duty of disclosure was deliberate or reckless, i.e. the insured knew that it was in breach of the duty of fair presentation, or did not care whether or not it was in breach of that duty. 

Underwriters have not in the past had any interest in ascribing a moral hashtag to an insured's breach of the duty and it seems to us that other than in the most improbably rare and outrageous case, the remedy of avoidance ab initio has ceased to exist – other than in a legal museum showcase.  (That raises other issues for the future like how do you respond to suspected fraud which we leave over for another time.)

In place of avoidance ab initio, the law has embraced proportionality and the interesting and expensive enquiry into what would have happened if the duty had been properly discharged.  If the insurer would have entered into the contract (whether the terms relating to matters other than the premium would have been the same or different), but would have charged a higher premium, the insurer may reduce proportionately the amount to be paid on a claim.

“Reduce proportionately” means that the insurer need pay on the claim only X% of what it would otherwise have been under an obligation to pay under the terms of the contract:

Underwriters will no doubt adapt and survive.  The Commission says that disclosure is now a “shared duty”. 

Sadly, we think this is PR spin.  The proposed changes are, in our view, about shifting the transactional cost and risk of disclosure from the insured and his agent to the underwriter.

The chance that the risk has been played down by inadequate disclosure is, in our view, now part of the overall risk that the underwriter must price for, and in the long run the costs of the inadequately disclosed and therefore under-priced risk will be transferred to the larger group of insureds who meticulously discharge the duty and possibly pay more for their diligence.

So, given that underwriters are not going to be able to stop these changes how might they adapt to them?

A renaissance in underwriting?

The first, and possibly most important, line of defence must be the professional skill of the underwriter.  Contrary to our pessimism it may at last be that this is recognised and the diligent underwriter who seeks out information will be rewarded and thrive.  And when this blog starts believing in fairy stories we will tweet you!.  Underwriters are not remunerated for the risks they turn away only those that they take!

In practice what we think will happen is, not a renaissance in underwriting expertise, but a race to the bottom where the prudent and diligent underwriter is simply bypassed in favour of the cowboy who will write the risk for a groat, no questions asked!

Having said that, it is not necessarily the case that the dumbing down of disclosure standards that we expect are inevitable and, even if they are, it would not be prudent to simply carry on as before.

While the remedy for non-disclosure has changed, the extent to which the duty itself has changed,  is we think,  more difficult to dissect.  But whatever the duty is, if its breach has little consequence what does it matter?

The essence of the changes to the duty of disclosure are found at Section 3(4) of the Act:-

“The disclosure required is as follows, except as provided in subsection (5) -

(a) Disclosure of every material circumstance which the insured knows or ought to know, or

(b) Failing that, disclosure which gives the insurer sufficient information to put a prudent insurer on notice that it needs to make further enquiries for the purpose of revealing those material circumstances.”

We are only concerned with commercial or “non-consumer” contracts.  What kind of test is this going to be? The words “failing that” suggest that the insured gets two chances: first of the conventional test reproduced in the first limb but if that does not get him home then he can use the back door and come in by the second limb. 

But why even bother to make full and proper disclosure under the first limb if you can get home under the lesser standard of the second limb?

Is “just enough” good enough?

The Commission’s final report provides some comfort to underwriters:-

“we think that the courts would treat Section 3(4)(b) as an alternative only where the insured has tried but failed to comply with section 3(4)(a) and shows that it has given the insurer good base on which to make its enquiries.”

 Perhaps, but has that laudable purpose been achieved by the words actually used?

We think only time will tell whether the statutory formula adopted actually achieves the result the Commission suggests.  It looks to us like fertile ground for abuse and consequent litigation.  Once there is a qualifying breach the insured still keeps his coverage subject to proportionality unless the underwriter can prove it was a deliberate or reckless breach.

There is no obvious mechanism whereby if there is a “breach” there is then a burden on the insured to show that it was not deliberate or reckless.

Consequently, we do not see any need for the insured to affirmatively show that he did make any particular quality of effort to try to properly comply with the first limb of the duty.  To the contrary, he would, on our reading of the words actually used, be entitled to say to the underwriter “if you say I was reckless or even dishonest” – prove your case. 

It can be noted that Section 4(4) provides that an insured ought to know (and therefore disclose) what should have been revealed by a reasonable search. 

But once a qualifying breach has been found there appears to be no requirement on the insured to prove that he ever carried out such a search unless the underwriter can make that a relevant issue in any proceedings.

To take the Commission's example, if the insured had set out only to disclose enough to put the underwriter on notice that he should ask more questions in the hope that he would not, does that in itself make the non-disclosure deliberate or reckless and, if so, how will the underwriter prove it?

Certainly there is nothing in Section 2 of Schedule 1 to support even a presumption of the insured having to show that he did not set out to do “just enough” disclosure.  We can imagine a scenario where the underwriter says that the insured structured their presentation to provide “just enough” clues to get through the second limb of Section 2(4) with the deliberate intention of leading the underwriter into a trap.  The difficulty with this is that on our reading of the Act, if the underwriter was given “just enough” then there is no breach so whether it was deliberate strategy or reckless is irrelevant.

