DMC Category Rating: Confirmed

This case note is based on an Article in the April 2006 Edition of the ‘(Re)insurance Bulletin’, published by the Insurance/Reinsurance teams at the international firm of lawyers, DLA Piper Rudnick Gray Cary. DLA Piper is an International Contributor to this website

Background
On 6 July 1994, the bulk carrier "North Star" was damaged by an explosion caused by a device located about 1 metre below the water line. The vessel was owned by North Star Shipping Ltd, a one-ship company managed by Kent Trading Corporation. Kent was beneficially owned by two brothers, H and M Petrakakos.

The vessel's war risk cover, placed in April 1994, was for US$4 million and incorporated the Institute War Clauses 1.10.83. If the explosion had been caused by an explosive device put in place either by terrorists or by some other outsider in order to cause malicious damage, it would have fallen within the insured perils.

The owners claimed under the war risks policy for a constructive total loss. Insurers, however, maintained that the loss was not covered, because the explosion had been deliberately caused or procured by the owners.

Alternatively, insurers claimed they had validly avoided the policy for material non-disclosure. Before the war risks policy was entered into, the owners failed to disclose:

(1) Four separate pending criminal proceedings in the Greek courts: H Petrakakos was named (amongst others) as a defendant in all four actions, M Petrakakos in one;

(2) Civil proceedings in Panama against the Kent Group companies involving allegations of fraudulent trading;

(3) That the vessel's insured value at US$4 million was excessive - the actual value was approximately US$1.3 million;

(4) That the previous year's hull and machinery insurance had been cancelled for non-payment of premium; and

(5) That the owners were in a serious financial position.

In April 2005, Mr Justice Colman found in favour of insurers on both complicity and non-disclosure. Permission to appeal was initially refused, but subsequently granted with limitations and on the basis that the appeal on non-disclosure would be heard first.

One of the limitations was that the owners were not able to challenge the judge's decision that the underwriter was induced by the non-disclosures to write the insurance on the terms he did. This hearing, therefore, was solely concerned with whether the (non-disclosed) information was material. Was the judge right to find that certain facts not disclosed by owners to underwriters would have influenced the judgment of a prudent underwriter?

The Appeal Court only dealt with the first four material facts listed above. The fifth (the owners' financial position) was adjourned to the appeal relating to allegations of complicity, since the two issues were inextricably related.

Allegations
Insurers primarily relied on the allegations of dishonesty made against the owners in the Greek criminal proceedings and Panamanian civil proceedings. They did not assert that they could establish the truth of the allegations, but claimed the allegations themselves were material.

The Greek proceedings concerned allegations of financial fraud involving an investment scheme, whereby individuals would invest sums of money on the promise of obtaining a guaranteed minimum repayment. At the date the war risks cover was placed (April 1994), all four actions were progressing.

In relation to one of them, solicitors acting for H Petrakakos had obtained a letter from the Serious Fraud Office in London stating that it regarded "Mr Petrakakos" as a victim of a fraud perpetrated by others and that it hoped he would give evidence on behalf of the Crown at the trial of those others on related charges of fraudulent trading.

All the charges were dismissed by the Greek court in 1995 and 1996.

The civil proceedings in Panama arose out of a dispute with a previous business partner and had resulted in one of the owners' vessels being arrested for nearly a year, contributing to their financial problems. It was alleged that Kent, controlled by H Petrakakos, had fraudulently endorsed to the claimant an insurance policy relating to another vessel, without disclosing it had already been endorsed to a bank.

Disclosure
The owners argued that the allegations were not material. In this they relied on their expert witness, Mr Posgate, whose evidence was that moral hazard considerations played only a peripheral role in war risk insurance and had little practical significance. In his view, the scope of a war risks cover was sufficiently narrow as to make the risk of fraudulent claims very remote.

In any event, the owners argued that the letter from the SFO rendered the allegations of dishonesty immaterial to a prudent underwriter.

At first instance, Mr Justice Colman accepted that the scope of war risk cover was such that, by comparison with hull and machinery cover, there were fewer opportunities for faking an insured loss. Nevertheless, the potential for fraud was not negligible. In his view, there was no logical basis for differentiating between the two types of cover when considering issues of moral hazard.

He concluded that the court proceedings in both Greece and Panama were material and discloseable. There was no doubt that the information would have influenced the decision of a prudent underwriter. Even if there was evidence to suggest the insured was innocent (such as the SFO letter) this could not diminish the materiality of the allegations.

On appeal, the owners widened their argument to suggest the court should distinguish between allegations that relate to the risk and allegations that do not. Allegations that have no bearing on the risk and which later turn out to be false (as in this case) should not be considered material. Insurers, however, argued that the test for materiality was already clear and could not be side-stepped in this way.

Judgment
Lord Justice Waller, who gave the leading judgment in the Court of Appeal, recognised that this is an area of difficulty in the current law. What is the correct approach to an allegation of dishonesty which, at the time of placement, the insured says is false and which, after placement, turns out to be false?

