Broker Negligence on BI Policy Advice

A recent ruling of the Commercial Court held brokers Heath Crawford Ltd (“HC”) liable to pay a former client £2.3 million in damages, for uninsured loss resulting from negligent advice on placement of a business interruption (“BI”) insurance policy.

Infinity Reliance Ltd v Heath Crawford Ltd [2023] EWHC 3022 (Comm)

The Claim

Following a fire at warehouse premises used for its online retail business, Infinity Reliance Ltd (“Infinity”) claimed for lost sales revenue and costs to fit out new premises under its insurance with Aviva. The BI sum insured was based on forecast gross profit of around £25 million over two years but the right figure would have been closer to £33 million. Infinity was underinsured and the doctrine of average applied (reducing pro rata the indemnity paid by the proportion of underinsurance) – since the insured exposure was 26% less than the total loss, Infinity recovered only 74% of its adjusted loss.

Infinity claimed the shortfall from HC, alleging it would have been fully insured if proper advice had been given on (1) calculation of the sum insured, (2) whether to obtain declaration linked cover, and (3) provision for costs to fit out alternative premises.

Types of BI Cover

Traditional “sum insured” BI cover requires the policyholder to forecast insured profit for the indemnity period, with a fixed premium payable in advance. If the policyholder has underestimated the risk or grows faster than expected, average would apply to any claim, however carefully the forecasts were made. So if the insured gross profit is £1 million but the actual gross profit is £2 million, the insurer will pay only 50% of the loss – even if the loss is far below £1 million. The policyholder is treated as having chosen to insure only part of its revenue, and to have self-insured the rest, so that the insurer and policyholder contribute rateably to any loss.

It is important for policyholders to estimate future gross profit correctly for the full indemnity period, bearing in mind that loss may be suffered on the last day of the insured period. For example, if the policy provides for a two year indemnity period (as Infinity’s did), i.e. it may compensate the policyholder for up to two years’ lost revenue after a loss begins, gross profit must be estimated for three years from inception of the policy.

Alternatively BI insurance may be taken out as “declaration linked” cover, originally developed during the 1970’s to cope with the problems faced by policyholders forecasting revenue during periods of high inflation. When covered on this basis, the policyholder must still declare its turnover and profit in advance, so that the initial premium can be assessed, but at the end of each period of insurance, the actual performance may be considered. Within broad limits, if it is higher than forecast, the policyholder pays an additional premium; if it is lower, premium is returned. The insurer agrees not to apply average. Effectively, the actual risk is retrospectively rated by adjusting the premium. It is only if the policyholder’s original estimate was very badly wrong that a claim may be at risk.

The policy arranged by Infinity’s previous brokers prior to 2018 was declaration linked cover. For the 2018/19 renewal, HC placed a new commercial combined policy with Aviva. At some point during the renewal process, Infinity told HC that it did not want BI cover on a declaration linked basis, because it had been hit by a premium adjustment previously and wanted premiums fixed in advance. However, HC did not explain to Infinity the potential downside of taking out BI insurance on this basis, including the significance of average in cases of underinsurance. HC did not make sure that Infinity knew what it was giving up, or whether its preference for traditional BI cover represented a genuine willingness to retain part of its BI risk.

Sum Insured Calculation

Leading up to the 2019/20 renewal, Infinity was provided with a generic document produced by HC entitled “How to Calculate Gross Profit”. The guidance contained the following statements under the heading “Sum Insured”:

“For many businesses, the basis of the Sum Insured will be the annual Gross Profit figure, which for BI purposes represents:

Annual turnover plus closing stock and work-in-progress less

Opening stock and work-in-progress plus variable expenses.

Variable expenses are those expenses which would reduce, or disappear entirely, in the event of a stoppage to the business.

Once an accurate and current BI Gross Profit figure has been calculated, it must be adjusted upwards to allow for anticipated growth in the business during the period of insurance itself and the Indemnity Period selected, bearing in mind that it is possible for a ‘worst case scenario’ loss to occur on the last day of the period of insurance.

As an example, if the current annual Gross Profit figure is £100,000, the period of

insurance is 12 months, the Indemnity Period selected is 24 months and business growth is estimated at 10% per annum, the correct Gross Profit sum insured is £254,100:

Gross Profit during 12 month period of insurance = £100,000 + 10% = £110,000

Gross Profit during 1st year of Indemnity Period = £110,000 + 10% = £121,000

Gross Profit during 2nd year of Indemnity Period = £121,000 + 10% = £133,100

Gross Profit sum insured = £121,000 + £133,100 = £254,100″

As a guide to calculating the sum insured for purposes of the Aviva policy, this was incorrect. Based on the Aviva policy insuring clauses and definitions, insured profit did not constitute the difference between turnover and “expenses which would reduce, or disappear entirely, in the event of a stoppage of the business”; it was the difference between turnover and the cost of material for production and discounts received.

