Covid-19: exposing legal risk in insurance

Insurance markets worldwide operate on the basic premise that insurers know the risks for which they want to provide coverage ex ante. Professor Robert Vivian and Dr Albert Mushai note that these risks must meet certain pre-conditions, however, for insurance to work

One of these conditions is that, for a risk to be insurable, the chance of loss must be random or independent. In other words, the insured event must not be one where every individual with that type of insurance (covering that event) suffers loss if a loss-causing event occurs. If that happens, the chance of loss is no longer random but covariate. 

It is on this basis that insurance is said to operate on the principle that losses of the few are borne by the many. While it is possible to insure against some events that give rise to covariate losses, such as floods or earthquakes, the losses they generate are not global – as seen from the Covid-19 pandemic. 

Therefore, in a pool of 1 000 people who buy insurance coverage against something like burglary, for example, the expectation is that not everyone among the insured group will suffer loss. 

If it happens that all of the 1 000 premises insured against burglary suffer loss, in any period of insurance, the essence of insurance as a risk mitigation mechanism ceases to exist. After all, the main source of funds that insurers use to pay claims are premiums from those who do not suffer loss. This is the principle of risk pooling that operates as the piston of the insurance mechanism. Without it, insurance becomes unworkable. 

A simple illustration helps explain how the principle of risk pooling works. In our pool of 1 000 people who buy burglary insurance, the insurance company must try to estimate how many out of that pool will suffer loss in the period of insurance. Once it makes that determination, it spreads the cost of those claims across the entire pool in the form of premiums. 

For the whole mechanism to work, a number of important conditions must hold true. One is that the people expected to suffer loss must be fewer than the size of the pool. Another is that the insurance company’s estimation of the expected losses must be as accurate as possible. 

Consequently, the premium that each individual in the pool pays will be a small fraction of the maximum loss each stands to incur. If the expectation is that all the individuals in the pool will suffer loss, there is no point in buying insurance in that case because each member’s premium will equal to the maximum value of loss they face. The concept of pooling thus disappears. 

With this in mind, insurance companies then draft contracts that they sell to their clients. These contracts specify the events they wish to provide coverage against and the circumstances under which losses from those events are indemnifiable. 

Therefore, the insurance contract is the reference point in the determination of whether a particular loss event falls within the scope of the insurance coverage available. Since it is the duty of the insurer to draft the insurance contract, the obvious assumption is that the contract is a true reflection of losses that the insurer is willing to cover. 

All this sounds straightforward. Beyond this point, however, things get complicated. As always with things of a contractual nature, things can go wrong for a number of reasons.  

Firstly, what one intends is not always consistent with what is in the contract itself. Secondly, since the role of interpreting contracts vests in the courts, the interpretation given to certain aspects of the contract could turn out to be inconsistent with what one of the parties intended.

The Covid-19 pandemic illustrates this quite well. Following the outbreak of the pandemic, most governments placed their countries under lockdown. Businesses ceased all operations, except those that fell into the essential services category. 

Suspension of business activities meant a loss of revenue and profit for the firms concerned. Of those firms that had business interruption insurance (or consequential loss insurance), many turned to their insurers for indemnification. 

Insurers turned to their contracts and interpreted them according to what they intended to achieve – which is to confine business interruption coverage only to those events where the interruption results from an event causing physical loss. 

A typical loss situation that most insurers thought they covered is where fire destroys machinery. Because of the damage to machinery, production stops completely or is reduced. The reduction in production is an interruption resulting from physical damage to machinery. In cases such as these, insurers have no problem paying the losses resulting from the interruption. In many cases, insurers thought this is what their contracts said. 

However, as recent events have shown, things have turned out to be more complicated, especially in connection with business interruption insurance under Covid-19. 

When governments placed economies under lockdown, insurers faced a flood of lockdown-induced business interruption claims. When insurers declined these claims because there was no antecedent physical harm, courts became involved on the interpretation side. That is when things started to take an unexpected turn for insurers. 

Business interruption insurance contracts in many parts of the world have many variations and extensions purporting to cover business interruption losses in a variety of situations. Nevertheless, none of these extensions contemplated business interruption losses arising from a national lockdown as those seen under the global Covid-19 pandemic. 

This is because insurance doesn’t work where every individual in the risk pool files a claim from the same event. Insurers have always known this and hence they never intended to cover the lockdown-type business interruption losses. 

Yet it is one thing to say insurers in all probability did not intend to cover business interruption losses from a national lockdown and quite another to say that their contracts actually reflected this intention. 

In the UK, the Financial Conduct Authority took a test case against eight insurers before the High Court for it to provide guidance on the extent of coverage that the insurers’ policies provided for lockdown business interruption losses. 

The court handed down its judgment. In some cases, the 162-page judgment confuses things even further but, to a large extent, the judgment shows that what insurers may intend their policies to reflect is not always consistent with what comes out when courts get involved. 

In some of the policies insurers purported to cover business interruption losses from infectious disease within a vicinity of 25 miles. Insurers argued that this meant their intention was only to provide coverage for business interruption losses from a local disease, not a global pandemic. 

The court rejected this argument, viewing it as an attempt to separate losses using a narrow conceptualisation of causation. In South Africa, similar cases have gone before the courts and a decision is pending on whether lockdown-induced business interruption claims are valid. 

Global developments around business interruption insurance under lockdown and Covid-19 conditions highlight the pervasive nature of legal risk in the insurance market. Legal risk generally refers to any unexpected or unwelcome judicial or regulatory decision with the potential to impose costs on firms affected by the decision. 

There is no question that insurers in various parts of the world had no intention to pay consequential losses from a national lockdown. Many of these insurers were certainly confident that their policies made this intention clear. However, following a string of litigation in countries like Canada, the US, the UK and South Africa this position is being tested and outcomes from these court cases will have significant implications for the future of insurance, including business interruption insurance in particular.