Risk and reward – commercial insurance laws and mitigating risk

12 June 2015

With the UK’s commercial insurance laws about to receive a much-needed overhaul, John Hurrell, CEO of UK risk management association Airmic, explains why a solid understanding of risk management should be at the core of every company’s philosophy.

In February, the UK Government passed legislation that will fundamentally change the way commercial insurance is governed. In 2016, the law will shift radically in favour of policyholders who act in good faith, a change that should be strongly welcomed by UK businesses.

The new legal framework created by the 2015 Insurance Act is designed to guard against payments being withheld unfairly on obvious technicalities. Under the century-old system it replaces, trivial, mistakes, like misspelled names, can void policies. Claims might also be refused where buyers fail to provide all material information at the time of purchase, even when it has not been requested by insurers.

The old process works most of the time. Generally, insurers will pay out whenever clients are deemed to have acted in good faith. There is no guarantee that this will happen, though, and what is the point of insurance that cannot be relied upon for support in moments of greatest need?

SMEs are especially vulnerable to loopholes being exploited, since they have less buying power - and therefore reduced clout - with insurers, and probably do not have the same close relations with their underwriters as multinational companies.

"No other area of business would allow contracts worth potentially hundreds of millions of pounds to go through without board-level scrutiny."

Furthermore, over the last five to ten years, a cultural sea-change has seen an increase in the use of lawyers to scrutinise claims. Even if this happens only rarely, it is likeliest on the largest claims - when insurance is paramount. As a legal professional told me recently, a new, commercial imperative exists. "Increasingly, insurers like to get lawyers involved," she said. "If the claim is large, I find that, if not to refuse the claim altogether, they try to negotiate a reduction, even if they have a strong relationship with the client."

Business-critical insurance

Next year's overhaul is long overdue, then, and is a cause for celebration. It is of particular significance to CFOs because insurance is often a company's biggest single capital investment, certainly if you take into account the potential level of payout. Insurance can, therefore, be of critical importance to the financial well-being of companies. Some policies may be purchased for relatively small amounts of money - perhaps £1 million - but the value of the indemnity they are insuring will be worth hundreds of times that figure.

A common, and erroneous, perception is that insurance is all much the same. There is a world of difference, however, between a dependable, well-constructed policy, and one that has been thrown together on the cheap. It is crucial, therefore, that CFOs and executive boards understand what underpins contracts; no other area of business would allow contracts worth potentially hundreds of millions of pounds to go through without top-level scrutiny.

It is particularly important that CFOs recognise that price should not be the only selection criterion for insurance. It is much better to pay more for a policy and be confident that it will deliver when it is needed. This means that policy wordings, underwriting submissions and limits, and sums insured should be questioned and scrutinised before contracts are signed. Above all, it should be clearly established how a policy will respond in the event of a claim. This may seem like a statement of the obvious, but it is surprising how often companies only find out the answer when it is too late.

Bringing the UK into line

When it comes into force next year, the 2015 Insurance Act will protect any policyholder who has acted in good faith, but may have overlooked some technicality. Most of the rest of the developed world has already made equivalent reforms, leaving the legal framework in England and Wales out of kilter. The Law Commission has made several attempts at reform over the years, but support from the insurance market was considered essential, and the size and scope of the London and UK markets meant this took time to acquire.

Airmic worked closely with the Law Commission and insurance market to help bring about this positive change in attitude. It supplied written support for the reforms and gave evidence to the House of Lords to ensure that policyholders' interests were reflected in the new law as accurately as possible. This has largely been achieved.

Responses have been mostly positive. It was widely acknowledged that a system based on laws from 1906 had left the UK out of step with the rest of the world, and while certain parts of the London speciality sector resisted some of the provisions of the new legislation, the new act ought now to be embraced enthusiastically. There will be an 18-month transition period before the new laws are enforceable, but it is hoped the market will move rather faster than that.

It must be stressed that the new legal framework will still require commercial insurance buyers to behave in a professional, thorough manner and provide accurate information.

This means going through every line of a policy with a professional adviser: it won't be the most exciting job in the world, but could save a lot of disappointment and heartache.

Raising the profile of risk

As mentioned earlier, no other area of business in which millions of pounds are at stake is signed off without board-level approval.

Insurance is, of course, part of a much bigger picture, though. No policy is a substitute for good risk management based on complete information and a thorough understanding of a company's vulnerabilities. This must driven from the top, but too often senior executives get involved only once something has gone wrong.

The aim of Airmic's annual conference in June is to get risk management firmly on the boardroom agenda.

Research carried out by Cass Business School for Airmic in 2011 investigated common underlying causes of corporate failure, and found that problems all too often emanated from an inadequate grasp of risk at the very tops of companies. Indeed, in a series of case studies involving corporate crises, the boards involved were far less concerned with threat than they were with reward and opportunity. This was largely because information on risk, while freely available elsewhere within organisations, frequently failed to reach board level.

"Companies that systematically apply risk management principles to business strategy and operations repeatedly prove to be more profitable and resilient than those that do not."

By way of comparison, research by Cranfield School of Management in 2014 showed that robust and successful companies tended to approach risk management in a structured and thorough way, from the top of the firm down. Furthermore, these companies were not only more resilient in the face of crises, but were also more profitable.

This message has been reinforced by the guidance on risk management published by the Financial Reporting Council in Septmeber 2014. This essentially raised the standards for risk management expected of companies and their board members.

According to the guidance, "ultimate responsibility" should lie with the board of directors. While risk managers will continue to take care of everyday responsibilities, the board must ensure that appropriate policies are in place, that senior-level understanding of potential perils are high, that risks are contained within tolerable levels and with appropriate mitigation.

Many companies already regard this as a matter of best practice, but scrutiny of top executives and their understanding of the company's principal risks will undoubtedly increase. Airmic would encourage all senior employees to take this seriously, and not just for compliance reasons. Companies that systematically apply risk management principles to business strategy and operations repeatedly prove to be more profitable and resilient than those that do not.

Airmic will be exploring these themes, which go to the heart of what it takes to make a business successful.

The 2015 Insurance Act

Three main changes will come into force in August 2016:

  • Fair presentation of risk: the bill amends the duty on business policyholders to disclose risk information to insurers before entering into an insurance contract, introducing a duty of 'fair presentation' of the risk. The new law also provides proportionate remedies where the duty of fair presentation has been breached. For example, if the breach was accidental, but the insurer would have entered into the contract in full anyway, the insurer still has to pay out in full. However, if the insurer would have still entered the contract, but on different terms, the insurer may proportionately reduce the amount to be paid on a claim. If the breach is deemed reckless or deliberate, the insurer can avoid the contract and keep the premium.
  • Warranties: the bill abolishes 'basis of the contract' clauses, which have the effect of converting precontractual information supplied to insurers into warranties without further discussion. It also provides that the insurer's liability should be suspended, rather than discharged entirely, in the event of a breach of warranty. The new law also prevents an insurer from relying on non-compliance with a warranty as grounds for avoiding liability for a loss of an entirely different kind than that envisaged by the warranty. For example, it would no longer be viable to avoid paying a claim for fire damage simply because the burglar alarm was not switched on, as the two are clearly unrelated.
  • Fraudulent claims: the bill provides the insurer with clear, robust remedies when a policyholder submits a fraudulent claim.

John Hurrell was appointed CEO of Airmic in 2008 after a career of almost 30 years in the Marsh and McLennan Group of Companies. Prior to that, he was with Royal Insurance Company. Hurrell has worked in insurance since 1968, and is a Fellow of The Chartered Insurance Institute.