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The Actuary The magazine of the Institute & Faculty of Actuaries

Banking and insurance contracts

Who are you?
I am a partner in the London office of international
law firm Reed Smith Richards Butler. I handle a
range of financial transactions including reinsurance/
insurance as well as banking transactions.
Would you agree there are fundamental
differences between insurance/reinsurance
contracts and banking contracts?
Although there has been some convergence in
recent years, significant differences remain.
Why is this the case and can you please highlight
some of the key differences?
I’m glad you asked me that. Please read on
Once upon a time there was a (fairly) clear dividing
line between the kinds of transactions undertaken
by banks and the kinds of transactions undertaken by
insurers (and reinsurers). Bankers accepted deposits
and made loans. Insurers (and reinsurers) charged
premiums for assuming risks.
In recent times the dividing line has become
blurred, and banks and insurers (reinsurers) are
increasingly offering functionally similar solutions. For
example, a bank may offer a derivative product that
simulates the response of an insurance policy or a
reinsurance contract. Banks and insurers may offer
similar credit enhancement products.
However, banks and insurers/reinsurers are to
some extent still playing different sports under different
rules. There are a number of special rules that
apply to insurance and reinsurance contracts but do
not apply to banking contracts.
Insurable interest
Insurers are legally obliged not to carry on any commercial
business other than insurance business and
activities directly arising from that business, and pure
reinsurers are legally obliged not to carry on any business
other than the business of reinsurance and
related operations.
Lawyers may argue about what that really means.
However, as a practical matter, most insurers and
reinsurers interpret this to mean that they can write
only transactions that are properly characterised as
insurance or reinsurance, which normally requires
that the counterparty must have an insurable interest
Ian Fagelson makes a lawyer’s comparison
of banking and (re)insurance contracts.
in the underlying subject matter. Banks are not
so constrained.
Utmost good faith
A banking contract is generally enforceable in accordance
with its express terms. The bank will be bound
to honour the written terms of its contract unless it
can show that it was induced to enter into the contract
by fraud or misrepresentation on the part of the
Insurance (and reinsurance) contracts are different.
They are regarded by the law as contracts of utmost
good faith with the consequence that an insurer (or
reinsurer) is entitled to avoid the contract if the
(re)insured failed to disclose a material fact before
the contract was entered into, even if the (re)insurer
failed to ask about it.
This difference has a profound impact on the
dynamics of contract negotiation. A prudent bank will
want to ensure that the contract includes a full slate
of representations. Traditionally, insurers (reinsurers)
have taken a more relaxed approach, safe in the
knowledge that they can rely on the insured/
reinsured’s duty of full disclosure to fill in the blanks.
Many a slip
This may be one reason why insurance and reinsurance
transactions have often been concluded on very
slim documentation (cover notes and slip contracts)
compared to the complex, lengthy and detailed
agreements favoured by banks.
However, sophisticated policyholders and ceding
companies are increasingly uncomfortable with a rule
that enables an underwriter to avoid liabilities on the
ground of material non-disclosure in the absence of
actual fraud or misrepresentation. Quite often, a contract
is negotiated in which the (re)insurer’s remedies
for non-disclosure are specifically excluded.
In addition, the new regulatory environment in
which contracts are required to express accurately
the economic substance of the transaction, is encouraging
insurers and reinsurers to transact business on
the basis of detailed documents that increasingly
resemble banking agreements.
Banking contracts are written under ‘ordinary’ contract
law. In ordinary contract law, a warranty is a
contractual provision of relatively minor importance.
Unless the contract expressly provides to the contrary,
breach of a warranty by a bank’s customer will
entitle the bank to claim damages for losses caused
by the breach but will not enable the bank to walk
away from its contractual obligations.
In insurance law, a warranty is a provision of such
fundamental importance that its breach by the policy-
holder/cedant automatically discharges the insurer/
reinsurer from any further obligations to perform the
contract with effect from the date of the breach (not
ab initio). This is an automatic consequence, regardless
of how small the breach or how insignificant its
As soon as the insured commits a breach of warranty,
the insurer’s obligations under the contract
come to an end. The insurer continues to be liable
for indemnity obligations that arose before the date
of the breach and can retain the whole of the premium.
However, where the warranty was broken at
the very outset of the contract, for example a warranty
as to existing facts contained in a proposal form
that is subject to a ‘basis of the contract clause’, the
effect is similar to avoidance ab initio but the insurer
can keep the premium. Indeed, it seems that even
future instalments of premium can remain payable.
Quite often, and especially where insurance or
reinsurance solutions are offered as capital markets
products, a lot of time and effort is expended in
negotiating contract language designed to ensure that
the rights and obligations of the parties are spelled
out in the contract so that the special insurance law
rules about warranties do not apply.
Law reform
The English and Scottish Law Commissions are
engaged in a project to examine and suggest possible
reforms to insurance contract law. This may well
result in legislation designed to remove some of the
differences between insurance contract law and ordinary
contract law. In the meantime, the market has
to operate on the basis of the special rules of insurance
contract law modified as appropriate, by
specific agreement between the parties on a caseby-
case basis.
How can I find out more?
This article is one of a series promoted by the
actuarial profession’s Action Group for Banking
(AGB) and explores situations where the actuarial
and banking worlds overlap to the benefit
of both sectors. The articles serve the following
broad purposes:
? Push: to demonstrate where actuarial skills
and thinking have been applied in a banking or
financial context to add real commercial value.
? Pull: to highlight tools and skills available in
banking and finance that may be of use to traditional
life and pensions actuaries.
Please contact either the author or Mark Symons
(mark.symons@actuaries.org.uk) for more information
on the article and the AGB’s activities.