The Insurance Contract

1.  Insurance contract

Insurance has a history that appears to go back to the Babylonians and was certainly well established among the town guilds of Europe by the mid-fourteenth century. However, it was the rapid growth in international trade by sea from the fifteenth century, which was centred, in particular, around the great Italian city states, that led to the development by those states of recognisably modern methods of insurance. This trade involved enormous financial risks for the merchant and insurance enabled these risks to be shared, either through an agreement with other merchants to provide cover if one member of the group suffered a loss or through an insurer, who, in exchange for the payment of a premium, agreed to cover specified losses and who would then seek to spread that risk among other insureds.¹ By the 1680s, insurance provision for merchants in London centred on Edward Lloyds Coffee House in Tower Street, where the proprietor had built up a regular clientele among merchants and shipowners. It was from these origins that the present Lloyds market emerged and, although much has changed, its purpose remains to provide a place in which those who seek insurance and those who provide it can conduct their business. The marine trade represented the core of the early insurance business. The so-called Bubble Act 1720 (6 Geo I, c 18) authorised the Royal Exchange and London Assurance companies. In spite of assumptions that this Act was a reaction to the crash of the South Sea Company in 1720, it was, in fact, passed some two months earlier and represented an attempt by the company, which had been established to acquire part of the National Debt, to limit competition for investors from rival companies by prohibiting the establishment of a joint-stock company without a royal charter or an act of parliament. The Act did, however, permit the establishment of the two insurance companies because of their offer to pay off part of the King’s Civil List debt.² Nevertheless, the Lloyd’s market remained, and economic expansion during the eighteenth and nineteenth centuries led to further development of insurance beyond its marine origins. Indeed, the investment by insurers of income from premiums played a key role in that economic expansion and the insurance industry continues to be a major source of funds for business. Insurers provided cover for those private individuals whose wealth was invested in tangible property: so, for instance, from the late seventeenth century a strong market emerged in private fire insurance. All of these policies were contracts of indemnity: that is, the insurer indemnified the insured against loss and, therefore, the insured could not recover more than the actual loss suffered.³ As a consequence the insured could not recover the same loss from different insurers and the insurer who paid for the loss acquired the right of subrogation, which, in effect, meant the insurer could take action against any third party who was responsible for the loss.⁴

The eighteenth and nineteenth centuries also saw the development of life assurance policies under which the payment due on the death of the life insured is determined by the sum fixed in the contract and not by an estimate of the loss suffered. Much later – and particularly following the expansion mortgage lending for the purchase of residential property – some of these policies combined life assurance with investment: such as an endowment policy which, for an increased premium, builds up a fund that is paid provided the insured survives beyond a specified date.⁵ Since such contingency contracts do not indemnify the insured, there is no rule against double insurance and the insurers have no right of subrogation, which means the insured will retain any payment from another insurer and any damages from a tortfeasor.⁶ The insurance industry has expanded the range of such policies. For example, in the nineteenth century specialist insurers began to offer policies that provided a fixed amount in the event of the insured suffering injury or death as the result of an accident,⁷ or combined elements of indemnity and contingency insurance: under the accident policy in Theobald v Railway Passengers Assurance Co,⁸ the insurer promised to pay a fixed sum on death and to compensate for pain and loss suffered up to £1,000.

These indemnity and contingency policies provide first-party insurance, which means, broadly, they cover property or a life in which the insured has an interest,⁹ but insurers also write third-party insurance against the risk of the insured incurring liability to a third party: third-party motor insurance covers the liability of the motorist for injuries caused to another person.¹⁰

2.  Definition

The courts and Parliament have been somewhat reluctant when it comes to defining a contract of insurance.¹¹ Megarry V-C thought it ‘a matter of considerable difficulty’,¹² and, while prepared to discuss the issue in so far as it assisted in the determination of the case before him, declined the opportunity to attempt an all-embracing definition, remarking that, ‘it is a concept which it is better to describe than to attempt to define’.¹³ Similarly, Templeman J believed that ‘a general definition was undesirable … because definitions tend sometimes to obscure and occasionally to exclude that which ought to be included’.¹⁴ Nonetheless, some notion of what constitutes insurance is important since, although subject to the general principles of contract law, special rules also apply to such contracts. Moreover, those who carry on insurance business without authorisation are committing a criminal offence.¹⁵

Legislation provides some guidance for the purpose of regulation. The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (as amended) does not define contract of insurance, but does set out a list of indicative activities that require authorisation by the Financial Services Authority (FSA). Furthermore, the FSA has recognised that in view of both the general prohibition against unauthorised persons engaging in insurance business and the importance attached to clear and accountable regulation, there is a need for clear guidelines as to how it will exercise its discretion. The FSA has, therefore, issued its own criteria based on the judgment of Channell J in Prudential Insurance Co v Commissioners of Inland Revenue,¹⁶ which concerned the application of stamp duty to insurance policies. He said that a contract of insurance is an agreement in which:

