Proposed Reforms to Warranties in Insurance Contracts: Focusing on Consumer Insurance, Slides of Contract Law

Download Proposed Reforms to Warranties in Insurance Contracts: Focusing on Consumer Insurance and more Slides Contract Law in PDF only on Docsity! Insurance Contract Law Issues Paper 2 Warranties November 2006 This paper should not be quoted as representing the fixed policy of either Commission. The paper has been drafted by the teams working on the insurance contract law review at the English and Scottish Law Commissions and is intended simply to promote discussion before the formal consultation process begins. It has not been subject to formal scrutiny by Commissioners. 1 SUMMARY PURPOSE AND CONTENT 1. This is the second in a series of Issues Papers produced by the teams working on the insurance contract law review at the English and Scottish Law Commissions. These papers have not been subject to formal scrutiny by the Commissioners and their contents should not be quoted as representing the view of either Commission. Our intention is that they should promote discussion of some of the main matters within the review and give a focus for debate at the seminars we are holding. 2. The proposals outlined below are only tentative. Our formal proposals will be published in a Consultation Paper in summer 2007. 3. Below we start by looking at basis of the contract clauses (whereby answers on a proposal form may be converted into warranties). We then consider undertakings about past and existing fact, followed by warranties of future conduct. BASIS OF THE CONTRACT CLAUSES 4. In 1980, the Law Commission described basis of the contract clauses as a “major mischief”. Such clauses allow insurers to use a form of words that few policyholders understand to extend the protections already available to them for misrepresentation to cover answers that are not material to the risk, or are made without fraud or negligence. At our first working seminar on non-disclosure and misrepresentation, there was a widespread consensus that basis of the contract clauses should be rendered ineffective in consumer insurance. There was more debate about how far insurers in business insurance should be able to add to the proposed remedies for misrepresentation, so as (for example) to reject claims where there has been an innocent misstatement. However there are strong arguments that even if insurers are able to add to their remedies, this should not be done through basis of the contract clauses. 5. It will be seen that below we argue that for consumer insurance, and possibly for business insurance also, the only remedies that should be available when the insured has made a false statement of fact should be those for misrepresentation. This would make all basis of the contract clauses redundant. 6. We tentatively propose that: (1) In consumer contracts “basis of the contract” and similar clauses that have the effect of turning statements of fact in general into warranties should be of no effect. (para 7.31) (2) In business insurance, as a minimum, a “basis of the contract” clause in the proposal form should no longer be effective to turn the statements made by the proposer into warranties. If warranties of past or existing facts are to be permitted at all, each statement warranted should be set out either in the policy, or in some document incorporated by reference to the policy. This rule would be mandatory. (para 7.35) 4 Reinsurance 15. Are there any reasons why the reforms should not apply to reinsurance contracts? (para 7.130) THE EFFECT OF A BREACH 16. We tentatively propose that a breach of warranty should no longer result in the insurer being automatically discharged from liability. (para 7.135) 17. We ask whether the reforms should provide that: (1) a breach of warranty gives the insurer the right to repudiate the contract? (para 7.135) (2) the insurer has a choice between repudiating the claim only, or the policy for the future, or both? (para 7.138) (3) where the insurer accepts the insured’s breach of warranty (so as to terminate future liability), the insured should cease to be liable for future premiums? (para 7.145) (4) an insurer who terminates a policy following the insured’s breach of warranty should normally provide a pro-rata refund of the outstanding premium, less any damages or administrative costs (para 7.149) (5) the insurer should be obliged to give notice that the contract is being terminated. If so, what would constitute a reasonable time for an insured to make other arrangements? (para 7.153) 18. If, as suggested above, a breach of warranty would give the insurer the right to terminate the contract for breach, the law of waiver would be affected. Loss by waiver of the insurer's right to repudiate the contract would be determined in accordance with the general rules of contract. We welcome views on whether it is necessary to include a specific provision on this point in any new legislation. (para 7.143) AN UNFAIR TERMS APPROACH? 19. We invite views on whether: (1) Clauses that define the risk and exclusions in business insurance contracts written on the insurers’ standard terms should be subject to a test of fairness. (2) If so, should the protection apply to all businesses or only those defined as small? (para 8.23) 20. We would consider this option only if it were really needed. There would need to be evidence that businesses require better protection not only against warranties but also against unexpectedly narrow definitions of the risk or unexpectedly wide exceptions, and that the approach set out in paragraph 13(3) above is unacceptable. i CONTENTS PART 1 : INTRODUCTION 1 Background 1 Status of issues papers 1 Our objectives 1 The structure of this paper 2 PART 2 : BACKGROUND 3 What is a warranty? 3 A hierarchy of terms 6 Basis of the contract clauses 7 PART 3: THE LAW COMMISSION'S 1980 REPORT 10 Identifying the problems 10 The recommendations 11 Why just warranties? A problem with the 1980 report 13 PART 4: ARE WARRANTIES STILL A PROBLEM? ALTERNATIVE METHODS OF PROTECTION 17 The construction approach 17 The ABI Statements of Practice and FSA rules 22 Unfair terms in consumer contracts: the 1993 Directive and 1999 Regulations 26 The Financial Ombudsman Service 34 PART 5: EVALUATION OF THE PRESENT POSITION 38 Introduction 38 ii Basis of the contract clauses 39 Specific warranties of fact or future conduct: 40 PART 6 : WARRANTIES IN OTHER JURISDICTIONS 45 Australia and New Zealand 45 Canada 55 The USA 57 Civil law jurisdictions 58 PART 7 : PROVISIONAL PROPOSALS 61 Our tentative proposals on misrepresentation and non-disclosure 62 Warranties of past or existing fact 66 Warranties as to the future: a written statement 73 Requiring a connection between the breach and the loss 74 Other types of clause 78 Should the reforms apply to marine, aviation and transport insurance? 81 Should the reforms apply to reinsurance? 86 Reforming other provisions of the MIA 1906 87 PART 8: AN UNFAIR TERMS APPROACH TO COMMERCIAL INSURANCE? 95 The Unfair Contract Terms Act 1977, sections 3 and 17 96 The arguments for extension 98 The arguments against extension 99 Conclusion 100 2 THE STRUCTURE OF THIS PAPER 1.6 The paper is divided into seven further parts: (1) Part 2 provides a background to the discussion, by explaining the current nature of an insurance “warranty” and where warranties fit within a hierarchy of terms in insurance contracts. (2) Part 3 summarises the English Law Commission 1980 report, setting out both its analysis of the problems and its recommendations for reform. (3) Part 4 asks whether warranties are still the problem they were in 1980. It discusses four developments since the report was published: (a) the courts’ approach to construing warranties as other terms; (b) voluntary statements of practice and Financial Services Authority (FSA) rules; (c) the Unfair Terms in Consumer Contracts Regulations 1999; and (d) the Financial Ombudsman Service (FOS). It argues that each of these offers a partial solution to the problems, but difficulties remain. (4) Part 5 provides a brief evaluation of the current state of the law. (5) Part 6 looks at how other jurisdictions have dealt with warranties. (6) Part 7 sets out our provisional proposals, namely that basis of the contract clauses should be abolished, and that warranties should be set out in writing and made subject to a causal connection test. It asks whether these protections should apply to all insurance, including marine, aviation and transport insurance and reinsurance. Finally, it considers the consequences of our proposals for the Marine Insurance Act 1906. (7) Part 8 considers the arguments for and against making standard terms in commercial insurance contracts subject to a test of fairness, along the lines of sections 3 and 17 of the Unfair Contract Terms Act 1977. It asks whether in commercial polices on standard terms, warranties and terms having the same effect as warranties should be made subject to a fairness test. 1.7 Finally, Appendix A provides background to Part 7, with a brief summary of the implied warranties in marine insurance. Appendix B describes the approach taken by the Financial Ombudsman Services. It analyses 50 final ombudsman decisions concerning consumer disputes about policy terms. 3 PART 2: BACKGROUND WHAT IS A WARRANTY? 2.1 The word “warranty” causes considerable confusion, as it is used in many different senses. In general contract law, a warranty is normally a term of minor importance, and a breach of warranty gives rise only to damages.1 Within the insurance industry, the word may be used to connote a variety of obligations placed on the insured. As a matter of insurance law, however, warranties are extremely important terms: the insured must comply with them strictly or face harsh consequences. Here we summarise the main characteristics of a warranty within insurance law, as set out in the Marine Insurance Act (MIA) 1906. Undertakings for the future and affirmations of fact 2.2 A wide variety of obligations on the insured can be given warranty status if the contract makes this sufficiently clear. Section 33(1) of the Marine Insurance Act (MIA) 1906 describes “promissory warranties” as terms by which the assured undertakes that some particular thing shall or shall not be done, or that some condition shall be fulfilled, or whereby he affirms or negatives the existence of a particular state of facts. In other words, warranties may apply to past or existing facts, or to future conduct. Strict compliance 2.3 The MIA states that a warranty “must be exactly complied with, whether it be material to the risk or not”.2 So if an insured has “warranted” that certain facts are true, the warranty will be broken even if the answer made no difference, or if the insured was not at fault in any way. As we shall see, the insurer will be discharged from liability. Later remedy irrelevant 2.4 Furthermore, once a breach has occurred, the fact that it has been remedied does not prevent the contract from being discharged. As section 34(2) states: Where a warranty is broken, the assured cannot avail himself of the defence that the breach has been remedied, and the warranty complied with, before loss. 1 See e.g. Sale of Goods Act 1979, s 11(3) (“Whether a stipulation in a contract of sale is a condition, the breach of which gives rise to the right to treat the contract as repudiated, or a warranty, the breach of which may give rise to a claim for damages but not to a right to reject the goods….”) 2 Marine Insurance Act 1906, s 33(3). 4 2.5 For example, in De Hahn v Hartley,3 the insured warranted that the ship would sail from Liverpool with 50 hands. In fact, when the ship left Liverpool it had only 46 hands, though it picked up six more hands in Anglesey and had 52 hands at the time of the loss. The court held that the insurer’s liability terminated when the ship left Liverpool. The insurer was not liable for any losses that arose after this date, however caused. Automatic discharge from liability 2.6 Section 33(3) spells out that a warranty must be complied with exactly. If not, the insurer is discharged from liability under the contract, which means that an insurer is not liable for any claims arising after the breach. It states that if a warranty is not exactly complied with, then subject to any express provision in the policy, the insurer is discharged from liability as from the date of the breach of warranty, but without prejudice to any liability incurred by him before that date. 2.7 These words should be taken literally. In its 1980 report the Law Commission said that on a breach of warranty the insurer was “entitled to repudiate the policy”. 4 In The Good Luck, Lord Goff criticised this formulation, saying that it was inappropriate to describe the insurer as “repudiating the policy”.5 It is more accurate to keep to “the carefully chosen words” of the 1906 Act and say that the insurer is discharged from liability as from the date of the breach.6 This means that, following breach, the insurer has a good defence to any claim without taking further action. The insurer may, however, waive the breach and restore their liability.7 “Subject to any express provision” 2.8 Section 33(3) is subject to any express terms of the policy. This means that the parties can contract out of automatic termination if they wish. For example, marine insurance contracts commonly include “held covered” clauses, which allow the policy to continue after the breach of warranty. Thus the Institute Time Clauses (Hull) include the following: 3 (1786) 1 TR 343. 4 Insurance Law, Non-Disclosure and Breach of Warranty (1980) Law Com No 104, para 6.2. 5 Bank of Nova Scotia v Hellenic Mutual War Risks (“The Good Luck”) [1992] 1 AC 233, at pp 263-4. Lord Goff said that the Court of Appeal had been “led astray” by passages in certain books and other texts which refer to the insurer being entitled to avoid or repudiate for breach of a promissory warranty. 6 Above, pp 263, quoting Marine Insurance Act 1906, s 33(3). 7 Marine Insurance Act 1906, s 34(3). The means by which such waiver can occur raises difficult legal issues, and is discussed further in Part 7. 7 For example, in Farr v Motor Traders Mutual Insurance the policyholder insured two taxi-cabs, stating that they were only driven for one shift every 24 hours.14 For a short time, one of the cabs was driven for two shifts while the other was being repaired. The cab was then used for one shift a day in the normal way and a couple of months later was damaged in an accident. The Court of Appeal rejected the insurer’s argument that the assured had breached a warranty. Instead the words were merely “descriptive of the risk”. This meant that if the cab was driven for more than one shift per day, the risk would no longer be covered, but as soon as the owner resumed one-shift working, the insurer again became liable. (4) Innominate terms, where the remedy for a breach depends on its seriousness. Where the breach is serious, the insurer may repudiate the policy (that is, treat the contract as terminated). Where it is minor, the remedy would be in damages only. In Alfred McAlpine Plc v BAI (Run- Off),15 it was suggested that a serious breach of a notification clause may lead to a rejection of the claim while a minor one may not. However, this has now been doubted,16 and we discuss the issue further in Part 4. (5) Mere terms, breach of which gives rise to a claim for damages, but which do not affect the insurer’s liability to pay claims. 2.14 The category a term falls into is a matter of construction for the courts. There are many statements within the cases that any ambiguity should be resolved in favour of the insured.17 If the insurer wishes to treat a condition as a warranty or condition precedent, they must use clear words.18 They should not escape liability unless terms are put before policyholders “in words admitting of no possible doubt”.19 BASIS OF THE CONTRACT CLAUSES 2.15 The problems with warranties are exacerbated by the use of “basis of the contract” clauses. This is a device whereby potential policyholders are asked to sign a clause at the bottom of the proposal form, declaring that they warrant the accuracy of all the answers they have given. The clause usually states that the answers “form the basis” of the contract. It is well established that such a clause may elevate the answers to contractual terms, even if the terms are not to be found in the policy itself. 14 [1920] 3 KB 669. The case was approved in Provincial Insurance v Morgan [1933] AC 240. For further examples of cases where courts have rejected insurers’ arguments that a term is a warranty and have instead declared it to be descriptive of the risk: see Part 4. 15 [2000] 1 Lloyd’s Rep 437. 16 Friends Provident Life and Pensions v Sirius International Insurance [2005] 2 Lloyd’s Rep 517; [2005] EWCA Civ 601. 17 See the discussion in Part 4. 18 Provincial Insurance Company v Morgan [1933] AC 240, per Lord Wright at p 255. 19 As above, per Lord Russell, at p 250. 8 2.16 The use of basis of the contract clauses means that an insurer may avoid liability for an inaccurate answer, even if the answer was not material, and even if it was given innocently. For example, in Dawson Ltd v Bonnin,20 the insured was asked where a lorry was garaged. They inadvertently gave the firm's place of business in central Glasgow, though the lorry was usually kept on the outskirts. This did not increase the risk in any way (and arguably decreased it). However, when the lorry was destroyed by fire, the insurers argued that the accuracy of the answer had been elevated to a warranty. Given the breach, the insurers were no longer liable. The House of Lords agreed (by a three to two majority) that even though the misrepresentation was immaterial, the insurers were not liable. 2.17 There has been widespread criticism of basis of the contract clauses. The 1980 report quoted judicial criticisms of such clauses dating from 1853.21 In 1908, Lord Justice Moulton said he wished he could “adequately warn the public against such practices”.22 In 1927, Lord Wrenbury described their use as “mean and contemptible”: Here, upon purely technical grounds, [the insurers], having in point of fact not been deceived in any material particular, avail themselves of what seems to me the contemptible defence that although they have taken the premiums, they are protected from paying.23 2.18 Despite these criticisms, however, the use of basis of the contract clauses has been upheld as recently as 1996. In Unipac (Scotland) Ltd v Aegon Insurance the company answered two questions on the proposal form inaccurately.24 They said they had been carrying on business for a year, while they had been incorporated for less than a year; and they said they were the sole occupiers of the premises, when they were not. Following a fire, the insurers refused to pay the claim. The policyholders brought an action arguing that they had not warranted the accuracy of the answers, only that they were true to the best of their knowledge and belief. In the absence of a specific warranty, the insurer could avoid liability on the basis of a misrepresentation only if it was material. The Court of Session rejected these arguments, stating that the words used were clear. The court stressed the importance of freedom of contract in ringing terms: 20 [1922] 2 AC 413. 