Focus: The duty of the utmost good faith – May 2001
Is the duty expanding?
In brief: The duty of good faith requires insurers to act with due regard to the insured's interests in situations where there is a conflict of interest. The duty also requires the insured to act honestly when dealing with the insurer. As a broker is usually regarded as the agent of the insured, the broker will also be subject to this duty. Examples of both the insurer's and the broker's duties will be identified in this paper. It will also discuss the history of the duty and its current status in Australia and why it should not be expanded into an all-purpose weapon, wheeled out as an excuse to start any type of action against the other party. Roger Loo, Lawyer, Insurance Practice Group reports.
- History of the duty and remedies
- The duty of good faith
- What does this mean to the insurer?
- What does this mean to the broker?
- Expansion of remedies in other jurisdictions
- How far does the duty go?
Common law and its scope
The duty of good faith initially arose to explain why the insured was required to disclose to the insurer all information relevant to the risk insured. This duty, however, was also placed on the insurer, so that there was a mutual obligation of disclosure prior to entering into the contract. In Carter v Boehm (1766) 3 Burr 1905, Lord Mansfield stated at pages 1909-1910:
'The policy would be equally void against the underwriter, if he concealed; as if he insured a ship on her voyage, which he privately knew to be arrived: and an action would lie to recover the premium... Good faith forbids either party, by concealing what he privately knows, to draw the other into a bargain from his ignorance of the fact, and his believing the contrary.'
While the most common manifestation of the duty of good faith is the pre-contractual duty of disclosure, the duty also extends throughout the period of the policy (i.e. it is also a post-contractual duty). For example, Boulton v Holder Brothers (1904) 1 KB 784 at 791 held that the duty of good faith commences before a policy is made via the duty the disclosure and continues so long as the parties are in a contractual or continuing relationship with each other. Manifestations of the post-contractual duty of good faith usually arise in relation to claims - either the way the insured made the claim or the way the insurer handled the claim.
It has been held in Australia that the duty of good faith continues, even if the parties commence litigation in respect of the policy, until judgment (and perhaps, even after that) - Horbelt v SGIC (unreported, Supreme Court of South Australia, 26 June 1992). A different approach was taken in England in Manifest Shipping & Co Ltd v Uni-Polaris Insurance Co Ltd ('The Star Sea')  1 LI LR 651 where it was held the duty of good faith ends once litigation commences, as the parties have become adversaries and the Rules of Court will govern disclosure (without the need to be supplemented by the duty of good faith). While the English interpretation is more sensible, it remains to be seen what decision the higher Australian courts will come to.
Insurance Contracts Act 1984 (Cth)
The duty of good faith is now an implied statutory term inserted into every general insurance contract in Australia under section 13 of the Insurance Contracts Act 1984 (Cth) (the ICA). Section 13 requires both the insurer and the insured to act towards the other, in respect of any matter arising under or in relation to it, with the utmost good faith. Therefore, like the common law, the duty spans from the pre-contractual stage (duty of disclosure) to the post-contractual stage (the making and handling of claims). In addition, being a contractual term, damages are allowed to the innocent party in case of a breach (discussed further below).
The Insurance Contracts Act does not, however, apply to all insurance contracts. For example, the common law duty of good faith still applies to the following types of insurance contracts:
- reinsurance contracts
- health insurance contracts;
- insurance contracts entered into by a friendly society;
- marine insurance contracts; and
- workers compensation contracts.
The duty of good faith under the ICA, however, is not vastly different than that under the common law - it is merely made more explicit as it is now in statute form. For example, section 12 states that the duty is not to be read down in any way by any other law or any other provision of the ICA. However, in practical terms, the duty under the ICA does not require a higher duty of disclosure for the insured than under the common law.
Section 14 states that if the reliance by a party on any provision of the contract would fail to be an act of good faith, then the party cannot rely on that provision. This is generally aimed at the insurer and is merely another way of saying that the insurer must have due regard to the insured's interests when the insurer is placed in a position of conflict (such as deciding whether to pay out on a claim).
The main difference between the common law duty and the duty under the ICA, however, is the nature of the remedies.
Under the common law, a breach allows the innocent party to avoid the contract. If the breach occurs prior to the contract's execution, then the contract is avoided from the very beginning. If the breach occurs after contract formation (e.g. during claims) then the traditional view has been that the contract may also be avoided from the very beginning of the contract. The more logical approach, however, is that the contract is avoided from the time of the breach. This avoids the situation of having earlier claims (which were made honestly) being tainted by the later act of bad faith. This was recognised by the Australian Law Reform Commission 'Insurance Contracts' No 20, 1982 p 147 which stated:
'The strict application of the doctrine of utmost good faith might conceivably result in the insurer being entitled to avoid the contract ab initio [from the beginning]. If so, an insurer might be entitled to deny a prior claim untainted by fraud or to require repayment of moneys paid by it in connection with such a claim.'
