In brief - Insurers must be aware of risks of adding insureds to policies
The Full Federal Court, in the case ABN AMRO Bank NV v Bathurst Regional Council  FCAFC 65, has amongst other issues determined, held that a third party beneficiary is not bound by the duty of disclosure under section 21 of the Insurance Contracts Act 1984 (Cth). Any remedies for insurers for non-disclosure by third party beneficiaries will need to be created under contract.
No duty of disclosure defences for insurers on third party indemnity claims
A common question arising when dealing with disclosure issues is whether an entity or person who is not a party to an insurance contract, but is a named insured, is bound by the same duty of disclosure as the contracting insured.
The Full Federal Court has provided a level of clarity on this question and held that non-contracting insureds are not bound by the duty to disclose matters which may affect an insurer's decision to accept a proposed risk prescribed by section 21 of the Insurance Contracts Act.
This aspect of the decision has ramifications for insurers, as duty of disclosure defences will not be available to insurers when assessing non-contracting party insureds' claims for indemnity.
The principles extracted from the case as they related to section 21 are only a small part of a much wider decision: the case has been widely reported for other reasons, in particular the findings on proportionate liability under section 1041E of the Corporations Act 2001.
Losses on Rembrandt notes lead investors to sue for damages
In 2006, the investment bank ABN AMRO Bank NV created a constant proportion debt obligation (a form of financial instrument or structured financial product) which it proposed to sell in Australian dollars under the name “Rembrandt notes”. Standard & Poors (S&P) assigned an AAA rating to the Rembrandt notes.
ABN AMRO marketed and sold the Rembrandt notes to Local Government Financial Services Pty Ltd (LGFS), which in turn dealt with local government authorities. LGFS purchased $10 million of the Rembrandt 2006-2 notes ($6 million on behalf of StateCover Mutual Limited and $4 million which it purchased in its own name and subsequently transferred to StateCover). LGFS then purchased $45 million of the Rembrandt 2006-3 notes and sold a substantial portion of them to 13 municipal councils in NSW.
StateCover and the councils lost much of the amounts they invested in the Rembrandt notes and subsequently sued ABN AMRO, S&P and LGFS for damages.
Cover denied to subsidiary for failing to comply with duty of disclosure
The American Home Assurance Company (AHAC) entered into an insurance contract with FuturePlus Financial Services Pty Ltd. Under the policy, "the insured” was defined as the policyholder and the policyholder’s subsidiaries existing at the inception of the policy period. LGFS was a subsidiary of FuturePlus.
LGFS claimed against AHAC and alleged that it was entitled to cover under the policy in respect of its liability to StateCover and the councils. AHAC denied cover to LGFS on the basis of it failing to comply with its alleged duty of disclosure under section 21 of the Insurance Contracts Act.
AHAC contended that before it entered into the policy with FuturePlus, LGFS knew that its Australian Financial Services License did not permit it to deal in or give advice in respect of derivatives, that the Rembrandt notes were or might have been derivatives, and that LGFS had not attempted to ascertain whether the Rembrandt notes were derivatives or not.
AHAC also contended that LGFS knew that these matters were relevant to AHAC's decision regarding whether to accept the insurance risk in relation to LGFS and that LGFS did not disclose facts material to that risk. Alternatively, AHAC’s case was that a reasonable person in the circumstances would have known that the Rembrandt notes were derivatives and that this was material to AHAC’s decision to accept the insurance risk.
The trial judge held that the LGFS owed a duty of disclosure to AHAC under section 21 of the Insurance Contracts Act by virtue of section 48(2) and (3) of the Act. Section 48(2) imposes on the person who is not a party to the contract, but who has a right of recovery, the same obligations to the insurer as the person would have if it were insured.
Duty of disclosure among issues on appeal before the Full Federal Court
AHAC claimed that its liability was reduced to nil by section 28 of the Insurance Contracts Act because of the non-disclosure by LGFS, in breach of the duty to disclose known material facts to a proposed insurer prior to policy inception, which is created by section 21 of the Insurance Contracts Act.
LGFS contended that it did not owe a duty of disclosure, submitting that the term "insured" in section 21 means an insured who is a party to the contract and does not extend to third parties who may be named insureds in the policy. Further, it contended that section 48(3) of the Insurance Contracts Act did not affect this conclusion.
LGFS relied heavily on the reasons of Clarke JA (with Meagher JA agreeing) in CE Health Casualty & General Insurance v Grey (1993) 32 NSWLR 25 [at 46].
Did LGFS owe the section 21 of the ICA duty of disclosure?
The trial judge held that section 48(2) extended the duty of disclosure obligations prescribed by section 21 to LGFS.
The Full Federal Court rejected this view. It held that the obligations referred to under section 48(2) were "in relation to the person’s claim" and, therefore, not referable to the pre-contractual obligations prescribed by section 21.
