With the Insurance Act 2015 set to come into force within the next two weeks, contractors will be turning their attention towards the new provisions to clarify their legal obligations under policies incepted after 12 August 2016.
In anticipation of these significant and wide-ranging reforms to insurance contract law, the courts have begun the task of interpreting the new provisions and, in doing so, have endorsed the legislative movement towards a re-balanced law of insurance that better serves the requirements of the modern insurance market.
Last week, in the landmark case of Versloot Dredging BV v HDI Gerling Industrie Versicherung AG, the Supreme Court considered the fraudulent claims rule as it applied to policies under the Marine Insurance Act 1906 and as it will apply to policies incepted under the 2015 Act. It decided that fraudulent devices or “collateral lies” advanced in support of an otherwise genuine claim will not have the effect of invalidating that claim. However, that is not to say that contractors should take this as an invitation to embellish their insurance claims without fear of consequence. It is only lies that have no bearing on the recoverability or amount of a claim that will disentitle the insurer to deny the indemnity.
The fraudulent claims rule
The common law rule relating to fraudulent claims has been a feature of insurance law since the mid-19th century. An insured who advances a fabricated or fraudulently embellished claim forfeits the right to recover the entirety of that claim, including any genuine losses alongside the fraudulent embellishment.
Though judicial treatment of the rule has traditionally regarded it to be an application of the duty of utmost good faith to the post-contractual relationship between the parties, the Supreme Court’s preferred view in Versloot Dredging was that the fraudulent claims rule is a contractual term implied or inferred by law, rather than an instance of the duty of good faith. In any event, the 2015 Act has now separated the fraudulent claims rule from the concept of good faith to stand as a discrete rule of insurance law that will apply subject to any bespoke contractual terms setting out alternative consequences for an insured.
Although the forfeiture of the genuine part of a fraudulently exaggerated claim may operate harshly against the insured, the historic justification advanced for the rule is that it is intended to act as a deterrent to fraudulent claims and to benefit the honest policyholders who would otherwise bear the financial burden of the costs of investigating and detecting those frauds through increased premiums. Judicial attention has focused on denying an insured the ability to make a one-way bet, a consideration emphasised by Lord Hobhouse in Manifest Shipping Co Ltd v Uni-Polari Insurance Co Ltd (The Star Sea):
“The fraudulent insured must not be allowed to think: if the fraud is successful, then I will gain; if it is unsuccessful, I will lose nothing.”
What remained undecided under the previous case law and the 2015 Act left for further elucidation by the courts was the issue of what amounts to a “fraudulent claim” and, in particular, whether the rule only applies to fabricated and fraudulently exaggerated claims or whether it would also apply to collateral lies advanced in support of an otherwise genuine claim.
Versloot Dredging BV v HDI Gerling Industrie Versicherung AG
This issue before the Supreme Court arose in relation to damage sustained by a vessel after an ingress of water into the engine room caused losses of €3.241 milliion.
At first instance, Popplewell J determined that the loss was proximately caused by a peril of the sea, which the policy would in principle respond to. However, during the investigation of the claim, one of the vessel managers had falsely represented that the bilge alarm had activated and that crew members had confirmed this story, a lie intended to accelerate the claim and secure a faster payout from the insurers. The lie was later discovered but turned out to be irrelevant to the merits of the substantive claim, and the point to be determined was whether this collateral lie would fall under the fraudulent claims rule and defeat the owners’ otherwise genuine claim under the policy.
The Supreme Court accepted it as settled that a fraudulent exaggeration to an otherwise genuine claim would defeat the entire claim, a matter that had been determined conclusively by previous case law and placed on a statutory footing by the 2015 Act. However, more careful consideration would need to be given to instances where the insured instead proffered a collateral lie, one that may have been intended to benefit the insured in some way (such as by securing a faster settlement with the insurer), but which, ultimately, turned out to have no bearing on the merits of the underlying claim. Since the fraudulent claims rule had been imposed as a matter of public policy to deter instances of fraud, the penalty of forfeiture would only be justified where it was proportionate to that aim of deterrence.
