Fundamental changes to insurance contract law: The Insurance Act 2015

Extensive reforms and their importance for the insurance market

The Insurance Act 2015 (the "2015 Act") has already been passed (as of 12 February 2015) and is scheduled to come into force from 12 August 2016. This 18-month timeframe was built into the 2015 Act to allow parties in the insurance market to understand the reforms and make any necessary changes to their business practices or policy documents. Considering the wide-ranging and fundamental nature of the reforms – which are likely to affect how parties underwrite risk, approach disclosure and due diligence, negotiate, discuss settlement, litigate and so on – it is crucial to understand the impact of the reforms and appreciate the areas where the law remains unclear. For those interested in the origins of the 2015 Act, the Insurance Bill was introduced in Parliament on 17 July 2014 following a Law Commission report1 which aimed "at ensuring a better balance of interests between policyholders and insurers". The Law Commission explained that the existing law, based on principles developed in the 18th and 19th centuries and codified in the Marine Insurance Act 1906 (the "1906 Act") and extended to non-marine insurance cases, was out of line with best practice in the modern insurance market and in need of reform. English insurance contract law had failed to keep up with developments in other areas of commercial and consumer contract law as well as with insurance law in other jurisdictions (including jurisdictions which had modelled their laws on the 1906 Act and subsequently implemented their own reforms). The 2015 Act has implemented nearly every recommendation made by the Law Commission. For reference, see the full text of the 2015 Act.

Scope of the Act

The 2015 Act will apply to contracts of insurance governed by English law which are:

• new agreements concluded after 12 August 2016; and
• variations made after 12 August 2016 to existing contracts of insurance entered into at any time.

The 2015 Act will not apply retrospectively to English contracts of insurance entered into prior to 12 August 2016. The 2015 Act will also apply in the context of reinsurance and retrocession which are contracts of insurance under English common law. The underlying insurer in relation to these contracts will owe the duties set out in the 2015 Act, as a reinsured, to the reinsurer. At the outset, it is important to note that the 2015 Act distinguishes between a "consumer insurance contract" and a "non-consumer insurance contract". The two primary reasons for doing so are that:

• the duty of fair presentation under the 2015 Act and prohibition of "basis of contract" clauses only apply to non-consumer insurance contracts (because the duty of fair presentation and prohibition of basis of contract clauses already applies to consumer insurance contracts under the Consumer Insurance (Disclosure and Representations) Act 2012); and
• the application of the 2015 Act to consumer insurance contracts is mandatory and cannot be contracted out.

Contracting out

An immediate question for many will be whether parties to an insurance contract can opt out of the reforms implemented by the 2015 Act. In short, there will be no ability to contract out in relation to consumer contracts but there is some scope to contract out in relation to business contracts, albeit with some restrictions. Basis of contract clauses will be ineffective and this cannot be contracted out. Other provisions of the 2015 Act can be contracted out but only if:

• the insurer takes "sufficient steps" to draw to the attention of the insured (or its broker) the terms which would have applied pursuant to the 2015 Act but which are being contracted out; and
• such terms must be clear and unambiguous "as to their effect" in the contract.

On the first requirement, the insurer need not ensure that the insured has actual and full knowledge of the terms being contracted out. However, the insurer must ensure that it has taken "sufficient steps" to draw it to the insured's attention, although what exactly amounts to sufficient steps will depend on the characteristics of the insured and the circumstances of the transaction. In the context of a broker acting on behalf of the insured, the insured will not be able to rely on any failure by the insurer to take sufficient steps to draw a clause to the insured's attention if the broker already had actual knowledge of the clause when the contract was agreed (constructive knowledge or what a reasonable broker ought to have done in the circumstances would not be sufficient). On the second requirement, the insurer must be cautious since it is not sufficient for the terms to be drafted clearly because it is their effect in the contract which must be clear and unambiguous. This may require contracts of insurance to include more detailed explanatory notes with the relevant exclusion clauses.

Summary of main reforms

The 2015 Act does not exhaustively address every eventuality and instead sets out rules intended to be flexible enough to apply broadly to different situations. The main reforms discussed in this note are summarised below. Duty of fair presentation Scope of the duty The 2015 Act replaces the existing duty on non-consumer parties to disclose all material circumstances (including any circumstances which it ought to know in the ordinary course of its business) to insurers before entering into an insurance contract. Knowledge of the parties The 2015 Act specifies what both an insured and an insurer (a) know; or (b) ought to know/are presumed to have known. Remedies for breach The remedy of avoidance for material non-disclosure will no longer be automatically available to an insurer. Instead, a tiered set of remedies will be available based upon the insured's intent for the breach (whether deliberate or reckless) and the insurer's appetite for the risk in the non-disclosed circumstance (whether the insurer would have still contracted even if on different terms or at a higher premium). Warranties A breach of a warranty will no longer give rise to an automatic remedy to an insurer to avoid the policy. Instead, breaches of warranty can potentially be cured and any warranties will apply as "suspensive conditions" ie they will only suspend cover for the duration of the breach. Connection between breach and loss There must be a connection between a term (whether or not it is a warranty) being breached and the loss which is claimed by the insured. If the breach did not increase the risk of the loss arising then an insurer will not be entitled to avoid a policy. Basis of contract clauses Basis of contract clauses have been abolished and it will no longer be possible for representations to be converted into warranties. Breach of the duty of good faith Any law permitting an insurer to avoid a policy on the basis that the duty of utmost good faith had not been observed has been abolished. Fraud claims Specific remedies for insurers are set out in relation to fraudulent claims (including terminating the contract and denying cover) with particular provisions relating to group policies.

