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The potential unfairness caused by the law on breach of warranty in insurance contracts, particularly in consumer insurance. The author proposes that statements of existing fact should be treated as representations rather than warranties to limit insurers' right to reject claims. The document also suggests applying the causal connection test to express warranties in marine insurance contracts and the implied marine warranties set out in the Marine Insurance Act 1906. Furthermore, the document discusses the ABI Statements of Practice, unfair terms in consumer contracts, and the Financial Ombudsman Service.
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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) 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)
(2) in consumer insurance, there should be an additional requirement. 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. (para 7.65)
Causal connection
(1) the law should afford policyholders some protection against claims being denied for reasons unconnected with the loss. (para 7.68)
(2) 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. (para 7.76)
(3) if a breach contributes to only part of a loss, the insurer may not refuse to pay the part not related to the breach. (para 7.81)
(1) the causal connection rule should be mandatory in business insurance. (para 7.83)
(2) the protection should 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. (para 7.89)
(3) the causal connection test should be subject to an exception where the insurance relates to one purpose, activity or place, and the loss arises from another purpose or activity or in another place. In these circumstances, we suggest that the claim should not be paid if the loss related to an activity which was so far outside the terms of the cover that a reasonable insured could not have expected the loss to be covered. (para 7.97)
Marine insurance
(1) express warranties in marine insurance contracts (para 7.108); and
(2) the implied marine warranties set out in sections 39 to 41 of the Marine Insurance Act 1906 (para 7.119)
Reinsurance
(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)
(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)
iii
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.
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).
Held covered in case of any breach of warranty as to cargo, trade, locality, towage, salvage services or date of sailing provided notice be given to the Underwriters immediately after receipt of advices and any amended term of cover and any additional premium required by them be agreed.^8
2.9 In other words, once the insured gives prompt notice of the breach, the insurer is obliged to provide additional cover, if necessary on amended terms and for an additional premium. Where the parties cannot agree on the terms or premium, the matter may be referred to a court or arbitration.
Creating a warranty
2.10 Most warranties are created expressly by the parties. There is no single form of words that confers warranty status on a term. The use of the word “warranty” has been said to be indicative but by no means decisive. 9 As Lord Justice Rix put it in HIH Casualty and General Insurance Ltd v New Hampshire Insurance Co ,
It is a question of construction, and the presence or absence of the word “warranty” or “warranted” is not conclusive. One test is whether it is a term which goes to the root of the transaction; a second, whether it is descriptive or bears materially on the risk of loss; a third, whether damages would be an unsatisfactory or inadequate remedy.^10
The case concerned film finance insurance, in which the original insured had undertaken to make six films. This was held to be a warranty, even though the word warranty was not used, because it was a fundamental term with a direct bearing on the risk.^11
2.11 In marine insurance, the law will also imply certain warranties into the contract (which are set out in Appendix A).
(^8) ITCH 1995, cl 3. (^9) Barnard v Faber [1893] 1 QB 340. (^10) HIH Casualty and General Insurance Ltd v New Hampshire Insurance Co [2001] 2 Lloyd’s Rep 161 at para 101; [2001] EWCA Civ 735. (^11) By contrast, courts have sometimes been prepared to hold that a clause described as a warranty is not a warranty. In Roberts v Anglo-Saxon Insurance Ltd (1927) 27 LI L Rep 313, Bankes LJ argued that the phrase “warranted: used only for commercial travelling” did not create a true warranty: When persons insert clauses, whether described as warranties or whether described as part of the description of the vehicle, indicating that the vehicle is to be used in some restricted way, my opinion… would be that the parties had used that language as words descriptive of the risk, and that, as a result, when the vehicle is not being used in accordance with the description it is not covered; but it does not follow at all that because it is used on some one occasion, or on more than one occasion, for other than the described use, the policy is avoided. It does not follow at all. (at p 314). This was approved by Lord Buckmaster in Provincial Insurance v Morgan [1933] AC 240 at p 247.
2.12 Warranties are best understood in the context of a hierarchy of different sorts of terms that impose obligations on policyholders. Warranties are the most severe, though breaches of other types of term may also extinguish insurers’ liability for particular claims.
