English law on late payment of insurance claims is unfair, say Law Commissions

Under current English law, even if payment of an insurance claim is delayed for years, the insured cannot claim compensation for any additional losses caused by that delay.

But in an Issues Paper published on 23rd March, the English and Scottish Law Commissions say this position is unfair, biased and ignores commercial reality.

The Commissions have been looking into the question of late payment as part of their comprehensive review of insurance contract law. Their tentative solution is to amend the law so that policyholders would be able to claim damages in cases where an insurer acts in bad faith and to make insurers liable if they fail to pay a valid claim within a reasonable time.

David Hertzell, the Law Commissioner leading the project for England and Wales, said: "In this area, English law is out of step with today’s commercial realities. We are seeking a solution which balances the insurer’s need to investigate claims against the policyholder’s expectation that valid claims will be paid on time."

No firm proposals have been made as yet. The paper is only intended to promote discussion before any formal consultation process begins. The Commissions have asked interested parties to submit their comments by 24th June.

Fiction

In normal contract law, if one party breaches a contract, the other can generally claim damages for any actual loss caused by the breach, provided the loss was foreseeable at the time the contract was made.

But in English law, insurance is a special case. The normal breach of contract rules do not apply. Instead, liability is based on a legal fiction that the insurer has promised to keep the insured safe from harm. If harm does occur, the insurer has breached that promise and is liable to pay the amount of the claim as damages.

This means that, if the insurer rejects a valid claim or pays it late, and the insured suffers additional loss as a result, he cannot claim additional compensation from the insurer because English law says you can’t claim "damages on damages". The insured is only entitled to interest and his legal costs.

This was the situation that faced Mr Sprung in the leading case of Sprung v Royal Insurance, reported in 1999.

When plant and machinery at Mr Sprung's factory were vandalised, his insurers disputed the claim. Mr Sprung could not afford to carry out the repairs himself or get a loan and his business collapsed. Four years later, the court found the insurance claim should have been paid within a few months and awarded him an indemnity for the damage to his property, plus interest and costs.

But the Court of Appeal said he could not be compensated for losing the opportunity to sell the business, a loss estimated at £75,000. Under English law, there can be no award of damages for the late payment of damages.

The situation is very different in Scotland, where the courts follow ordinary contract principles. Under Scots law, the insurer has an obligation to pay a claim once it has had an opportunity to investigate its validity. If there is unjustifiable delay, or if the insurer wrongfully denies liability, it will be liable to pay the insured damages for any reasonably foreseeable losses suffered as a result.

In fact, in a survey of other jurisdictions, the Law Commissions found no other country that follows the same approach as English law.

The Law Commissions argue that the "hold harmless" fiction is simply unrealistic. Insurers are in no position to prevent fire, theft or flood from occurring, nor would their policyholders expect them to do so. Policyholders pay for the promise that, if something does go wrong, the insurer will pay valid claims under the policy.

Good faith

Two broad approaches to reform are outlined in the paper. The first would be to amend the Marine Insurance Act 1906 to enable policyholders to claim damages where an insurer has acted in bad faith.

Both parties to an insurance contract have a duty to act with utmost good faith towards each other. Most of the law in this area, however, has concentrated on the insured's duty to the insurer - for instance, the duty to disclose all material information before the contract is entered into. Under current law, the only available remedy for breach of the duty is for the contract to be avoided, as if it never existed.

The Law Commissions tentatively suggest that it should be part of the insurer's duty of good faith to investigate claims fairly, give reasons for refusing claims and, where it decides the claim is valid, pay within a reasonable time. The duty could not be excluded or limited by terms in the insurance contract.

Delay, by itself, would not necessarily constitute a breach of the duty. Nor would a refusal to pay a claim if the insurer reasonably, but incorrectly, thought the claim was invalid. But where the insurer is shown to have acted in bad faith, the Law Commissions believe the insured should be able to claim damages for any foreseeable loss caused by the breach.

Contract principles

The second approach would be to remove the "hold harmless" fiction from English Law.

An insurer's primary obligation would be to pay valid claims after it has had an opportunity for reasonable investigation. If an insurer breaches this obligation, the Law Commissions suggest it should be liable for actual loss caused to the insured, provided the loss was foreseeable.

Following ordinary contract principles, the policyholder would also have to show that it acted reasonably to mitigate any loss. But if, like Mr Sprung, the insured could not afford to take such steps, this would not amount to a failure to mitigate.

The Law Commissions envisage that, in business insurance, it would be open to the parties to expressly exclude this liability in the insurance contract. In consumer insurance, however, any such exclusion would be likely to fall foul of the Unfair Terms in Consumer Contracts Regulations and be unenforceable.

In some consumer cases, damages for distress, inconvenience and discomfort might also be claimable if the policy was sold to provide peace of mind – for example, where the insurer's breach leaves the consumer's home in serious disrepair or delays medical treatment. Again, this would follow the approach taken in normal breach of contract cases. Such damages would not be available in business insurance.

The Law Commissions predict that, in practice, these reforms would only result in a handful of successful actions, but they would like to receive any information about the likely costs and benefits.

Later this year, they will publish further papers on the insured's duties of good faith after entering into the insurance contract, the broker’s liability for premiums under the Marine Insurance Act and a policy statement on pre-contract disclosure and misrepresentation in business insurance.