Life insurance and the duty of disclosure
The new legislative regime introduces a significant and flexible remedy for an insured’s breach of the duty of disclosure in an insurance market that is growing more complex by the day.
In certain circumstances insurers are permitted to vary their contracts to the position they would have been in, had the correct disclosure been made. In some respects this imitates the position with general insurance, where a similar remedy has been available since the 1984 reforms embodied in the Insurance Contracts Act (the Act).
However, given the longer term nature of life insurance, and its critical role in wealth protection and asset building in the modern Australian economy, the legislation has introduced a further restriction on the insurer’s right to modify for non-disclosure – the “not inconsistent” with the industry test.
The “not inconsistent” test is new and there appears to be no available judicial consideration of it.
The test is not used in the general insurance legislation but, after a “test run” in the area of life insurance, the legislature may introduce such a test in the general insurance area (although it may be too cumbersome in its current form given the short-term nature of most general insurance).
However, before insurers consider this remedy they should note that proving consistency (or more correctly, lack of inconsistency) with what the reasonable and prudent insurer would have done will require sufficient evidence and the opinion of others in the industry. This may cause some difficulties in light of the longer term nature of the life product and the industry practice.
The legislative framework
Section 21 imposes a duty to disclose to the insurer, before the contract of insurance is entered into, every matter that is known to the insured that:
- The insured knows to be a matter relevant to the insurer’s decision whether to accept risk and the terms of that acceptance; and
- A reasonable person could be expected to know to be a relevant matter, considering the nature and extent of the cover, and the class of persons who would usually seek that kind of cover.
There are exclusions to this disclosure obligation, such as for common knowledge, matters that diminish risk and other matters an insurer ought to know.
The legislation also imposes such a duty in relation to:
- a contract of life insurance under which a person (other than the insured) would become a life insured – s 31A;
- under group life contracts (where applicable) – s 32; and
- by the holder of a retirement savings account – s 32A.
In the event that the insured fails to disclose those relevant matters, or they misrepresent them, s 29 applies. This will always be the case, unless the insurer would have entered the contract regardless of the insured’s failure to comply [or where the failure was in respect of the date of birth of an insured – s 29(1)]: generally see Schaffer v Royal & Sun Alliance Life Assurance Australia Ltd  QCA 182; Tyndall Life Insurance co Ltd v Chisholm  ANZ Ins 90-104.
Avoiding a policy – any time or the 3 year rule?
An insured’s misrepresentation or failure to disclose may be fraudulent on the one hand, or merely a mistake or misunderstanding on the other.
Under s 29(2), if the non-disclosure/misrepresentation was fraudulent, then the insurer may avoid the contract at any time.
However if the non-disclosure/misrepresentation was not fraudulent, the insurer may only avoid the contract within 3 years from the date the contract was entered.
It is clear why the legislation permits insurers to decline at any time for fraudulent non-disclosure/misrepresentation as the industry and society at large have an interest in deterring fraud.
The 3 year rule for innocent non-disclosure/misrepresentation also makes sense because life policies offer long term protection and the smoothing effect of premiums and the passage of time on health means that there would be an element of unfairness should (for example) an insurer be able to avoid a policy (say) 11 years after policy inception on the basis that an insured failed to disclose a health-related condition more than a decade prior to inception.
An option for insurers – to vary the sum insured
If the insurer chooses not to avoid the contract for the failure/misrepresentation, then the insurer may vary the contract by substituting the sum insured (including any bonuses) with a sum that is not less than the sum of S = P/Q, where,
- S is the number of dollars that is equal to the sum insured (including bonuses);
- P is the number of dollars that is equal to the premium that has, or to the sum of the premiums that have, become payable under the contract; and
- Q is the number of dollars that is equal to the premium, or to the sum of the premiums, that the insurer would have been likely to have charged if the duty of disclosure had been complied with or the misrepresentation had not been made.
