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Law Commissions tackle 'confused' law on fraudulent insurance claims

Insurance law should clearly spell out the insured's duty to act honestly when claiming under the policy and that any fraud will forfeit the whole claim, the Law Commissions of England and Scotland suggested this month.

The proposal would not radically change the way courts in the UK currently handle fraudulent claims, but it would clear up the law, which the Law Commissions believe has become "unnecessarily confused".

The comments are made in the Law Commissions' most recent issues paper on insurance law reform, which examines the insured's duty to act in good faith during the period of cover.

In March 2010, the Commissions considered insurers' duties when dealing with claims. They tentatively concluded that policyholders should be able to claim damages where an insurer acts in bad faith and that insurers should be held liable if they fail to pay a valid claim within a reasonable time.

This paper, published on 9 July, looks at the other side of the same coin - the insured's duty to bring claims honestly and the remedies available to insurers if that duty is breached.

Insurance fraud

Research carried out last year by the Association of British Insurers found that fraudulent insurance claims worth over £730 million were detected during 2008. But the estimated value of undetected fraud is much greater at £1.9 billion a year.

Criminal prosecutions for insurance fraud, however, are relatively rare, so the burden of providing an effective deterrent lies with the civil law. The problem, however, is that there is a discrepancy between the way in which courts in the UK approach fraudulent claims and the law as set out in the Marine Insurance Act 1906.

Under section 17 of the Act (which applies to all forms of insurance), the parties to an insurance contract owe each other a duty of utmost good faith, both before and after the contract is entered into.

Before the contract, utmost good faith mainly comprises the insured's duty to disclose and not misrepresent all material facts to the insurer. Post-contract, it means the insured must act honestly when making any claim under the policy.

If one party breaches the duty of utmost good faith, the only remedy under the Act is for the other party to avoid the contract in its entirety - i.e. treat the policy as if it never existed. In the context of a fraudulent claim, this means that, in addition to not paying the claim in question, the insurer is entitled to avoid any liability (and recoup any payment made) for any previous, genuine claims under that policy.

The courts, however, see avoidance of the whole policy as disproportionate. Instead, they have applied a special common law rule, so that the fraudulent claim is forfeited but the policy is not. Valid claims made before the fraud are unaffected.

The Law Commissions believe this is the correct approach and tentatively suggest that section 17 of the 1906 Act should be amended to resolve the current inconsistency. They also consider the phrase "good faith", rather than "utmost good faith", is more appropriate to describe the post-contract duty. 

"The law should state that it is a breach of the duty of good faith for the insured to make a fraudulent claim, and the appropriate remedy is forfeiture of the claim," the issues paper concludes.

"We do not see this as a change in substance. This is already the position taken by the courts.  However, it will provide a helpful simplification of the law."

The paper also asks for comment on whether a fraudulent claim should give the insurer the right to terminate the contract but not affect a valid claim arising between the fraud and the termination.

Fraud and exaggeration

Insurance fraud may arise in any number of circumstances. The insured may have suffered no actual loss at all, or he may have deliberately caused the damage. More common are those cases where the insured suffers a genuine loss but invents other losses to add to the claim or exaggerates the value of the genuine loss.

Insureds also sometimes present claims in a dishonest way, for instance, by hiding the fact that the circumstances fall within a policy exclusion or by faking an invoice to prove the value of an otherwise genuine claim.

Where a claim is partly genuine and partly fraudulent, the whole claim will be forfeit as long as the fraudulent element is "more than minimal". Judges have resisted applying a hard and fast rule to what is more than minimal and will look at the fraud on its own and in the context of the claim as a whole.

Courts also tend to be more lenient in cases where the insured has exaggerated the claim, recognising that the insured may anticipate some element of horse trading in settlement negotiations.

The paper concludes that the courts approach fraud in a "pragmatic and sensible way".

"Our view is that this element of the law is best left to the courts to develop and it does not require statutory reform. It is true that the exact definition of fraud is not always clear-cut. But we think that this arises from the nature of the issue."

The Law Commissions, however, ask whether insurers should be able to recover damages from a policyholder to cover the reasonable costs of investigating a fraudulent claim. This remedy is currently not available to insurers under the 1906 Act.

Express clauses

Many policies include specific clauses that set out the consequences of making a fraudulent claim. The courts will uphold these if they are clearly expressed.

In consumer insurance, such terms must also satisfy the Unfair Terms in Consumer Contracts Regulations, which means they must be drafted in plain, intelligible language and be fair. A clause which is unexpectedly harsh might be considered unfair if it is not brought to the insured's attention.

Public policy, however, prevents a party from including a term in the insurance that excludes or limits liability for its own fraud. The Law Commissions think this is right, but ask whether parties should be allowed to exclude or limit liabilities for the fraud of an agent such as a broker. 

"We can understand that most insurers would be very reluctant to assume the risk that the insured's agent is fraudulent. However, we are not sure that the law should prevent an insurer from doing so if the parties so wish."

Joint insurance

A particular problem can arise where two or more people have identical interests insured under the same policy and one of them submits a fraudulent claim. A common example is where husband and wife own and insure their home together. If one party commits a fraud, the other will lose any claim under the policy, even if they were wholly innocent.

The Law Commissions tentatively suggest that, in this situation, there should be a presumption that the fraud was committed on behalf of them both, but that the innocent party should be able to rebut that presumption.

"If the innocent party produces evidence that the fraud was not carried out on their behalf or with their knowledge, then the claim should be paid," the issues paper states. "It is important that the recovery is limited to the innocent party's particular loss and that the guilty party should not benefit."

The same problem does not arise if the parties' have different interests insured under the same policy. The policy (known as a composite policy) will treat each policyholder separately and fraud by one of them will not affect the other.

Other issues

The Law Commissions also consider group insurance schemes, where, typically, a policy is taken out by an employer for the benefit of employees. They ask whether there should be a special rule that would give the insurer the same remedies against a group member bringing a fraudulent claim as it as it would have if the group member was the insured.

The paper also questions whether UK law should impose an ongoing duty on the insured to disclose if the risk materially increases during the period of cover.

Currently, courts in the UK do not impose such a duty. Even where there is an express clause requiring the insured to disclose any material changes, judges will interpret such clauses very restrictively. In Europe, however, where polices commonly last for several years, insureds are under a continuing duty to notify the insurer of any aggravation of the risk.

Next steps

Responses to these proposals should be lodged by 11th October 2010. Later this month, the Commissions will publish a paper on the broker's liability to repay premiums under the Marine Insurance Act and, by the end of the year, a paper on the requirement under the Act for marine insurance to be embodied in a policy. A formal consultation paper drawing together all these issues is due in 2011.

Following the publication of the Law Commissions' draft Consumer Insurance Bill last December, a policy paper setting out their recommendations on disclosure and warranties in business insurance is still awaited.

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