21 para 7.2, referring to Anderson v Fitzgerald (1853) 4 HL Cases 484, 10 ER 551. 22 Joel v Law Union and Crown Insurance Co [1908] 2 KB 863, at p 885. 23 Glicksman v Lancashire and General Assurance Co [1927] AC 139 at pp 144-5. See also Mackay v London General Insurance Co [1935] Lloyd’s Law Reports 201 and Lord Russell’s comments in Provincial Insurance v Morgan [1933] AC 240 at p 250. 24 1996 SLT 1197. 9 We recognise that a consequence of holding that the declaration contains an express warranty of the truth of the answers to the questions in the proposal is that if there was an error in, for example, the postcode or telephone number of the proposer, the result would be that the defenders would be entitled to avoid the policy. That however is a consequence of the parties agreeing to an express warranty with the result that the defenders would have a right to avoid the policy if an answer was untrue whether or not the untrue item was material. We are not persuaded that that would be a ludicrous result. It is simply a consequence of what parties have agreed to by contract and parties are free to agree what they like.25 2.19 While it is true that parties are free to agree what they like, normally they must do so in the contractual document itself. “Basis of the contract” clauses form an exception to this normal rule.26 Although in commercial policies the basis of the contract clause may often be referred to in the policy itself, this is not necessary under the current law.27 Clarke comments that it is difficult to square basis of the contract clauses “with the notion underlying the parole evidence rule”, namely that a document such as a policy “which looks like the whole of the contract should be treated as the whole of the contract”.28 25 as above, at p 1202. 26 In Scotland, section 1 of the Contract (Scotland) Act 1997 now provides that where a document appears to comprise all the express terms of a contract, then unless the contrary is proved it shall be presumed that it does comprise all the express terms. Since this is merely a presumption it does not appear to preclude an insurer from arguing that a basis of the contract clause in a proposal constitutes an additional express term. 27 Different rules apply to marine insurance, where we are told that basis of the contract clauses are rarely used. Under section 35(2) of the Marine Insurance Act 1906, “an express warranty must be included in, or written upon, the policy, or must be contained in some document incorporated by reference into the policy”. This means that the basis of the contract clause used in the Unipac case would not have been recognised in a marine insurance policy, as it was only printed on the proposal form and was not referred to in the policy itself. It seems anomalous that protection available to marine insured since 1906 should not be available to other policyholders. 28 M Clarke, The Law of Insurance Contracts (4th ed 2002), para 20 –2A1, p 630. 12 3.8 The report explained that if an insured has completed a proposal form and given answers relating to the future, the insurer could comply with this obligation by giving the insured a copy of the completed form. Normally, the insured would do this at or before the contract was entered into. However, in some cases a warranty may be given and cover granted over the phone. Here the insurer should be required to confirm the warranty in writing as soon as practicable. This “may be done in a cover note, in a certificate of insurance, or even by letter”.7 3.9 It is clearly right that any promissory warranty should be brought to the insured’s attention as soon as possible. The problem with this provision, however, is that it could be complied with in a purely formalistic way. It does not ensure that the warranty is presented clearly or expressed in plain language. An insurer could comply with clause 8(2) even if they buried the warranty in a mass of small print. Substantive safeguards The working paper test 3.10 In its working paper the Law Commission had provisionally proposed a three-part test. For a term to be effective as a warranty, the insurer would have to show: (1) that it was material to the risk, in the sense that it would influence a prudent insurer in deciding whether to accept the risk and if so at what premium; and (2) the type of loss that occurred fell within the commercial purpose of the warranty. For example, the commercial purpose of a warranty that a vehicle should be kept roadworthy is intended to relate to the risks that arise when the car is being driven. A breach should not affect liability if the car is stolen. Once the insurer had established this, it would on the face of it be entitled to reject the claim. However, the insurer would still be liable to pay if the policyholder could prove: (3) that the breach could have had no possible connection with the actual loss that had occurred. 3.11 It was envisaged that this final test would place heavy onus on the policyholder. The working paper gave an example of a warranty in a fidelity policy that the insured employer would engage no one without first taking up satisfactory references. The employer failed to take up references on employee A, who stole the employer's money. The paper argued that the insurer should “clearly be entitled to reject the claim, because the commercial purpose of the warranty was to guard against this very type of loss”. Furthermore, “it should not be open to the insured to resist this by seeking to show, for instance, that A would have produced satisfactory or forged references if he had been asked for any”. The court should not be invited to speculate on what might or might not have occurred. However, if the money were stolen by employee B, whose references were satisfactory, then the insured could show that there was no possible connection between the failure in relation to A and the actual loss. 7 para 6.14. 13 The test in the final report 3.12 Following consultation, the Law Commission changed its approach. It was persuaded that insurers should not have to show that a warranty was material to the risk. Instead it should be assumed to be material unless the insured showed that it would not have influenced a prudent underwriter. Similarly, it was decided that the onus should be on the insured to show that the type of loss did not fall within the commercial purpose of the warranty. 3.13 This led to a convoluted approach. If a claim were rejected for breach of warranty, the policyholder would have a choice between three possible lines of attack. The draft Bill would allow the insured to challenge the decision on any one of the following grounds: (1) the warranty does not relate to a matter which is material.8 (2) the warranty was intended to safeguard against a risk of a description “which does not include the event which gave rise to the claim”;9 or (3) the breach of warranty could not have increased the risk that the event which gave rise to the claim would occur in the way in which it did in fact occur.10 3.14 It is likely that in practice most policyholders would focus on (3), showing that the breach could not have increased the risk that the loss would occur in the way it did in fact occur. 3.15 Finally, the report recommended that insurers should be able to rely on a breach of warranty to repudiate policies in the future. To do this, they would need to serve a written notice on the insured. But the notice would not affect past claims. The Law Commission argued that the issue of past claims and future repudiation should be treated separately. An insurer should be able to pay past claims and repudiate the policy for the future; it should also be entitled to reject claims, without repudiating in the future. WHY JUST WARRANTIES? A PROBLEM WITH THE 1980 REPORT 3.16 There is a problem with the recommendations and draft bill in the 1980 report. The defence available to a policyholder only applies if the term is classified as a warranty. If a term is merely descriptive of the risk, the policyholder may no longer argue that the breach did not increase the loss. Yet policyholders’ breach of such terms may also invalidate claims, even though there is no causal connection between the breach and the loss. Birds and Hird suggest that the fact the 1980 recommendations were limited to warranties in the strict sense was a major difficulty with the report. Its recommendations “might have been easily evaded by insurers resorting to the use” of other conditions and exceptions.11 8 Draft Bill, clause 8(1). 9 Draft Bill, clause 10(5)(a). 10 Draft Bill, clause 10(5)(b). 11 J Birds and NJ Hird, Birds Modern Insurance Law (6th ed 2004) p 166, note 36. 14 3.17 One example is where motor insurance is written on the basis that the vehicle will be used for one purpose and it is used for another purpose. A clause stating that a car is “insured only for private use” is usually construed as being “descriptive of the risk”, following the Farr case. In other words, insurance cover is suspended when the car is being used for other purposes, but revives once the car is again used for private purposes. The consequences are not as severe as for breach of warranty, where a single episode of commercial use would discharge the insurer from all further liability. However, it is possible for a claim to be denied even though the policyholder could prove that the breach could not have increased the risk that the loss would occur in the way it did in fact occur. 3.18 This point was established in 1927 in Roberts v Anglo-Saxon Insurance Ltd.12 A car was said to be “warranted for commercial travelling”, but suffered a fire while being used for another purpose. The arbitrator held that the insurer was nevertheless liable to pay the claim because the change of use did not in any way contribute to the fire or to the loss. Bankes LJ said this was a clear error of law: It is perfectly obvious that this is an error on the face of the award, because it is quite immaterial whether or not the fact that the car was being used in this way was or was not "a contributory cause of the fire or the actual cause or loss of the motor vehicle by the fire”.13 3.19 In Murray v Scottish Automobile, the car was insured for private use but was actually used as a taxi.14 It was damaged by fire while parked overnight in a garage. Again, the Court of Session held that the “private use” term was descriptive of the risk. Nevertheless, the insurer was not liable to pay the claim. Lord Sands stated that the time the car was parked in the garage “must be attributed to one use or the other”. It was best seen as ancillary to the use to which the car has been put during the day. On this logic, the car was still being used as taxi when parked overnight, and the insurer was not liable to pay the claim. 3.20 This raises questions about how Murray would be decided if the 1980 report were to be implemented. If the term were to be construed as a warranty, then the policyholder could argue that the fire had nothing to do with the fact that the car had been used as a taxi during the day. If they succeeded, the insurer would be liable to meet the claim. However, if the term were merely descriptive of the risk, then the 1980 draft Bill would not apply. The insurer could successfully argue that the loss was outside the scope of the cover, as properly defined. This seems unduly formalistic. The Murray case raises difficult policy issues, which we discuss in Part 7. Whichever result is right, however, the same answer should apply to both warranties and descriptions of the risk. It should not depend on formalities about how the term has been written. 12 (1927) Ll L Rep 313. 13 As above, at p 314. 14 1929 SLT 114. 17 PART 4: ARE WARRANTIES STILL A PROBLEM? ALTERNATIVE METHODS OF PROTECTION 4.1 One argument against reform is that warranties are no longer a problem in practice. It has been suggested that any potential difficulties with the law can be dealt with by the courts as a matter of construction. 4.2 As far as consumers are concerned, three further types of protection are available: (1) voluntary statements of practice and Financial Services Authority (FSA) rules; (2) an assessment of fairness under the Unfair Terms in Consumer Contracts Regulations 1999; and (3) the Financial Ombudsman Service (FOS). 4.3 Below we outline the protections provided by each of these approaches, and consider how far they remove or change the need to reform the law of warranties. THE CONSTRUCTION APPROACH 4.4 As mentioned in Part 2, it is well-established that warranties should be construed strictly, against the party who has put them forward1 (in practice, usually the insurer2). This common law rule is now supplemented in consumer insurance by the Unfair Terms in Consumer Contracts Regulations, which state that “if there is a doubt about the meaning of a written term, the interpretation which is most favourable to the consumer shall prevail”.3 4.5 The normal remedy against an insurer’s unreasonable use of a warranty is for the court to hold that the term is not truly a warranty, but something else (such as a clause descriptive of the risk) or that the term does not cover the issue in hand. Over the years, the courts have found several ways to attack the unreasonable use of warranties and these methods are used extensively in commercial cases. 1 Provincial Insurance Company v Morgan [1933] AC 240. 2 In some cases, the ambiguous wording may have been put forward by the insured’s broker. Where this happens, it does not necessarily follow that the term should be construed against the insured, as the insurer may be partially at fault in not correcting ambiguous wording (see B Soyer, Warranties in Marine Insurance (2nd ed, 2006), at p 22). Soyer cites Coleman J’s comment in Zeus Tradition Marine Ltd v Bell (“The Zeus V”) [1999] 1 Lloyd’s Rep 703 at p 718, although the decision was reversed by the Court of Appeal on other grounds (see [2000] 2 Lloyd’s Rep 587). 3 SI 1999 No 2083, reg 7(2). 18 (1) The warranty applies only to past or present facts, and not to the future.4 For example, in Hussain v Brown, the insured had signed a proposal form to say that their premises were fitted with an intruder alarm.5 This was said to be the basis of the contract. The statement was true at the time of the contract, though the firm later failed to pay the charges and the alarm service was suspended. The Court of Appeal held that the statement on the proposal form related only to present facts and did not make any promises about the future. Any continuing warranty would be a “draconian term” and “if underwriters want such protection then it is up to them to stipulate for it in clear terms”.6 (2) The warranty is relevant to only some sections of the policy. For example, in Printpak v AGF Insurance Ltd, the insured had taken out a “commercial inclusive” policy, which covered a range of risks, including fire and theft.7 The theft section included a warranty that the insured would maintain a burglar alarm. Meanwhile Condition 5 stated that a failure to comply with any warranty would invalidate any claim. The insured suffered a fire while the alarm was not working. The Court of Appeal held that the policy was not a seamless document, but instead consisted of separate schedules, each concerned with a different type of risk. Despite the wording of Condition 5, the alarm warranty only applied to the theft risk and not the fire risk. (3) The clause is not a true warranty but merely descriptive of the risk.8 As we have seen, in Farr v Motor Traders Mutual Insurance, the Court of Appeal rejected the insurer’s argument that a statement that taxis were to be driven for only one shift a day was a warranty.9 Instead, the statement described the risk. Cover was suspended while the taxi was used for two shifts a day; and once the owner resumed one shift the insurer became liable again. 4 Woolfall & Rimmer v Moyle [1942] 1 KB 66; Kennedy v Smith 1976 SLT 110; Hair v Prudential Assurance Co Ltd [1983] 2 Lloyd’s Rep 667. 5 [1996] 1 Lloyd’s Rep 627. 6 per Saville LJ at p 630. 7 [1999] Lloyd’s Rep IR 542. 8 See, for example, Kler Knitwear Ltd v Lombard General Insurance Co Ltd [2000] Lloyd’s Rep IR 47. 9 [1920] 3 KB 669. See also Roberts v Ango-Saxon Insurance Ltd (1926) 26 Ll L Rep 154; and CTN Cash & Carry Ltd v General Accident [1989] 1 Lloyd’s Rep 299. 19 (4) The wording of the warranty does not apply to the facts in question. The leading case is Provincial Insurance Co v Morgan.10 Here coal merchants declared that their lorry would be used for coal, which became the basis of the contract. On the day of the accident, the lorry was also used to carry Forestry Commission timber. However, at the time, the timber had been unloaded and only coal was on-board. The House of Lords held an endorsement on the policy stating that the use was “transportation of own goods in connection with the insured’s own business” did not mean that the vehicle was to be used exclusively for the insured’s own goods. On “a strict but reasonable construction” the declaration and the clause only meant that transporting coal was to be the normal use. Transporting other goods would not terminate liability under the policy.11 How far can construction be used to remove unfairness? Kler Knitwear 4.6 A difficult question is whether the courts should be prepared to disregard the clear language of the policy in order to achieve justice between the parties. Kler Knitwear v Lombard General Insurance Co is an example of a case where the judge arguably went beyond merely resolving ambiguity in order to protect the policyholder from an unfair outcome.12 Here the policyholders had agreed that their sprinkler system would be inspected 30 days after renewal. In fact, the inspection was about 60 days late and showed that the system was working. The factory later suffered storm damage (which was wholly unconnected with the sprinklers). Mr Justice Morland accepted in principle that if on a proper construction of the clause, the parties intended it to be a warranty then the Court “must uphold that intention” however harsh and unfair the consequences. However, this particular clause was merely “a suspensive condition”, limiting the risk. 4.7 The surprising thing about Kler Knitwear was that the term was clearly stated to be a warranty and the policy later went on to spell out the consequences, namely that non-compliance would bar any claim, “whether it increases the risk or not”. Birds and Hird comment that It is difficult to see how the insurer could have stipulated this in any clearer terms. The term itself was called a warranty and was drafted in clear and intelligible language and the consequences of non- compliance were spelled out.13 10 [1933] AC 240. 11 See also English v Western [1940] 2 KB 156; and Houghton v Trafalgar Insurance Co Ltd [1954] 1QB 247; 12 [2000] Lloyd’s Rep IR 47. 