DLA Piper's Practical Guide for Claims Managers in 2022 - Part 5

By: Leon Taylor | Andrew Kelmanson | Oliver Saunders

Introduction

In this fifth in the series of our monthly Practical Guides for Claims Managers in 2022, we consider certain key principles associated with terms that are commonly used in commercial insurance contracts, including warranties, conditions precedent and also 'mere' (or 'bare') conditions¹. The legal consequences of non-compliance with each of these types of term differ significantly.

Claims Managers are therefore advised to be aware of how such terms are treated by the courts, including the potential remedies available in the event of any qualifying breach. We review examples of these typical policy terms below. We also address the abolition of 'basis of contract' clauses in non-consumer insurance contracts effected by the Insurance Act 2015² (the Act).

The effect of the Insurance Act 2015

The Act introduced significant changes to the legal effect of certain terms in insurance (and reinsurance) contracts. This followed the Law Commission's view that certain aspects of insurance law had become outdated since the Marine Insurance Act 1906 (the MIA) was passed almost 120 years ago.

The Law Commission's view had been that, prior to the Act, certain key insurance contract terms operated to favour insurers over policyholders. For policies entered into on or after 12 August 2016 (including renewals, amendments and endorsements to policies entered into before 12 August 2016) the Act has materially impacted the meaning and effect of certain key terms³.

Although several commentators predicted that a wave of policyholder/insurer litigation was likely to follow in the wake of the Act, that has so far failed to materialise. Insurers should nonetheless be alive to future judicial decisions relating to policy terms and conditions, given that many of the issues that we touch upon in this article would benefit from further consideration by the courts.

Of course, whilst investigating a claim, insurers remain entitled to reserve their rights, subject to the provisions of the Act and the law more generally. We considered the topic of (p)reserving rights in detail in our third edition of this series.

The different types of policy terms

‘Basis of contract’ clauses

Under section 9 of the Act (Warranties and Representations), the use of ‘basis of contract’ clauses has been abolished, and the parties are not entitled to contract out of section 9. Under the previous regime, a pre-contractual statement could be converted into a warranty by using ‘basis of contract’ language. These clauses were frequently used by insurers to turn all of the answers in the proposal form into warranties, with the effect that any inaccuracy in the proposal form would discharge insurers from all liability under the policy from inception.

For contracts that come within the scope of the Act, the position now is that any representation made by the policyholder in connection with a “proposed” policy is no longer capable of being converted into a warranty by means of any term in either the policy, or the proposal.

Warranties

The MIA (which remains good law save where its provisions are substituted or amended by the Act) defines a ‘warranty’ as a term “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 negates the existence of a particular state of facts”. The Act has not re-defined a warranty. In other words, it remains an undertaking by the policyholder that something will – or will not – be done, or that a particular state of affairs does – or does not – exist.

Prior to the changes effected by the Act, if a policyholder breached a warranty, this automatically entitled the insurer to treat the policy as at an end, regardless of whether the breach gave rise to any loss or prejudice to the insurer. The insurer’s liability under the policy was discharged with immediate effect, and there was no recourse available to the policyholder whereby they were entitled to remedy that breach⁴.

Following the Law Commission's review, it was recommended that a breach of warranty should be capable of being remedied by a policyholder. As a result, the law has been softened by the Act with the effect that – if the policyholder takes appropriate steps to remedy the breach – then a breach of warranty no longer automatically discharges insurers’ liability. Instead, a breach merely suspends insurers’ liability unless and until it is remedied by the policyholder⁵.

In summary, the Act has resulted in the following key changes:

• Insurers have no liability in respect of any loss occurring or attributable to something happening whilst the policyholder remains in breach of a warranty.
• Any breach will be taken as remedied either when the policyholder ceases to be in breach, or if the risk becomes the same as was originally contemplated by the parties.
• Where the breach is remedied before the loss is suffered, insurers must pay the claim, subject to any other relevant policy terms.

For example, if the policyholder warrants that it has a working burglar alarm, the insurer will not be on risk during the period for which that undertaking is not being fulfilled because the alarm has, say, stopped working, but they will be back on risk once the alarm has been repaired. If the policyholder is in breach of a warranty to take a particular step by a particular time, it will have remedied the breach for the purposes of the Act once the step is taken⁶. A warranty may also be subject to section 11 of the Act (Terms not relevant to the actual loss), which we consider below.