Their Honours interpreted the reference to "the insured" under section 21 to mean a "proposed insured" who is proposing to enter into a contract of insurance with the insurer. In accordance with this interpretation, they held that the relevant "proposed insured" was FuturePlus because it had submitted the insurance proposal to AHAC. The fact that LGFS fell into the definition as an “Insured Entity" under the policy did not affect this result.
In arriving at this conclusion, the Full Federal Court adopted the comments of Clarke JA in CE Health Casualty & General Insurance v Grey, which referred to the dichotomy that exists in using the words "insurer" and "insured" in relation to the parties to the contract and a person who is not party, but who is entitled to benefit under the policy.
In that case, Clarke JA stated at  that where section 21 speaks of the duty of an insured to disclose the matters set out in section 21(1), it is talking about the party which proposes to enter into a contract of insurance in the context of those provisions in the Act which spell out the consequences of the failure by a person who has entered into the contract to comply with that duty.
His Honour also observed that fraudulent non-disclosure will allow the insurer to avoid the contract, but mere misrepresentation will only entitle the insurer to reduce its liability pursuant to section 28(3) of the Insurance Contracts Act.
Consequences of non-compliance only on persons actually entering contract
The Full Federal Court observed that what is clear from sections 21 and 28 of the Insurance Contracts Act is that the obligation to disclose, and not to make misrepresentations, is cast upon a person intending to enter into a contract of insurance and the consequences of non-compliance are visited only upon persons who actually enter into such a contract.
Importantly, their Honours held that, as a result, there is no obligation imposed upon a person who is not a party to the contract (but who may have the benefit of the insurance cover provided by the policy) to disclose, or not misrepresent, before a contract is entered into.
Nothing in section 28 provides that anything that person does, or fails to do, before the contract is concluded in any way disentitles him or her from successfully maintaining a claim.
In support of their finding, their Honours further observed that they did not think it was the legislature's intention to give rise to a situation where an insurer could avoid a contract at the expense of the other party because of the failure of a non-party insured to comply with the duty of disclosure under section 21.
Ramifications: Insurers cannot impose pre-contractual duty of disclosure on third parties
The outcome of the ABN AMRO decision is that an insurer cannot impose the pre-contractual duty of disclosure on a non-contracting named insured (section 21) and accordingly avail itself of any of the section 28 remedies in the case of non-disclosure.
This is particularly significant because aside from whatever recourse might be found within the terms of the policy itself, the insurer has no other remedies outside of the Insurance Contracts Act for a failure by the insured to disclose before the contract was entered into.
Potential solutions: Contractual warranty under policy may protect insurers
One potential solution is to include a contractual warranty under the policy which obliges the contracting insured to make all reasonable inquiries of any third party insureds as to the matters set out in section 21.
Under those circumstances, it is arguable that damages may be available to the insurer if the contracting party fails to make such inquiries and it later emerges that those inquiries would have unveiled matters which would have affected the insurer's decision to accept the proposed risk.
Amendments to section 21 to clarify what insured must disclose
The Insurance Contracts Amendment Act 2013 will result in an overhaul of section 21 when those relevant sections come into force on 28 December 2015. The amendments to section 21 provide clearer guidelines on what must be disclosed by an insured under the duty of disclosure.
However, unlike with the duty of utmost good faith, the amending act has not expressly extended the duty of disclosure to third party beneficiaries. Curiously, the amended heading to section 21 makes reference to "insureds' duty of disclosure' (plural) as opposed to the previous "insured's duty of disclosure". It is not clear whether this slight change in semantics has the potential to extend the duty of disclosure to all insureds under a policy.
Amendments to section 48, but still doubt if duty of disclosure extends to third parties
The amending act has already resulted in changes to section 48, which sets out insurers' defences in actions by third party beneficiaries.
The amendments to section 48(1) and 48(2) have been refined to use the term "third party beneficiaries". The introductory bill to the amending act explains that the changes were made to ensure that third party beneficiaries are in no better position, in terms of their ability to claim, than the insured. The introductory bill also says that in defending an action by a third party beneficiary:
- an insurer may raise defences in relation to the conduct of the insured; and
- the conduct raised may have occurred prior to the contract being entered into (for example non-disclosure).
Despite Parliament's comments on the purpose of the changes to section 48, there is still doubt as to whether the duty of disclosure extends to third party beneficiaries, given the Full Federal Court's view that section 48(2) relates to “a person’s claim” and, therefore, is not referable to the pre-contractual obligations prescribed by section 21.
Consider risk of adding insureds to policy and create remedies under contract
Given the issues with disclosure, insurers must continue to be very aware of the risks when looking to "add" insureds to the policy. In addition, insurers should be conscious that any remedies for non-disclosure by these third party beneficiaries will need to be created under contract as they do not exist in the Insurance Contracts Act.
A condensed version of this article first appeared in Insurance & Risk Professional.