No damages are allowed in Australia under the common law for a breach of the duty of good faith.
The ICA expressly allows damages for post-contractual breaches of the duty of good faith. The ability to cancel the contract in all cases of a breach is also preserved.
Damages are allowed as the duty is an implied contractual term of the contract. From the insurer's point of view, however, the damages will manifest in the form of reduced claim payouts. Section 54 states:
54(1) Subject to this section, where the effect of a contract of insurance would, but for this section, be that the insurer may refuse to pay a claim, either in whole or in part, by reason of some act of the insured or some other person, being an act that occurred after the contract was entered into but not being an in respect of which sub-section (2) applies, the insurer may not refuse to pay the claim by reason only of that act but his liability in respect of the claim is reduced by the amount that fairly represents the extent to which the insurer's interests were prejudiced as a result of that act.
54(2) Subject to the succeeding provisions of this section, where the act could reasonably be regarded as being capable of causing or contributing to a loss in respect of which insurance cover is provided by the contract, the insurer may refuse to pay the claim.
Therefore, to the extent that the post-contractual breach of the duty resulted in the event causing the insured's claim, the insurer may refuse to pay the claim.
The insurer is also allowed to cancel the contract from the time of the breach under section 60(1) of the ICA.
What is it?
Usually, the duty is described as requiring the insurer and the insured to act honestly with each other throughout the duration of the policy. More recently, the insurer's post-contractual duty of good faith has been described by the Queensland Supreme Court in Re Zurich Australian Insurance Ltd  QSC 209 as acting with due regard to the insured's interest in situations where the insurer has a conflict of interest (such as in paying out on claims). It is not a fiduciary duty in that it does not require a party to regard the other party's interest higher than its own. The duty does, however, involve notions such as honesty and fairness. As such, the duty of good faith can be seen as involving both an objective and subjective element.
What does 'act with due regard' or 'fairness' mean? This is the objective element. This objective element is combined with the notion of 'honesty', the subjective element. The test in determining whether the duty has been breached is an objective test based on subjective facts. In other words, would an objective person (a 'reasonable person'), knowing what the insurer actually knows, act the same way? An example is when an insurer decides to delay paying out on a claim it knows to be valid, solely in the hope that the insured will not contest the delay and give up on the claim. In this case, the insurer cannot be said to be acting with due regard to the insured's interests - the insurer knows it is delaying the claim on reasons which cannot be justified on an objective basis.
Note that the subjective ('knowledge') element is crucial to a claim based on good faith (hence the use of the term 'faith'). A mere mistake will not breach the duty of good faith. Negligence will also not breach the duty of good faith. The phrase 'good faith' implies some sort of intention. One extreme of this is a fraudulent claim. The other extreme is a deliberate delay to pay out on a claim, in the hope that the insured will not pursue the claim.
The duty of good faith has resulted in the following general duties for the insurer:
Disclosure and non-misrepresentation
Generally, an insurer must not misrepresent facts about the policy (or any other facts) that are material to the policy. The insurer must also disclose any relevant policy terms that have major consequences (such as denial of claims). In the ICA, this general duty has manifested itself into the following duties for the insurer:
The insurer must ask the insured specific questions relevant to the risk. Failure to do so waives the insurer's ability to claim that the insured failed to disclose the relevant fact (s 21A(3)). The insurer must specifically ask the insured about exceptional circumstances which (s 21A(4)):
- are known to the insurer;
- is what a reasonable person in the circumstances would know is a matter relevant to the risk; and
- is something which the insurer would not be expected to specifically ask about.
The insurer must inform the insured in writing about the insured's duty of disclosure and the effect of non-disclosure (s 22).
The purpose of these sections is to ensure that the insured is prompted to provide the correct information and that they are made aware of the consequences of failure to comply with the duty of disclosure (and the duty of good faith).
The insurer must draft its policies in clear, plain English so that the policy can be easily understood by the insured. This is implemented in the ICA by the requirements above (that the insurer must ask specific questions about the risk). In addition, the insurer must bring to the insured's attention any unusual terms of the policy (s 37). This is merely a manifestation of the insurer's duty to have due regard to the insured when drafting its policies.
Naturally, when deciding whether to approve claims, the insurer's interests will conflict with the insured's interests. The duty of good faith therefore requires the following from the insurer:
- to manage, administer and process claims efficiently and without undue delay;
- to decline claims only with reasonable evidence or belief that the claim should be declined;
- to investigate the claim before declining a claim;
- to investigate claims in a reasonable manner; and
- to not use inappropriate reasons to deny a claim (such as a minor misrepresentation which did not impact on the event causing the claim - manifested as s14 of the ICA).