The power to vary the sum insured applies differently in a contract with a surrender value, or a contract that provides insurance cover in respect of the death of a life insured.
This remedy probably reflects a simpler age of the industry, where often the salient feature of any life policy was the sum insured. It made sense to allow life insurers to reduce sums insured, a remedy which reached back at least to the Life Insurance Act 1945, but such a remedy does not exactly fit the modern, investment and retirement driven aspects of life products.
Why change? – The need for the new regime
In hindsight, the remedies available to life insurers for non-disclosure/misrepresentation were fairly limited: on the one hand, there was the draconian remedy of cancellation for fraud, and on the other (unless the non-disclosure/misrepresentation were detected within 3 years) a fairly anodyne formula to reduce the sum insured.
The availability of the remedy for fraudulent non-disclosure/misrepresentation throughout the policy often led to difficult proceedings alleging fraud, and an empirically observed judicial reluctance to make findings of fraud and void policies against often unsophisticated consumers.
This framework took no account of the myriad ways in which non-disclosure/misrepresentation could have an impact upon premiums, endorsements and exclusions, for example. It is fair to say the remedial regime for general insurers set out in s 28 is more sophisticated than the fairly blunt tools available to life insurers.
The Second Reading of a Bill often provides an insight into the motives behind legislative change. The Parliamentary Secretary to the Treasurer stated that the change would make remedies in respect of life insurance contracts more flexible and more suitable to modern life insurance products.
He stated that “the amendments to the Act struck an appropriate balance between providing certainty for insurers and ensuring that insureds are able to obtain appropriate outcomes.” This balance has far-reaching implications as “the law governing contracts of insurance has a direct influence on the effectiveness and efficiency of the insurance markets”: House Hansard 14 March 2013, p. 2107.
It goes without saying that courts will approach the legislation as is, with limited recourse to what was stated in Parliament. In our view, the wording of the legislation is sufficiently clear that the reading speech will be of little value in judicial interpretation of the legislative amendment.
The new regime – varying the entire policy
The s 29 amendments took effect on 28 June 2014 and apply to policies incepting after that date, or to certain variations occurring after that date in a previously incepting policy. Examples of such variations would be an increase in the sum insured, additional levels of cover, or non-automatic variations.
Section 29(6) states that:
“If the insurer has not avoided the contract or has not varied the contract under subsection (4), the insurer may, by notice in writing given to the insured, vary the contract in such a way as to place the insurer in the position (subject to subsection (7)) in which the insurer would have been if the duty of disclosure had been complied with or the misrepresentation had not been made.”
An insurer does not have the ability to use s 29(6) if the policy has a surrender value or if the policy insures death. This obviously would have a difficult and presumably unintended consequence due to the fact that most policies also include a death component. Section 27A provides that combined life policies can be unbundled when applying remedies for non-disclosure and misrepresentation.
In the case of s 29, this would mean that a life and TPD cover policy would be unbundled into its various parts so that the insurer could vary a particular part of the insurance contract (compare s 762B of the Corporations Act, which provides for the unbundling of regulated financial products that form part of a broader facility).
The new regime – is it truly new?
The amendments bear a real similarity to provisions in respect of general insurance, in particular to s 28(3) of the Act, which states:
“If the insurer is not entitled to avoid the contract or, being entitled to avoid the contract (whether under subsection (2) or otherwise) has not done so, the liability of the insurer in respect of a claim is reduced to the amount that would place the insurer in a position in which the insurer would have been if the failure had not occurred or the misrepresentation had not been made.”
The parallels are imperfect however, as the life insurance remedy is to vary the contract while the general insurance remedy is only to reduce liability under the contract.
This means that, for example, a life insurer could increase premiums or convince a court that it would have written certain exclusions into the policy which (although not dissimilar to the retrospective remedy available in general insurance) could have significant a long-term impact on a life policy.
