Royal Commission fallout: extending unfair contract terms protections to consumer and small business insurance contracts
The Financial Services Royal Commission recommended a number of significant reforms to the Australian insurance industry. One of its key recommendations was that the existing unfair contract terms regime should be extended to apply to consumer and small business insurance contracts. Regulatory special counsel Nicholas Blackmore explains how the regime will apply to consumer and small business insurance contracts, which clauses might be considered unfair, and how Australian insurers can prepare themselves for change.
The Financial Services Royal Commission (the Commission) made 15 recommendations for reforming the Australian insurance industry, covering all aspects of the insurance product lifecycle, from how products are offered and sold, to the way claims are handled. This article focuses on a key recommendation — to endorse the Department of Treasury’s proposal to extend the current unfair contract terms (UCT) regime set out in the ASIC Act 2001 (Cth) to insurance contracts.
The UCT regime, introduced in 2010, applies to most Australian businesses that use standard form contracts in their dealings with consumers and small businesses. Until now, it has not applied to most insurance contracts (except for private health insurance and State government insurance contracts) on the basis that they are regulated by the Insurance Contracts Act 1974 (Cth) (the ICA).
While it remains to be seen if and how the Morrison government will implement the Commission’s recommendation, insurers can start preparing for the impact of the extended UCT regime now.
Applying the UCT regime to insurance contracts
The proposed model amends section 15 of the ICA, which currently provides that no legislation other than the ICA itself applies to insurance contracts, to provide an exclusion for the UCT regime in the ASIC Act. As a result the UCT regime would apply to insurance contracts as it does to contracts for other products and services.
The extended UCT regime would apply to standard form contracts for the provision of insurance to a consumer or small business where:
- a “consumer” is an individual who acquires insurance for predominantly personal, domestic or household purposes, and
- a “small business” means a business with fewer than 20 employees, although small business insurance contracts would be excluded from the UCT regime if upfront costs (the premium and possibly the excess) exceed $300,000 (or $1,000,000 if the term is longer than 12 months).
Under the proposed model, a consumer or small business would not have to be a party to the insurance contract; the UCT regime will apply if any third party beneficiary under the contract is a consumer or small business.
The ASIC Act does not define “standard form” contract, but sets out the factors which a court must considering in determining whether a contract is standard form. These include the relative bargaining power of the parties, whether the contract was prepared by one party before any negotiation took place, and whether the other party was effectively required to accept or reject those terms.
Under the proposed model, even if a policyholder was given a range of options to choose from – such as coverage levels, excess amounts, sums insured and exclusions - for an insurance contract, this would not prevent the contract from being considered standard form.
It seems likely that, under this definition, the vast majority of insurance contracts currently sold to consumers or small businesses in Australia would be considered standard form.
What is an unfair contract term?
An “unfair” term is defined as one that:
- causes a significant imbalance between the rights and obligations of the parties arising under the contract;
- is not reasonably necessary to protect the interests of the party that receives the benefit of the term; and
- would cause a detriment to the other party if it were to be applied or relied on.
The UCT regime provides that terms contained in a standard form consumer or small business contract which are “unfair” are void and therefore legally unenforceable. Under the proposed model, a term in an insurance contract would be deemed not to be unfair if it:
- reasonably reflects the underwriting risk accepted by the insurer; and
- does not disproportionately or unreasonably disadvantage the insured.
This recognises that an insurance contract is fundamentally an agreement under which the insurer agrees to bear a particular risk in return for a particular premium.
It is therefore within an insurer’s legitimate interests to be able to precisely and transparently specify the risk it is accepting in the insurance contract through, for example, the use of exclusions and conditions. These types of terms will not be considered unfair, provided they do not disproportionately or unreasonably disadvantage the insured.
On the other hand the proposal would exclude terms which:
- describe the insured subject matter;
- describe the amount of the premium, and possibly also the excess; or
- are required or expressly permitted by law, from the UCT regime.
This final exclusion is very narrow and adds little protection for insurers. While these terms themselves could not be void for unfairness, they would still be taken into account to the question of whether other terms under the insurance contract are unfair.
The proposal would also expand the remedies available to a court beyond simply declaring an unfair term to be void. Depending on the term and the circumstances, it may be more beneficial to the policyholder to have the option to void an unfair term, or enforce it and seek compensation for any resulting loss.
How the UCT regime interacts with the Insurance Contracts Act
The ICA already contains several provisions which prevent insurers from relying on certain terms of an insurance contract:
- section 14 prevents insurers from relying on a term if to do so would breach their duty to act with the utmost good faith;
- section 53 provides that a term of an insurance contract which allows the insurer to unilaterally vary the terms of the contract to the detriment of any other party to the contract will be void; and
- section 54 prevents insurers from relying on breaches by the policyholder to refuse payment of claims, unless the breach actually prejudices the claim.
The UCT regime will apply in addition to these provisions. In some cases the impact will be minimal — many potentially unfair terms could be unenforceable already under these sections.
However, these sections also contain various exceptions that are not available under the UCT regime. For example, guaranteed renewable sickness and accident insurance contracts are exempt from section 53. Unless similar exceptions are included in the extended UCT regime, a unilateral variation term in this type of insurance contract may no longer be enforceable.
The Treasury proposal does provide an exception to allow the insurer to increase premiums unilaterally in guaranteed renewable life insurance policies.
Factors a court considers in assessing whether a term is unfair
In considering whether a term is unfair under the UCT regime, a court will take all relevant circumstances into account, in particular:
- whether the term is transparent; and
- the contract as a whole.
A term is “transparent” if it is expressed in plain language, is clear and legible, and is readily available to the consumer or small business. A term that is not is “transparent” is more likely to be considered unfair.
