Is your pool a non-disclosure time bomb?

It is a fundamental principle of insurance law that the (re)insured must disclose and not misrepresent all material facts at inception. This duty includes facts relevant to "moral hazard" - broadly, matters relevant to the honesty and reliability of the prospective insured.

Under English law, it has long been the position that criminal convictions concerning dishonesty will be material where honesty is relevant to the assessment of the risk. Under the Rehabilitation of Offenders Act 1974, criminal convictions are "spent" after a specific period of time according to the sentence, and need not be disclosed. However, convictions that result in a sentence of over two and a half years' imprisonment will never be spent, and therefore remain disclosable.

Even where there has been no actual conviction, the insured's "propensity to dishonesty" can also be material. In Insurance Corporation of the Channel Islands Limited v The Royal Hotel Limited (1998), the insured had prepared false invoices exaggerating the hotel occupation figures to show his bank, but had not actually ever given the false information. Nonetheless, this propensity to dishonesty was considered material and disclosable to the insurers of the fire insurance policy.

Issues of moral hazard are matters of utmost good faith and so still have to satisfy the usual requirements of non-disclosure if insurers are to be entitled to avoid the policy. The information has to be material to a hypothetical prudent underwriter, and it must have induced the actual underwriter to write the business on the terms he did - in other words, had he known of the undisclosed fact, his underwriting judgement would have been affected.

The English courts have been inclined to deal with moral hazard issues on a case-by-case basis. The recent case of ERC Frankona Reinsurance v American National Insurance Co (2005) is a good example of this.

ERC Frankona (Frankona) were quota-share reinsurers of American Nation Insurance Co (Anico) in respect of their interest in a US personal-accident business programme, the National Accident Insurance Group (NAIG), managed by National Accident Insurance Underwriters (NAIU).

The NAIG pool was created in December 1996, when Crown Life Insurance Company (Crown), Anthem Life Insurance Company (Anthem) and Philadelphia Insurance Company (Philadelphia Life) entered into an underwriting agreement with NAIU as manager. US brokers Sedgwick Re were asked to find reinsurers for Philadelphia Life's interest in the pool. They, in turn, instructed London brokers Bradstock, Blunt and Crawley, who approached Frankona.

In 1997, Frankona accepted a 45% line on the reinsurance.

The individual at Philadelphia Life responsible for their participation in the pool was Mr Steven Schouweiler. In 1997, Crown and Anthem decided not to participate in the NAIG pool for 1998. Following discussions between NAIU and Mr Schouweiler, it was agreed that Philadelphia Life would underwrite the whole programme. At renewal of the quota-share reinsurance for Philadelphia Life in 1998, Frankona reduced their participation to 32.5%.

During the course of 1998, Mr Schouweiler left Philadelphia Life and joined Anico. Following his departure, Philadelphia Life decided not to continue with the NAIG pool. NAIU approached Mr Schouweiler at Anico and an agreement was reached that Anico would take over Philadelphia Life's interest. A separate firm of London brokers, Kininmonth, broked Anico's reinsurance. Initially, Frankona took a 35% line, but subsequently agreed to increase this to 50%.

Frankona then sought to avoid the reinsurance and the agreement to increase their line on the grounds that Anico had not disclosed information about NAIU's chairman and chief operating officer, Mr Irving Drobny.

In 1983, while an attorney at the Ilinois bar, Mr Drobny was convicted by a jury for securities fraud and aiding and abetting, and was sentenced to four years' imprisonment. The offence involved a cheque written for $300,000 on an account that did not have enough funds to meet it. Mr Drobny had untruthfully told the receiving bank that he was a director of the bank on which the cheque had been drawn, and that the cheque would be honoured.

In the same year, Mr Drobny was charged with conversion of $43,000 that he held in an escrow account as an attorney. However, he was never convicted of this charge, and there was no information before the court as to whether the charge was dropped and if so, in what circumstances. In any event, he was struck off the Illinois bar that same year.

NAIU disclosed this information to their regulators but not to Frankona.

