In brief - Unfair contract terms regime to extend to insurance contracts and come into effect in April 2021
Recommendation 4.7 of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry suggested the application of the unfair contract terms (UCT) regime to insurance contracts. The Australian Government in 2017 announced an intention to apply the regime to insurance contracts, and in 2018 Treasury published a proposals paper for a model to do this.
The recommendation and Government proposals have now been realised.
The law will be amended to extend the UCT regime under the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) to capture insurance policies covered by the Insurance Contracts Act 1984 (Cth) (ICA).
The UCT regime will apply to insurance policies that are:
The regime will come into effect in April 2021.
UCT applies to all consumer and small business insurance policies
The application of the regime to distribution, as well as the actual financial product or service is an important consideration particularly for insurance policies where distribution is through a broker, or an insurer dispenses with an AFSL (Australian financial services licence) altogether under protection of certain exemptions in the Corporations Act 2001 (Cth).
The involvement of a broker for a consumer or small business contract does not exclude the financial product (including an insurance policy) from the UCT regime. This also means distribution through an intermediary (such as a broker) may result in multiple consumer or small business contracts for consideration.
Australian and international application
Broadly, the UCT regime applies to "a contract that is a financial product" or "a contract for the supply, or possible supply, of financial services" (each a "financial or credit contract").
Insurance policies are financial products but have to date been excluded from the operation of all other legislation by section 15 of the ICA. Insurance policies will shortly be subjected to the UCT regime for financial products.
In brief, the UCT regime is as follows:
if a term of a financial or credit contract is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, then
the party relying on that term must prove it is otherwise fair in the circumstances.
Main subject matter of the policy
Certain terms are excluded from the operation of the UCT regime. These are terms that define the main subject matter, up front price payable or that are required by Commonwealth, state or territory law.
Naturally, there is much debate on what these terms are. For insurance policies, a further exclusion is provided for transparent excess terms, discussed further below.
The policy basis for the exclusion of terms that define the main subject matter of a standard form contract is to ensure that a party cannot challenge a term concerning the basis for the existence of the contract.
The "main subject matter" for insurance policies is defined as the description of what is being insured. The replacement explanatory memorandum provides further explanation for this and states that relatively few terms in insurance contracts will qualify for this exemption [main subject matter exemption], this will be determined on a case-by-case basis. The replacement explanatory memorandum provides examples for home, car, income and life insurance as follows:
Isla purchases home insurance for a house at 17 Drayton Street. The contract describes the house as a four bedroom, brick veneer freestanding house. This description (a four bedroom, brick veneer freestanding house at 17 Drayton St) is the main subject matter of the contract and therefore outside of the unfair contract terms regime.
Jess purchases car insurance. The contract describes the car as a 2018 Kia Carnival S 2.2-litre four-cylinder turbo-diesel with a modification to take wheelchairs. This description (a 2018 Kia Carnival S 2.2-litre four cylinder turbo-diesel with a modification to take wheelchairs) is the main subject matter of the contract and therefore outside of the unfair contract terms regime.
Tom is a 46-year-old marine biologist who earns an income of $100,000 a year. He purchases income protection insurance for the value of $6,250 a month and discloses no significant ill health. The contract describes Tom as a 46-year old man with no significant ill health and also states the sum insured is $6,250 a month. Both the description of Tom and the statement of the sum insured are the main subject matter of the contract and therefore outside of the unfair contract terms regime.
Yvonne buys life insurance cover for herself and her husband Bob, for the value of $100,000 for each life insured. The description of Yvonne, Bob and statement of the sum insured is the main subject matter of the contract and therefore outside of the unfair contract terms regime.
The narrow definition of the subject matter means that conditions and (importantly) coverage exclusions will be subject to the UCT regime.
Terms carved out from the UCT
There are carve-outs from the UCT regime for certain terms that apply for insurance policies and types of medical insurance contracts:
transparent excess terms are excluded from the prohibition for unfair terms. Transparent excess terms are terms that set the quantum of the excess or deductible in a policy as long as they are presented transparently, and
policies for medical indemnity cover for medical practitioners and registered health professionals are excluded
Experience in respect of other financial products may assist to assess the application of the UCT regime to insurance policies.
What is an unfair term?
Briefly, in its recent regulatory findings study (which you can read more about in our article) ASIC explained that it considers the following terms to be unfair:
preventing lenders being held contractually responsible for statements or representations outside of contracts (commonly implemented through an "entire agreement" clause), and
broad event of default rights that may trigger a disproportionate action relative to the event and unilateral variation rights
Internationally, Europe and the UK have provided consumer protection in the form of an unfair contracts regime for financial products and financial services for a number of years (European Council Directive 93/13/EEC). This includes insurance policies.
The UK FCA (Financial Conduct Authority) has undertaken various regulatory inquiries and actions in respect of the Consumer Rights Act 2015 and the Unfair Terms in Consumer Contracts Regulations 1999 (which implemented the directive), including for insurance contracts. These inquiries and actions may provide assistance in how ASIC and Australian courts may assess Australian insurance contracts. Examples are:
The policy documents contained cancellation terms that allowed the insurer to cancel a consumer's home or car insurance policy at any time, with seven days’ notice in writing, without having to explain why it had done this.
