Legal principles to watch out for in trade credit insurance

In my last article, I wrote about Trade Credit Insurance (TCI) and its usefulness.

As mentioned, however, legal problems can sometimes arise under such policies (as with any insurance). An analysis of the decisions in the English High Court over the last ten years shows that over half of all the disputes in the insurance field which come to a hearing arise from just two issues: alleged failures on the part of the insureds’ employees or agents to have disclosed full or accurate information relevant to the risk which they were insuring (‘non-disclosure or misrepresentation’ – collectively ‘non-disclosure’) or arguments as to the insureds’ compliance with pre-conditions to insurers’ liability under the policy - ‘breaches of warranty’.

Disputes in the TCI sector are often resolved by the parties by negotiation or, more formally, mediation. Those that are not, generally go to private arbitration, but in our experience what is true for insurance as a whole, holds good for TCI: most issues in the sector arise from non-disclosure or breach of warranty.

A principle of English insurance law is that agreements to insure constitute contracts of ‘utmost good faith’. One of the consequences of this is that before an insurance contract is concluded a prospective insured is under a duty to disclose to its insurers, and disclose truthfully, all ‘material circumstances’ – everything that ‘a prudent independent underwriter’ working in the sector (the test is objective) would have wanted to have in mind when deciding whether or not to insure a risk; the premium to be charged; the policy’s terms.

There does not have to be a causal connection between the alleged non-disclosure or misrepresentation and the loss giving rise to the claim.

If it is established that the duty has not been honoured and if the insurers can then show one of the factors that led them to underwrite the policy issued was the information withheld or misrepresented, they are entitled to treat the policy as if it had never been underwritten. They return any premium paid and are do not have to pay any claims. In legal terms, they ‘avoid’ the policy.

As for ‘warranties’, policy wordings contain many terms setting out the insured’s obligations. Some of these are more important than others. The terms may be explicit pre-conditions to recovery under the policy.

Others deal with excluded losses. With such provisions an insured should know where it stands, but other terms do not spell out the consequences if there is a breach.

There are terms where breaches ‘sound in damages’: the insured is only penalised if and to the extent that its insurers have suffered financial prejudice. Some policy terms are ‘warranties’. These significantly increase an insured’s operational risk.

Under English insurance law, a warranty is a contractual term which is a condition precedent to the insurers’ liability: perhaps a clause in which the insured promises either that a state of affairs existed prior to the inception of the insurance cover or undertakes that it will continue to exist during the currency of the risk.

The matter warranted need not be relevant to the risk insured or to have contributed to the loss claimed. Breach of a warranty discharges the insurers’ liability on the policy from the time the breach occurred. This will be the case even though the loss claimed has no connection with the breach and even if the breach had been put right before the loss.

There also has to be ‘exact compliance’ – it is not possible to argue that the spirit of the clause has been honoured or that it is impossible to comply with the warranty. Neither ignorance nor innocence of the insured is any answer to a defence by insurers based on breach of warranty.

The use of the express term ‘warranty’ (or indeed, its absence) is also not necessarily conclusive as to the status of a clause in an insurance policy. Although the terms contained in the Warranty section of a TCI policy are usually of sufficient importance to constitute insurance warranties, there may be clauses elsewhere in the contract of insurance that have warranty status without using the term. For example, there is the ‘basis clause’.

In the proposal forms which prospective insureds are required to complete, including those employed in TCI, one frequently finds a statement along the lines:

“The Applicant… agrees that this proposal form shall form the basis of and be part of any… Policy [that may be issued].”

Something similar may also be contained in the policy wording. It is often not realised that such terms have the effect of warranting the truth of the information provided.

If then, the information proves to be inaccurate the insurer can repudiate all liability on the policy on the basis of a breach of warranty at the policy’s inception. This is irrespective of questions of the insured’s belief in the truth of the information, or, again, the relevance of the incorrect information supplied. Even the most insignificant of inaccuracies can prove fatal to a claim.

Most insureds seeking trade credit insurance protection will be sufficiently sophisticated or well-advised to understand the need for their insurers to protect themselves from being selected against by shortcomings in disclosure of important information at the time of placing and that certain serious breaches of contract on their part will result in a failure to recover their claims.

If they are aware of the English legal principles of non-disclosure and warranties in insurance they will be careful to ensure that their disclosure obligations and the policy warranties are honoured.

Problems, nevertheless, can still arise after a deal has been done; a project embarked upon; finance provided; the policy has been issued. The insured may assign new personnel to supervise the insured venture. They may be unfamiliar with the requirements of the policy or the serious impact of any breach of the continuing obligations contained in a warranty.

The position in the TCI sector has been improved for financial institutions with the arrival of clearer and more liberal policy wordings designed to meet the requirements of ‘credit risk mitigation’ instruments under the Basel II Convention.

English insurance law is also on course to be statutorily amended. The changes contemplated will be generally in the insured’s favour.

This, however, is a couple of years away. In the meantime, TCI proposal forms and policy wordings are likely to continue to contain basis clauses and be silent as to the consequences of non-disclosure, misrepresentation and breach of warranties.

I hope that this article will both alert readers to areas of operational risk which are inherent in insurance generally and will also enable them better to anticipate and deal with any problems that may arise so as to maintain the value of trade credit insurance policies.