A term can only be unfair in the context of the whole of the contract. That means that a term that initially appears unfair may ultimately be fair after other terms of the contract are considered. For example, a term that allowed the insurer to repair an insured property or pay a monetary sum that was less than the cost of repair could still be considered fair if the contract allowed the insured to chose which benefit to take.
It is important to note that a court will consider the effect of a term on the assumption that the insurer will always enforce the term whenever it applies.
Accordingly terms must be drafted carefully so that they can never be construed as unfair; insurers cannot include broad contract terms and resolve that to enforce them only when the situation warrants.
Clauses that might be considered unfair
The Commission report and the Department of Treasury proposal cited several examples of clauses that might be at risk of being considered unfair:
Limitation of benefits
A term in a home insurance policy that allows the insurer to choose whether to perform building repair works itself, or to pay the insured the cost of the repair works, based on the lowest quote received by the insurer. The Commission noted that this term may be considered unfair because the lowest quote received by the insurer would likely include discounts that would not be achievable by the insured.
The Commission did not explain why this term might be unfair but presumably it is because home insurance is marketed and sold on the basis that, in the event of a claim, the insurer will either repair the insured property, or pay the cost of the insured repairing the insured property.
A term that permits the insurer to pay less than the “actual cost” of repairing the property may be unfair but, as explained above, not the insured had the option of which benefit to accept, or if the limitation was clearly disclosed before the policy was issued.
More broadly, any term which limits the benefits available under an insurance contract in a way which undercuts the stated purpose of those benefits is at risk of being considered unfair.
Insured’s rights dependent on actions of a third party
A term in an insurance contract that makes the insured’s ability to make a claim conditional on the conduct of a third party, over whom the insured ha no control. An example of this might where a third party claim is covered under the insurance contract only if the third party provides full particulars of their claim against the insured within a specific timeframe.
This reflects the broader principle that a term in an insurance contract might be considered unfair if it disadvantages an insured based on the actions or inactions of a third party who is beyond the insured’s control.
Not allowing recovery of premiums
A term in an insurance contract which is “linked” to another contract (for example, a property insurance contract that is linked to a loan agreement and insures property used as collateral for the loan) which limits the insured’s ability to obtain a premium rebate under the insurance contract if the linked contract is cancelled early.
This suggests that a term in an insurance contract might be considered unfair if it does not allow the insured to recover part of their premiums when the insured risk ceases to exist.
It is also worth considering the types of terms that have previously been held to be unfair in other kinds of consumer contracts under the UCT regime to date:
Terms that allow a party to a contract to avoid or limit their obligations under a contract have often been ruled to be unfair. In insurance contracts, the most common terms that do this are exclusion clauses.
Exclusion clauses that are most at risk of being considered unfair are those that exclude liability for losses or claims that the insured would reasonably expect to be covered, either because it is generally covered under that type of insurance or because coverage is implied in marketing materials or policy documentation.
For example, some cyber insurance policies contain a broad exclusion for liability arising from acts of war or terrorism. However, that exclusion might be considered unfair if used to exclude liability for a hacking attack carried out by a terrorist or government organisation, which would ordinarily be covered if carried out by ordinary criminals. The fairness of this term may also depend on whether the insured was given reasonable notice of the exclusion.
This does not mean the end of exclusion clauses but it does mean that insurers need to consider their exclusion clauses more carefully.
Terms that allow a party to a contract to unilaterally interpret the contract have often been ruled to be unfair. Subjective wording is not uncommon in contracts – for example, “if we determine that you have breached this agreement” – and insurance contracts are no different.
Subjective wording may render a term unfair because it allows the term to be enforced in situations where objectively it should not be enforceable. In the example above, the insurer could enforce the term if it determined that the other party had breached the agreement, regardless of whether they actually had.
Insurers should replace subjective language in insurance contracts with objective language – for example, “if you have breached this agreement”.
Unreasonably severe consequences (or no consequences) for breach
Terms that permit a party to terminate the contract or have other severe consequences for minor breaches by the consumer have often been considered unfair, if the consequences are not necessary to protect the party’s legitimate interests.
In the insurance context, section 54 of ICA already prevents insurers from relying on breaches by the policyholder to refuse payments of claims, unless the breach actually prejudices the claim. However, the extended UCT regime may also affect terms that impose other unreasonably severe consequences for breaches, besides denial of coverage.
Similarly, clauses that prevent the policyholder from terminating under any circumstances, or do not give the policyholder reasonable rights in a breach of contract by the insurer, might also be considered unfair.
How insurers can prepare for the extended UCT regime
Insurers should be reviewing their standard form consumer and small business policy wordings already.
The first task should be to ensure that policy wordings are “transparent” - in plain and clear language, in a legible-size font, and set out in a single document that is easily accessible to the policyholder.
The second task should be to review the substance of policy wordings carefully to identify clauses that may be at risk of being considered unfair under the extended UCT regime. In particular, terms that:
- limit the benefits under an insurance contract in a way which undercuts the stated purpose of those benefits;
- disadvantage an insured based on the actions or inactions of a third party who is beyond the insured’s control;
- do not allow the insured to recover part of their premiums when the insured risk ceases to exist;
- exclude liability for losses or claims that would otherwise be covered by the insuring clauses and that policyholders might not necessarily expect;
- have severe consequences for minor breaches by the consumer or give the consumer no right of redress if the insurer breaches the contract; and
- enable the insurer to unilaterally interpret or vary the policy terms.
Insurers should also look out for broadly-drafted terms that could potentially be unfair when enforced in some situations, even if they are not commonly enforced. If a broadly-drafted clause is intended to protect a specific interest, it should be narrowed so that it only protects that specific interest.