There is something unjust in the notion that insurers can avoid a policy in such circumstances. On the other hand, it is difficult to contradict an underwriter who gives evidence that an allegation of fraud would have had an influence on his underwriting judgment if it were not known at the time whether the allegation was true or false.

Different judges have come to different conclusions on the issue. In Reynolds and Anderson v Phoenix Assurance Co Ltd [1978] 2 Lloyd's Rep 440, it was found that an insured did not have a duty to disclose allegations which were not true. But other cases, such as March Cabaret Club & Casino Ltd v The London Assurance [1975] 1 Lloyd's Rep 169, and The Dora [1989] 1 Lloyd's Rep 69, have concluded that unresolved allegations are discloseable.

Mr Justice Colman in The Grecia Express [2002] 1 Lloyd's Rep IR 669  followed the second approach. The fact that an allegation can later be shown to be unfounded does not mean it was not material at placement. But he thought it would be a breach of insurers' duty of utmost good faith if they persisted in taking the point at trial after the allegation had been shown to be untrue.

The Court of Appeal in Brotherton v Aseguradora Colseguros SA [2003] 1 Lloyd's Rep IR 746 confirmed this conclusion on materiality, but rejected the idea that any potential injustice could be mitigated at trial. It was irrelevant to try to establish the truth or otherwise of an allegation at trial because it was the allegation itself that was material to be disclosed. Lord Justice Mance, however, commented that the court could take into account any material the insured could have produced at placement to show his innocence.

In the North Star, Lord Justice Waller doubted that saying the court could take into account such material provided a practical solution, unless the material proved beyond doubt the allegation was false (it which case it would no longer be material). An underwriter was unlikely to spend much time considering the strength or otherwise of an allegation and, in many instances, would simply decide there was no smoke without fire.

Under the present law, the obligation to disclose information relevant to moral hazard can only be limited if underwriters give evidence that they would not have been influenced by the information, or by a robust judge rejecting the underwriter's evidence that he would have taken it into account. It was unrealistic to expect that an underwriter called to give expert evidence on materiality would ever say that a prudent underwriter would not take into account a recent allegation of serious dishonesty, even if it was quite unconnected with the insurance or the risk being insured.

Should moral hazard be confined by law to facts which go to the risk of the insured destroying the subject of the insurance? Should there be some consideration of whether the obligation to disclose should be confined to what a reasonable insured would consider material? Should the insurer’s absolute right to avoid the policy be reconsidered? What would prevent injustice that may result from the obligation to disclose the false allegation of serious dishonesty but, at the same time, protect the underwriter who has to assess the risk?

These are issues that it is hoped will be addressed by the Law Commission in its current review of insurance contract law.

Lord Justice Longmore also commented on the possibility of law reform: "It is much to be hoped that this area of the law will receive the Law Commission's detailed consideration and that proposals emerging from that consideration will be enacted. Australia with its Insurance Contracts Act 1984 is well ahead of the United Kingdom in this field."

These considerations, however, did not affect the outcome for the owners of the North Star. The Court of Appeal unanimously rejected their argument that, because this was a war risk insurance, the allegations were not material. The SFO letter did not come close to proving that the allegations were untrue, and was, in any event, clearly not the end of the matter as the Greek proceedings continued for some time afterwards.

Once one formed the view that the allegations had to be disclosed, together with the SFO letter, materiality was established. The judge's conclusion that the charges in the Greek criminal proceedings were discloseable was unimpeachable.

The question whether the underwriter, taking this information into account, would have continued to write the risk related to inducement, which was outside the scope of this appeal.

As to the non-disclosure of the Panamanian civil proceedings, if the allegations in the Greek proceedings were material and discloseable, the judge was right to consider that a different allegation of dishonesty by another third party would become material, even if, arguably, it had not been material on its own. Mr Justice Colman, however, concluded that the allegations of fraud in the Panamanian proceedings were material in their own right, and that was a finding he was entitled to make on the evidence before him.

The other non-disclosures were more problematic. The insured value of the vessel was stated to be US$4 million when its market value was between US$1.12 and US$1.4 million. In order to show that an insured value is excessive, it has to be shown to be far in excess of a "disparity consistent with prudent ship management".

Mr Justice Colman concluded that an insured value of US$3 million would not necessarily fall outside the range of what was consistent with prudent ship management. But the additional US$1 million was excessive, material and discloseable. On appeal, however, Lord Justice Waller had doubts that, on its own, the overvaluation was discloseable. The underwriter could see for himself the difference between US$4 million and the vessel's market value and might prefer to take the extra premium rather than investigate whether there were good management reasons for the valuation.

As for non-payment of premium, it was not absolutely clear that the judge would have found this material on its own. But he appeared to conclude that, when taken with other factors, it was.

Insofar as this concerned the owners' financial situation, that was a matter that would be dealt with at a later date. But in connection with the allegations issue, Lord Justice Waller doubted that it was legitimate to say that what was not material on its own somehow became material when other factors were taken into account. The non-payment was either material on its own or not. Since the information seemed to go to the owners' credit risk and not to the risk insured, he would have thought it was not material.

It was not, however, necessary to reach a concluded view on either the overvaluation or the non-payment issue because of the decision on the allegations point.

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