As will be seen in Chapter 5 below, the premium does not have to take the form of money, although there must be some benefit provided in exchange for the offer of insurance: for example, the Marine Insurance Act 1906, in section 85(2), recognises mutual marine insurance agreements under which members agree to contribute to losses suffered by fellow members, if and when they arise. Similarly, the insurer must promise a benefit. In Re Digital Satellite Warranty Cover Ltd,¹⁸ Warren J firmly rejected the proposition that a contract of insurance had to provide for the payment of a sum of money by the insurer and held that there could be an insurance where the obligation took another form, such as to repair or replace goods, or to provide services.¹⁹ Where the relevant party has no obligation to provide a benefit, but only discretion over whether to do so, there will not be a contract of insurance.²⁰ This will, however, depend on the nature of the discretion: where the obligation to meet the hire costs of a replacement motor car only arose if the company determined that the existing car was unroadworthy and the motorist had not been at fault, this amounted to insurance because the discretion was not absolute and could have been exercised by another party.²¹

Channell J suggested that the agreement must relate to a risk which involves uncertainty in that the loss might or might not occur, or it will occur at a time that cannot be predicted: there is uncertainty in fire insurance because the house might not catch fire, and, although in life assurance it is certain that the insured life will die, the time of death is uncertain. In other words, a contract of insurance is a contract upon speculation.²² Yet, uncertainty is not unique to insurance: the insurers’ liability to pay damages in the uncertain event that the insured suffers loss mirrors the liability of any contracting party to pay damages in the uncertain event that it commits a breach.²³

Channell J’s view that this uncertain event had to be one which is prima facie adverse to the interest of the assured might accurately describe most insurance contracts, but it is difficult to understand why it is required and, perhaps, it is not.²⁴ He may have linked this factor to the requirement that the insured have an interest in the subject-matter. The insurable interest distinguishes an insurance contract from a wager. Furthermore, an insurance contract is void under the Marine Insurance Act 1906, section 4(1) and (2) if the insurer agrees to provide cover irrespective of whether the insured has an insurable interest (known as a policy proof of interest or ppi clause).²⁵ Of course, in both wagering and insurance contracts the parties make judgments about the occurrence of uncertain events, whether it is a house that might burn down or a horse that might or might not win a race. The difference lies in the fact that the risk of loss to the house owner exists independently of the contract, whereas the risk on the horse race is created by the contract. Moreover, someone with no interest in the house will lose nothing if it burns down and the only risk that person runs is the loss of the consideration paid in exchange for the promise of payment if the house does burn down. In other words, in a wagering contract the risk is created by the agreement for without it the contracting party would have suffered no loss, whereas in an insurance contract the risk exists whether or not there is such a contract.²⁶ Blackburn J put the matter succinctly: ‘I apprehend that the distinction between a policy and a wager is this: a policy is, properly speaking, a contract to indemnify the insured in respect of some interest which he has against the perils which he contemplates it will be liable to.’²⁷ Interestingly, the courts have tended to set themselves against contracts designed to insure against losses from gaming, even though they would seem to fit the definition of an insurance contract in that the risk arises not from the insurance contract but from the gaming contract.²⁸

More difficult is the distinction between a contract of insurance and a contract of guarantee. In terms of regulation, the distinction is less significant than previously because under the Financial Services and Markets Act (Regulated Activities) Order 2001 contracts of insurance include fidelity bonds, performance bonds, bail bonds, customs bonds or similar contracts of guarantee where these contracts are effected by someone not undertaking banking business, are not merely incidental to another business carried out by the person effecting them and are effected in return for the payment of a premium. Nevertheless, there are significant differences between the treatment of contracts of insurance and contracts of guarantee at common law. Harman LJ suggested that the attempt to distinguish between them is fraught with difficulty and ‘has raised many hair-splitting distinctions of exactly the kind ‘which brings the law into hatred, ridicule and contempt by the public’.²⁹ In a contract of guarantee, Alex (the guarantor) promises Toytown Bank (the creditor) that, if it will enter into a contract to lend money to Yasmin (the debtor), Alex will be responsible for Yasmin’s debt should she default. Under a contract of guarantee there is a less rigorous duty of disclosure or even no duty at all, and while in insurance the primary liability is on the insurers, in a contract of guarantee that primary liability is on the debtor and the guarantor’s liability arises only if the debtor defaults. Furthermore, under section 4 of the Statute of Frauds Act 1677, a guarantee must be in writing, but there is no such requirement in respect of a contract of indemnity. In Re Denton’s Estate, Vaughan Williams LJ suggested that the key to distinguishing between these contracts lay in whether it was appropriate to apply the duty of disclosure to the agreement:

The traditional justification for this approach is that insurance is a commercial relationship in which the insured has knowledge of facts material to the risk, whereas in a guarantee, it has been assumed, the guarantor acts out of motives of friendship and is assumed to be aware of the risk, so that there is no need for disclosure. The problem is that guarantees are common in commercial transactions and guarantors do not necessarily know the facts. To determine whether an agreement is a guarantee or an insurance the courts will look at the contract as a whole in order to discover its effect, and neither the use by the parties of the words ‘insurance’ or ‘guarantee’, nor the fact that one of the parties is an insurance company will be conclusive.³²