Selling political risk cover in Asia should be as easy right now as shooting fish in a barrel. Many parts of the region are still in flux, despite a substantial measure of recovery after the crisis in 1997. In the Philippines, the crisis in Mindanao has focused attention on the shortcomings of the current government. In Thailand, the political environment is regarded as becoming increasingly unstable during the approach to the General Election, which must be called by mid-November this year. In Indonesia the current government remains under threat of military intervention, and secessionist pressures continue. Further north, the tensions between the People's Republic of China and Taiwan remain over the issue of the PRC's claim to sovereignty over its neighbour.

The position is more complex than it would appear on the surface. According to Gerald Lim, Managing Director of Aon Trade Credit Asia, multinationals and lender institutions are leading the drive for political risk cover. There is greater resistance from local companies, which tend to the view that they “know their patch.” As a consequence of this attitude Asian companies, if they do intend to purchase cover, often find the premiums too expensive. The problem is exacerbated by the fact that their motivation to buy often comes at a point when capacity has all but dried up, meaning even higher premiums, or when underwriters are no longer willing to cover risks in the country concerned. In contrast, Asian companies' inclination to buy credit risk cover has been more common since the Asian crisis of 1997. The challenge to insurers is to produce products that really meet the needs of the insured. It is an interesting market from the viewpoint of hybrid insurance and capital market products.

In the meantime, capacity for political risk insurance provided by the private market has grown, and is now stabilising, according to the specialist London-based political risk brokerage firm Berry Palmer & Lyle. The four broad classes of political risk business are Contract Frustration, Confiscation and Expropriation, War on Land, and Currency Inconvertibility. Contract frustration cover provides insurance against default by government entities on payment or performance obligations. The capacity in 1998 was approximately $600 million, but by 1999 it was $800 million. Just over half is provided through the Lloyd's market.

Confiscation and expropriation cover capacity increased from about $1.4 billion in 1998 to about $1.8 billion in 1999. Lloyd's accounts for over $1 billion of this type of cover. Capacity for war on land cover, for the physical loss of property, is estimated to have increased from about $1 billion in 1998 to $1.2 billion in 1999. Again, over half of the private war on land cover is proved by Lloyd's, as is the case with currency inconvertibility capacity, which grew from $800 million in 1998 to a little over $1 billion in 1999. Capacities remained roughly constant from 1999 to 2000.

Clearly, in terms of experience and capacity, Lloyd's is well placed to provide political risk insurance. It can play to its traditional strengths of providing a niche product with a depth of expertise in the field concerned. Recently Lloyd's enjoyed good publicity resulting from its prompt payment of a $72.5 million Indonesian political risk claim, believed to be the largest private-market-investment insurance claim settlement in over a decade. The claim related to Omaha-based Midwestern Energy Holding Company's loss of its investments in independent power projects in Indonesia, as a result of the upheavals there prior to the change of government.

Three key legal issues surround political risk policies, which should be remembered by buyers. Most private market policy risk policies are written or reinsured in London, and provide for English law and London arbitration, so the following comments are therefore given from an English law viewpoint.

The duty of utmost good faith

Under English law insurance contracts are contracts of the utmost good faith, or uberrimae fides. The principle imposes an extra-contractual duty on both the insurer and the insured to disclose all material facts and to avoid making any material misrepresentation when negotiating or renewing the insurance contract. Breach of the duty will render the contract voidable at the instance of the innocent party.

The obvious question which arises is: what is a material circumstance? Section 18(2) of the Marine Insurance Act 1906 (which applies to both marine and non-marine policies) provides: “Every circumstance is material which would influence the judgment of a prudent insurer in fixing the premium or determining whether he will take the risk.” The test is objective, as it is the mind of the prudent underwriter which has to be influenced, rather than the mind of the actual underwriter.

The burden of providing materiality rests upon the insurer. It is usual to call an expert witness to give evidence on what would influence the judgment of a prudent underwriter. But who qualifies as a prudent underwriter? It has been said that: “There seems to be no reason to impute to the insurer a higher degree of knowledge and foresight than that reasonably possessed by the more experienced and intelligent insurers carrying on business in that market at that time.”

The prudent underwriter test involves asking the expert witness to put himself hypothetically in the position of the actual underwriter at the time the risk was written, and to say whether his judgment would have been influenced by the non-disclosure or misrepresentation which has occurred. But what is meant by “influenced”? Does there have to be a decisive influence, or is it sufficient if the underwriter would merely have wished to take the matter into account when making his judgment? This question was considered by the Court of Appeal in CTI vs Oceanus.

It was decided that the words “influence the judgment” in Section 18(2) meant that the disclosure was one which would have “an impact on the formation of his (the prudent underwriter's) opinion and on his decision-making process in relation to the matters covered.” It is not necessary to show that the judgment of the prudent underwriter would have been changed by the disclosure of the material fact. It is possible, therefore, that a matter could be material if it is something the prudent underwriter would want to know, even if, having taken it into account, he would accept the business on the same terms as he would have done had the matter not been disclosed.

CTI vs Oceanus was the subject of considerable criticism as being too favourable to underwriters, most significantly, in Pan Atlantic v. Pine Top. It was criticised as being “remarkably unpopular in the legal profession and in the insurance markets” and an “unhappy example (of) where the law manifestly does not produce a satisfactory result.” The Pan Atlantic vs Pine Top case was a reinsurance case which concerned the 1982 renewal of an excess of loss treaty reinsuring losses on liability policies issued by Pan Atlantic to American insureds. In essence, the reinsured disclosed the results for the previous five years, up to 30 September, 1981. However, there were two outstanding losses which were omitted, by mistake, from the 1981 statistics. Further losses had been reported for the 1981 year for the last quarter, and these were not disclosed.