Duty of fair presentation

Scope of the duty The existing duty on insureds under the current law is that they must (a) disclose material information/circumstances to an insurer prior to entering into the contract of insurance; and (b) must not make any misrepresentations of the risk to the insurer. The 2015 Act reforms this pre-contractual duty by requiring the insured to:

• disclose every material circumstance which the insured knows or ought to know; or
• failing that, disclose sufficient information so as to put a prudent insurer on notice of the need to make further enquiries for the purpose of revealing those material circumstances; and
• the disclosure must be done in a manner which is reasonably clear and accessible to a prudent insurer.

The duty is, therefore, two-fold in that its scope must be sufficient (either complete disclosure or sufficient disclosure to put a prudent insurer on notice to make further enquiries) and the format of the disclosure must be appropriate (a large "data dump" is not likely to be appropriate). The 2015 Act does, however, make clear that the disclosure need not be contained within a single document or oral presentation – it can be done through a series of exchanges between the parties. If the insurer receives sufficient information to be on notice of having to make further enquiries but does not do so, an insured is not required to disclose a specified set of circumstances (e.g. any circumstances which diminishes the risk, which the insurer knows or which the insurer ought to know). The insured will, however, need to ensure that it discloses matters which relate to a warranty under the contract of insurance. Under existing law2, an insured is not required to disclose a circumstance which is superfluous to disclose by reason of a warranty. However, 2015 Act will repeal this existing provision which is not mirrored elsewhere in the 2015 Act³. This is of particular importance given the separate changes in the 2015 Act to warranties and their suspensive nature in the event of their breach. Knowledge of the parties The 2015 Act specifies what an insured or an insurer are taken to know or ought to know:

The requirement of a "reasonable search" potentially imposes a far more onerous obligation on insureds compared to existing law which relates to the insured's knowledge in the ordinary course of its business. A company may more readily satisfy itself that it is aware of circumstances which arise through the ordinary course of its business (even if the way in which it runs its business is not efficient or lacking in internal record keeping or information sharing). By comparison, a company required to conduct a reasonable search may need to go beyond its own business and make reasonable enquiries of its employees or third parties such as its consultants, agents or business relationships. Similarly, the requirement on insurers for its employees to have reasonably passed on information or to have information readily accessible to them creates a more onerous obligation. It will require insurers to give some consideration as to how it stores data and records and how it makes this available to its underwriters. Remedies for breach A significant reason for the reforms under the 2015 Act was that the remedy of avoidance in the event of a breach of the insured's pre-contractual duty to disclosure was viewed as draconian. The remedy of avoidance has not been removed entirely but the range of remedies will now be dependent upon the nature of the breach of the duty of fair presentation which, along with the other remedies, are described in the table below.

The burden of establishing whether a breach was made deliberately (ie the insured knew the non-disclosure was a breach) or reckless (ie the insured did not care whether or not the non-disclosure was a breach) is on the insurer. This, combined with the obligation on the insurer to establish whether it would have entered into the contract at all but for the non-disclosure or on different terms (ie the issue of "inducement"), potentially puts insurers in a difficult position and the appropriate remedy available may not be easy to determine without extensive fact finding.

Warranties – breach and cure

The rule that a breach of a warranty could result in an insurer's liability being discharged will be abolished entirely. Warranties will instead have a "suspensory" nature for an insurer's liability. An insurer will remain liable for acts or circumstances arising prior to a breach of a warranty as well as after that breach has been remedied by the insured. The liability will not arise only for the period during which the insured is in breach of the warranty. It is important to understand how a breach of warranty can be taken to have been remedied for the purposes of the 2015 Act. Insurers will likely need to undertake more detailed assessments of an insured's circumstances when entering into the contract of insurance as well as the insured's actions during the contract but the breach and remedy will depend on the individual facts of the case and the nature of the warranty. The 2015 Act does not provide extensive detail on remedial action but gives a general framework as follows: (i) Time-based warranties – the breach is remedied "if the risk to which the warranty relates later becomes essentially the same as that originally contemplated by the parties". Example – an insured owns stock in a warehouse. The policy covering loss of stock contains a warranty that an effective burglar alarm will be installed by 2 February. The insured does not install the alarm system until 20 April. Some stock is stolen from the warehouse on 5 May (but after the alarm system had been installed). The insurer is not entitled to avoid cover for the stolen stock notwithstanding the breach of the warranty. (ii) All other warranties – the breach is remedied "if the insured ceases to be in breach". Example – as with the above example, the policy covering loss of stock instead contains a warranty that an effective burglar alarm must remain installed and maintained. Some stock is stolen and the alarm is not triggered due to the lack of maintenance. The insurer is entitled to avoid cover for the stolen stock due to the breach of the warranty. However, if the insured repairs the alarm then the insurer is not entitled to avoid cover for any stock stolen or lost after the repairs are made4.