13 J Birds and NJ Hird, Birds Modern Insurance Law (6th ed 2004) p 161. 22 The construction approach: conclusion 4.18 Courts’ willingness to construe warranties against the interests of insurers provides a partial solution to the unfairness inherent in the existing law. It does so at the cost of adding complexity and uncertainty to the law. We anticipate repeated litigation over both warranties and notification clauses. 4.19 Furthermore, there are still harsh decisions that cause injustice to policyholders. In Unipac (Scotland) Ltd v Aegon Insurance, for example, the Court of Session upheld a basis of the contract clause which converted all the statements in the proposal form into warranties.22 We do not think that courts’ willingness to construe clauses against the interests of insurers removes the need for reform. THE ABI STATEMENTS OF PRACTICE AND FSA RULES 4.20 Insurance companies have long argued that the defects in the present law can be remedied through voluntary action. In 1977 the Association of British Insurers agreed to two statements of practice: one for general insurance and one for life. The 1980 report explained that the statements were the result of concern about the decision to exclude insurance from the Unfair Contract Terms Act 1977, and were designed to reassure consumers that they would not be dealt with unfairly.23 The statements covered both warranties and “basis of the contract” clauses. Below we look at each issue in turn. We then consider the FSA’s more general initiative to encourage insurers to treat their customers fairly. Provisions on warranties Statements of Practice 4.21 The 1977 Statement of General Insurance Practice (SGIP) dealt with the perceived problems with warranties by stating that: Except where fraud, deception or negligence is involved, an insurer will not unreasonably repudiate liability to indemnify a policyholder… on grounds of a breach of warranty or condition, where the circumstances of the loss are unconnected with the breach.24 4.22 The references to deception or negligence were later removed, so as to confine the right to repudiate only where fraud is involved. The 1986 version of SGIP read: An insurer will not repudiate liability to indemnify a policyholder on the grounds of a breach of warranty or condition where the circumstances of the loss are unconnected with the breach unless fraud is involved.25 22 1996 SLT 1197. 23 para 3.23 24 Clause 2(b)(ii). 25 Clause 2(b)(iii). 23 4.23 The 1977 Statement of Long-Term Insurance Practice (SLIP) did not specifically refer to warranties at all, and merely said that “an insurer would not unreasonably reject a claim”. However, in 1986 SLIP was revised, to be similar to SGIP.26 4.24 In 1980 we made three criticisms of the 1977 Statements: (1) The statements only covered private (that is, consumer) insurance, while the problems covered both consumers and businesses.27 (2) The provision in effect conferred “a discretion on insurers to repudiate a policy on technical grounds if they suspect fraud but are unable to prove it”.28 (3) The statements lacked the force of law “so that an insured would have no legal remedy if an insurer fails to act in accordance with them”. 4.25 We concluded that far from being an argument against reform, the statements were “evidence that the law is unsatisfactory and needs to be changed”. FSA rules 4.26 The Statement of General Insurance Practice has now been abolished and replaced by ICOB 7.3.6. For long-term insurance, SLIP has been supplemented by COB 8A.2.6. ICOB Rule 7.3.6 states that insurers may not: except where there is evidence of fraud, refuse to meet a claim made by a retail customer on the grounds: (c) in the case of a general insurance contract, of breach of warranty or condition, unless the circumstances of the claim are connected with the breach. 4.27 COB 8A.2.6 is in similar terms, except that it only applies to breaches of warranty and not conditions. It goes on to state that the warranty must be “material to the risk” and must be “drawn to the attention of the policyholder before the conclusion of the contract”. 4.28 These provisions replicate the difficulties identified with the 1977 Statement. First they only cover retail (that is, consumer) insurance. Secondly, they continue to permit insurers to repudiate claims where they suspect but cannot prove fraud: although the insurer must show some evidence of fraud it does not have to be conclusive evidence. 26 Clause 3(b) states that Except where fraud is involved, an insurer will not reject a claim or invalidate a policy on grounds of breach of a warranty unless the circumstances of the claim are connected with the breach … It then goes on to deal with basis of the contract clauses by stating that these are permitted for “life of another” policies (provided they are material and within the knowledge of the proposer). Warranties for own life policies must relate to specific matters material to the risk and must be drawn to the proposer’s attention at or before the making of the contract. 27 para 3.29. 28 para 6.10. 24 4.29 Thirdly, the rules fail to give an insured a normal legal remedy if the insurer does not act in accordance with the rules. It is true that in the case of widespread breach, the FSA may bring disciplinary action against the insurer, leading to fines or (ultimately) withdrawal of authorisation. However, the issue is more likely to arise in the context of an individual claim. Individuals may have a remedy under section 150(1) of the Financial Services and Markets 2000, which states that A contravention by an authorised person of a rule is actionable at the suit of a private person who suffers loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty. 4.30 This would suggest that if the matter were to be raised before a court, the court would have to find for the insurer on the basis of the strict law. Then (in the same or separate proceedings) the consumer could claim damages on the ground that the point should not have been taken. 4.31 This is a solution of a kind but we wonder whether in practice any consumer would claim damages for breach of statutory duty because of the costs involved. In addition, the result is that the law is at best hard to understand and arguably is incoherent. The COB and ICOB rules are difficult to reconcile with the decision in The Good Luck, that following a breach of warranty, the insurer need not take steps to repudiate a policy but is instead automatically discharged from liability.29 It would appear that an insurer may breach an FSA rule by doing no more than refusing to meet a claim for which they are not liable. This overlap of law and regulation is neither clear nor simple, and has the potential to bring the law into disrepute. We do not think that FSA rules remove the need for reform. Rather, like the statements, they appear to be evidence that the law is unsatisfactory and needs to be changed. Provisions on “basis of the contract” clauses 4.32 This issue was not directly addressed in the 1977 statement. However, the 1986 SGIP effectively outlawed their use. Clause 1(b) said: Neither the proposal form nor the policy shall contain any provision converting the statement as to past or present fact in the proposal form into warranties. But insurers may require specific warranties about matters which are material to the risk.30 4.33 In other words, insurers agreed that they would no longer put provisions on proposal forms that automatically converted the answers given into warranties. If they wished to include warranties in the contract, they would have to be specific and material to the risk. 29 Bank of Nova Scotia v Hellenic Mutual War Risks (“The Good Luck”) [1992] 1 AC 233. 30 Clause 1(b). 27 4.42 In Director General of Fair Trading v First National Bank Plc, the House of Lords explained that the core terms provisions should be interpreted narrowly.37 As Lord Bingham put it, the object of the Regulations and Directive “would plainly be frustrated” if the definition of core terms were “so broadly interpreted as to cover any terms other than those falling squarely within it”.38 Lord Steyn confirmed that the provision must be given a restrictive interpretation, or “the main purpose of the scheme would be frustrated by endless formalistic arguments about whether a provision is a definitional or an exclusionary provision”.39 4.43 There has been some debate about how far these provisions apply to insurance contracts. The insurance industry has long opposed the idea that such terms should be subject to judicial review, and was very concerned at the possible impact of the Directive. To assuage their fears, the Directive included the following words in Recital 19: For the purposes of this Directive, assessment of unfair character shall not be made of terms which describe the main subject matter of the contract nor the quality/price ratio of the goods or services supplied…. It follows, inter alia, that in insurance contracts, the terms which clearly define or circumscribe the insured risk and the insurer’s liability shall not be subject to such assessment since these restrictions are taken into account in calculating the premium paid by the consumer. 4.44 This has been taken to mean that any terms which “clearly define or circumscribe the insured risk” are core terms within the meaning of the Directive and Regulations, and therefore exempt from review. We examine this argument in more detail below. To make the discussion easier to follow, we deal first with exceptions and then with warranties. Exceptions and UTCCR Are exceptions “price” terms? 4.45 The words in Recital 19 do not mean that an exception within an insurance contract “relates to the adequacy of the price”. An insurer may well take such exceptions into account in calculating the price, but this could be true of any term within the contract. As Lord Steyn put it in First National Bank: After all, in a broad sense all terms of the contract are in some way related to the price or remuneration. That is not what is intended.40 37 [2002] 1 AC 481. 38 Above, at para 12. 39 Above, at para 34. 40 As above. 28 4.46 First National Bank itself was about the terms of a loan. Clearly, the interest rate itself was the price (and not subject to review) but a clause stating that the same rate was payable on default was merely incidental to the substance of the bargain. The House of Lords held it was subject to review. A price escalation clause would also be subject to review “or there would be a gaping whole in the system”41 (even if, presumably, the supplier had taken account of the presence of such escalation clause in calculating the initial price). Do exceptions “define the main subject matter of the contract”? 4.47 Although an exception to the cover is not a price term, there is a strong argument that it does define the main subject matter of the contract. Clearly, the main subject matter of an insurance contract is the cover the policyholder receives. MacGillivray considers that the exemption extends to terms which describe the perils insured against and specify the measure of indemnity afforded by the cover, but not to procedural requirements to give notice of claims.42 Birds and Hird also argue that the definition of the main subject matter should be taken to include both “the risks covered and excepted”. They point out that the Regulations must be read subject to Recital 19, which refers to terms which “clearly define or circumscribe the insurer’s liability”.43 4.48 This was the view taken by Mr Justice Buckley in Bankers Insurance Co v South.44 A holiday-maker had taken out a travel insurance policy which exempted “compensation or other costs arising from accidents involving … possession of any … motorised waterborne craft”. Whilst riding a jet ski he had been involved in an accident which seriously injured another jet skier. The victim then attempted to argue, first, that the exemption did not apply to jet skis. Secondly, if it did, it was an unfair term within the meaning of the regulations. Buckley J held that the term was in plain intelligible language and therefore exempt from scrutiny.45 Unfortunately for our purposes, he did not develop this point. The judge also said that in any event he could see nothing unfair in the term. It was available to the holiday-maker, and he could have read it if he had wished. He also pointed out that the insurance was relatively cheap.46 4.49 We accept that an exception to cover may be taken as defining the cover: for example, a clause that states cover is limited to roadworthy vehicles has the potential to be a core term. However, it does not follow that all exceptions are exempt from review as being core terms. There are two restrictions. First, the definition of the main subject matter of the contract is only exempt from review “so far as it is in plain intelligible language”. Secondly, a term cannot be “the definition of the main subject matter of the contract” if it is substantially different to what the consumer reasonably expected. 4.50 We take these points in turn in the paragraphs that follow. 41 per Lord Steyn, above. 42 MacGillivray on Insurance Law (10th ed 2003) para 11-36, p 294 and para 10-91, p 261. 43 J Birds and NJ Hird, Birds Modern Insurance Law (6th ed 2004) p 208, note 24. 44 [2004] Lloyd’s Rep IR 2, [2003] EWHC 380. 45 at para 24. 46 at para 24. 29 Does an exception have to be in plain language? 4.51 The exclusion from review only applies to core terms “in so far as these terms are in plain intelligible language”. If an exclusion is not clearly worded, it will not be treated as a core term, and will be subject to review for fairness. As MacGillivray states, “failure to word a core term of the insurance clearly will result in it losing its exemption from assessment for fairness”.47 4.52 This requirement of the Directive is not universally accepted. Clarke, for example, includes a footnote in which he refers to the argument that “if core terms are not plain and intelligible they shall be assessed for fairness”. He describes this result as “startling”, “new” and having “no basis in the Directive”. He refers to the opening words in Recital 19, that “assessment of unfair character shall not be made of terms which describe the main subject matter of the contract”. He points out that this opening phrase is “unqualified”, and does not state that the term must be in plain intelligible language.48 We do not think this view is correct. Recital 19 must be subject to the clear words of Article 4(2), which states that the exemption from assessment only applies “in so far as these terms are in plain intelligible language”. Furthermore Recital 19 itself is confined to terms which “clearly define or circumscribe the insured risk”. Exceptions that are substantially different from what the consumer reasonably expects 4.53 Recital 20 suggests that the requirement is not just one of plain language. It says that contracts should not only be drafted in plain, intelligible language but also that “the consumer should actually be given an opportunity to examine all the terms”. 4.54 This leads to the question of whether a term that is itself clearly worded can be exempt from review as a core term if it is not what the consumer reasonably expected, for instance if it is hidden among the small print of a contract where consumers are extremely unlikely to read it. When the two Law Commissions examined the law on unfair terms in contracts, we endorsed the view put forward by the Office of Fair Trading that a term only defines the main subject matter of the contract if it is part of the way consumers perceived the bargain. As the OFT put it: A supplier would surely find it hard to sustain the argument that a contract’s main subject matter was defined by a term which a consumer had been given no real opportunity to see and read before signing.49 4.55 We explained that: 47 MacGillivray on Insurance Law (10th ed 2003) para 11-36, p 294. 48 M Clarke, The Law of Insurance Contracts (4th ed 2002), para 19 –5A, p 614, note 13. 49 Unfair Contract Terms Bulletin 2 (OFT 170, September 1996) para 2.26. This is quoted in Unfair Terms in Contracts (2002), Law Com Consultation Paper No 166, Scot Law Com Discussion Paper No 119, para 3.23. 32 Do warranties define the subject-matter of the contract? 4.65 First, we have wondered whether a warranty, however clearly worded and prominently set out, can ever be a “core term”, simply because it does not describe the subject-matter of the contract. In effect it circumscribes the insurer’s liability if the right lock is not installed, and might be thought of as the kind of “incidental” or “subsidiary” term that the House of Lords, in its decision in DGFT v First National Bank plc, recognised as not being “core”.53 On reflection, however, we do not think this argument is correct. A warranty is correctly interpreted as an obligation on the insured, and there is no reason why (if it is clear and “reasonably expected”) it should not be as “core” as the obligation to pay the premium. The effect of warranties and reasonable expectations 4.66 A second restriction does seem to bite on warranties. We think that unless the insurer expressly spells out in full the effect of a breach of the warranty, it will be subject to review because it will almost inevitably fail the “reasonable expectations” test. 4.67 Consider the legal effect of a breach of the warranty. It will discharge the insurer from liability under policy automatically, so that there is no liability for any loss even if the matter warranted was immaterial, or the loss was completely unrelated to the breach (for example, flood damage). The insurer is discharged from liability even if the breach of warranty has been cured before the claim arose. As we argued earlier, it is most unlikely that these results accord with the reasonable expectations of any insured, least of all a consumer - unless he or she happens to be an insurance lawyer. Thus for the warranty to be exempt as a “core term”, the consequences of a breach of a warranty would have to be spelled out in full, in clear and intelligible language and in a way that left the consumer in no doubt what to expect. 54 4.68 If the term were not sufficiently central to the way the bargain was presented to be a core term, the court would need to consider whether it was fair. It should be noted that under the UTCCR, the court is required to assess the fairness of the term at the time the contract was made. It is not asked to assess whether the term has been applied fairly in the particular circumstances of the loss. Thus if the term gives the insurer the right to avoid even when the breach of warranty was immaterial, it will be no answer that in the particular facts the loss that has been incurred was caused directly by the breach of warranty. If the warranty as a whole was unfair, the insurer simply cannot rely on it at all. 53 [2001] UKHL 52, [2001] 1 AC 481, esp at [12] and [34]. See further Unfair Terms in Contracts (2002), Law Com Consultation Paper No 166, Scot Law Com Discussion Paper No 119, para 3.25. 