The insurer’s position upon variation
A key aspect of the amendments is defining in what circumstances the insurer is permitted to vary its position under the contract. Section 29(7) provides:
“The position of the insurer under a contract (the relevant contract) that is varied under subsection (6) must not be inconsistent with the position in which other reasonable and prudent insurers would have been if:
- It had entered into similar contracts of life insurance to the relevant contract; and
- There had been no failure to comply with the duty of disclosure, and no misrepresentation, by the insureds under the similar contracts before they were entered into.”
“Inconsistent” is not a term of art but carries connotations of “lacking in harmony”, “discrepancy” and “incongruity”: Burwood Council v Ralan Burwood Pty Ltd (No 3)  NSWCA 404.
“Reasonable” commonly means rational: The Australian Doctors’ Fund Limited v Commonwealth of Australia (1994) 49 FCR 478 and a “prudent” insurer is one that is “acting with care or thought for the future… shrewd or thrifty in planning ahead… and wary”: Re VCA and APRA (2008) 105 ALD 236; Mayne Nickless Ltd v Peglar  1 NSWLR 228.
Interestingly, there are also similarities in the “not inconsistent with reasonable and prudent” insurers test to the Bolam test in tort: Bolam v Friern Hospital Management Committee  1 WLR 582; which was overruled by the High Court in Rogers v Whitaker  HCA 58 but in effect reinstated by the civil liability reforms in the early 2000s.
The term “similar” means provides insurance cover that is the same or similar to the kind of insurance cover provided and was entered into at or close to the time that the contract in question was entered into. The idea of similarity does raise the question of how to compare different policies, which can entail difficulties in practice: Stevens v Colonial Mutual Life Assurance Society Ltd & Commonwealth Financial Planning Ltd  NSWDC 94;  NSWCA 444.
The practical implications
There are two “gates” that an insurer must pass through in order to satisfy the provisions of the new regime.
Firstly, the insurer must show what it would have done had the correct disclosure been made. This is relatively uncontentious and continues the current retro-underwriting logic process, although “hindsight” evidence is distrusted: Odisho v Bonazzi  VSCA 11; McKay v Commissioner of Main Roads (No 7)  WASC 223.
The onus rests with the insurer. In Hitchens v Zurich Australia  NSWSC 825, Zurich used the views of the original underwriter to state what would have occurred had the correct disclosure been made.
In Montclare v MetLife Insurance Ltd and Anor  VSCA 336, another senior underwriter from the original team was used when the actual underwriter who assessed the application was unavailable.
In showing what the insurance company would have done, it must actually show that at a relevant point in time, the application for insurance would have been declined: Schaffer v Royal & Sun Alliance Life Assurance Ltd  QCA 182.
The witnesses and evidence required to satisfy the requirements for the first threshold are fairly clear and this is not a novel issue for life insurers. To show what would in fact have occurred requires the evidence of the underwriter and potentially the reinsurer who was involved in the application.
However since the evidence must relate to the time of the policy’s inception, the long time frames envisaged could become an issue due to the difficulty in showing what may have occurred years earlier.
Rigorous document retention and internal guidelines would assist insurers, particularly with manuals and materials related to the underwriting process.
The second gate is new and subtle. It is comparative in nature, and the insurer must show that what it would have done had the correct disclosure been made is not inconsistent with what other reasonable and prudent insurers would have done.
“Not inconsistent” is not synonymous with consistent. This is similar to a “not insignificant” risk in tort law. The “not inconsistent” test is likely a fairly low threshold to pass, although an insurer will need some evidence beyond mere logic or obviousness to surmount it.
The Explanatory Memorandum to the Bill explained that an insurer would require the view of one or more “third parties” as proof. Who those people are will become critically important to life insurers.
According to the Parliamentary Secretary to the Treasurer, those third parties may include underwriters. Underwriters are cited specifically due to their good understanding of the development of life insurance in the market place.
