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Aspen Opinion

Contract Certainty

April 21, 2016

Clive Edwards

Regional Product Leader – Property & Casualty and CUO of Aspen Insurance UK Ltd

Tel: +44 20 7184 8230

Clive Edwards reflects on some fundamentals of insurance given the upcoming implementation of the Insurance Act in 2016.

Download a PDF of this Aspen Opinion

Clarity and Certainty of Contract

Knowledge of contract terms has improved greatly with the advent of market initiatives such as Contract Certainty. This was introduced in response to the challenge from the Financial Services Authority to end the "deal now; detail later" culture. "Back of an envelope" quotations featuring the premium and little else are certainly no longer compliant given the insurer would be failing to make the buyer fully aware of the policy terms and conditions. The Insurance Act 2015, which comes into force on 12 August 2016, updates legislation that has been in existence since 1906 and reinforces the insured's duties to make a fair presentation of the risk.

Post implementation, insureds are likely to build more time into the pre renewal period so that the necessary information can be properly collated and then presented. This information should enable the insurer to fully understand the risk, which presupposes that the data is clear and accessible. "Data dumps" from insureds are unhelpful and so a distinction should be made between relevant information and other background material that does not inform the underwriter about the risk they are accepting.

For complex commercial insurance there is no market standard data set since each risk is, given its complexity, likely to be different. A fair presentation of risk is not dependent on standard issue proposal forms. While this may generate different formats and styles of presentation of the information, the categories of risk disclosed are likely to be the same. Insurers will no longer be able to use this information as the basis of the contract (the "basis clause"). Removal of this clause prevents insurers finding fault in the data set, regardless of whether material and relevant to the loss, and declining a claim on the basis that the information given was not accurate.

For the insureds, reassurance is provided through an insurer that is both informed and inquisitive as this suggests the proposal is fully understood and, as a consequence, reduces the potential for the claim to be dealt with on a reservation of rights basis or imposition of cover restrictions. For example, if the insured’s regime for cleaning is not revealed, the insurer can impose a system, perhaps by the application of a policy condition requiring annual steam cleaning by an appropriate contractor. The stipulation of conditions rather than the insured’s response avoids the need for the insurer to ask further questions. Reducing the number of claims handled on a reservation of rights basis is not just down to a good claims team but assiduous underwriters who can quickly affirm "we know the insured undertook this activity and our policy is designed to respond".

Common sense would suggest a fair, complete and nonmisleading presentation at the pre inception stage is the ideal for both insurers and insured. A claims experience that is a post – event fact finding mission benefits neither client nor underwriter. Clause 11 of the Insurance Act addresses terms not relevant to the actual loss and will stop pedantic insurers using a breach of non-relevant warranties to deny a claim. This may not avoid the subsequent claim fueled debate over, for example, the definition of period to comply with the insurer’s imposed cleaning regime – an imposition made in place of further fact finding. The insured may well have thought that an annual steam clean during the Easter Week shut down was acceptable. However, Easter Week is a variable occurrence and depends on the lunar cycle and is not bound by the 52 week year. Clarification of this point avoids a potential point of frustration by an insurer strictly adhering to a breach of policy condition.

Obtaining certainty at inception avoids uncertainty when a claim occurs as, from my experience, a surprise at time of loss is not usually a good one.

Definition of Terms

The UK’s vulnerability to weather claims was highlighted by the wet end to 2015. The UK insurance market has the rare capability of offering "all risks" or fire and perils insurance that includes storm, flood and other natural catastrophes up to the policy liability as standard. Other countries typically impose limits or access central pools. Flood Re, which was launched in April 2016, will provide flood insurance capacity for UK individual homeowners via insurers who are a member of the scheme initiative. This does not apply to businesses - including those businesses that own domestic dwellings. So, what is likely to be the outcome for business insurance and cover for floods?

First, one needs to ascertain the definition of flood. The policy wording should differentiate between storm, flood and escape of water/burst pipes. Storm events can be described as when water heads towards a watercourse - such as heavy rainfall from a thunderstorm. Flood events occur when water breaches the confines of a watercourse - such as a river bursting its banks. While water that has escaped from a pipe or apparatus and "flooded the basement" is categorized as escape of water/burst pipes. These descriptions give greater clarity since the Ombudsman and courts have simply described various water damage scenarios as flood where there is an abnormal accumulation of water. The differentiation is important as water damage from these events may call for different policy terms. The point is illustrated by the example of an unoccupied building, which is therefore unheated. The risk of damage following an escape of water from a burst pipe caused by a cold snap increases with the risk of water damage from a breach of the nearby river banks remains the same.

Differentiation of Risk

So, the property's susceptibility is relative not only to the general water damage risk but also the type of water damage. Insurers are professional managers of risk and accordingly should differentiate between the risks that are presented by each business proposition. Such differentiation is typically expressed by a combination of premium and the extent of cover offered. Responsible insurers who are interested in providing the client with a value added service will take time to understand the risks and differentiate their terms accordingly. In contrast, transactional insurers will simply offer "all risks" or "no risks" (by not quoting) and avoid entering a discussion to explore the appropriate level of risk transfer and terms required to meet these needs.

The December 2015 floods in the UK were unusual. The extent of the affected area was not as great as previous floods yet the severity of individual damage was arguably much worse – i.e. extremely intense, yet localized. It underlined the need for all involved in the procurement of insurance - i.e. the buyers, their advisers and the insurers - to understand the potential severity of the risk and appropriate avoidance tactics.

While the flood defenses had recently been improved they failed to protect the inhabitants of Cockermouth, Cumbria.1 In explanation, Alison Baptiste, Director of flood and coastal risk at the Environment Agency, perhaps stated the obvious, "The defenses worked but the amount of rain, and the water in the river, overtopped them," She continued, "Whenever we build defenses, we build them to a certain height but that does not mean that will prevent flooding because you can always get water levels higher than that, in which case it will go over the top." This highlights the crux of risk management. The risk cannot be completely removed and the level of loss mitigation will depend on the technical and economic constraints. The loss would have occurred if flood defenses had not been built, but what level of efficacy is required for the mitigation effort to be considered a worthwhile investment?

A similar question applies to the transfer of risk through insurance although there may be a difference in perception of risk between insurer and insured. Not having a flood "in my lifetime" is no guarantee that it will not occur. Prudent insurers model loss potential over several lifetimes. In this example, the risk perceived by the insurance buyer, which is based on personal experience, is likely to be very different from the insurer’s perception based on modelled potential over, say, a 250 year period. This difference in risk perception is often exacerbated by standard claims experience only going back 3 to 5 years. For the insurance buyer in December 2020 may not consider the events of December 2015 – it would be as if the floods in that year never happened!

It is vital for the insurer to understand “the deal” and be able to differentiate terms accordingly. The insured should gain confidence from this understanding which most importantly brings a high level of certainty of purchase and thus builds a strong foundation for a long term relationship.

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The above article/opinion reflects the opinion of the author and does not necessarily represent Aspen's views. The article reflects the opinion of the author at the time it was written taking into account market, regulatory and other conditions at the time of writing which may change over time. Aspen does not undertake a duty to update these articles.