54 We do not think it matters that it is the general law of insurance, rather than the term of the contract itself, that provides for these consequences. It is true that under the Regulations terms that merely reflect what would be the law anyway are probably exempt from review. see Reg 4(2) and recital 13 of the Directive, discussed in CP 166 para 3.37. However, the insurer would not be discharged from the contract unless the warranty term had been included, so this exemption does not apply. 33 4.69 It might be argued that most warranties are fair on their face. The unfairness arises only because of the way they are applied. However, before assessing the fairness of a term the court must interpret it. Suppose, for example, that an insurer seeks to rely on the lock warranty to reject a claim for flood damage. The court would first have to decide whether the term was a true warranty, and was intended to exclude flood claims in this way. If the court accepts the insurer’s case that the term has a wide meaning, then it is likely to hold that the term is unfair. The court may be influenced by the fact that this use of the term specifically breaches ICOB Rule 7.3.6. As a result, the term would not be binding on the consumer, and the insurer could not rely on it to avoid paying the claim. If the court gives the term a narrow meaning, to merely except burglary claims while the lock is not fitted, then the term is more likely to be considered fair – but it would not assist the insurer to resist liability for flood damage. Preventive powers 4.70 A major innovation in the 1994 Regulations was that enforcement was not left to the parties alone. Instead, the Director General of Fair Trading was empowered to bring proceedings for an injunction (or interdict) against suppliers using unfair terms in their contracts with consumers. In 1999, the list of enforcement organisations was extended, and in 2001 the Financial Services Authority was added. The FSA is now the organisation primarily responsible for preventing insurers from including unfair terms within their contracts.55 4.71 The FSA has reached agreements with insurance companies to alter terms: for example, the FSA complained about a cash-back scheme underwritten by insurers, which only met claims if consumers submitted numerous forms within strict time limits. The insurers agreed that they would accept claims within 6 months of the specified dates and would issue replacement documents on request.56 55 See the Concordat between the OFT and FSA, set out in OFT, Unfair Contract Terms Bulletin 16, December 2001. An account of how the FSA uses its powers is given in FSA Handbook Enforcement Manual (Chapter 20). See also, FSA, Fairness of Term in Consumer Contracts: Statement of Good Practice, May 2005. 56 See: FSA website at: http://www.fsa.gov.uk/consumer/updates/updates/unfair_contracts/cases(last checked 8 August 2006). The FSA has also taken action to prevent an insurer from varying long-term insurance premiums without giving reasons for the changes. It also took action against an insurance policy guaranteeing the return of deposits paid to home improvement suppliers. The cover ceased on the original installation date – which meant that if installation was delayed, the deposit could not be returned. 34 4.72 In July 2006 the FSA took action against a term in a legal expenses insurance policy which bore some similarities to a warranty. It stated that “cover will end at once” if the insured dismissed their appointed representative, or if the representative refused to act for the insured. This was thought to be unfair as the insured may have a legitimate reason for dismissing the representative (for example, in the event of fraud), or the legal representative may refuse to act for the consumer for reasons beyond the consumer's control. Following FSA intervention, the insurer rewrote the term to state that the cover will only end if the insured dismisses the representative without good reason, or the representative refuses to act for a good reason.57 The impact of the Unfair Terms in Consumer Contracts Regulations 4.73 The regulations have been in place since 1994, applying to all contracts entered into after 1 July 1995. So far, they appear to have had surprisingly little impact on the insurance industry. With the exception of the Bankers case, we have not located any cases in which the issue was argued in the courts. 4.74 The Regulations have the potential to provide protection to consumers. However, we do not think that in practice they give consumers adequate protection. Here, we have attempted to spell out how the Regulations affect the case of a warranty applied to a non-causally connected loss, but it has not been an easy task: it has produced considerable discussion among members of the team and with our advisers. Any consumer attempting to argue such a case before the courts would need to overcome several hurdles: first, that the warranty was not a core term or, if it was, it was not in plain language; and secondly that it was unfair at the time the contract was entered into. We think that even in consumer cases it would be useful to spell out that a breach of warranty should not absolve the insurer from liability to pay an unrelated claim. This test looks not at the fairness of the term at the time of the contract, but at the way it is applied to the particular circumstances of the claim. We discuss this causal link requirement in more detail in Part 7. THE FINANCIAL OMBUDSMAN SERVICE 4.75 The Financial Ombudsman Service (FOS) has a general discretion to decide cases according to what is fair and reasonable. In practice, dissatisfied consumers are more likely to take a case to the FOS than to court. 4.76 To understand how the FOS currently approaches disputes over policy terms, we read 50 final ombudsman decisions concerning terms in consumer policies. We are very grateful to FOS for allowing us access to these cases. A fuller discussion of our findings is to be found in Appendix B. Issues of causal connection 4.77 Our brief analysis of ombudsman cases suggests that warranties are not common in consumer cases. Although a few exclusions appeared to be written in wide terms, it is doubtful if a breach is intended to discharge the insurer from all liability under the policy (as spelled out under section 33(3) of the Marine Insurance Act 1906). 57 See FSA website, above. 37 4.86 Case 14 concerned a critical illness policy offering a defined sum in the event of a heart attack. A policy term defined “heart attack” as “the death of a proportion of heart muscle as a result of inadequate blood supply”, as evidenced by three symptoms: chest pain; “electrocardiograph changes”; and raised cardiac enzymes. The complainant was diagnosed and treated for a heart attack involving pain and elevated enzymes, but which did not show changes on an ECG. The insurers refused the claim on the grounds that one of the essential elements of the definition was not met. 4.87 The ombudsman pointed out that neither the key features document nor the headline illness highlighted that a heart attack was only covered if it was of a certain severity or if it involved satisfying a three-limb test. When a definition significantly restricts the meaning of the headline illness in a way that is inconsistent with either a policyholder’s or a doctor’s reasonable understanding of when a critical illness or event has occurred, then I consider it would be unfair of a firm to rely on a narrow interpretation of a definition to defeat an otherwise valid claim. In my judgment, the complainant’s claim should be met because it falls within the spirit of what the policy was designed to cover and how it was sold. 4.88 It is worth noting that the FOS will be prepared to strike down a narrow definition of the risk contained within the policy small print if this was not in accordance with reasonable expectations and was not made clear to the consumer. 38 PART 5: EVALUATION OF THE PRESENT POSITION INTRODUCTION The law 5.1 The law on insurance warranties in general is clearly set out in the Marine Insurance Act 1906. The Act states that warranties must be exactly complied with, whether material to the risk or not.1 A breach cannot be remedied,2 but automatically discharges the insurer from liability from that date.3 5.2 By including a “basis of the contract clause” in the proposal form, the insurer may convert every answer given by the proposer into a warranty. This means that any mistake discharges the insurer from all liability under the contract from the outset, even if the mistake is innocent and immaterial to the risk. The problems 5.3 The provisions of the Marine Insurance Act have the potential to lead to unfair results. They mean that insurers may refuse to pay a claim for actions or omissions that: (1) are immaterial to the risk. For example, an insurer may refuse to pay a claim because the insured innocently said that a lorry was kept at the wrong address, even though this did not increase the risk.4 (2) are only relevant to other risks. For example, a failure to employ watchmen may discharge an insurer from liability for a storm claim.5 (3) have already been remedied. For example, once a ship has entered an excluded zone, it remains uninsured even if it leaves that zone as soon as possible.6 5.4 The problems are exacerbated by the use of basis of the contract clauses. Proposers are unlikely to appreciate the legal effect of a clause giving warranty status to all the answers given on a proposal form. 1 MIA 1906, s 33(3). 2 s 34(2). 3 s 33(3). 4 Dawsons Ltd v Bonnin [1922] 2 AC 413. 5 See Forsikringsaktieselkapet Vesta v Butcher [1989] AC 852. 6 Bank of Nova Scotia v Hellenic Mutual War Risks (“The Good Luck”) [1992] 1 AC 233. 39 5.5 In 1980 the Law Commission described these results as wrong and unjust.7 We agree. They are wrong because they do not accord with policyholders’ reasonable expectations. If a proposer has given incorrect information but the true position does not alter the risk or reduces it, the policyholder may well not realise that the policy is ineffective. If a policyholder is slow in repairing a fire alarm, they may well think that their fire cover is suspended while the problem persists. However, those unfamiliar with the niceties of insurance law are unlikely to think that this also invalidates their flood cover. Nor are they likely to realise that they will continue without fire insurance after the alarm has been fixed. 5.6 Insurers have told us that they would rarely apply the strict letter of the law. They would not, for example, refuse to pay a claim because of a breach that had already been remedied before the loss. It is difficult to know how many claims are turned down each year for breaches of terms that are not causally connected to the loss. Our own small survey of complaints brought to the FOS does not suggest that the practice is widespread, though we note that the FSA reports cases where it has occurred.8 The case for reform does not depend on evidence of widespread abuse. If insurers no longer think that the Marine Insurance Act 1906 embodies fair principles, this is itself strong evidence that the law should be brought into line with acceptable practice. 5.7 In the rest of this part we deal first with basis of the contract clauses, which cause the same problem in all types of insurance. We then consider specific warranties of fact or future conduct. BASIS OF THE CONTRACT CLAUSES 5.8 In our first Issues Paper on Misrepresentation and Non-disclosure we said that basis of the contract clauses should no longer be effective to convert a statement of fact into a warranty in any kind of insurance. 5.9 Although judges have severely criticised the use of basis of contract clauses for the last 150 years, their use has been consistently upheld. In 1996 the Court of Session justified them on the grounds that the parties are free to agree what they like.9 We find this unconvincing. In most cases the insured’s signature at the bottom of the proposal form containing a clause stating that “this proposal shall be the basis of the contract between us and the insurers” would not represent a true agreement because the proposer will have no idea of the implications of the statement. An insurer may have good reasons for making cover dependent on particular facts but, if so, it must make this clear to the insured. 7 para 6.9. 8 FSA, General Insurance and Pure Protection Products: Treating Customers Fairly, July 2006, p 18. 9 Unipac (Scotland) Ltd v Aegon Insurance 1996 SLT 1197. 42 5.20 It could be argued that insurers should have some discretion not to pay claims where they have robust evidence that nevertheless falls short of proof. We will return to the definition and proof of fraud in a subsequent paper. However, we do not think that the problem insurers have in proving fraud is a good reason for permitting them to retain technical or unmeritorious defences to paying claims. Suppose for example, an insurer suspects (but cannot prove) that a policyholder has inflated the costs of repair following storm damage. If the insurer refused the claim because the burglar alarm was not working, it could undermine trust on both sides. The insured would be unable to defend themselves on the substance of the charge, while the insurer would not have established the substance of the wrongdoing. 5.21 Secondly, the FSA rule does not give the insured a ready remedy. In a private law contract claim, the court would be required to find for the insurer on the basis of strict law. The consumer may then have a claim to damages for breach of statutory duty under section 150(1) on the ground that the insurer should not have taken the point. However, it is difficult to reconcile this with the strict legal position that an insurer is automatically discharged from liability with no need for further action on its part. It is odd to think that an insurer may be sued for damages for failing to pay a claim for which it is not liable. It must be asked whether any consumer insured would understand the position, let alone actually make a claim. The Financial Ombudsman Service 5.22 Our research did not reveal a case directly on the need for a causal connection between a loss and a breach of warranty. However the case of the stolen bicycle described earlier12 (which involved an exception rather than a warranty) shows that the Ombudsmen would almost certainly insist that the insurer pay the claim. 5.23 We do not think that the existence of the FOS scheme is a sufficient reason for leaving the law as it is, however. The reason is just the same as in other cases we have considered. Not all cases will reach the FOS; and it makes no sense to have different rules for the courts on the one hand and the FOS on the other. This incoherence and complexity alone is a good reason for reform. Conclusion 5.24 It is our conclusion that although the UTCCR, the FSA Rules and the FOS offer valuable protection to consumer insureds in relation to breaches of warranty, there is a clear need for reform of the underlying law in consumer insurance cases. 12 Above, Part 4. 43 Business insurance 5.25 The problems with the law on breach of warranty are not confined to consumer insureds. We do not think it accords with the expectation of any class of insureds that the insurer should be discharged by an immaterial breach of warranty, or one that has been cured before any claim arose. Nor would policyholders expect a claim to be rejected on the ground of a breach of warranty that had no connection to the loss. We discuss below whether the parties should be able to agree expressly that a breach of warranty should have such consequences. However, we do not think that this should be the “default” rule for breach of warranty (that is the rule that will apply if nothing different is provided in the contract). 5.26 Neither the FSA rules nor UTCCR cover businesses. For insured businesses, their only protection lies in inviting the court to construe a term to give it a fair meaning. The courts are often prepared to do this, sometimes finding ambiguities in the words used, even when the words appear firm and clear.13 However, we do not think that it is an adequate substitute for law reform. The process of re- interpreting the effect of contractual terms can cause considerable complexity and difficulty, as is shown by the case law on whether a notification clause can be an innominate term.14 And in some cases the courts are prepared to give terms their traditional (harsh) meaning.15 5.27 The problems caused by the harshness of the law can affect any business, but they appear most severe for small and medium businesses. They may not understand the import of words such as “warranty” and, even if they do, they lack the bargaining position to change the insurer’s standard wording. Furthermore, they are particularly vulnerable to legal uncertainty as they lack the legal knowledge and resources to argue cases before the courts. Insurers may therefore be able to use the harshness of the law as set out in the MIA 1906 as a negotiating tool. 13 The clearest example of this is Kler Knitwear v Lombard General Insurance Co [2000] Lloyd’s Rep IR 47. 14 See Alfred McAlpine Plc v BAI (Run-Off) [2000] I Lloyd’s Rep 437 and Friends Provident Life and Pensions v Sirius International Insurance [2005] 2 Lloyd’s Rep 517. 15 See Unipac (Scotland) Ltd v Aegon Insurance 1996 SLT 1197. 44 5.28 Large businesses are more able to protect themselves. They have the resources to understand the issues, and the bargaining position to renegotiate terms. We were told, for example, that one large company refuses to agree to warranties in any circumstances. This does not suggest, however, that reform is unnecessary for large businesses. Rather it suggests that all businesses might benefit from the change we are proposing. The fact that businesses which are able to do so exclude the rule, and presumably pay any resulting increase in premium, suggests that it is a poor rule in the first place. We conclude that the law on breach of warranty requires reform in all types of insurance. The question is exactly what shape the reform should take. 47 6.10 In a 1982 case, the judge explained that the purpose behind sections 5 and 6 was to alleviate the harshness and artificiality resulting from the common practice of insurers requiring proponents to warrant the complete accuracy of all answers to questions put by insurers, with the result that any inaccuracy, whether by way of positive misstatement or omission, and whether major or trivial, material or immaterial to risk or loss, voided the policy.1 6.11 Tarr and Kennedy comment that The combined effect of these sections meant that an insurer could only avoid a policy when the difference between what was stated in the proposal and what was actually correct would have been considered material by a prudent insurer and would have influenced that insurer’s judgment in fixing the premium or determining whether he or she would have taken or continued the risk upon substantially the same terms.2 Australia 6.12 The Australian Law Reform Commission (ALRC) recommended substantial changes to the law on non-disclosure and misrepresentation. It was concerned that an insurer may seek to evade these recommendations by converting any statement into a warranty of existing fact. Consequently, it argued that “all warranties of existing fact should be treated as representations”.3 6.13 This recommendation has been implemented in section 24 of the Insurance Contracts Act 1984: A statement made in or in connection with a contract of insurance, being a statement made by or attributable to the insured, with respect to the existence of a state of affairs does not have effect as a warranty but has effect as though it were a statement made to the insurer by the insured during the negotiations for the contract but before it was entered into. This renders ‘basis of the contract’ clauses of no effect where the statement is about existing facts, as opposed to promises about the future. 