Reinsurers may be relevant witnesses. However an insurer’s own reinsurers or related parties are unlikely to be sufficiently independent to provide evidence (even if they could, as outside facultative cover, it is hard to see how a reinsurer could opine on the reasonableness or otherwise of a cedant’s individual underwriting), and other reinsurers’ independence may be questionable as all cedants are potential clients of all reinsurers in a competitive market.
The considerations for an underwriter in determining whether an insurer’s actions are not inconsistent with a reasonable and prudent insurer are likely to be the following:
- Opining on Gate one evidence;
- Assessing the Gate one procedure and the outcome that procedure brought about; or
- Comparing the Gate one outcome with other comparable products in the market.
This brings to the fore commercial confidentiality concerns, as any sensitive underwriting manuals or procedure may be released to a third party for assessments.
It may therefore be prudent for insurers to generate a pool of independent experts who are not competitors, and who can opine on industry practice at the inception date.
We have given some thought as to what exactly the gate two expert must prove. In our view, and noting that the issue has yet to be reported in the authorities, the test will be along the following lines:
- The expert was working as an underwriter as at or close to the Commencement Date of the Policy
- The expert’s work included underwriting (IP, Trauma, TPD) policies similar to the Policy in question
- The expert has relevant experience including the length of time working as an underwriter, nature of industry experience, scope of experience underwriting (IP, Trauma, TPD) policies
- The expert identifies “similar” contracts of life insurance at or close to the Commencement Date of the Policy using s 29(8)
- The expert states what the market of reasonable and prudent insurers might have done had the disclosure been made before the policy was entered into
- The expert opines whether the Proposed Variation not inconsistent with that
The right to vary the contract is a powerful tool in the hands of insurers and arguably represents a more flexible and fair means of righting the bargain where there has been innocent but substantive non-disclosure in a previously incepting policy. While insurers may draw comfort from an additional avenue to ensure insureds are upholding their end of the disclosure bargain – the remedy carries additional responsibilities.
However, to avail itself of this remedy, an insurer will be obliged as a matter of practice to show exactly how it would have acted differently had disclosure been made at the time that the contract was incepted. It will then need to find the relevant outside/third party expert, with appropriate experience and qualifications to give evidence that what the insurer would have done is “not inconsistent” with what other reasonable and prudent insurers would have done. Frankly, it is unlikely that other competitors will be interested in giving such evidence and insurers will have to locate and build a pool of suitable experts and provide properly collated and preserved documentation to them, often after a significant lapse of time.
The true commercial cost of this burden will become more apparent as court consideration develops, however insurers should already be maintaining records of their practices, manuals and staff directions in readiness to defend their position.
Colin Biggers & Paisley invites you to attend the first of a series of national seminars on recent developments and legal issues in the life insurance industry followed by networking with drinks and canapes.
Toby Blyth, Special Counsel, will address the remedies available to life insurers under section 29 of the Insurance Contracts Act, and the practicalities of meeting the reasonable and prudent insurer test.
David Kerwin, Partner, Emma O’Conner, Senior Associate, and Laura Reisz, Special Counsel, will provide an update on the implementation of the Life Insurance Code of Practice on 1 July 2017, and what the year ahead might hold.
Vanessa Kemp, Partner, and Carolyn Wait, Senior Associate, will address how the move from lump sum TPD payments to instalments might impact the industry and consumers.
Date of event:
- Sydney / Thursday 27 July
- Melbourne/ Thursday 10 August
- Brisbane/ Thursday 17 August
Time of event:
4.15pm for a 4.30pm start
- Colin Biggers & Paisley | Level 42, 2 Park Street, Sydney
- Colin Biggers & Paisley | Level 23, 181 William Street, Melbourne
- Colin Biggers & Paisley | Waterfront Place, Level 35, 1 Eagle Street, Brisbane
RSVP at your earliest convenience to our events team at firstname.lastname@example.org or contact 02 8281 4648. Please specify which seminar location you will be attending.
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