Damage limitation

The Law Commission’s “tentative” proposals that insurers should be liable for loss caused as a result of an unjustified delay or refusal to pay a claim have been given qualified backing by insurance practitioners.

However, they are concerned about how any changes may be made and are keen to be involved in the reform process to ensure it avoids creating new problems.

The issue has been raised as part of a joint review of insurance contract law by the Law Commission and the Scottish Law Commission. Responses to their issues paper, Damages for late payment and the insurer’s duty of good faith, are due by next Thursday (24 June) and will feed into a full consultation paper planned for early 2011.

At present, the English case of Sprung (see box, right) means that a policyholder cannot recover losses suffered as a result of the late or non-payment of an insurance claim, even if the insurer has wrongfully refused to pay out on time and the policyholder has gone out of business as a result. This is out of step with Scottish law and other common law jurisdictions where damages are payable, provided that the loss is considered foreseeable at the time the contract is made.

The British Insurance Law Association (BILA) is submitting comments on the issues paper. Its immediate past chairman, Jacquetta Castle, who is also partner with niche insurance practice Robin Simon, says: “The principle defect in the law as it stands is Sprung, which can produce unfair results in practice. The rationale for the law is that, under indemnity insurance, claims for late payment are classified as damages, not debts, and English law does not recognise an obligation to pay damages for a failure to pay damages.

“Everyone sees that there are injustices and anomalies in the current law, but we want to make sure that if there is change, we get it right and don’t just end up creating new problems.”

QBE European Operations’ head of strategic claims management, Mike Noonan, believes the issues paper’s analysis that the current position is biased against policyholders and ignores commercial reality is fair. “Most insurers would recognise that. When you read the Sprung case, your heart goes out to him. The law needs to be tidied up and brought into the 21st century.”

For Forum of Insurance Lawyers president Dan Cutts, the starting point must be a careful examination of the evidence of any alleged policyholder detriment. Cutts, also director of insurance at national law firm Weightmans, says: “It is of concern that the Law Commission feels there is ‘limited evidence’. This is a question of balance. Any change in the law will involve increased risk to insurers and thus increased costs to policyholders. In the present economic climate, this would not be welcome if there is no clearly demonstrable need for change on the ground.”

Maladministration

The paper makes it clear that its suggestions are aimed at cases of maladministration. So, what are the implications for insurers and the claims process?

“The changes should not make that much difference to a well-run claims department,” Castle says. “There could be a tendency to reject claims more readily to avoid any suggestion of delay but I can’t really imagine that.”

What’s unclear at this stage, says AXA head of governance and operations Russell Whitehouse, is exactly what losses a commercial business could recover. “Businesses can take out property damage insurance and business interruption cover. We don’t want to be in a position where there is any suggestion that an insured doesn’t need to bother with business interruption cover because they can recover any loss of profit through a change in the law.”

This is a concern, agrees David Kendall, co-chair of the insurance and reinsurance department of international business law firm Edwards Angell Palmer & Dodge. “If a factory burns down and the insurer is found to be dilatory or to have acted in bad faith, the factory owner will, in effect, have a claim of business interruption.

“But that will only arise if the insurer has mishandled the claim. Although one can draw an analogy between business interruption and consequential loss, they are not really the same.”

For Lockton International general counsel Charley Taggart, the question is whether the suggested reforms could lead to insurers taking a more “entrenched” position from the outset to avoid accruing a claim as a debt. This could make it harder for brokers to negotiate on behalf of their client.

“It is a sad fact that some businesses do go bust because of a policy's failure to respond and that needs to be addressed,” she says. “But over-protectionism could have a negative impact on rates and the competitiveness of the London market.”

If insurers become obliged to pay without having been given a reasonable opportunity to investigate, she continues, a right to claw back will be required – if it transpires that the claim should not have been paid or insurers will have to withhold some of the claims monies.

She also stresses that any debt should be triggered only after the insurer has had an opportunity to review and adjust the claim, not by the loss itself.

Stalling tactics

When it comes to delay, the issues paper considers whether it is used as a stalling tactic. Noonan says some claims take a long time to investigate. “Using stalling tactics as a matter of policy is vanishingly rare in my experience, but it doesn’t mean it doesn’t happen. One of the attractions of this paper is that as well as providing an effective remedy, it would remove any temptation to act in this way.”

The paper also looks at the consequence of bringing English law into step with Scottish law.

“My understanding is that the system works well in Scotland and the courts are very restrained in the way they award damages,” says Fiona Heyes, partner with law firm Pinsent Masons’ insurance and reinsurance team. “Establishing a claim against an insurer for delay or bad faith is a high hurdle, so there isn’t suddenly going to be a huge amount of litigation.”