6.14 The policy behind section 24 would appear to be similar to the policy behind Clause 9 of the Law Commission’s draft Bill, though the wording is simpler and more all embracing. It covers all statements of current fact, not just those made in answer to pre-set questions. It would also cover specific statements made in the policy itself. 1 Preece v State Insurance General Manager (1982) 2 ANZ Insurance Cases 60-493, by Thorp J at 77-807. 2 AA Tarr and JA Kennedy, Insurance Law in New Zealand, 2nd ed 1992, p80. 3 ALRC, Insurance Contracts (1982) at para 195. 48 Conclusion 6.15 Given the level of criticisms of basis of the contract clauses, it is not surprising that both New Zealand and Australia have enacted provisions to abolish them. Such reform would also appear to be necessary to prevent evasion of any changes to the law of misrepresentation in insurance contracts. We discuss these further in Part 7. 6.16 We are not aware that either provision has caused problems. Abolishing basis of the contract clauses would appear to be practicable, and there are several legislative models to choose from in drafting appropriate provisions. A causal connection between the breach and the loss 6.17 Both New Zealand and Australia have enacted provisions to curb the insurers right to avoid liability for a breach of warranty if the policyholder is able to prove that the breach did not cause or contribute to the loss. 6.18 The first thing to note about these reforms is that they apply to all terms which exclude or limit liability – not just to warranties. As the ALRC put it, “the form in which the insurer seeks to protect itself from an increase in risk should not be allowed to affect the extent of that protection”. It said that its recommendations should extend not only to strict warranties and other terms imposing obligations on the insured, but also to exclusions from cover of certain risks. Were they not to extend to temporal exclusions, legislation based on the present recommendations might be avoided simply by rephrasing an obligation (“the insured warrants that the car will be kept in a roadworthy condition”) as a temporal exclusion (“the insurer will not be liable while the car is in an unroadworthy condition”). The legislation might also be avoided if obligations and exclusions were omitted and the cover itself stated in such a way as to achieve the same ends (“cover is granted in respect of the roadworthy car”).4 6.19 The New Zealand and Australian provisions have a common core. However, the Australian Act goes further than the New Zealand one, and provides an additional level of protection for policyholders. New Zealand 6.20 The Insurance Law Reform Act 1977 forbids certain exclusions. Section 11 states: Where – (a) By the provisions of a contract of insurance the circumstances in which the insurer is bound to indemnify the insured against loss are so defined as to exclude or limit the liability of the insurer to indemnify the insured on the happening of certain events or on the existence of certain circumstances; and 4 As above, para 229. 49 (b) In the view of the court or arbitrator determining the claim of the insured the liability of the insurer has been so defined because the happening of such events or the existence of such circumstances was in the view of the insurer likely to increase the risk of such loss occurring, - the insured shall not be disentitled to be indemnified by the insurer by reason only of such provisions of the contract of insurance if the insured proves on the balance of probability that the loss in respect of which the insured seeks to be indemnified was not caused or contributed to by the happening of such events or the existence of such circumstances. 6.21 In Barnaby v South British Insurance Co, Hardie Boys J explained the effect of the section as follows: The key to this section is to be found in the last words of para. (b): the section is designed to deal with those kinds of exclusion clauses which provide for circumstances likely to increase the risk of a loss which the policy actually covers. The most common examples are found in the field of motor vehicle insurance, such as driving a motor vehicle whilst under the influence of alcohol, or driving a motor vehicle while it is in an unsafe condition. The section is not designed to deal with exclusion clauses which specify the kind of loss or the quantum of loss to which the cover does not apply at all.5 6.22 It has been accepted that section 11 applies to promissory warranties.6 However, insurers may still avoid a policy for a breach of warranty before a loss occurs, and this has been criticised by academics.7 6.23 Section 11 is more generous to the policyholder than the test suggested in the Law Commission’s 1980 draft Bill. This is because the New Zealand test allows the insured to recover if they prove that the loss was “not caused or contributed to” by the breach. By contrast, the English recommendation would require the insured to prove that the breach “could not have increased the risk that the event… would occur”. The Australian Law Reform Commission explain the difference in the following example: 5 Barnaby v South British Insurance Co Ltd (1980) 1 ANZ Insurance Cases 60-401, 77,008 per Hardie Boys J. 6 Norwich Winterthur Insurance (NZ) Ltd v Hammond (1985) 3 ANZ Insurance Cases 60- 637. This is despite some suggestions that originally the provision was only attended to apply to definitions of the risk: see the discussion in ALRC, Insurance Contracts (1982) at para 223. 7 Borrowdale, “Insurance Law Reform in New Zealand: A Decade On” (1988) 1 Insurance Law Journal 261 at 268. 52 6.30 However, in Antico v Heath Fielding Australia Pty Ltd, the High Court reached the opposite conclusion.11 This case concerned legal expenses insurance, where indemnity was conditional upon the insurer consenting to defend the claim. The policyholder failed to obtain consent, and the question was whether this amounted to an omission, which could be excused under section 54. The High Court found that section 54 applied: the word “omission” did just refer to a failure to discharge an obligation, but also included “a failure to exercise a right, choice or liberty which the insured enjoys under the contract of insurance”.12 6.31 However, most of the litigation about section 54 has been about “claims made and notified policies”. These policies are common in the professional indemnity market, and are a way in which insurers protect themselves against long-tailed claims that may not arise for many years after the policy has been issued. Typically, a “claims made” policy only applies if the claim is made during the period of cover. A “claims made and notified policy” usually extends cover to claims made after cover has ceased, provided that the claim arises from an occurrence which has been notified to the insurer during the relevant period. It is common for such policies to include a deeming clause, stating that where the facts have been notified to the insurer within the period of insurance it is deemed to be a claim made during the policy period. 6.32 There have been a series of cases in which policyholders failed to notify the insurer of an occurrence during the relevant period. Policyholders have argued that this failure amounts to an omission within the terms of section 54(6) and that the section offers them protection.13 The leading case is the High Court’s decision in FAI v Australian Hospital Care Pty Ltd.14 Here, the professional indemnity policy contained a deeming clause of the sort described above. The insured had been aware of facts giving rise to an injury during the period of cover, but had not notified the insurer because it did not expect that a claim would be made. It argued that this omission could be cured by section 54. To the alarm of the insurance industry, the High Court found for the insured. The Court drew a distinction between “an inherently essential element of the claim” (where section 54 does not apply) and other ancillary or procedural matters (where it does apply). Where the demand must be made within the period, or where the insured must become aware of facts within the period – and these requirements have not been met - the claim does not fall within the policy. No relief can be given. However, here the failure to notify was a procedural matter, and the relief applied. 11 (1997) 188 CLR 652. 12 Above, at pp 669-70. 13 See FAI General Insurance Co Ltd v Perry (1993) 30 NSWLR 89; Greentree v FAI General Insurance Co Ltd (1998) 158 ALR 592; and Permanent Trustee v FAI General Insurance Co Ltd (1998) 44 NSWLR 186. 14 [2001] HCA 38. 53 6.33 An added twist to these difficulties is that under section 40 of the Insurance Contracts Act 1982 a “claims made policy” is deemed to be a “a claims made and notified policy”. The statute states that the insurer must pay where the insured gave notice in writing to an insurer of the facts that might give rise to the claim. Section 54 goes one step further by opening up the possibility that claims must be paid even if the facts are not notified. The combined effect of sections 40 and 54 has made it difficult for professional indemnity insurers to limit their liability for long-tailed claims, and there have been extensive calls for reform.15 6.34 That said, it is possible to exaggerate the difficulties associated with section 54. First, even if the section applies, it does not necessarily require that the claim is paid. The claim may be reduced by an amount which “fairly represents the extent to which the insurer’s interests were prejudiced” as a result of the act or omission. In Ferrcom Pty Ltd v Commercial Union Assurance Co of Australia, the High Court found that the prejudice to the insurer was equivalent to its entire liability.16 The owners of a mobile crane had failed to notify the insurer that there had been a change of circumstances, and that the crane was now registered to be driven on public roads. The court found that if the insurer had been told it would have exercised its right to cancel the policy and would not have been liable to meet any subsequent claim. 6.35 Secondly, in 2003 the Commonwealth Treasury Review of the section commented that “not a single stakeholder has sought the removal of section 54”.17 It found that the section worked satisfactorily in relation to the vast majority of occurrence insurance, and “the prominent message from meetings and submissions is that the operation of section 54 in relation to ‘occurrence’ policies should remain unchanged”.18 The review recommended reform only in relation to “claims made” and “claims made and notified” policies. THE ALRC REVIEW OF MARINE INSURANCE 6.36 The 1982 Act did not cover marine insurance. In 2001, the ALRC considered whether similar reforms should be introduced for marine insurance.19 The Commission concluded that as currently drafted, section 54 went too far to be suitable to the marine area. In important respects, its practical effect was “to allow the insured to unilaterally alter the bargain made by the parties, arguably to the extent of fundamentally changing the scope of the insurance”.20 The degree of discretion involved in assessing the extent of prejudice the insurer had suffered allowed too much room for dispute. 15 It is unlikely that the same issues would arise in the UK, where business is more usually written on a “claims made” rather than a “claims made and notified” basis, and where section 40 does not apply. 16 (1993) 176 CLR 332. 17 A Cameron and N Milne, Review of the Insurance Contracts Act 1984: Report into the Operation of Section 54 (2003), Commonwealth of Australia, p 9. 18 As above. 19 ALRC, Review of the Marine Insurance Act 1909 (2001) No 91; http://www.austlii.edu.au/au/other/alrc/publications/reports/91/ch9.html 20 Above, at para 9.120. 54 6.37 Subsection (4) could also introduce unacceptable uncertainty. This allows “some part of the loss” to be paid where the insured proves that that act did not cause that part of the loss. The ALRC commented that “this approach may lead to practical difficulties in quantifying an insurer’s liability”, and could increase the cost of litigating disputes.21 6.38 Despite these problems, however, the ALRC found a wide consensus that marine warranties could operate in a harsh and unfair manner. The Queensland Commercial Fishermen’s Organisation were particularly concerned, and instrumental in prompting the review. Even submissions from insurers expressed considerable support for reform. 6.39 The Review concluded that an insurer should only be discharged from liability as a result of a breach of the insured’s obligations, if the loss was caused by the breach. Otherwise the remedy should lie in damages. 6.40 In some ways, the ALRC thought that section 54 did not go far enough. Section 54 talks about acts “causing or contributing to a loss”, which could cover any situation where there was a connection between breach and loss.22 The ALRC thought that the test should require “proximate causation”, which is a well understood insurance law concept, and more generous to the insured. 6.41 For these reasons the ALRC recommended that the amended MIA should permit the parties to include a term that the insurer is discharged from liability to indemnify the insured for loss proximately caused by a breach by the insured of an express term of the contract. An express term providing for the insurer’s discharge from liability could be drafted to apply to the insured’s obligations generally or only to particular breaches. In the absence of such a term, breach of the contract will entitle the insurer only to such relief as may be available under the general law of contract, which would generally be the award of damages.23 Conclusion 6.42 In both Australia and New Zealand there is a consensus that insurers should not be permitted to avoid liability for breaches of insurance terms that are unrelated to the loss. This consensus has endured, despite some serious problems with the way that section 54 has been drafted. 6.43 There does not appear to be a problem with drafting legislation to deal with terms where “the happening of such events or the existence of such circumstances was in the view of the insurer likely to increase the risk of such loss occurring”. In these circumstances, it is possible to provide that the policy should not be avoided where the breach did not in fact increase the risk, or cause the loss. These provisions have secured acceptance within the industry. 21 Above, at para 9.121. 22 Above, paras 9.125 - 9.127. 23 Above, para 9.129. 57 6.53 Soyer argues that on the facts there was a clear intention that the term should be a warranty. He thinks the English courts would have regarded it as an express warranty.29 This is an open question. Some cases suggest that the English courts may take an approach which is similar to the Canadian one. For example, in Kler Knitwear v Lombard, Mr Justice Morland cited Bamcell II and used it to justify overriding the clear words of the policy. However, this decision is only at first instance and it has been subjected to academic criticism.30 The English courts also tend to construe marine insurance contracts more strictly. 6.54 The reasoning in Bamcell II and Kler Knitwear is predicated on the existence of some ambiguity in the term, which is construed against the insurer. It is difficult to know how far the Canadian court will go in overriding unambiguous words simply to achieve fair outcomes. Soyer quotes the British Columbia Builders’ Risk Clauses as an example of insurers’ attempts to prevent the courts from applying Bamcell II to reinterpret warranties as descriptions of risk. Clause 1 is as unambiguous as possible: This policy contains warranties and general conditions none of which are to be interpreted as suspensive conditions. The Underwriters have agreed to accept the risk of insuring the Vessel on the condition precedent that the Assured will comply strictly and literally with these warranties and conditions. If the Assured breaches any of these warranties or conditions, the Underwriters at their option will not pay any claims arising thereafter, regardless of whether or not breach is causative or in any way connected to such claim. 6.55 It is not clear how the courts would deal with a Bamcell II type case in the light of such clear, definite and unambiguous wording. Conclusion 6.56 As we have seen, the English courts have gone some way to temper the unfairness associated with the strict application of warranties, and these developments have been taken further by the Canadian Supreme Court. Although these developments prevent unjust decisions, they also introduce some uncertainty and incoherence into the law. The danger is of repeated litigation, as insurers respond to court decisions by rewriting their contracts in even less ambiguous terms. THE USA 6.57 Traditionally, US marine insurance law followed the British approach and was considered to be a federal matter. This, however, changed in 1955 following the Supreme Court decision in the Wilburn Boat case.31 29 Baris Soyer, Warranties in Marine Insurance (2nd ed, 2006), p 45. 30 See Part 4. 31 [1955] AMC 467, 58 6.58 The case concerned a small houseboat, kept on a lake between Texas and Oklahoma. The policy contained various stipulations that the policyholders had breached. Contrary to the terms of the policy, the insured had pledged the boat, carried passengers on several occasions and had at times leased the vessel. A fire destroyed the boat while it was moored, in circumstances that had nothing to do with the breaches of warranty. The insurers argued that, under Federal law, there was no need for a causal link between the breaches and the loss. The policyholders, however, argued that the matter should be dealt with under Texan law, where breaches of the policy would not defeat the claim unless they contributed to the loss. Eventually the case found its way to the Supreme Court, which held that insurance law was a matter for each state. 