DMC Category Rating: Confirmed

This case note is based on an Article in the October 2005 Edition of the ‘(Re)insurance Bulletin’, published by the Insurance and Reinsurance teams at the international firm of lawyers, DLA Piper Rudnick Gray Cary. DLA Piper is an International Contributor to this website.

Background
In September 1998, Frankona reinsured the interest of American National Insurance Co ("Anico") in a US programme called the National Accident Insurance Group ("NAIG"), managed by National Accident Insurance Underwriters ("NAIU"). In April or June 1999, Frankona increased its line by 15%. In these proceedings, it claimed to have validly avoided that reinsurance and the subsequent agreement because Anico had (amongst other things) failed to disclose the criminal record of the chief operating officer of NAIU.

The NAIG pool was set up at the end of 1996 to write personal accident business. An Underwriting Agreement gave NAIU, as manager, extensive responsibilities. Management, supervision and direction of the business was under its sole control and it had had authority for (amongst other things) underwriting, collecting premiums, settlements, contesting claims and obtaining reinsurance for the common account of the participants.

The reinsurance
NAIU engaged US brokers to find interested reinsurers for Philadelphia Life, one of the three participants in the pool. The US brokers, in turn, instructed London brokers, Bradstock, Blunt and Crawley Ltd, who approached Frankona.

Papers provided to Frankona during the presentation of the risk included a document about NAIG, which said that NAIU would undertake any approval and licensing requirements necessary: "Irv Drobny, President and Chief Operating Officer [of NAIU], was for many years a key regulator in the Illinois Department and his network of relationships are invaluable in such activities".

In February 1997, Frankona signed a slip subscribing to a 45% quota share of Philadelphia’s one-third participation in the Pool. The agreement ran from 1 January to 31 December 1997.

The following year, the two other participants in the NAIG programme decided not to take part. Philadelphia Life, however, agreed to underwrite the whole programme. A new underwriting agreement gave NAIU much the same authority and duties as the previous year. Bradstock was again involved in placing Philadelphia Life’s reinsurance, and Frankona signed up to a 32.5% quota share in January.

In April 1998, the key individual at Philadelphia Life, Mr Schouweiler, left the company to join Anico. Philadelphia Life no longer wanted to continue to write the NAIG programme, and it was agreed that, with effect from the beginning of 1998, Anico would take over Philadelphia Life's interest in NAIG by providing Philadelphia Life with full reinsurance cover. Anico and NAIU signed an underwriting agreement reflecting the new arrangement.

Anico was to be reinsured as to 90% of the risk. A new broker, Kininmonth, took over the placing of the reinsurance from Bradstock. On 23 September 1998, Frankona agreed to write a 45% line, although in the end this was written down to 35%. The previous 1998 quota share was cancelled as at 1 January 1998.

The increased line
In April 1999, one of Anico’s other quota share reinsurers wanted to end its participation. On 30 April, Frankona’s underwriter scratched an endorsement but added the letters "TBE" ("to be entered"). Anico required an adjustment in the deductions it could make for commission and it was not clear when, or if, this issue was resolved. On 4 June, however, another underwriter at Frankona initialled the endorsement for the increased line and deleted the letters "TBE".

This gave rise to some doubt about the date on which Frankona was bound and the effect of the note "TBE". The judge held that the initials, on their own, merely suggested that the underwriter did not have his records readily available to mark up his entry. They did not indicate he was withholding commitment to the risk. Frankona was, therefore bound as from 30 April.

The conviction and the charge
The moral hazard issue concerned Mr Drobny, who in 1997 was the president and chief operating officer of NAIU. In 1983, whilst an attorney at the Illinois Bar, he was convicted of securities fraud and sentenced to four years’ imprisonment. His offence was that he had written a cheque for US$300,000 on an account which had insufficient funds, but he had assured the recipient bank (untruthfully) that he was a director of the bank on which the cheque was drawn and that it would be honoured. At about the same time, he faced a further charge of conversion in relation to US$43,000 that he held in an escrow account as an attorney. The charge did not result in a conviction and it was not clear whether and in what circumstances it had been dropped. In any event, in December 1983, Mr Drobny was struck from the roll of attorneys.

Biographical information provided to NAIU's regulators, the Department of Insurance of the State of Texas, described Mr Drobny as "inactive for health reasons" between 1983 and 1988, but, in 1999, as word of his background was beginning to circulate, the regulators obtained a corrected version. NAIU was fined, but its licence was not revoked. In addition, in 1998, Mr Drobny disclosed the conviction to the Department of Insurance of Illinois and obtained their consent to his continued employment by NAIU.

