Understanding the novelties of insurance with financial transactions
A large, reputable finance institution makes a loan secured by assets that are insured by a policy with an unconditional waiver of defences. An insurance company issues a surety bond covering the routine delivery of oil and natural gas, but not providing financial guaranty coverage for payments due under a loan. These two transactions, though seemingly unrelated, are opposing interpretations of the nearly $1 billion dispute in JP Morgan Chase v. Liberty Mutual et. al., which has become a case study in the need for clear documentation between insurance companies and entities seeking coverage for financial risks.
Insurance products are increasingly being used to transfer the risk of financial transactions like loans, bonds and derivatives. But while the use of insurance may be attractive (not least because of pricing), there are a number of issues that financial institutions need to address to prevent an insurer from denying coverage, and thus negating the risk hedge, These points-duty of disclosure, breach of warranty, insurable interest, indemnity and regulatory authorization-can become issues of contention because cultural differences exist between the ways banks and insurers approach transactions, particularly influenced by the legal principles of insurance contracts. By examining the legal theories behind the construction and enforceability of insurance contracts-presented here from U.K. and New York perspectives-organizations from both sides can start to navigate the best path toward combining the worlds of finance and insurance.
Duty of Disclosure
The duty of disclosure arises out of the centuries-old duty of ubermai fides, or “utmost good faith,” imposed on insureds, but not applicable to financial instruments or other contracts. As such, some insurers tend to document transactions and perform due diligence less thoroughly at the time of under-writing, relying on their right (under insurance law) to negate an insurance contract if material facts are not disclosed by the insured. It is the insured”s duty, under many types of insurance, to disclose all known circumstances that could reasonably be expected to materially affect the risk being covered, whether those facts are requested by the insurer or not.
Under English law, materiality is determined from the perspective of the insurer, i.e., whether it would have influenced the insurers’ underwriting decisions. The disclosure obligation from New York insurance law precedence provides that an insured has a duty to reveal facts that it has reason to know the insurer would consider material. This assumes that the insured understands what the insurer expects.
Under either English or New York law, the remedy for duty of disclosure breach is draconian; it entitles the insurer to avoid the policy ab initio, or “from the start.” Insurers are permitted to treat the policy as if it never existed and all premium and claim payments become repayable.
So is it possible in the context of financial guarantee insurance to limit or even eliminate the duty of disclosure (and the insurer’s remedies)? Under English law, the answer is yes. Remedies for fraudulent misrepresentation, however, cannot be waived. In New York insurance law, waivers are common in the surety context, although there is no case law holding that the insured’s duty of utmost good faith may be waived. Case law does indicate, however, that even fraud may be waived under certain circumstances. In such waivers, “the mere general recitation that a guarantee is `absolute and unconditional’ is insufficient,” but when assessing enforceability, “the touchstone is specificity.” A word of caution, though: the court in the JP Morgan Chase case, in a summary judgment motion against the insured, created a hypertechnical categorization of the medium and physical location of fraudulent statements within insurance contracts. The consequence of these distinctions is still unclear.
Breaches of Warranties
Warranties in the insurance context are different from those in the ordinary contractual context. In insurance, warranties are terms that are so fundamental to the risk being insured that failure to comply with them would substantially alter the risk. Even contract terms that are not expressly designated as such can be considered warranties. Under New York insurance law, a warranty need only have the effect of requiring (as a precedence to the contract becoming effective) the existence of a fact that diminishes (or nonexistence that increases) the risk of loss, damage or injury within the scope of the contract.
When such warranties are breached in an ordinary contract, the other party is entitled to recover damages suffered. Insurance law, however, is unique. Under English law, the breach of warranty in an insurance contract terminates the contract as of the date of the breach; the insurer does not terminate the contract, it is cancelled automatically. Under New York law, the insurer is entitled to reject the contract if the breach “materially increases the risk of loss, damage or injury within the coverage of the contract.”