The courts are unlikely to allow underwriters the luxury of fishing for evidence of the true intention on disclosure in the proceedings so it seems to us that, absent a whistleblower, it is likely that the underwriter will, in practice, have affirmed the contract long before he can find any evidential basis to allege deliberate or reckless conduct. 

More alarmingly, and why we say the Commission is indulging in spin, is the fact that a trial Judge could and will conclude that, if the insured has done “just enough” to pass the second limb, there is no “qualifying breach”, thus the insured's moral hashtag is irrelevant and would thus be entitled to prevent the underwriter investigating it at trial.

Is the duty to make a reasonable search meaningless?

We mentioned above the duty to make a search under Section 4(6) and we wonder what would be the response if an underwriter in proceedings for a declaration of his right to avoid under Schedule 1(2) asked for specific disclosure of all documents relating the insured's search?  We suspect the underwriter would meet a judicial brick wall!

We think that in reality if there is any chance of using Schedule 1(2) or of investigating the insured's performance of its duty under Section 4(6) of the Act, the groundwork must be done by the underwriter before inception of the contract.

Not a rosy prospect but it might just be better for underwriters than the de facto status quo. 

At para 7.36 the Commission lets the cat out of the bag when it says, “… even under the current law, an insured complies with the duty of disclosure if it discloses enough information either to allow the insurer to make an assessment of the risk or to put the insurer on notice that it needs to ask for more information.”

So the common law has already downgraded the pass mark – whatever The Marine Insurance Act may have said, the common law has already re-written the test so that a fair presentation of the risk simply requires the insured to have given the underwriter sufficient signposts that if it wants to know it can ask. 

If that is right it seems to us possible but very unlikely that the new law will be interpreted in such a way that it puts the non-disclosing insured in a worse position than already exists at common law.

One of the reasons for not asking too many questions in the past has been that it was far too easy to be fobbed off with inadequate answers and then find an otherwise good non-disclosure avoidance spoiled by alleged waiver.

So what does the future hold?

We suggest that under the new regime, insurers are just as susceptible to waiver if you don’t ask than if they do, so the starting point is to ask.  But note, simply asking a question does not necessarily make the response material.

Perhaps the first question should be to require the insured to disclose the process and procedures that it has used to prepare its presentation.  As we can see from Section 4(3) a corporate insured is deemed to know what is known by its senior management “or” those responsible for the insured's insurance.

Anyone who has followed the never-ending run of scandals from rogue dealers to phone hacking to LIBOR knows that senior management almost always know nothing about anything embarrassing.  As for the risk manager he will only know what he is told or what he tries to find out.

Consequently, the process that has been used to collate the presentation is the first and arguably one of the most important risks the underwriter faces.  So ask detailed questions about it. 

The scope and methodology should be readily available and the insured has no real grounds to object as Section 4(6) says that the insured ought to know what should reasonably have been revealed by a reasonable search of information available to the insured. 

Well, that’s all right then – honours all round!

Do not be comforted by the Commission's spin.

In para 7.40 it states “given the overarching duty of good faith we do not think the courts would employ section 3(4)(b) to aid an insured who intentionally disclosed a limited amount of information, hoping that that the insurer would fail to make further enquiries to reveal the full picture.”

Does the wording of the proposed Act actually deliver on the Commission's very reasonable sounding expectation?  We think it is unlikely to do so.

First of all, the burden of proving that the insured intentionally sought not to comply with the first limb of Section 3(4) will be virtually impossible to discharge.  An insured is not going to admit that its strategy was to rely on getting through on the second limb and, as discussed above, it is difficult to see how an insurer could get disclosure of any documentary evidence (if it even exists) given the present trend to discourage “fishing expedition” disclosure requests in litigation.

So, in our view, if the insured did deliberately intend to tailor disclosure to get home under the second limb it will be very difficult if not impossible for the underwriter to prove it.

Secondly, assuming against the trend of experience that the underwriter can establish that there was a policy of limited disclosure such that the ideal of limb one is missed but “just enough” is done to meet limb two, what sanctions can it bring to bear against the insured?

One might be tempted to utter vagaries about good faith as the Commission itself does at paragraph 7.40 of its report where it rather surprisingly talks of an “overarching duty of good faith”. 

This is hard to reconcile with the actual words of Section 14(2) “any rule of law to the effect that a contract of insurance is a contract based on the utmost good faith is modified to the extent required by the provisions of this Act …”.

To our mind, there is nothing in Section 3 which applies a practicable and verifiable test of good faith to the operation of the two-limb gateway in Section 3(4). 

If the Commission had been serious in its intentions as to how the second limb was to apply only if a bona fide attempt had been made to comply with the first limb it would have been a very simple matter to incorporate that requirement into the clause itself.

For example, Section 3(4)(b) might contain rather stronger words than “failing that”.  It could have said “this sub clause only applies where an insured who has failed to comply with the previous sub clause can prove that it acted in good faith and made a reasonable attempt to comply with its duty under the previous sub clause.”

It is not impossible that the words “failing that” might be interpreted by the courts to make the second limb a contingent gateway only available when an insured acting in good faith has fallen short of discharging the duty under the first limb, but we doubt it.