The information, however, was not disclosed to Frankona, either in 1998 or 1999. This was not disputed. The issue was whether, at the relevant time, Anico knew (or ought in the ordinary course of business to have known) of these matters. Frankona also alleged that, even if Anico did not have the requisite knowledge, NAIU, as Anico's agent, had a duty to disclose them.

As with any allegation of a breach of the duty of utmost good faith, Frankona also had to show that the non-disclosure was material to the reinsurance and that it had induced the underwriter to enter the contract on the terms he did.

Knowledge
Frankona argued that Mr Schouweiler, who had been instrumental in involving first Philadelphia Life and then Anico in the NAIG programme, knew of Mr Drobny's conviction and charge. Anico did not deny that it would be "fixed" with what Mr Schouweiler knew, but maintained that he did not have the requisite knowledge at the relevant time.

On the facts, however, the judge found that Mr Schouweiler had known about Mr Drobny's background. Even if he had not had actual knowledge of the conviction and the charge (which, the judge found, he did) he ought to have been aware of them in the ordinary course of business. Consequently, Anico knew about these matters and should have disclosed them to Frankona.

The same did not apply to NAIU. Although, by September 1998, NAIU knew of Mr Drobny's background, it did not follow that it had any duty to disclose this information to Frankona.

There are three situations where there is a duty to disclose matters known to the insured’s agent (Simner v New India Assurance Co Ltd [1995] 1 Lloyd's Rep 240):

• Where the agent - although not effecting the insurance on behalf of the insured - is relied upon by the insured for information concerning the subject matter of the insurance (known as the "agent to know").
• Where the agent is in such a prominent position in relation to the insured that his knowledge can be regarded as the insured's knowledge. It was not claimed that NAIU fell into this category.
• Where the agent is used to effect the insurance (in other words, the "agent to insure").

In the case of an agent to insure, the agent is required to disclose, not only material circumstances the insured is bound to disclose, but also material circumstances known to the agent. He will be deemed to know every circumstance which, in the ordinary course of business ought to be known by, or to have been communicated to, him (section 19(1) of the Marine Insurance Act).

In this instance, Kininmonth were Anico's agents to insure. Should Kininmonth in the ordinary course of business have known about Mr Drobny's background because, in the ordinary course of business, NAIU should have told them about it?

The judge thought not. Although NAIU had authority to negotiate and secure reinsurance, the judge found it had not exercised that authority. NAIU supplied the US brokers with information about the business written by the pool, which was duly passed on to Kininmonth, but it did not assume a role of passing on information about the officers of NAIU.

But was it Anico's "agent to know"? Frankona argued that, because NAIU ran the NAIG programme, it was Anico's agent to know about that part of Anico's underwriting, so whatever NAIU knew about it was to be disclosed - including Mr Drobny's background. The judge did not accept this argument. There was no basis for suggesting that Anico, by appointing NAIU as its agent, was relying on NAIU for information, not only about the programme and the business written under it, but also about NAIU's officers and employees.

Materiality and inducement
There was no real dispute that the conviction was a material fact, even though it was 15 years old. The offence was sufficiently serious to result in a four-year sentence and involved dishonesty on the part of an attorney. Mr Drobny held a senior position in NAIU, which had been entrusted with underwriting and claims handling authority and other wide powers over the NAIG programme. Lastly, this was a quota share reinsurance of Anico's risk and included a ‘follow the settlements’ provision.

Except for the fact of the conviction, the same considerations applied to the charge of conversion. The allegation was undeniably serious. Even though no conviction resulted, a prudent underwriter assessing the quota share would have wanted to take it into account.

The judge was also satisfied that the non-disclosure induced Frankona to participate in and increase their line. The underwriter's evidence was that Frankona would not engage in business with a company whose key functions were controlled by someone with a conviction for dishonesty. Not only would there be an increased danger that funds might be misapplied, but there would be serious doubts about whether Frankona could rely on the representations, underwriting and other decisions of such a person. In any event, had he known of Mr Drobny's past, the underwriter would not have had authority to write the risk and would have had to refer it to his superior, who would have rejected it.

Although Anico criticised Frankona's underwriting standards and the underwriter's failure to keep proper records, this did not, in the judge's view, undermine his evidence about the effect disclosure of Mr Drobny's background would have had on Frankona's underwriting decision. Frankona was, therefore, entitled to avoid the reinsurance contract for non-disclosure.

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