Court defence / Settlements
When conducting an insured's court defence or negotiating settlements on the insured's behalf, the following duties apply:
- to conduct the defence efficiently, economically and to consider the insured's interests as well as the insurer's own interests; and
- to consider the insured's interests in respect of settlement amounts. For example, it may be bad faith for the insurer to not offer a settlement amount solely on the basis that there is a small chance the court may award a lower amount against the insured. This is because continuing the trial may run up large defence costs for the insured (assuming the insured is liable for court costs).
Renewal of policies
The duty of good faith may be breached where the insurer offers uncommercial terms to an existing policyholder in an attempt to rid itself of that policyholder. This should not be a breach, however, if the insurer has honest commercial reasons for doing so.
A broker is generally considered to be the agent of the insured. As such, the actions of the broker will be seen as the actions of the insured. This means a broker's actions may effectively result in the insured breaching its duty of good faith. This can happen in a variety of ways:
- making a false claim;
- intentionally leaving out relevant information (either in entering into the policy or in making a claim); or
- refusing to assist the insurer with its defence or rights of subrogation.
If a breach does occur as a result of the broker's actions, then the insurer will be able to cancel the contract and (under the ICA) reduce the amount payable under the relevant claim. The result is that the insured will make a claim against the broker for negligence.
However, the insured's duty of good faith is generally only that of disclosure and the duty to not make false claims. This means that the insurer is unlikely to bring an action for the breach of good faith - rather, the insurer will merely cancel the contract for non-disclosure or deny a fraudulent claim. Nevertheless, the result for the broker is still the same - whatever losses the insured suffers as a result of the broker's actions will result in the insured bringing a claim of negligence against the broker.
What does this mean to the broker? It means that the broker must be aware of the insured's duty and ensure that it does not breach that duty on the insured's behalf.
Duty on its own account
A broker has no duty of good faith to the insurer on its own account - it only owes that duty to the insurer as agent of the insured.
For a while, the NZ courts entertained the idea of allowing damages for a breach of the common law duty of good faith. In Cedenco Foods Ltd v State Insurance Ltd (1997) 6 NZBLC 102, 221, the NZ High Court hinted that damages are available for an insurer's breach of the common law duty of good faith. This case, however, was later overturned by the NZ Court of Appeal.
In the US, the courts have introduced the concept of a tort of bad faith, which is based on the power imbalance between the insurer and the insured. The tort adopts the principle that insurance is entered not only for profit but for peace of mind. This has resulted in breaches allowing not only compensatory and punitive damages, damages for emotional distress. As such, it has resulted in vast amounts of litigation. The principle of an insurance contract being entered into for peace of mind has resulted in a wider scope of what is bad faith than in Australia. The following are examples of US bad faith (although they would also breach the duty of good faith in Australia) which may result in emotional distress damages:
- the insurer offering to settle claims for an amount less than that the amount of the claim with no reason other than the insurer knows that the insured desperately needs the money and is unable to wait for trial to contest the amount.
- the insurer not having any reason to deny the claim other than to try and force the insured to settle on a smaller settlement.
- the insurer not having adequate evidence to refuse a claim and being reckless in obtaining adequate evidence.
- the insurer failing to investigate the claim before declining on the basis that more likely or not, the insured would not contest the claim.
As stated earlier, the duty is not a fiduciary duty where one party's needs are placed higher than the other's. Indeed, there is a misconception (especially given that the ICA is very insured-friendly) that the duty requires an insurer to act to the insured's benefit to the detriment of its own. However, this is not the case. In Re Zurich Australian Insurance Ltd, Chesterman J commented on the various definitions of the duty and how it had been elevated to such an extent that.:
'This decision appears to me, with respect, wrong. A duty, the essence of which is to act honestly, is elevated to an obligation in an insurer to coddle its insured and to allow idiosyncratic judicial solicitude to replace principle.'
The duty merely requires fair consideration of the other party's interest and an honest application of the policy. If the policy allows the insurer to refuse a claim, the insurer can do so. If the policy does not allow the insurer to refuse a claim, the duty of good faith prevents the insurer from stretching the policy's interpretation so as to refuse the claim. The duty does not, however, require the insurer to sacrifice its business to ensure that the insured does not suffer any harm.
This paper is intended only to provide an alert service on matters of concern or interests to readers. It should not be relied upon as advice. Matters differ according to their facts. The law changes. You should seek legal advice on specific fact situations as they arise.
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