It is important to note that insurers will not have a remedy for breach of a warranty in the following circumstances:

• The warranty ceases to be applicable due to a change in circumstances.
• If compliance with the warranty is rendered unlawful by subsequent law.
• The insurer waives the breach⁷.

What amounts to a change of circumstances is yet to be tested before the courts and therefore remains an open question.

‘Mere’ conditions -v- conditions precedent

Conditions can be sub-categorised into 'conditions precedent' and 'mere' (or 'bare') conditions. English law has traditionally regarded a breach of a ‘condition precedent’ in a policy as meriting very different consequences compared with breach of a ‘mere’ condition.

‘Mere’ (or ‘bare’) conditions

A policy will typically include many terms which are 'mere' conditions. These are commonly concerned with the policyholder’s conduct during the policy period. In the majority of circumstances, and indeed only where insurers can demonstrate that they have suffered prejudice, a breach of a 'mere' condition will only entitle insurers to compensation in damages to the extent that they can demonstrate they have suffered actionable loss as a result of the breach of the condition.

Conditions precedent

A policy may also contain different types of conditions precedent. One type which may be found is a condition precedent to the validity of the contract. In this case, the condition must be satisfied before the risk will incept or attach (eg an obligation to pay premium before the insurer goes on cover). A second and more frequent type of condition precedent is a condition precedent to the insurer’s liability under the policy, where the condition must be satisfied before the insurer is liable in respect of a claim. This latter type of condition precedent is often concerned with the claims process (e.g. notification of a claim within a specified time or in respect of the policyholder’s obligations of co-operation).

The attribution of condition precedent status to a policy term will depend on a number of factors, including whether:

• A term is expressly labelled a condition precedent.
• Any other terms are expressly labelled conditions precedent.
• There is a general term making compliance with all conditions a condition precedent to liability (or words to that effect).

No single factor is determinative, and, in accordance with general principles applicable to contractual interpretation, the courts will construe the policy as a whole to determine the proper meaning of a particular clause in its broader contractual, factual and commercial context.

By way of example, in the case of Aspen Insurance UK Ltd & ors. v Pectel Ltd [2008] EWHC 2804 (Comm), which concerned a clause requiring notice of a claim, the court held that the term under consideration amounted to a condition precedent due to a general provision stating that insurers’ liability was conditional upon the observance of the terms and conditions of the insurance. The court held that by its very nature the commercial purpose of the notice provision (allowing the investigation of the claim) justified compliance being a condition precedent to insurers’ liability. In addition, the court held that it did not matter that the clause at issue did not expressly say that it was a condition precedent.

Remedies for breach of condition precedent

For policies that have been entered into before 12 August 2016, in principle a policyholder’s failure to comply with a condition precedent automatically entitled the insurer to deny a claim entirely, irrespective of whether the breach of the condition precedent was in any way related to the loss or the claim.

For policies that were entered into since 12 August 2016, when the Act came into force, the position is now more nuanced, and potentially more uncertain. This is because of the effect of section 11 of the Act, which has introduced new rules requiring, in certain cases, there to be a degree of relationship between the policyholder’s breach of a condition precedent, on the one hand, and the risk of loss as a result of the breach, on the other hand, before an insurer can deny a claim.Section 11 applies generally to terms which are not relevant to the actual loss, and so it can apply to warranties and conditions alike, and equally it applies regardless of whether the terms are expressly stated in the policy or implied into it. The new rules under section 11 apply to terms where compliance with the term (whether a warranty or condition) would tend to reduce the risk of loss of a particular kind, or at a particular location, or at a particular time. These types of term are sometimes described as ‘risk mitigation terms’. An example would be the situation mentioned earlier, where a warranty requires the installation and maintenance of a burglar alarm on the insured premises. Such a warranty would tend to reduce the risk of loss, namely theft from the premises.

With regard to these types of terms, insurers cannot rely on breach of the term to exclude, limit or discharge their liability under the policy, where a loss has occurred if the non-compliance in question could not have increased the risk of the loss that actually occurred. Put simply, the breach of the term by the policyholder must be at least loosely relevant to the actual loss that happened for the insurer to be in a position to claim a remedy for the breach.

So, taking again the example of the warranty requiring the policyholder to maintain the burglar alarm, the insurer could not rely on the failure to maintain a functional burglar alarm to refuse a claim for loss due to a fire on the premises. Unless the malfunctioning burglar alarm actually caused or contributed to the fire, the policyholder’s failure to maintain the burglar alarm could not have increased the risk of the loss that actually occurred, namely the fire.