2.13 Within English law, It is possible to identify the following types of terms in insurance contracts:^12
(1) Warranties carry the most severe consequences for policyholders if they are breached. A breach discharges the insurer from any liability under the contract, even if the breach is minor or remedied later. In effect, compliance with a warranty is a condition precedent to liability arising under the policy as a whole.
(2) Conditions precedent to a claim. Here breach will discharge an insurer from liability to pay a particular claim, but will not affect other possible claims under the policies. Such conditions are most likely to be procedural, requiring (for example) notice of claims.^13
(3) Clauses which are “ descriptive of the risk ” for which the insurer is liable. These state that the insurer will only cover losses arising in particular circumstances, and if a loss arises in other circumstances, the insurer is not liable. Such terms are sometimes called “suspensive” conditions, on the basis that they merely suspend liability while a breach taking the risk outside the policy continues. If a policyholder remedies the problem the insurer resumes liability.
(^12) Scots law may refer to some of these categories, but does not have a strict classification of terms. It retains flexibility by leaving the effect of a term to be determined according to its construction in the particular circumstances of the case. (^13) This category of term was recognised in Alfred McAlpine Plc v BAI (Run-Off) Ltd [2000] 1 Lloyd’s Rep 437, at para 27. Here Waller LJ cited Weir v Northern Counties of England Co (1879) 4 LR Ir as “an example of a term not being a condition precedent, but on its language being a term which, until it is complied with, entitles the insurer not to meet the claim”. In K/s Merc-Scandia XXXXII v Certain Lloyd’s Underwriters (“The Mercandian Continent”) [2001] 2 Lloyd’s Rep 563 Longmore LJ confirmed the existence of “a further category of term” would give underwriters “the right to reject the claim without having to accept the breach of contract as being a repudiation of the contract as a whole” (para 14).
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.
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.
3.3 The 1980 report attempted to cure these defects by both procedural and substantive means. First, the Law Commission recommended procedural safeguards affecting how warranties may be created. These would have effectively abolished basis of the contract clauses and required insurers to provide policyholders with written documents containing any warranties they had given. Substantively, policyholders would have a right to have their claim paid if they could show that a breach of warranty was unconnected with the risk. They could do this by showing that it was immaterial to the risk, or immaterial to the particular risk that had occurred, or could not have increased the risk that a loss would occur in the way it did occur.
3.4 Below we look at each recommendation in more detail.
Procedural safeguards
Basis of the contract clauses should be abolished
3.5 The recommendation on “basis of contract” clauses was designed to prevent statements of fact within the proposal form from being converted into warranties. Clause 9 of the draft Bill applied to “any statements affirming or denying the existence of, or giving his opinion with respect to, any fact or state of affairs at any time past or present”. It provided that any such statement would not constitute a warranty if it were contained in a proposal form, or “made by reference to a provision in a proposal form”;^5 nor could it be converted into warranties by an incorporation clause within the contract itself.
3.6 The report states that the Commission did not “intend to ban specific undertakings by the insured as the existence of past or present facts”.^6 A specific fact could still constitute a warranty, provided it was in the policy itself. What insurers could not do was elevate the insured’s answers into warranties en bloc. In other words, if a particular fact were so crucial to cover that the entire existence of the policy depended on it, the insurer must say so specifically in the policy. For example, a policy may state that the insured warranted that a building was made of brick and slate. However, a policy term could not convert all the answers the insured had given on a proposal form into warranties. The Commission wanted to prevent minor inaccuracies (such as a wrong address or telephone number) from invalidating cover. Nor could an answer be given warranty status by a notice on the proposal form. The term had to be in the contract itself.
Insurers should provide written statements as soon as practicable
3.7 This recommendation was set out in clause 8(2) of the draft Bill. It states that an insurer shall not be entitled to rely on a breach of warranty unless the insured was supplied with “a written statement of the provision which constitutes the warranty”. The statement must either be supplied at or before the time the contract was entered into, or “as soon thereafter as was practical in the circumstances of the case”.
(^5) clause 9(1)(a). (^6) para 7.10.
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.
