UK: The Continuing Duty of Good Faith?

Last Updated: 1 November 2001
Article by Simon Goldring

If an insured fails to disclose material facts prior to the inception of an insurance contract, then insurers may elect to avoid that contract and treat it as if it never existed, even if the non-disclosure is not causally connected to the loss in any way.

While the existence of the duty of good faith prior to policy inception is taken as read, does it continue so that insurers are entitled to avoid for the insured’s conduct that takes place after policy inception? The answer is a qualified "yes".

S17 Marine Insurance Act 1906 provides that "a contract of ... insurance is a contract based upon the utmost good faith and, if the utmost good faith be not observed by either party, the contract may be avoided by the other party". Unlike the following provisions of the statute, s17 is not limited to a pre-contractual context. This gives rise to the argument that insurers are also entitled to avoid insurance contracts for breaches of good faith that take place after policy inception.

The Litsion Pride1 seemingly represented the "high water mark" for those who argued that the duty of good faith continued after policy inception; the courts retrenched in the 15 years since then, and it was generally believed that the continuing duty of good faith applied in only two situations: where the insured invites underwriters to extend the risk, such as under a "held covered clause"; and where the insured submits a claim.

However, this analysis has been fundamentally revised by Longmore L J in the Court of Appeal decision of K/S Merc-Scandia v Lloyd’s Underwriters2 . It is now clear that the duty of good faith survives the inception of the policy and continues at least until litigation ensues. However, insurers will only be entitled to avoid the insurance in situations analogous to those where they have an existing right to terminate the contract.

In this case, the insured fraudulently forged correspondence to support their application to have their dispute with the shipowners heard in Trinidad because they (erroneously) believed this to be a more favourable jurisdiction. Once this fraud was identified, the jurisdiction application was abandoned and insurers elected to avoid the policy. Judgment was entered against the insured who were soon afterwards wound up, and so the shipowners commenced proceedings directly against the insurers.

It was common ground that the commission of this fraud by the insured constituted a breach of the contractual obligation to keep insurers "fully advised". This condition was not stated to be precedent to liability and was therefore an innominate term. However, this breach was found not to have caused insurers any serious prejudice, because the fraud was irrelevant to their ultimate liability; their insured would have been liable whether or not it had forged this correspondence. In the absence of serious prejudice, insurers were unable to reject the claim in accordance with the principles set out in Alfred McAlpine plc v BAI (Run Off) Ltd3 and in the absence of any loss, they were also unable to claim damages in respect of the breach. Notwithstanding this, the insurers argued that the fraud constituted a breach of the continuing duty of good faith and so they were entitled to avoid the contract, even in the absence of prejudice.

At first instance, Mr Justice Aikens found that the duty of good faith only extended beyond policy inception if there was an invitation to underwriters to extend the risk, or where the insured submits a claim. Since the insured’s fraud, in this case, did not fall within one of these "good faith occasions", there was no duty and so insurers were unable to avoid the contract.

On appeal, Longmore L J found that there was a continuing duty, but a breach of this did not necessarily entitle insurers to avoid the contract. Since avoidance ab initio is such a draconian remedy, for it to be available to insurers his Lordship considered that the insured’s conduct must be material in the sense that it would have had an effect on underwriters’ ultimate liability and the gravity of the insured’s conduct must be such as would enable the underwriters, if they wished to do so, to terminate for breach of contract.

In this particular case, the fraud perpetrated by the insured was not relevant, ultimately or at all, to insurers’ liability. Consequently, because in this case they were not entitled to terminate the contract, insurers would not be entitled to avoid the contract for the same conduct. Longmore L J emphasised that the right to avoid the contract with retrospective effect is only exerciseable in circumstances where insurers would, in any event, be entitled to terminate the contract. It would seem that it is not available where insurers are only entitled to reject a claim and so, it appears that only materially fraudulent conduct on the part of the insured will entitle insurers to avoid, because in the absence of fraud, insurers’ remedies are generally limited to rejecting the claim, rather than the termination of the contract.

It seems that the concept of materiality in this post-contractual duty is different in nature from the concept of materiality that applies to pre-contractual non-disclosure. In the post-contractual context, the fraud must be material to liability and so the commission of the fraud must prejudice insurers before they are entitled to avoid. By contrast, insurers are entitled to avoid a contract for non-disclosure made on proposal, even if that non-disclosure is in no way related or causative of the eventual loss or claim.

This judgement significantly widens the scope of the continuing duty of care, but restricts the remedy of avoidance to exceptional circumstances that will be of rare practical benefit to insurers; it will be interesting to see how this analysis develops in the coming years.

1 [1985] 1 Lloyd’s Rep 437

2 LTL 31st July 2001, TLR 3rd September 2001

3 [2000] 1 Lloyd’s Rep 437

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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