What is a contract of insurance and why it matters?
30 June 2011
Falling on the wrong side of the line has significant consequences: the court ordered the sellers' winding-up. This shows the critical importance of recognising the characteristics of insurance to minimise risks for the business and its officers.
Regulation of insurance business
A person/company is prohibited from carrying on a "regulated activity" in the UK without authorisation or exemption from the FSA (s.19, FSMA). Carrying on insurance business is an example of a "regulated activity" (Article 10, FSMA (Regulated Activities Order 2001) (RAO)). Selling insurance without FSA authorisation has consequences for all the parties involved: the seller, its officers and the buyer of the policy.
If a company sells insurance without authorisation, its directors risk imprisonment (maximum of two years) and/or a fine (s.23, FSMA) and/or striking off; the company itself could be fined (s.23, FSMA), investigated by the FSA and/or wound-up. Obviously, both the directors and the company face particularly significant reputational risks.
The buyer of an unauthorised policy has two choices: enforce the policy against the insurer or cancel it.
An unauthorised policy remains a valid contract against the insurer, but is unenforceable against the buyer. This means that the buyer can choose to enforce the policy and seek coverage for the risk. However, the policyholder needs to consider whether the choice is viable. This would be so only if the insurer has resources to meet the claim. If the insurer has become insolvent or is subject to numerous and concurrent policyholders' claims, the policyholder may be left with a valid, but worthless claim.
Alternatively, if the insured chooses to cancel the policy, they will be entitled to recover the premium paid plus interest. Again this is a viable course of action only if the insurer has funds to meet such claims. Although the policyholder may recover the premium and the interest, they will be left without compensation if the risk has already materialised.
Contrast the position of the insured if they bought a policy from an FSA-authorised firm, which has insufficient funds to meet the claim. The insured can turn to the Financial Services Compensation Scheme, which covers, inter alia, the insurance policies of customers of authorised firms only (the limit is 90% of the claim for non-compulsory and 100% for compulsory policies).
Digital Satellite Warranty Cover Ltd and others  EWHC 122 (Ch) flags that insurance products may not always be easily recognisable. Given the perils involved in unknowingly selling/buying unauthorised insurance, it is useful to be aware of the characteristics of an insurance contract to minimise risks for you as a product seller/buyer.
What is an insurance contract?
Neither FSMA, nor RAO define "insurance". RAO contains the circular statement that insurance means "any contract of insurance which is a contract of long-term insurance or a contract of general insurance" (Article 3). It further lists types of insurances in Schedule 1. The FSA has issued a helpful overview of what the courts have considered throughout the years to be "insurance" (PERG 6). However, this guidance has its limitations as it only gives the FSA's approach and "cannot state what the law is, as that is a matter for the courts" (PERG 6.4.1).
The cases do offer some guidance. Prudential v Commissioner of Inland Revenue  2 KB 658 lists the three main facets of insurance:
- consideration – the premium secures to the insured "some benefit, usually but not necessarily the payment of a sum of money, upon the happening of some event";
- event – it must be uncertain "whether the event will ever happen or not, or if the event is one which must happen at some time there must be uncertainty as to the time at which it will happen";
- financial loss – the cover is for "a loss or detriment which will or may be suffered upon the happening of the event".
The fundamental characteristics of insurance were laid down in 1904. Whilst there has been further consideration in later cases, they still predate FSMA 2000, RAO 2001 and the establishment of the FSA. It is therefore important to turn to the most recent case which revisits these elements.
Re Digital Satellite
The case concerns entities selling extended warranties for satellite TV equipment. The target audience were customers who had purchased Sky and whose original warranties were soon to expire. The entities undertook simply to repair or replace the equipment covered; they had no obligation to pay money to their customers.
The FSA's position was that the entities were selling insurance without FSA authorisation. The entities disputed this on, inter alia, the following grounds:
- Prudential "did not envisage a case where there could be no obligation to pay money [to the insured] at all"; and
- The purchasers of the extended warranties did not suffer financial loss, because the entities repaired/replaced the equipment at their own cost.
In effect these arguments attacked the first and third characteristics of insurance laid down by Prudential. The court rejected those submission on the following grounds:
- Mr Justice Warren pointed out that counsel's submission for the entities contradicts the reasoning in Prudential that insurance secures "…some benefit, usually but not necessarily the payment of a sum of money".
- If the insured's equipment broke down, the insured will have to pay for repair/replacement. Therefore, "…a contract which brings about the result which [the insured] would otherwise have to pay to achieve…can properly be categorised as a contract which protects him from financial loss. And this is so whether or not the insurer is obliged to pay the cost incurred by the insured if, in fact, the insured himself pays for the repair or replacement in the fist instance."
This case is a reminder that a contract may not initially appear like insurance, but could nonetheless fall within this category. Some examples include extended warranties, badly drafted derivatives contracts, repayment contracts. An insurance contract does not need the label "insurance" to be one, neither is it limited to a monetary payment from insurer to insured. It can be as subtle as a provision of assistance or activation of an arrangement upon the occurrence of an event/risk. It is therefore important to be open-minded about the concept of insurance and alert to the risks involved in selling/buying an unauthorised policy.