As mentioned above, only some degree of relationship between the breach and the loss is necessary. Indeed, the Law Commission had indicated that the connection required was intended to be something less than causal, but it is not certain how the courts will apply the wording of section 11 to different factual scenarios.

It is also important to bear in mind that section 11 does not apply if the term in question is not a ‘risk mitigation term’ in the sense described above, or if the term defines the risk as a whole. The Law Commission cited as an example of a term defining the risk as a whole the requirement that a property or vehicle should not be used for commercial purposes. It will often be necessary to look at the policy as a whole in order to determine whether a particular term is one that defines the risk as a whole, in which case section 11 would not apply to that term.

It seems unlikely that section 11 would apply to clauses such as claims conditions that are invoked following the loss, eg those requiring notice of a claim (so, for example, if a condition precedent to liability to give notice of the claim is not complied with, then insurers are likely to be entitled to deny the claim).

Contracting out

With limited exceptions, it is open to the parties to agree policy terms that contract out of provisions of the Act. The exceptions are that it is neither possible to contract out of the Act’s provisions that abolish ‘basis of contract’ clauses (discussed above) nor to contract out of the term implied into policies under section 13A of the Act, namely that insurers must pay claims within a reasonable time, to the extent that insurers’ breach of that obligation may be deliberate or reckless.

The enforceability of any permissible contracting out will depend upon whether insurers have satisfied the provisions relating to contracting out in section 16 of the Act, or whether they are otherwise constrained, for example by professional minimum terms.

In order to contract out of provisions of the Act, section 17 of the Act (The transparency requirements) stipulates that insurers must satisfy two hurdles to reflect the fact that they have indicated to the policyholder with appropriate transparency that the policy does not incorporate these provisions:

• First, insurers should draw any disadvantageous term – ie that which is sought to be contracted out of pursuant to the Act – to the attention of the policyholder (unless the policyholder or its broker already had actual knowledge of the disadvantageous term).
• Second, any such term should be drafted so that it is clear and unambiguous as to its effect on the policyholder⁸.

In determining whether the above requirements have been met, the characteristics of policyholders of the kind in question, and the circumstances of the policy in question, are to be taken into account.

Policy terms and what they mean for insurers: Practical takeaways

Here are our top tips for insurers to help with policy terms and what they mean:

• Bear in mind that different terms in a policy can have different legal status – and different consequences in the event of breach. This can be the case regardless of how a particular term is labelled in the policy. Ask yourself: what is the intended effect of the provision under consideration?
• In particular, a condition precedent to insurers’ liability need not be specifically labelled or described as such to be a condition precedent – the court will look at the entire clause in context to decide its meaning.
• If the term is not a warranty or a condition precedent, insurers will not be able to decline or reduce a claim for breach of the term, unless the breach resulted in actionable loss on the part of the insurer – which can then be legally set off against the value of a claim.
• If the term is a warranty, non-compliance with the term will entitle insurers to come off risk – unless and until the policyholder can remediate the non-compliance.
• If the term is a condition precedent to liability, non-compliance with the term will entitle insurers to deny the claim in its entirety – unless the term is a ‘risk mitigation term’, ie compliance with the term would tend to reduce the risk of loss of a particular kind, or at a particular location, or at a particular time.
• For ‘risk mitigation terms’, the section 11 rules apply, meaning the policyholder’s non-compliance with a particular term or terms must have increased the risk of loss of the kind that actually occurred before the insurer can rely on any breach to exclude, limit of discharge their liability under the policy, or deny a claim. Ask yourself: is the impact of section 11 nullified because it is a term that can be said to describe the risk as a whole?
• Have insurers successfully contracted out of the provisions of the Act? This will require insurers to show they complied with the ‘transparency requirements’ at the time the policy was placed.
• The legal effect of ‘basis of contract’ clauses in a proposal form or policy has been abolished – if you are considering a policy entered into on or after 12 August 2016, and you find a ‘basis of contract’ clause, do not try to rely upon it to decline a claim.

This publication is intended as a general overview and discussion of the subjects dealt with under English law at the time of original publication and does not create a lawyer-client relationship. It is not intended to be, and should not be used as, a substitute for taking legal advice in any specific situation.