Thus, if an insured warrants that the documentation of a loan is properly executed and it turns out it was not, under English law the policy will be effectively cancelled from the date of the inception of the policy. Under New York law, the insurer will have the right to cancel. Under English law the insurer can do so even if the insured subsequently cures the defect.
In a film finance case, HIH Casualty and General Insurance Ltd. v. New Hampshire Insurance, the insurers insured the risk that revenue from films would not reach a designated sum within a certain period. The term that six films would be made was held to be a warranty, even though not expressly designated to be such. This term was material to the risk in that the number of films has a substantial effect on the amount of revenue, the shortfall of which was being insured. The number of films made was “the essence of the risk underwritten” and therefore constituted a warranty.
Warranties are, however, contractually controllable. A provision in the contract that states “warranties” are only those terms expressly designated as such (or that there are no warranties in the contract) should prevent the possible implications of an unforeseen breach.
Another unique area of insurance law is the insurable interest principle, which requires that the insured have sufficient interest in the insured property so that it suffers a loss if the insured peril occurs. Under English law, the courts have required that the insured have a legal or equitable interest in the subject matter. This is a relatively stringent test and has caused one court to hold that the sole shareholder of a company has no insurable interest in the assets of the company. The position under New York insurance law is more lenient in that it only requires that the insured have a “lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage.” As such, a shareholder in a corporation with only a few shareholders has been held to have an insurable interest in property owned by that company.
A lack of insurable interest under English law may render a contract unenforceable as a matter of public policy. Under New York case law, the insurer may, in such cases, elect to cancel the insurance policy.
Unlike some of the other principles, the doctrine of insurable interest cannot be waived or abrogated contractually because of public policy concerns. (An English court could raise the point on its own.) Although the insurable interest doctrine could be avoided by applying a different governing law to the contract (e.g., French law), any dispute would have to be heard outside the country as an English court may apply its own law of insurable interest regardless of the contract’s governing law.
In several New York cases, however, insurers were prevented from using a lack of an insurable interest as a defense against claim payment. The courts noted that although the insurers were aware of relevant facts and circumstances concerning the insured’s economic interest in the property, they nevertheless issued policies and collected premiums.
Under New York law, an insured should fully disclose and document the extent of its economic interest in the covered property to the insurer. It should also consider obtaining a legal opinion from the insurer’s counsel to determine that it has an insurable interest. These efforts will provide evidence that could be helpful in an action to bar the insurer from asserting the lack of an insurable interest to avoid its obligations under the policy.
Indemnity requires that the insured recover no more than its actual loss on the insured peril. This prevents the insured from double insuring and profiting on a loss by having multiple insurers pay for the claim. In such cases, any money received by the insured from the defaulting party must be held in trust for and paid over to the insurer.
When policies are written for financial transactions, concerns may arise as to whether the insurer is authorized to write the particular type of insurance, e.g., financial guarantee insurance, at issue.
Under English law, this authorization is governed by the Financial Services and Market Act. The act requires that a provider of insurance be authorized and that insurers not write contacts other than insurance. An unauthorized insurer writing insurance or an insurer writing noninsurance only subjects the insurer to regulatory penalties.
New York law is comparable with several statutory provisions that any issuance of a policy in New York in violation of law will not render the policy void.
The Best Intentions
Often, the parties of an insurance contract that covers a financial transaction have essentially agreed on an unconditional indemnity, while the legal principles discussed here effectively make the insurers’ obligations conditional. By documenting the extent to which these principles will apply, the parties can create a contract that allocates risk in a way that meets their expectations and avoids misunderstandings.
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David Cohen is a partner in the London office and Earl Zimmerman is a partner in the New York office of Clifford Chance. The authors wish to thank Keith Andruschak and John Mark Zeberkiewicz, associates in the New York office of Clifford Chance, for their assistance with this article.
Copyright Risk Management Society Publishing, Inc. Aug 2002
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