Nevertheless the judge at first instance, applying the CTI decision, held that the reinsurers were entitled to avoid, because a prudent underwriter would have wanted to know that the 1981 year losses were US$465,000 at 31 December, 1981, rather than US$235,000 at 30 September, 1981. The judge was upheld on slightly different grounds in the Court of Appeal, from whence the case went to the House of Lords, which reviewed the law at length.

The Lords confirmed the objective requirement that for a non-disclosure or misrepresentation to be material, it must influence the judgment of the prudent underwriter. Their Lordships found, by a majority of three to two, that it is sufficient that the prudent underwriter would “want to know” of the fact when making his indemnity judgment. In this respect, the decision in CTI vs Oceanus was upheld.

The Lords also decided that there is a subjective requirement. When the non-disclosed or misrepresented fact is material, on the prudent underwriter test it is also necessary to show that it affected the decision of the actual underwriter. The actual underwriter must be shown to have been induced by the misrepresentation or non-disclosure to write the risk at the premium and on the terms accepted. So there is a two-stage process: first an objective test of materiality, and second a subjective test of reliance. Both tests must be satisfied if underwriters are to be entitled to avoid. In respect of the new subjective test there was a four to nil majority in the House of Lords in favour, with Lord Templeman not expressing a view. In this respect the House of Lords overruled CTI vs Oceanus.

The Lords found for the subjective test, despite the absence of any language in the Marine Insurance Act 1906 indicating its existence. Their Lordships reasoned that there had always been a subjective requirement of inducement, and Parliament cannot have intended to abolish it.

With regard to the subjective test, Lord Mustill commented upon the burden of proof as follows: “… the insured will have an uphill task in persuading the Court that the withholding or reinstatement of circumstances satisfying the test of materiality has made no difference. There is ample material both in the general law and in the specialist works on insurance to suggest that there is a presumption in favour of a causative effect.” This seems to amount to a rebuttable legal presumption that if a non-disclosure is (objectively) material, it would have (subjectively) induced the actual underwriter.

The result of the decision in Pan Atlantic vs Pine Top is that it will now be necessary for underwriters to take into account that they will have to satisfy the Court that their underwriter was induced to enter into the contract by the non-disclosure or misrepresentation. This shifts the balance back in favour of the insured or reinsured, and mitigates some of the unfairness that commentators felt resulted from the Court of Appeal decision in CTI vs Oceanus.

Apart from the common law duty of utmost good faith, the policy itself and the proposal form will almost certainly impose a contractual duty of disclosure which may widen the meaning of “material,” and make the duty a continuing obligation throughout the policy period.

It is vital for a policyholder to give full disclosure at all times of any circumstances that may be regarded as material, not just in relation to the questions on the proposal form, but also generally and especially when claims are likely. Equally important, any broker acting for the insured must make a fair presentation of the risk to the underwriter.

Insurable interest/loss payee/assignee

Under English law the insured must have an “insurable interest” in the subject matter of the policy. Such interest can include not only legal or equitable ownership, but also the limited or partial interest of a mortgagee or other lender. Although such a lender needs no insurable interest to be named as a loss payee or assignee of the policy proceeds, if the insured loses his insurable interest, for example by transferring the risk of loss through non-recourse financing with a bank, the insurer will have no liability to pay either the insured or the bank.

Similarly, any claim by a bank as a named loss payee or assignee will fail if, for example, the insured has failed to disclose material facts, or the assignment is in breach of a policy condition prohibiting assignments without the insurer's consents.

One way for a banker or other financier to avoid these problems may be for it to become a co-insured under the policy “for its respective rights and interest,” through a suitably worded endorsement. Although this will impose additional obligations on the bank, the effects may be ameliorated by a suitably worded endorsement, and the bank will have the right, if necessary, to claim directly on the policy as an insured. Moreover, since the interests of the bank and its customer covered under the policy will normally be different, the policy should be treated as composite, and any claim by the bank should not, subject to the terms of the policy, be affected by any separate breach of duty or condition by its customer.

Due diligence and subrogation

The insured is required to use due diligence, and to do and concur in doing all things reasonably practicable to avoid or minimise insured losses, and to protect and enforce any of his rights or remedies against the buyer/seller or other parties. This usually includes such steps as the termination of shipment of all goods and of performance of all services, the enforcement of any security, and the institution of legal proceedings. The insured will normally be entitled to look to the insurer to pay or reimburse reasonable costs incurred in taking such measures. Failure by the insured to comply with such conditions may result in the insurer rejecting a claim if the loss has been aggravated or recovery prospects prejudiced.

Due diligence and subrogation clauses often cause difficulties for insureds who do not realise or, for their own commercial reasons, choose to ignore the need to keep the insurer promptly and fully informed of any circumstances likely to lead to loss. However, the prudent insured will make every effort to give his insurer adequate opportunity to consider the potential loss situation before taking any proposed action, or losing the chance to do so. In this way the insured will avoid creating suspicion in the insurer's mind that he has not done everything reasonably possible to avoid or minimise loss.

It is worth noting that the insurer's opinion of what is a “reasonable” course of action in any given situation is not necessarily decisive. The insurer cannot force the insured to take or refrain from taking any step unless he can show that it is a proper one which a reasonable insured, having regard to his own interests as well as those of the insurer and the provisions of the policy, should have taken or refrained from taking.

Benjamin Macfarlane is a solicitor with Clyde & Co in Singapore.