6.59 The case has generated considerable debate within the US: some see it as a necessary part of the state/federal balance; others as a source of uncertainty and complexity.32 One element behind the decision, however, may have been the Supreme Court’s unhappiness with the harshness and rigidity of the English approach.33 6.60 The result is that the way warranties are to be interpreted and applied is largely a matter for state law. As we have seen, some states, such as Texas, require a causal connection between the breach and the loss before permitting the insurer to avoid paying a claim. 6.61 By contrast, in New York, the requirement is that a breach of warranty will avoid an insurance contract, provided that it “materially increases the risk of loss, damage or injury within the coverage of the contract”.34 If the contract specifies two or more kinds of loss (such as fire and theft) the breach will only avoid the particular kind of loss to which the warranty relates. This does not mean that the breach must cause or contribute to the specific loss, but it must be such that would materially increase the risk of a loss of the same sort. In other words, a breach of a burglar alarm condition would not affect a fire claim, but it would avoid a theft policy, so as to permit the insurer to refuse a claim for theft, however the thieves had entered the building. CIVIL LAW JURISDICTIONS 6.62 UK law on breach of warranty diverges from that of most other European States, which require that a breach be causally connected to the loss in some way before it can absolve the insurer from payment. 6.63 Baris Soyer provides a detailed analysis of the English, German and Norwegian approach to breach of warranty in marine insurance.35 He shows that in both Germany and Norway provisions exist to exempt the insurer from liability if the nature of the risk changes during the life of the policy. However, unlike the English law, these require some degree of culpability and causation. 32 For a discussion, see B. Soyer, Warranties in Marine Insurance (2nd ed, 2006), p 182. 33 T Schoenbaum, “Warranties in the Law of Marine Insurance: Some Suggestions for Reform of English and American Law”, 23 Tul Mar LJ 267 (1998-1999), 314. 34 New York Insurance Code, Article 31, section 3106(b). 35 Warranties in Marine Insurance (2nd ed, 2006). 59 6.64 An example will illustrate the main differences. Under German law, the insurer is not normally liable if the insured put a vessel to sea in an unseaworthy condition. But this is subject to two important limitations. First, the exemption only applies to loss caused by the conduct. If, for example, the loss was unrelated to the unseaworthiness, the insurance policy continues. Secondly, it is open to the insured to show that they were not “responsible” for the unseaworthiness - ie that it was not a deliberate or negligent act.36 Norwegian law is similar.37 By contrast, under the Marine Insurance Act 1906, voyage polices contain an implied warranty “that at the commencement of the voyage the ship shall be seaworthy for the purposes of the particular adventure insured”.38 This means that if the ship is not seaworthy at the beginning of the voyage, all liability is avoided even if the insured is not at fault; or the defect is remedied; or the loss is totally unconnected with the defect. 6.65 Trine-Lise Wilhelmsen, a Professor at the Scandinavian Institute of Maritime Law, comments that for most people in the Civil Law world, the UK concept of a warranty is “hard to understand and even harder to explain”. Although the words may seem “deceptively simple”, the consequences lack “logical reason” and cannot be explained in terms of either legal fairness or economic efficiency.39 6.66 John Hare, Professor of Shipping Law at the University of Cape Town is even more outspoken. He describes the Anglo-American marine insurance warranty as “a prodigal aberration from the European ius communis of marine insurance”. He suggests that “the prodigal, in whatever systems it has raised its unwelcome head, ought to be brought back into the fold in the interests of the very fairness, justice and equity to which English law so properly aspires”.40 6.67 UK warranty law is inconsistent with the mandatory, but milder, provisions concerning alteration of risk in several Civil Law countries. Wilhelmsen comments that if there are to be attempts towards harmonisation, it is unlikely that many other European States will move towards the British model: 36 Above, pp 186-7. See also Comite Europeen des Assurances, Insurance Contract Law In Europe (2004). This explains that German law requires an insured to notify details of an increased risk, but if they fail to do so, the insurer “may only refuse to pay compensation if there is a causal link between the occurrence of the risk insured against and the failure to notify details or the increased risk” (p 81): see article 23 and following of the "Versicherungsvertragsgesetz" or Insurance Contract Law of 30 May 1908, as amended 26 November 2001. 37 Under section 3-33 of the Norwegian Marine Insurance Plans 1996, the insurer is not liable for “loss that is a consequence of the ship not being in a seaworthy condition, provided that the assured knew or ought to have known of the ship’s defects at such a time as it would have been impossible for him to intervene”. 38 Section 39(1). 39 “Duty of Disclosure, Duty of Good Faith, Alternation of Risk and Warranties: An Analysis of the Replies to the CMI Questionnaire”, CMI Yearbook 2000 pp 392 and 409. 40 John Hare, The Omnipotent Warranty: England v The World, paper presented at International Marine Insurance Conference, November 1999, http://web.uct.ac.za/depts/shiplaw/imic99.htm (accessed 23 May 2006). 62 7.6 For business insurance we ask whether we should follow the same approach or whether warranties as to specific facts should still be a ground on which the insurer in business insurance policies may refuse to pay a claim, and possibly treat the contract as discharged. If warranties of specific fact are to be permitted, we later argue that they should be subject to certain formal requirements (such as the warranty being set out in a schedule to the policy). Furthermore, when the question is whether the insurer must pay a claim, the claim must be causally connected to the breach of warranty. 7.7 We then consider options for reforming warranties about future conduct. We make two tentative proposals: (1) to be valid, a warranty of future conduct should be set out in writing; (2) insurers should only be entitled to avoid liability to pay a claim because of a breach of warranty if the breach bears some connection with the loss. 7.8 We discuss whether a causal connection should also be required for other types of term that limit the risk, such as definitions of the risk and exceptions. We tentatively conclude that it should be required, unless it would be unreasonable for the insured to assume that it was covered by the policy at the time of the event. 7.9 We then inquire whether the reform proposals should apply to all forms of insurance. We ask whether different arguments apply first to marine, aviation and transport insurance (MAT) and then to reinsurance. Our present thinking is that the reforms should apply in these areas, though we welcome views on whether there are good reasons to treat these forms of insurance differently. Marine insurance raises particular issues about the implied warranties set out in the Marine Insurance Act (which we discuss briefly). We ask if these should be subjected to the same causal connection test that we have proposed for other warranties. 7.10 Finally, we consider the implications these reforms would have for sections 33 and 34 of the Marine Insurance Act 1906. We tentatively propose that insurance policies should no longer be discharged automatically as the result of a breach of warranty. Instead the insurer should have the option to terminate the contract for the future (without prejudice to its liability to pay any claims that have arisen already). This raises questions about whether the insured should be entitled to a pro-rata return of any premium paid, and whether the insurer should give notice of the termination. An insurer may also lose the right to terminate an insurance contract, because they are taken to have “waived” their rights. We consider the implications for our suggested proposals for the law of waiver and affirmation. OUR TENTATIVE PROPOSALS ON MISREPRESENTATION AND NON- DISCLOSURE 7.11 In our Issues Paper 1 on misrepresentation and non-disclosure,1 we made a number of tentative proposals. The principal proposals were as follows. 1 Available at http://www.lawcom.gov.uk/docs/insurance_contact_law_issues_paper_1.pdf 63 All insurance 7.12 For both consumer and business insurance we proposed that: (1) Insurers should only be entitled to a remedy for an insured’s non- disclosure or misrepresentation in so far as this is material, as defined below. The same test should apply to misrepresentation and non- disclosure. (2) First, the actual insurer must show inducement, in that had it known the true facts it would not have entered into the same contract on the same terms or at all. (3) Additionally, the insurer must show either (i) that the proposer 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, (ii) that a reasonable insured would have appreciated that the fact would be relevant to the insurer (in the sense set out above). (4) In assessing what a reasonable insured would appreciate, the courts should take into account the type of policy, the way the policy was advertised and sold, and the normal characteristics of consumers in the market. However, they would not look at individual circumstances, known only to the insured. 7.13 We tentatively proposed that: (1) Insurers should be allowed to avoid policies where the insured has acted fraudulently at the pre-contractual stage, (2) If the insured had reasonable grounds for believing the truth of what they said, or was not negligent in other ways (such as in failing to answer a question), the insurer should have no remedy for misrepresentation or non-disclosure. (3) If a consumer proposer has made a negligent misrepresentation, the court should apply a proportionate remedy by asking what the insurer would have done had it known the true facts. In particular: (a) Where an insurer would have excluded a particular type of claim, the insurer should not be obliged to pay claims that would fall within the exclusion; (b) Where an insurer would have declined the risk altogether, the claim may be refused; (c) Where an insurer would have charged more, the claim should be reduced proportionately to the under-payment of premium. 64 For business insurance, on point (c), we asked whether the remedy for negligent misrepresentation should be proportionate, in that it should aim to put the insurer into the position it would have been in had it known the true circumstances. 7.14 “Basis of the contract” clauses, whether in the proposal form or the contract itself, should be ineffective to make all the answers given by the insured into warranties. (This was a provisional proposal to be discussed further in the current paper, and was without prejudice to the decision whether or not to permit specific warranties of existing fact contained within the contract.) Consumers 7.15 Our tentative proposal was that in the consumer market, insurers should ask consumers clear questions about any matter that is material to them and that there should be no duty of disclosure on consumers. 7.16 It should not be possible to contract out of the new rules governing consumer insurance except in favour of the consumer. Businesses 7.17 We tentatively proposed that: (1) The duty of disclosure should continue to apply to business insurance contracts in general. (2) The law affecting business insurance should be changed to give the insured certain additional rights, but that the rules should in general not be mandatory. (3) We tentatively proposed that our earlier proposals for business insurance should apply to MAT; and we asked if there is any reason not to apply our earlier proposals for business insurance to reinsurance. Small businesses 7.18 We asked: (1) To what extent small businesses should be treated in the same way as consumers. (2) How small businesses should be defined for this purpose. A change in approach: mandatory rules for business insurance 7.19 In the light of the discussion of these proposals at the seminars, we have revised our approach on the question whether, in the case of business insurance, it should be possible for the parties to agree to vary the rules in favour of the insurer. We had suggested that in business insurance this should be permissible, but it should not be possible to agree to a ‘basis of the contract’ clause. 67 7.28 The last option is the most radical, since it would mean that even specific warranties of existing fact would have no special status; they would merely be representations. This would be so whether they were warranties of specific facts or became warranties by virtue of a general “basis of the contract” clause. We consider this radical third option after discussing whether basis of the contract clauses should continue to be effective, without prejudice to the question of specific warranties. We consider consumer insurance first and then business insurance. Basis of the contract clauses in consumer insurance 7.29 Even if warranties as to specific facts are still to be effective in business insurance, we are convinced that in consumer insurance, basis of the contract clauses should not be effective. We raised this question in our first Issues Paper on Misrepresentation and Non-disclosure, noting there has been widespread criticism of their use.2 In 1997, for example, the National Consumer Council described them as “completely unfair”.3 Although the ICOB Rules do not refer to basis of the contract clauses, their use was barred by the 1986 SGIP. The ABI has told us that the use of such clauses contravenes insurers’ duty to treat customers fairly.4 They have been outlawed in Australia and New Zealand. At the first working seminar there seemed to be widespread agreement with the suggestion in our Issues Paper that basis of the contract clauses should always be ineffective in consumer insurance.5 7.30 In consumer insurance it would not be adequate to reform the law merely by requiring that the warranty must either be in the policy, or “contained in some document incorporated by reference to the policy”. If all that is required were that there should be a clause in the policy that the insured warrants the truth of every statement made in another document, such as the proposal form, consumers would be no more likely to understand the effect than if the “basis of the contract” clause were in the proposal form. At the very least (and as will be seen in the next section, we would go further) we think that in consumer insurance warranties of existing fact should be effective only if each fact warranted is specifically set out in the policy or in a schedule to it. 7.31 We tentatively propose that “basis of the contract” and similar clauses that have the effect of turning statements of fact in general into warranties should be of no effect in consumer contracts.6 2 See, for example, the 1980 report para 7.2 and Joel v Law Union and Crown Insurance Co [1908] 2 KB 863, 885; Glicksman v Lancashire and General Assurance Co [1927] AC 139, 144 to 145; Mackay v London General Insurance Co [1935] Lloyd’s Law Reports 201 and Lord Russell’s comments in Provincial Insurance v Morgan [1933] AC 240, 250. 3 NCC, Insurance Law Reform, May 1997, p 28. 4 See the discussion in Part 4. 5 See Draft Issues Paper No 1, para 6.104. 6 If this were followed but specific warranties of fact were to be permitted (as to which see the next section), it might be necessary to draft the legislation by reference to what is permitted, since it is not easy to define a ‘basis of the contract’ clause. See 1980 report, Draft Bill cll 8 and 9. 68 “Basis of the contract” clauses in business insurance 7.32 Here we consider whether, if warranties as to facts are to remain effective, they should have to be created by the policy itself, rather than through a basis of the contract clause on a proposal form. Later we discuss whether to take a more radical approach, to say that all statements of existing fact made by the insured should be regarded as representations rather than warranties. 7.33 In the Issues Paper on Misrepresentation and Non-disclosure we tentatively proposed that basis of the contract clauses should no longer be effective in business insurance. There would need at least to be a provision that incorrect answers would not give rise to a remedy for breach of warranty unless there was a term to that effect in the contract itself, rather than merely a “basis of the contract” clause in the proposal form. In effect, if a statement made by the insured were to amount to a warranty it would have to be stated in the policy or in a document incorporated by reference. This is a rule that would have to be mandatory, otherwise the mere insertion of a “basis of the contract” clause might be taken as a ‘contracting out’ from all the rules proposed in this section.7 7.34 Again at the working seminar there seemed to be wide support for this, which is already the position in marine insurance. The only query raised was whether it was consistent to make this a mandatory rule while we had suggested that in business insurance it should be possible to contract out of the proposed restrictions on avoidance for misrepresentation. We discussed this question above. In any event, the thrust of the argument seemed to be that both sets of rules should be mandatory, so it does not affect the present discussion. 7.35 As will be seen below, we would consider going further than denying effect to basis of the contract clauses in business insurance; we ask whether all statements of existing fact made by the insured should be regarded as representations rather than warranties, as in the next section we will propose for consumer insurance. However, as a minimum, we tentatively propose that in business insurance, a “basis of the contract” clause in the proposal form should no longer be effective to turn the statements made by the proposer into warranties. Each statement of fact warranted should be set out either in the policy, or in some document incorporated by reference to the policy. This rule would be mandatory. Specific warranties as to past or existing fact Consumer insurance 7.36 In our first Issues Paper on the law of misrepresentation and non-disclosure, we suggested that the remedies proposed for misrepresentation should be mandatory in consumer insurance contracts, but default rules in business insurance contracts. In other words, for consumer insurance, an insurer’s remedies for a mis-statement of fact should be those set out in the new legislation: an insurer would not be entitled to add to those remedies by a term in the contract.8 7 Issues Paper 1, Para 7.82. 8 The insurer would be free to agree that the insured should have greater rights. 