The policy documents only specified customers missing a premium payment as grounds for a potential cancellation. The policies contained terms that allowed the firm to cancel the policy and charge an administration fee if a customer missed a premium payment, irrespective of why this had happened.
The FCA was of the view that these terms were unfair, as it meant that without good reason consumers could be left uninsured and perhaps find it difficult to arrange insurance elsewhere following a potentially unjustified cancellation (noting that most insurers will ask whether an insured has had a policy cancelled or a claim denied as part of the disclosure process, this could have a significant deleterious effect on the insured).
The FCA also considered that, in situations where a consumer's direct debit may fail for reasons outside their control, it would be disproportionate to cancel the policy if the consumer could easily rectify the situation if given the chance.
The terms required a consumer, at the consumer's expense, to provide all the information, reports, certificated plans, specification information and assistance when making a claim that the insurer may need in progressing the claim
The FCA was concerned that the terms had the potential to cause a significant imbalance to the detriment of the consumer by being an unreasonable and excessive requirement for consumers to comply with.
The FCA was of the view that insurers should not exclude or limit their liability in potentially unfair circumstances, such as where the firm is more appropriately liable, for example:
The FCA was of the view these terms may be unfair as the reference to "consequential loss" in a standard consumer contract is not plain and intelligible, and therefore, may be unfair.
The UK unfair contracts regime requires contracts to be written in plain, intelligible language. The term "consequential loss" has a legal meaning which the average consumer will not understand.
The policy contained a term that required customers to notify the firm of damage to the phone within 48 hours of the incident occurring.
The FCA considered that this may be unfair, because a time limit for reporting within 48 hours of the incident, as opposed to within 48 hours of discovery, is an unduly limited period of time as customers may not have realised their phone had been damaged within this period.
Lessons for insurers issuing policies in Australia
The Commissioner included a brief assessment of the potential application of the UCT regime to insurance contracts in the Royal Commission.
He used the following policy term from a case study relating to a home insurance policy as an example:
If we decide to pay you what it would cost us to rebuild or repair … we will pay you … the amount that we determine to be the reasonable cost of repairing or rebuilding. The amount that we determine to be the reasonable cost will be the lesser amount of any quotes obtained by us and/or by you for the rebuild or repair. Discounts may be available to us if we were to rebuild or repair.
The Commissioner stated with respect to the term:
"…as Treasury indicated, ‘terms that permit an insurer to pay a claim based on the cost of repair or replacement that may be achieved by the insurer, but could not be reasonably achieved by the policyholder’, are terms that may be unfair.".
It is important to note that UCT must be reviewed both prospectively and retrospectively:
Prospectively, when an insurer is drafting a policy, to determine whether terms are objectively unfair and in breach of the UCT on their face
Secondly, and this is much more difficult, retrospectively, as a facially neutral term can be unfair in operation in particular circumstances
The retrospective test carries a real sting, as it puts an insurer at the risk of an unpredictable finding by a court, with the result that a carefully priced policy can be knocked off balance entirely (at the product development stage, the insurer can price for the UCT risk).
However, insurers should be getting ready for prospective analysis of policies under the product development and distribution obligation in any event (see links to our recent articles below). Adding the UCT analysis to this should not add too much to insurers' cost burden.
Further, insurers should by now be getting used to courts' retrospective interpretation of exclusion clauses via section 54, which is now used by courts to adopt a purposive approach to exclusions (rather than simply an analysis of the objective meaning of the exclusions clause): Maxwell v Highway Hauliers Pty Ltd  HCA 33; Watkins Syndicate 0457 at Lloyds v Pantaenius Australia Pty Ltd  FCAFC 150.
The above point by no means dismisses the regulatory burden and pricing that the UCT will impose upon insurers, at the front end and the back end. The UCT substantially widens the avenues by which courts can retrospectively "amend" insurance policies, and insurers must attempt to price for this.
Further, regulators will be interested if a policy is too successful (from the insurers' point of view), as this may suggest to ASIC that the policy is unfair or "not good value", and breach of the product design and distribution obligation could lead to section 912A action. The UK cases are relevant here, as they show an active regulator taking similar action against UK insurers.
If a product is too unsuccessful from the insurers' point of view, APRA may investigate from a prudential angle.
While we are not suggesting that insurers' margins are particularly wide, the application of the UCT to consumer and small business products, where margins are notoriously tight, will make insurers' task of delivering value to both insureds and shareholders even harder.
What insurers can do to prepare for transition and implementation
The amendments commence on 5 April 2021 (commencement date).
Insurers should start strategic planning for compliance with the UCT regime soon, as a review of policies and other contractual documents will need to be undertaken and systems and procedures updated to account for the regime. Such planning should occur in parallel with planning for the product development and distribution obligation and FAR. You can read more about these in our articles:
ASIC consults industry on its proposed guidance for the new product design and distribution obligations
New Design and Distribution Obligations and Product Intervention Powers for Financial Products
Government proposes Design Distribution Obligation and Product Intervention Powers legislation following Financial System Inquiry
Treasury consults industry on its proposed Financial Accountability Regime
Ultimately, compliance with the UCT regime laws will form part of the product governance compliance framework for an insurer. Where a standard form insurance contract is proposed to be marketed or issued in a consumer or small business context, the product review process should include a review for compliance.