Did this entitle Frankona to avoid? The court had to answer three questions: 1) Did Anico know (or ought they to have known) of these facts? 2) Were they material to the reinsurance? 3) Did the non-disclosure induce Frankona to write the risk or to agree to increase their line?

Frankona argued that Mr Schouweiler knew of Mr Drobny's conviction and charge. Anico did not deny that they would have knowledge of anything Mr Schouweiler knew, but maintained that he did not have the requisite knowledge at the relevant time.

The judge found on the facts that Mr Schouweiler knew about Mr Drobny's background. Not only were he and Mr Drobny friends, but NAIU had informed the Illinois regulators in 1997 that the insurance companies involved in the NAIG pool had been made aware of Mr Drobny's background. At that time, Philadelphia Life was one of those companies, and Mr Schouweiler was the executive responsible for their participation in the NAIG programme.

There was no dispute between the parties' experts that Mr Drobny's conviction was a material fact. The judge accepted the experts' evidence in this respect. The main points here were: 1) the offence (securities fraud) was sufficiently serious to result in a sentence of four years' imprisonment; 2) the conviction involved dishonesty by an attorney in dealing with money; 3) Mr Drobny held a senior position in NAIU; 4) NAIU had underwriting and claims handling authority and other wide powers in administrating the NAIG programme for the pool participants; and 5) the reinsurance was a quota-share reinsurance with a "follow the settlements" provision.

The judge did not think the age of the conviction detracted from his view that a prudent underwriter would take the conviction into account when assessing the risk for the reasons set out above.

As to the charge, the same considerations applied. Out of the five factors listed above, only the first was not relevant. An allegation that an attorney had deliberately and unlawfully removed funds from an escrow account was undoubtedly serious, and something that a prudent underwriter would want to take into account. Even though the charge did not necessarily mean that Mr Drobny had, in fact, converted the funds, the judge found that the charge itself was disclosable.

On the basis that the conviction and charge were found to be material and disclosable, the next question was whether the non-disclosure had induced the actual underwriter to enter into the contract.

The underwriter's evidence was that Frankona would not have engaged in business with a company whose key functions were controlled by someone with a conviction for dishonesty, because of the danger that funds may be misapplied and because he would have been concerned about whether Frankona could rely on the representations, underwriting and other decisions made by such a person.

In any event, he would not have had authority to write the risk if the conviction had been disclosed, and would have had to refer the matter to his superior, who would have declined it. In his view, there was nothing the broker could have said that would have made the risk acceptable to Frankona. This applied just as much to the charge as to the conviction.

Anico responded by criticising Frankona's underwriting standards and challenging the underwriter's evidence as vague and unreliable. The judge, however, did not consider that these matters cast doubt on the underwriter's evidence as to how he would have responded had the conviction and the charge been disclosed.

The simple fact was that there had not been a fair presentation of the risk. If there had been, the underwriter would have assessed afresh whether NAIU were sufficiently reliable for Frankona to write the reinsurance as they did. The non-disclosure had, therefore, induced Frankona to write the risk and increase their line and, as a result, Frankona were entitled to avoid the quota-share reinsurance.

What this case shows

What Frankona v Anico demonstrates is that the courts are prepared to take a tough stance if the issue of moral hazard involves convictions or charges of offences relevant to honesty. This is despite the age of the conviction or charge (over 15 years in this case), and despite the fact that a charge does not necessarily mean that an offence has taken place.

A further point of interest is that the non-disclosure concerned information about the background - not of an employee of the reinsured, but of an employee of the pool administrators - that was known to the reinsured.

What this suggests, at least in the context of a quota-share reinsurance of pool programmes, is that it may not be sufficient for the reinsured merely to check and make appropriate disclosure relating to the background of its own officers and employees; it may be prudent for the reinsured to check also what information they have, or in the ordinary course of business should have, in relation to third-party administrators or managers who are involved in the underwriting, administration or claims functions of the underlying business.

The risk to the reinsured is that they may end up exposed, not only in terms of the business being written but also their reinsurance protection, should they find themselves in a similar position to Anico.