Delivering the leading judgment, Lord Sumption considered that a distinction should be drawn between a fraud that asserted an entitlement to payment beyond that which the insured had a genuine legal right to and one that merely “gilded the lily” without affecting the recoverability of the underlying genuine claim:
“The position is different where the insured is trying to obtain no more than the law regards as his entitlement and the lie is irrelevant to the existence or amount of that entitlement. In this case the lie is dishonest, but the claim is not. The immateriality of the lie to the claim makes it not just possible but appropriate to distinguish between them. I do not accept that a policy of deterrence justifies the application of the fraudulent claim rule in this situation.
Nor is it an answer to say, as the courts have often said of fraudulently inflated claims, that the insured should not be allowed a one-way bet: he makes an illegitimate gain if the lie persuades, and loses nothing if it does not. This observation, which is true of fraudulently inflated claims, cannot readily be transposed to a situation in which the claim is wholly justified. In that case, the insured gains nothing from the lie which he was not entitled to have anyway. Conversely, the underwriter loses nothing if he meets a liability that he had anyway.”
The risk of furnishing insurers with a disproportionate remedy was far more substantial when the insured had a legal entitlement to everything claimed under the policy, and so the majority determined that the penalty of forfeiture was disproportionately harsh in these circumstances. They declined to extend it to cover collateral lies.
Materiality of the fraud
The Supreme Court also gave guidance as to how the courts would distinguish between those frauds that were “collateral” to the underlying genuine claim and those that were instead “material” to it, and would fall under the fraudulent claims rule. Although an attenuated test of materiality was proposed by Mance LJ (as he then was) in Agapitos v Agnew (The Aegeon) requiring the lie to be one which “if believed would tend to yield a not insignificant improvement in the assured’s prospects of success prior to any final determination of the parties’ rights” in order to fall under the rule, the Court of Appeal in Versloot Dredging questioned the negative formulation of the rule and left open the issue of the correct test to be applied.
Lord Sumption went further and determined that a test of materiality (as understood in relation to pre-contractual misrepresentation) would be inapt to apply to mistruths told at this stage of the contractual relationship. Instead, the test would have to go to the recoverability of the claim as determined later during court proceedings. This was because any test based on the relevance of the lie to the insurer at the time it was communicated during the claims investigation was not “rational” when the insurer’s full liability had already crystallised at the moment of the loss:
“[W]hen deciding whether to accept a claim under an existing contract, the insurer’s position is very different. He has no discretion, because he is already bound. The only question properly before him is whether to acknowledge a liability that if it exists at all exists already, whether or not he realises it. Ultimately, his assessment is simply an attempt to predict what a court would decide. In that context, the only rational test of the materiality of a lie must be based on its relevance to a court which is in a position to find the relevant facts.
For this reason, although a lie uttered in support of a claim need not have any adverse impact on the insurer, I consider that it must at least go to the recoverability of the claim on the true facts.”
The Supreme Court therefore determined that it was immaterial whether a lie told by the insured induced the insurer into any form of action or was capable of prompting a faster settlement of the claim than would otherwise have been achieved. In order to fall within the fraudulent claims rule, the lie must go to the recoverability of the claim as determined retrospectively by the courts.
Thoughts for the construction industry
A great deal of fanfare has been made over the Supreme Court’s tacit endorsement of collateral lies told by an insured in order to improve the prospects of recovering what it may believe to be a questionable or weak claim without fear of legal consequences. However, employers and contractors must be wary that any attempt to “gild the lily”, which has the effect of increasing the amount recoverable under the policy (such as by exaggerating the losses actually sustained or disguising improvements to the building works in the reinstatement scheme proposed to the insurer), will forfeit the entirety of the claim once discovered. Even where a lie is entirely collateral to the genuine underlying claim, an insured who is shown to have acted fraudulently will likely be penalised by expensive costs orders and will, in any event, be required to disclose its claims history in any future insurance proposal, which will inevitably lead to increased premiums or an outright refusal to grant the policy.
Finally, a contractor or employer considering this course of action to obtain faster settlement of an insurance claim must of course look to the wording of the insurance policy as it remains possible for insurers to include clauses precluding the recovery of any claims supported by collateral lies or fraudulent devices, a possibility emphasised in Lord Mance’s dissenting judgment.