The issues paper sets out two broad approaches to reform. The first would be to amend the Marine Insurance Act 1906 to provide policyholders with damages for foreseeable loss where an insurer has acted in bad faith. It suggests spelling out the insurer's duty of good faith, which would be non-excludable.

But, says Whitehouse: “Rather than define what good practice is, it may be clearer to say we will impose a strict liability on the insurer where they have acted in bad faith, and define that – as acting maliciously or deliberately against the insured’s interests.”

The other option for reform is for the decision in Sprung to be reversed. The Law Commission has suggested the insurer’s primary obligation should be to “pay valid claims”, as in Scotland, and if the insurer fails in this obligation, normal contractual principles should apply.

Castle says: “This could be dealt with judicially by waiting for a suitable case to progress through to the Supreme Court.?But, given the very real anomaly of the situation, it really calls for more immediate legislation.”

Taggart questions the legislative route, saying: “Legislative reform did not work for third-party rights, so thought should be given to extending the application of the ICOB provision, which requires claims to be paid fairly and promptly. Regulation could then place the obligation on the insurer to justify the delay and the issue becomes one of regulatory risk, where insurer risk appetite is lower.”

Contracting out

Another issue being debated is whether insurers could contract out of their duties to pay within a reasonable time or limit liability. This would not apply to individual policyholders since such terms would be subject to the Unfair Terms in Consumer Contracts Regulations.

Noonan says he would be surprised if insurers tried to exclude liabilities, though they might try to cap the risk. “If I were a broker, I would be saying to an insurer: ‘Why do you want to exclude liabilities? You should be doing this right in the first place’.”

Any proposals for change will have to weigh up the likely costs, such as increased premiums, against the benefits.

It may be difficult to justify charging higher premiums initially, says Kendall. “The insurer would effectively be saying: ‘I have to charge you a higher premium because of the risk that I might mishandle the claim’, which isn’t very attractive. But if after a period of time there was an increase in the size of awards because of the consequential loss element, that would feed through to the claims statistics and could lead to a rise in premiums.”

More importantly, says Noonan, this will give insurers extra pause for thought before declining to pay a claim – “because if we get it wrong, it might come back to bite us. It might provide a basis for claims managers to say we should have stronger systems or put more resources into making higher-quality claims decisions”.

However, given that the number of successful claims is likely to be small, and legislative time limited, is reform necessary?

In principle, insurers agree that the law needs to be modernised, says Whitehouse.

For Noonan, commercial and consumer practice has left the law behind. “The law is catching up, but now and again it will trip up an unfortunate insured who is unlucky enough to come up against a difficult insurer. This is one of those last dark areas that needs cleaning up.” IT

Case study: Sprung v Royal Insurance

The case of a man, Mr Sprung, who lost his business after vandals damaged his factory and his insurer refused to pay out is at the heart of the Law Commission’s proposed reforms.

Unable to fund the cost of the repairs himself, Mr Sprung’s animal waste processing business collapsed. It took him four years to win an indemnity for the damaged property, plus simple interest and costs, after the insurer abandoned its defence. But he was not allowed to recover the cost of losing the opportunity to sell his business. He refused to give up and pursued his claim. The judge assessed his loss at £75,000 but found he was not entitled to recover that sum in law.

He fought on, representing himself at the Court of Appeal in Sprung v Royal Insurance (UK) Ltd [1996] 1 Lloyd’s Rep IR 111; [1997] CLC 70. He lost because the court decided it was bound by the principle that there could be no award of damages for the late payment of damages. As Mr Sprung had been compensated by an award of interest for the delay in payment, he was not entitled to damages as well. However, one of the appeal judges said he came to his decision with “undisguised reluctance”, while another called for the law to be reformed.

More than a decade on, the commission has used Mr Sprung’s case to illustrate the ‘unfairness’ of the current legal position. Had he been based in Scotland, he might have achieved compensation. He may also have received compensation via the Financial Ombudsman Service, which does not have to apply the law where the legal result would be unfair, but which only came into being in 2001.

Law Commissions’ key questions

The two law commissions are seeking industry responses to key questions:

1. Does the law on damages for late payment need reform?

2. Should legislation include specific guidelines on insurers’ duty of good faith?

3. Should damages be available for foreseeable loss as a result of the insurer’s breach of its duty of good faith?

4. Should the duty of good faith be non-excludable?

5. Should the “hold harmless” fiction – that the insurer’s obligation under an insurance contract is a duty to prevent harm from occurring – be replaced with a contractual obligation to pay valid claims within a reasonable time?

6. Should insurers who fail to meet that obligation be liable for the foreseeable losses that result?

7. Should parties to a business insurance contract be able to exclude this liability through the express terms of the contract?

8. Should consumer insurance contracts follow the Financial Ombudsman Service’s approach to the award of damages for distress, inconvenience and discomfort?