69 7.37 It would be consistent with this still to permit the insurer to rely on specific warranties of fact that were set out in a written document (or some similar formal requirement). This appears to have been the view of the Law Commission in 1980. The report recommended that basis of the contract clauses should be of no effect but specific warranties as to past or existing fact would be effective, subject to two provisos: (1) The warranty must be material (there would be a presumption that it was material); and (2) Once a claim had occurred, the insurer would not be entitled to refuse to pay the claim if the insured showed that the warranty was not intended to safeguard against the kind of event that materialised or that the breach of warranty did not increase the risk of the event occurring in the way it did.9 7.38 The requirements of materiality and of some connection between the warranty and the claim would limit the possibility for the insurer to use specific warranties as a way to avoid any restrictions on the current remedies for misrepresentation. Suppose, for example, that an insurance policy contained the following term: The insured hereby warrants that the house in question is made of brick and slate. 7.39 If the house was in fact timber-framed under a brick skin, the insurer would be able to serve notice on the insured repudiating the contract from the date of the notice if no claim had yet arisen; but if an event giving rise to a claim had occurred, whether the insurer would have to meet the claim would depend on the facts. If the event were a flood, the insurer would have to pay. If the event were a fire, it would depend on whether the construction of the house had increased the risk of the event that occurred. So a claim for smoke damage caused by a chip- pan fire might have to be met whereas a fire that affected the main structure might be different. 7.40 We now think this “specific warranty” approach would offer insufficient protection to consumers. First, it would still provide the insurer with the right to refuse a claim even though the consumer had not been fraudulent or even negligent. Secondly, we doubt that consumers would derive much protection from the formal requirements. Merely requiring that the warranty is put into a written document which is given to the consumer within a reasonable time will only protect the consumer who reads the document. Even if the statements have to be in a separate document from the body of the policy, we doubt that many consumers will read them. Normally they will only receive the document after they have, in their view, completed arranging their insurance. 9 Cl 10 of the draft Bill. See further below. 72 7.52 In our first Issues Paper we had proposed that, in business insurance, the insurer should be able to give itself the right to avoid for negligent or even wholly innocent misrepresentations, as in business insurance the new rules on misrepresentation would not be mandatory. As we explained earlier, we now think this was the wrong approach. If the insurer should be allowed to give itself remedies for “non-negligent” misstatements, the permitted way of doing this should be by the insured giving warranties of specific facts. 7.53 Were the law to be changed so as to prevent the insurer being able to rely on warranties as to specific facts (as in Australian law), that rule itself should be mandatory. To make it merely a default rule that could be altered by agreement would render it ineffective. Insurers could simply insert into their contracts a clause disapplying the relevant section of the new legislation and then continue to use specific warranties. Indeed the court might find that the parties had implicitly excluded the new rule simply because there is a warranty of fact in the contract. In either case, the insured who is not an expert will still not be aware of the potential consequences. In other words, any new “no warranties of fact” rule would have to be mandatory to have any effect at all. 7.54 So a choice has to be made. The alternatives are: (1) To continue to allow breach of warranties of specific facts to act as a defence to a claim provided the claim was causally connected with the breach. We think that specific warranties should be permitted only subject to formal safeguards, such as that the warranty is in a separate written schedule to the policy. We also think that an insurer should only be entitled to reject a claim on the ground of breach of warranty if there was a causal connection between the breach and the claim. We discuss these points in more detail in relation to warranties as to the future; or (2) To provide both that the insurer’s remedy for a misstatement of fact should only be through the remedies for misrepresentation, and that the rules governing these should be mandatory. This is the position in Australian law. This choice is difficult and we would welcome views. 7.55 In business insurance, we invite views on whether: (1) incorrect statements of past or existing fact should only amount to misrepresentations and not warranties (which would be a mandatory rule); or (2) breach of warranty of specific facts should continue to act as a defence to a claim provided the claim was causally connected with the breach, and that certain formal safeguards as to warranties generally had been satisfied when the contract was made. 73 Other types of clause dealing with existing facts 7.56 That leaves a question about policies that seek to achieve the same result by employing a narrow definition of the risk to be covered or an exception to the risk, for example by excluding from cover houses that are not built of brick and slate. The same issue arises in relation to warranties as to the future and is discussed below. WARRANTIES AS TO THE FUTURE: A WRITTEN STATEMENT 7.57 In 1980, the Law Commission recommended that insurers should not be entitled to rely on a breach of warranty unless the insured was supplied with a written statement of the warranty either at or before the contract was made, or as soon as possible thereafter. This recommendation is particularly relevant to promissory warranties, whereby the insured “undertakes that some particular thing shall or shall not be done”.13 However it would have applied also to the specific warranties as to past or existing fact that the Law Commission then thought should be permitted. 7.58 The law already requires that in marine policies express warranties must be in writing.14 We think that this requirement should extend to all forms of insurance. Where cover is conditional on an insured carrying out a specific task, or refraining from an activity that would be normal in the circumstances, it is important that there should be clarity on both sides about what is required. We think the insured’s obligations should be set out in writing and included or referred to in the main contract document. For these purposes, writing would include printed and electronic forms.15 7.59 We tentatively propose that a claim should only be refused because the insured has failed to comply with a contractual obligation, if the obligation is set out in writing and included or referred to in the main contract document. 7.60 For consumer insurance, it should not be enough for the warranty to be buried somewhere in the small print of an insurance policy. The insurer should take specific steps to bring the obligation to the insured’s attention. This is already regarded as good practice: ICOB Rule 5 requires that significant or unusual terms are brought to a consumer’s attention. And, as we discussed in Appendix B, the FOS already makes enforcement of the term dependent on this requirement. We found several cases where the FOS refused to uphold an unusual term if it was not brought to the customer’s attention. 13 See Marine Insurance Act 1906, s 33(1). 14 MIA 1906, s 35(2) states that “an express warranty must be included in, or written upon, the policy, or must be contained in some document incorporated by reference into the policy”. 15 The Law Commission discussed the definition of writing at length in its 2001 Advice to Government, Electronic Commerce: Formal Requirements in Commercial Transactions. It argued that the definition of writing in Schedule 1 of the Interpretation Act 1978 would include any “words in visible form”, including those held electronically. 74 7.61 We think the same protections should apply in a court of law. Like the FOS, a court should only enforce a specific obligation on the consumer if the insurer took sufficient steps to bring it to the consumer’s attention. The insurer should spell out both what the consumer must do (as in “you must fit a five-lever mortice lock”) and the consequences of not doing so (as in “if you do not, we may refuse any claim connected with your failure”). 7.62 There are different approaches to implementing this principle. One would be to impose detailed rules about how policyholders’ obligations should be spelled out. For example, rules could state that the obligation should be in the product summary (required by ICOB Rule 5.3.1); or on the cover note; or in a separate letter; on in one of the three. The statement could be required to be in plain language, legible and clearly presented; or one could go further and specify a minimum point size and prescribed warning. The FSA already has powers to make rules of this sort. 7.63 The alternative would be to set out the general principle that unusual terms should be brought to the consumers’ attention. It would then be left to the courts to decide whether the obligation has been complied with, bearing in mind any relevant FSA rules or guidance. 7.64 The first approach is more certain; the second is more flexible. It is more adaptable to new methods of sales and product information. Given the FSA’s current emphasis towards a more principles-based approach, with fewer detailed rules, we are inclined to favour the second approach. This would mean that a court would be left to decide whether the insurer had met its obligation to bring the warranty or similar obligation to the policyholder’s attention, having regard to any rules or guidance specified by the FSA. 7.65 In consumer insurance, we tentatively propose that an insurer may only refuse a claim on the grounds that the insured has failed to carry out a specific task (or refrained from a normal activity) if it has taken sufficient steps to bring the requirement to the insured’s attention. In deciding whether the insurer has taken sufficient steps, the court should have regard to FSA rules or guidance. REQUIRING A CONNECTION BETWEEN THE BREACH AND THE LOSS 7.66 The greatest and most obvious problem with the law on warranties is that it permits the insurer to escape liability for technical breaches that have nothing to do with the loss in question. 7.67 We think there is a need to introduce some form of causal connection test to protect policyholders from unfair treatment. An insured may readily agree to a warranty that their sprinkler system will be inspected, believing that if the failure of the sprinkler system causes a loss they will not be indemnified. However, policyholders would not understand this to mean that the insurers would refuse to pay if the breach were later remedied, or if the loss were totally unconnected with the sprinklers. This result defies logic and normal expectations, is inconsistent with good practice as recognised by the SGIP and risks bringing the UK insurance industry into disrepute. Whether we are discussing consumer or business insurance, the current law can properly be described as unjust. 77 Our provisional view 7.75 In our view, the onus should be on the insured to show that the breach did not contribute in any way to the accident. This means that in the modified car, the insured would be able to show that in fact the modifications did not “contribute” to the accident by proving that the brakes worked perfectly or that the car’s braking capacity was completely irrelevant to the accident. It would also be open to the insured to attempt to prove that the failure to take up references did not contribute to the loss because the employee’s references would have been satisfactory. However, the insured would need to prove this on the balance of probabilities. It would not be sufficient simply to invite the court to speculate about “might have beens”. Normally, a failure to follow proper procedures would contribute towards an employee theft. Similarly, the age and inexperience of a driver would be expected to contribute to an accident, even a no-fault accident. The insured would have to do more than merely show that the breach was not the main or dominant cause of the loss. 7.76 We tentatively propose that the policyholder should be entitled to be paid a claim if it can prove on the balance of probability that the event or circumstances constituting the breach of warranty did not contribute to the loss. Payment of premium warranties 7.77 At present, insurers may include “payment of premium warranties”, under which the insured warrants that premium instalments will be paid within specific time limits. In JA Chapman v Kadirga and others,21 it was held that if such a warranty was breached, the insurer is automatically discharged from any further liability under the contract, but the insured remains liable to pay all the premiums on the due date. This appears to be a harsh result.22 7.78 Late payment of a premium will almost never cause or contribute to a loss. It is therefore worth considering what effect a payment of premium warranty would have under our reforms. It would still be open to an insurer to make payment by the due date into a condition of the policy. Under normal contractual principles, if the insured breached the condition, this would be considered a repudiatory breach. It would be open to the insured to accept the repudiation and terminate the contract. Until a repudiatory breach is accepted, the contract continues and any claim must be paid. Once accepted, both parties’ obligations come to an end, so that an insured would not be liable for any payments arising after the termination (though the insured may be liable to pay damages for the insurer’s loss of profits). We think this is a fairer approach, and consider it in more detail below (see paragraphs 7.140- 7.149). 21 [1998] CLC 860. 22 In the Chapman case, the problems were compounded by section 53(1) of the Marine Insurance Act 1906, which places liability to pay marine premiums on the broker rather than the insured. This meant that if the broker went into liquidation, the insured could be deprived of the benefit of the insurance through no fault of their own. The Law Commissions will be considering the merits of section 53 at a later date. 78 Partial loss 7.79 The Australian provisions protect policyholders when a breach of warranty causes only part of the loss. Section 54(4) of the Australian Insurance Contracts Act 1984 states that: Where the insured proves that some part of the loss that gave rise to the claim was not caused by the act, the insurer may not refuse to pay the claim, so far as it concerns that part of the loss, by reason only of the act. For example, if a fire spreads from a well-maintained section of a building (A) to one where the sprinklers are not working (B), the insured is entitled to the part of their claim relating to the well-maintained section. 7.80 On balance, we think that such a provision is fair to policyholders, and a useful clarification of the causal connection test. If the fire spreads from section A to section B, the faults in section B cannot be said to have contributed to the loss in section A. It would, of course be different if the fire spreads from the faulty section. Here the breach would have contributed to the further loss. We welcome views. 7.81 We tentatively propose that the law should provide that if a breach contributes to only part of a loss, the insurer may not refuse to pay the part not related to the breach. A mandatory or default rule? 7.82 We have said that the current rule is unjust because it defeats the reasonable expectations of the insured. We think this will almost always be the case in consumer insurance, and we recommend that for consumers the rule should be mandatory. For business insurance it is perhaps arguable that it should be possible to alter the rule provided very clear words are used to do so. 7.83 We tentatively propose that the causal connection rule should be mandatory in consumer insurance. We invite views on whether it should also be mandatory in business insurance. OTHER TYPES OF CLAUSE 7.84 The 1980 Report applied only to warranties. For example, if the insured “warranted to maintain the car in a roadworthy condition”, then it would be open to the insured to argue that a fault with the headlights could not have increased the risk of a loss in broad daylight. However, if the same provision were expressed as a description of the risk (that the insurance only applied while the car was roadworthy) then the insured could not take advantage of the defence, and the insurer would not be required to pay the claim. 79 7.85 We think it would be unduly formalistic to confine the causal connection test to warranties. Birds and Hird are right to argue that this would merely encourage insurers to find other means of achieving the same ends.23 7.86 Both the New Zealand and Australian legislation take a more purposive approach. For example, the New Zealand 1977 Act applies to a provision in an insurance contract that meets two tests. (1) They must “exclude or limit the liability of the insurer… on the happening of certain events or the existence of certain circumstances”; and (2) this must be because the events or circumstances were (in the view of the insurer) “likely to increase the risk of such loss occurring”.24 7.87 A provision stating that the car was only insured while it was roadworthy would be caught by the section. This clause purports to exclude or limit the liability of the insurer in certain circumstances (that the car is unroadworthy) because when a car is unroadworthy, the risk of a loss increases. In contrast, the reform would not affect a notice clause. A failure to give notice could not increase the risk of a loss occurring as it would only apply once a loss had happened. Similarly, it would not affect a payment provision, as a failure to pay a premium does not increase the risk of a loss. Our provisional view 7.88 Our tentative proposal is that the reforms should follow the New Zealand approach: they should extend beyond warranties, to all terms that enable the insurer to refuse to pay a claim for events or circumstances that add to the risk of loss. It should not matter whether a clause is written as a warranty (“the insured warrants that the vehicle will be maintained in a roadworthy condition”) or as descriptive of the risk (“the insurance only applies if the vehicle is in a roadworthy condition”). In either case, the insurer should not be entitled to refuse a claim for a fault that has no connection to the loss: for example, a fault with the headlamps should not affect an accident in daylight. If the reform were confined to warranties, it would simply encourage insurers to draft policies in more ingenious ways. 7.89 Should the protection apply to any term that purports to exclude or limit the liability of the insurer for events or circumstances that are thought to increase the risk of a loss occurring? A proviso: where an activity is wholly outside the policy 7.90 That said, we have a particular concern where the insured has taken out a policy that is meant to be used for one purpose, activity or place and is trying to use the insurance for an entirely different purpose, activity or place. 