Warranties - basis of contract clauses

The 2015 Act prohibits any representations made by an insured in connection with a proposed policy or contract of insurance from being converted into warranties. This prohibition essentially negates the effect of any "basis of contract" clauses currently routinely found in proposal forms. It will not be possible for parties to contract out of this rule. Any provisions which are intended to apply as warranties must be expressly stated as such in the contract of insurance.

Terms unconnected with the loss

The 2015 Act prevents insurers from relying on the non-compliance or breach of a term of the insurance contract (and not only warranties) if that breach may have an effect on losses arising and covered under the policy but which did not impact the actual loss for which the insured is claiming. The burden is on the insured to establish that its non-compliance with a particular term "could not have" increased the risk of the loss for which the insured is actually claiming arose. Again, this is fact-specific and will likely require a more detailed analysis and which will not be always be a simple conclusion to reach.

Good faith

Any law permitting an insurer to avoid a policy on the basis that the duty of utmost good faith had not been observed has been abolished. Contracts of insurance remain contracts of utmost good faith but any rule of law which would have entitled the insurer to avoid the contract for breach of good faith can no longer be relied upon (including section 17 of the 1906 Act and any similar provisions which may have been established in case law).

Fraud claims

The 2015 Act sets out three remedies available to an insurer in the event that an insured submits a fraudulent claim, as follows:

• The insurer is not liable to pay the claim. The insurer will likely be entitled to reject the whole claim, even if parts of the claim were validly made.
• The insurer is entitled to recover any sums which it may have already paid to the insured in respect of that claim. This will also be a useful remedy for an insurer if it discovers a historical fraudulent claim.
• The insurer may, by notice to the insured, treat the contract of insurance as having been terminated with effect from the time of the fraudulent claim (and in such a case may retain any premiums paid by the insured). However, the insurer would remain liable for any claims for legitimate losses made prior to the fraudulent claim.

The effect of the reforms on parties' approach

The intention of the reforms brought by the 2015 Act (as the Law Commission explains in its report underpinning the reforms) is to strike a better balance of interests between policyholders and insurers in a market which has changed dramatically over the decades. In particular, the Law Commission viewed the 1906 Act as too "insurer-friendly" and that the extent to which insurers could avoid liability was too wide. The significant reforms under the 2015 Act needed to be flexible and sufficiently high-level to apply across the broad range of risks being covered and insurance products being offered while simultaneously giving sufficient detail for parties to know where they are likely to stand in the event of claims made by insureds or breaches of insurance contract terms. This, however, will likely lead to all parties having to give more consideration to the facts relevant to particular risks being insured and breaches of terms and warranties which could arise. This consideration will have to be given prior to entering into the contract as well as when losses arise and claims are being investigated. For example, it is likely that;

• Insureds will need to consider how to present circumstances to insurers in a systematic matter.
• Insurers will need to be certain that they have a sufficient understanding of the risks being underwritten (if they are put "on notice" of the need to make further enquiries).
• Insureds will need to look not only at what information they are likely to hold during the course of their business but also what further reasonable checks they can make to uncover material circumstances which insurers need to be made aware of.
• Insurers will need to revisit their internal information sharing procedures and recordkeeping rules to understand what knowledge they "ought" to have on particular risks (and staff may need to receive adequate training).
• Insurers may need to update their risk checks and recordkeeping to maintain adequate evidence of how they would have agreed to underwrite risk (or refuse to underwrite) if undisclosed material circumstances had been raised.
• Both insureds and insurers will need to investigate the facts in more detail when a breach of a warranty occurs and how the breach impacts losses which may arise.

Given the increased emphasis of factual analysis which is likely to become necessary as a result of the changes in the 2015 Act, there may also be less certainty as to where the parties stand and the likelihood of success should they decide (or be compelled) to litigate. This can impact discussions between the parties during negotiations as well as increase the factual or expert evidence required during litigation. Some provisions of the 2015 Act remain uncertain and will likely need to be tested in court proceedings to better understand how they will be interpreted and applied to different scenarios. While several months still remain before the 2015 Act is brought into effect (and insurers will want to utilise this time to consider how their business may be impacted), there is likely to remain a period of uncertainty during 2016 and onwards before the market can fully appreciate the effects of the 2015 Act.

1. Law Com No 353 (July 2014)

2. Section 18(3)(d) of the 1906 Act

3. Section 3(5) of the 2015 Act is broadly similar to section 18(3) of the 1906 Act but without the inclusion of superfluous disclosure by reason of a warranty.

4. See AC Ward & Sons Ltd v Catlin (Five) Ltd [2008] EWHC 3585 (Comm) for a judgment on this scenario prior to the 2015 Act reforms.