23 J Birds and NJ Hird, Birds Modern Insurance Law (6th ed 2004) p 166, note 36. See also the discussion in Part 3. 24 Insurance Law Reform Act 1977, s 11. See Part 6. 82 7.101 That said, there are reasons why marine warranties may need to be considered separately from warranties in other contracts. First, the English courts have tended to construe warranties more strictly in marine cases than in other forms of insurance. Secondly, the MIA 1906 implies warranties into marine insurance contracts by operation of law. The voyage conditions may also require review. Below we start by considering whether there are any good reasons for continuing to take a particularly strict approach to marine warranties. We then look specifically at the warranties implied into the marine insurance contracts by the MIA 1906 to see if a causal connection test should be applied to them. Finally, we ask whether we should review those voyage conditions within the MIA that discharge insurers from liability for reasons unconnected with the risk. The arguments for strict construction 7.102 The doctrine that marine warranties should be strictly construed has a long history. Developed by Lord Mansfield in the Eighteenth Century,27 it was enshrined in the 1906 Act and upheld by the House of Lords in The Good Luck as recently as 1992. Lord Goff justified the doctrine in the following terms: The rationale of warranties in insurance law is that the insurer only accepts the risk provided that the warranty is fulfilled. This is entirely understandable; and it follows that the immediate effect of a breach of a promissory warranty is to discharge the insurer from liability as from the date of the breach.28 7.103 The difficulty, however, is that the breach is usually only discovered after a loss has occurred. Where the loss is related to the breach, the doctrine is clearly understandable. But where the breach relates to a different risk, and no loss has materialised from that particular breach, the remedy can seem arbitrary and excessive. 7.104 We can understand that a strict approach had some justification when the doctrine was developed. In 1786, insurers had almost no information about the ship or the risk, except for what the insured told them and what the insured promised he would do. If the insured promised to do something, and then did not do it, it undermined his credibility and therefore the whole nature of the risk. However, the amount of information available to insurers has changed beyond recognition. The ISM and ISPS Codes, for example, require a large body of records to be kept, including records of training, shipboard operations, security threats, potential hazards, internal audits and reviews. This means that marine risks are much more like other risks in the market. Insurers are less dependent on the good faith of the insured, but can verify the information given through a variety of surveys and audits. It also means that they are more aware of technical breaches, even if those breaches did not result in any loss. 27 See Eden v Parkinson (1781) 2 Dougl KB 732, Hore v Whitmore (1778) 2 Cowp 784 and De Hahn v Hartley (1786) 1 TR 343. 28 Bank of Nova Scotia v Hellenic Mutual War Risks (“The Good Luck”) [1992] 1 AC 233, at p 263. 83 7.105 It has been put to us that a breach of warranty continues to undermine the credibility of the insured, and hence the nature of the risk, even in the absence of any specific causal connection between the two. In the Bamcell II, for example, the policyholders had specifically promised to place a watchman on board each night from 2200 hours to 0600 hours, but in fact had never hired a watchman at all. It could be argued that such behaviour fundamentally altered the nature of the risk. If the insured could not be trusted to do as they had promised, how many other unacceptable risks were they taking? Even without a direct causal connection between the lack of a watchman and the daytime loss, could there be said to be a connection through the addition of a moral hazard? 7.106 We have two concerns about this argument. The first is that behaviour that seems heinous to an insurer may seem innocuous to an outsider. There are several examples in the law reports, where (for example) insurers have argued that a minor conviction many years ago fundamentally alters the nature of the risk, in ways that the court has been unable to accept.29 The doctrine of warranties allows the insurer to play judge and jury by denying a claim when they think that the insured has committed a morally reprehensible breach, even for matters that appear merely technical to others. 7.107 Secondly, we do not think that the present rules on warranties meet the needs and expectations of an international market. We have not found any commentators outside the common law sphere who consider it is fair for an insurer to fail to pay a claim for a breach which is not connected to the loss. Several criticise the rule in scathing terms.30 Even within jurisdictions that share the legacy of the Marine Insurance Act, it is rare for a court to accept insurers’ arguments that a claim unrelated to a breach should not be paid. It was rejected by the US Supreme Court in Wilburn Boat, and by the Supreme Court of Canada in Bamcell II.31 The Australia Law Reform Commission reviewed marine insurance law in 2001, following complaints from the fishing industry and recommended that a breach of warranty should only justify avoiding a claim if it proximately caused the loss. 7.108 Given the international nature of the marine market, it is particularly important that its legal rules should correspond to internationally accepted notions of fairness. For this reason, we tentatively propose that the causal connection test outlined above should also apply to marine insurance. 29 See Roselodge Ltd v Castle [1966] 2 Lloyd’s Rep 113 and Reynolds v Phoenix Assurance Co [1987] 2 Lloyd’s Rep 440. 30 For example, Professor Trine-Lise Wilhelmsen comments that the English concept of a warranty is “hard to understand and even harder to explain” (Duty of Disclosure, Duty of Good Faith, Alternation of Risk and Warranties: An Analysis of the Replies to the CMI Questionnaire”, CMI Yearbook 2000 p 392). Professor Hare calls the Anglo-American marine insurance warranty “a prodigal aberration from the European ius communis of marine insurance” which should “be brought back into the fold in the interests of very fairness, justice and equity to which English law so properly aspires” (The Omnipotent Warranty: England v The World, paper to the International Marine Insurance Conference, November 1999). 31 See paras 6.51 and 6.52, above. 84 The implied marine warranties 7.109 The Marine Insurance Act 1906 implies four warranties into marine insurance contracts: seaworthiness, portworthiness, cargoworthiness and legality. These are described briefly in Appendix A. The warranty of seaworthiness is by far the most important, thought it operates differently in voyage and time policies. 7.110 A full review of the implied warranties is outside the scope of our project. In 1980 we commented that the rules were long-established and well-known, and that the professionals in the market could reasonably be expected to be aware of their niceties.32 The rules are certainly well-established. How far they are well-known is difficult to say; even the short description in Appendix A reveals some complexities and uncertainties surrounding them. However, we have not received demands for their reform, and a full-scale review would take more resources than we have available. 7.111 Here we are concerned with only one limited question, which is whether the requirement for a causal connection set out above should also apply to the implied marine warranties. Our view is that it should. Below we consider the four warranties, to see if they raise any special issues. Seaworthiness 7.112 The main effect would be upon the warranty of seaworthiness in voyage policies. It would effectively reverse the ruling in De Hahn v Hartley,33 by permitting warranties to be remedied. If, for example, a ship leaves port with insufficient crew, and later takes more crew on board, the insurer would be liable for subsequent losses. It would also mean that a technical breach (such as not carrying the required medicines, or not having the correct certificates on board) would not discharge the insurer from liability for an unconnected loss. 7.113 Our proposals are mild: in a voyage policy, the insured would only be paid if it could show, on the balance of probabilities that the breach did not contribute to the loss. This goes nowhere near as far as the requirement in time policies, where the insurer has to prove that the breach was a real or dominant cause of the loss. It does, however, go some way to lessening the difference between voyage and time policies. Given that the industry has lived with the time policy rule for over 100 years, we do not think that this lesser rule in voyage policies should cause undue difficulties. Portworthiness and cargoworthiness 7.114 These warranties are less likely to be a major cause of dispute, and we do not think that the proposed reform would have any great effect on the market. 7.115 At present, it may be possible for an insurer to argue that, if a problem in port is remedied before the ship is put to sea, the insurer is discharged from liability for an unconnected loss at sea. We do not think this result would be fair. Again, we believe that the insured should be able to put forward a defence that the breach did not contribute to the loss. 32 para 2.8. 33 (1786) 1 TR 343. 87 7.127 In 1980 the Law Commission recommended against extending the reforms to reinsurance contracts generally. It thought that the parties to reinsurance contracts would be “aware of the well-known and long-standing rules of law and practice governing the market in which they operate” and that its general recommendations on breach of warranty would be inappropriate to the market.38 It did however, attempt to protect insurers against the sort of anomalies that arose in the Vesta case. It recommended that where the reassured “substantially repeats the warranty broken by the insured”, the reinsurer would not have greater rights against the reassured than the reassured had against the original policyholder. 7.128 We are not convinced that the parties to reinsurance are always fully aware of the differences between legal regimes. If they were, the difficulties in Vesta would not have arisen. The greater the variation in the law applying to different types of insurance contracts, the more scope there is for confusion to arise. We would not wish to create differences between insurance and reinsurance law unless those differences were clearly necessary. We fear that the specific provisions to prevent anomalies of the type suggested by the 1980 report would add to the complexity of the law.39 7.129 We are interested to hear from the industry whether there are any reasons to treat reinsurance contracts differently. Our current thinking is that the reforms suggested above should apply to both insurance and reinsurance contracts. 7.130 Are there any reasons why the reforms should not apply to reinsurance contracts? REFORMING OTHER PROVISIONS OF THE MIA 1906 7.131 The reforms we have tentatively proposed have consequences for the Marine Insurance Act 1906. For example, the requirement for a causal connection is incompatible with section 34(2), which does not allow a breach of warranty to be remedied before a loss occurs.40 Here we consider other implications of our proposals on reforming the MIA provisions on warranties. Automatic discharge or repudiation? 7.132 The reforms we have proposed are incompatible with the idea that an insurer is automatically discharged from liability from the date of the breach. Section 33(3) states that 38 para 8.12. 39 There already appears to be considerable scope for argument about whether a clause in an insurance contract has be incorporated within a re-insurance contract in “manipulated” or “unmanipulated” form: see HIH Casualty and General Insurance Ltd v New Hampshire Insurance Co [2001] 2 Lloyd’s Rep 161; [2001] EWCA Civ 735. We would not wish to encourage disputes of this type, but imposing one set of legal rules where the reinsured gave an independent warranty and another where the reinsured “substantially repeated” the warranty given by the insured. 40 S 34(2) states that “where a warranty is broken, the assured cannot avail himself of the defence that the breach had been remedied, and the warranty complied with, before loss”. 88 …subject to any express provision in the policy, the insured is discharged from liability as from the date of the breach of warranty, but without prejudice to any liability incurred by him before that date. If an insurer is automatically discharged from liability from the date of the breach, it cannot logically be liable to pay a subsequent loss unconnected with the breach.41 7.133 If one were to repeal section 33(3) it would be necessary to put something in its place. If not, the repeal would only lead to confusion about how far the provision merely reflected the pre-existing common law position, which continued unchanged. The question is how far any statutory restatement should go in altering the current law. 7.134 If warranties are not to be given any special or pre-eminent status, then it would be more in keeping with general contractual principles to provide that a breach by one party merely gave the other party the choice. When an injured party becomes aware of the breach, it may either decide to repudiate the contract or to affirm it and continue with the relationship. 7.135 Should the reforms provide that a breach of warranty gives the insurer the right to repudiate the contract, rather than automatically discharging it from liability? 7.136 In 1980 the Law Commission argued that the issue of past claims and future repudiation should be treated separately. An insurer should be able to pay past claims and repudiate the policy for the future; it should also be entitled to reject claims, without repudiating in the future. 7.137 Under the tentative proposals in this paper, a breach of warranty would mean that an insurer was not liable for a loss causally connected to the breach (though, as we discuss below, it would be possible for the insurer to waive this breach). The breach would not affect any past unconnected losses. However, the question is whether the breach should also entitle an insurer to choose to bring the policy to an end. This means that the insurer would no longer be liable to meet any claims (whether causally connected to the breach or not) from the time the decision was communicated to the insured, 7.138 Should the reforms provide an insurer with a choice between repudiating the claim only, or the policy for the future, or both? The implications of termination: liability for premiums, notice and waiver 7.139 If the reforms were to provide that a breach of warranty gives an insurer the right to bring a contract to an end, this raises three further questions. First, should the insured continue to be liable to pay premiums after the contract is terminated? Secondly, should the insurer’s right to repudiate for the future be subject to a requirement to give reasonable notice? Finally, what effect would this have on the law of waiver? We explore these issues below. 41 Furthermore, if we were to extend the Unfair Contract Terms Act 1977 to insurance policies, as discussed in Part 8, it would be incompatible with s 29, which provides that a party may rely on provisions that are specifically authorised by statute. 89 Continued liability for premiums FUTURE PREMIUMS 7.140 Under general contract law, where one party accepts the other’s wrongful repudiation, the effect is to bring to an end both parties’ primary obligations under the contract. As Lord Diplock put it: (a) there is substituted by implication of law for the primary obligations of the party in default which remain unperformed a secondary obligation to pay money compensation to the other party for the loss sustained by him in consequence of their non-performance in the future and (b) the unperformed primary obligations of that other party are discharged.42 7.141 This means that neither the innocent nor the guilty party are required to perform any further primary obligations under the contract (though ancillary clauses, dealing with matters such as arbitration, may survive).43 If the guilty party has been paying by instalments, the normal rule is that the insured remains liable for any payments that fall due before the repudiation is accepted,44 but not for payments due after that date. The primary obligation to pay the instalments is replaced with a secondary obligation to pay damages for loss of profits. This contrasts with the rule for breach of warranty under section 33(3), under which only the insurer is discharged from liability: the insured remains liable to pay future instalments of the premium. As we have seen, under the current law if the insured breaches a payment of premium warranty, the insurer is automatically discharged from further liability, but the insured must continue to make payments.45 7.142 The question is what would happen if we were to repeal section 33(3) and replace it with an insurer’s right to accept repudiation? It is unclear whether the normal rule would apply, so that the insured would cease to be liable for the premium). The insurer might be able to argue that the separate instalments did not constitute different payments for divisible periods of cover (with, for example, each monthly instalment paying for each month’s cover). Instead, it could be said that the premium was one single indivisible payment for one single period of cover: it was just that the contract permitted the single premium to be paid over the course of time. 7.143 This latter argument was accepted in Chapman v Kardirga.46 Chadwick LJ commented: 42 Photo Production Ltd v Securicor Transport Ltd [1980] AC 827 at p 849. 43 See Yasuda Fire & Marine Insurance Co of Europe v Orion Marine Insurance Underwriting Agency Ltd [1995] 1 Lloyd’s Rep 525. 44 Hundai Heavy Industries Co Ltd v Papadopoulos [1980] 1 WLR 1129, where the party in default was entitled to claim an instalment which fell due on 15 July despite the fact that they had cancelled the contract on 6 September. 45 In JA Chapman v Kadirga and others [1998] CLC 860. 46 Above.