HC’s guidance document included the warnings that: “In the event that the Gross Profit sum insured is not calculated correctly, there is likely to be underinsurance and average would apply to the settlement of ANY claim … If cover is arranged on a Declaration Linked basis this may well offset the need for projection but the selected indemnity period and any exceptional changes to the business will still need to taken into account.” Infinity’s finance director read these statements but did not appreciate the significance, because he did not know what “average” is and assumed the sum insured was a limit of liability, so that provided the ultimate loss was below £25 million, the claim would be paid in full. HC did not explain how declaration linked cover worked, or how it could alter the consequences of underinsurance.      

Broker Duties

Brokers are required to exercise “reasonable skill and care in and about obtaining insurance on [the client’s] behalf” (JW Bollom v Byas Mosley [2000]). The extent to which an act or omission represents a breach of this duty depends on all the circumstances.

A major part of the broker’s role is to bridge a gap between the client’s knowledge and its own, in terms of cover available in the market. The broker must learn enough about the client’s needs and business to make sensible recommendations, and enable an informed decision to be made, depending on the attributes and sophistication of the individual client. Previous authorities demonstrate that brokers must:

• Aim to “match as precisely as possible the risk exposures which have been identified with the coverage available”, recommending “sufficient and effective” cover if available in the market (Standard Life v Oak Dedicated [2008]).
• Seek to assess the client’s needs beyond instructions to place specific insurance, in appropriate cases. A broker given highly specific instructions, for example, to place “mortality only” cover for a racehorse is not obliged to advise that theft cover should be obtained (O’Brien v Hughes-Gibb [1995]). However, a reasonable broker instructed to place suitable cover for exposure of a general class will consider the risks presented and what insurance will meet them.
• Enable an informed decision to be taken, by ensuring the client understands the key terms of the cover that is being obtained (Eurokey Recycling v Giles [2014]).
• Explain key aspects of the placement process including information required by insurers. There are technical complexities to insurance which a broker is expected to understand, but a client may not, which often relate to things that the broker personally cannot do for the client. The broker is required in such cases to educate the client so that it can do what it needs to do.

The duties apply on renewal as much as original placement of a risk. Whilst a broker comes to renewal with existing knowledge for use in the process, it cannot simply assume renewal is all that is required, even if nothing appears to have changed. Brokers must apply their minds to the client’s present circumstances and the sufficiency of cover in that situation.

Breach of Duty        

HC admitted breach of duty in providing generic information about how to calculate the sum insured which was not accurate in relation to the policy placed for Infinity. The Court and both parties’ experts agreed that a reasonable broker would have recommended declaration linked cover to a client in Infinity’s position.

The Judge rejected HC’s attempt to rely in defence upon Infinity’s instructions that it did not want declaration linked cover, since that was not an informed decision. It is not for a broker to force upon its client a type of cover that is unwanted, even if the broker disagrees with that preference, and even if it a foolish preference. However, the broker must ensure the client understands any disadvantageous consequences – such as the risk that underinsurance would lead to any claim being reduced by average. That would be an important point to hammer home because it is an aspect of insurance that may not be obvious to the typical client, even an otherwise financially literate one. Even when a preference has been expressed, the reasonable broker should check that it remains a genuine and informed choice at renewal, especially as circumstances change.

In relation to fit out costs, the Judge held that HC was in breach of duty in failing to obtain sufficient information to make a suitable recommendation for cover to address the obvious risk that Infinity would need to find alternative premises, in the event of a fire or similar event, putting the warehouse used for its business out of action. The broker is not expected to second-guess or audit the information it is given but must follow up reasonably obvious gaps or uncertainties as part of the dialogue leading up to placement of a policy. HC knew that the warehouse premises (owned by a logistics company) were critical to Infinity’s business but failed to ask further questions, to facilitate advice on suitable Additional Increased Costs of Working provision to mitigate a potential gap in coverage.

The “How to Calculate Gross Profit” guide included a disclaimer:

“Whilst we are able to provide … information about how to calculate the sum insured, we do not accept any responsibility for the adequacy of your indemnity period and sum insured – and in some instances, you may need to consider the assistance of a suitable professional service.”    

This did not absolve HC of responsibility. It was designed to make clear that HC could not undertake the BI sum insured calculations (which required a detailed financial understanding of Infinity’s business); but it was still obliged to provide accurate guidance on what the insurance policy required to be calculated.

In terms of quantum, Infinity’s recoverable loss was reduced by 20% due to contributory negligence, for carelessly failing to follow even the flawed guidance provided by HC.

Practical Implications

Brokers must take care to fully investigate and understand a client’s business and risk exposures prior to inception or renewal, so that appropriate cover can be obtained.  The advantages and disadvantages of different options available in the market should be clearly explained, with detailed notes taken of client meetings for future reference.

The decision in this case highlights the perils of underinsurance for policyholders and brokers alike. BI sum insured calculations may be especially complex and declaration linked cover will be preferable in most cases, to ameliorate the potential consequences of inaccurate forecasts. Policyholders need to know that the price paid for certainty about the premium may be uncertainty about recovery in the event of a claim. Brokers should be wary of providing generic guidance notes on policy coverage or sum insured calculations if policies are placed with multiple insurers, on variable standard wordings.

In an increasingly volatile commercial landscape, with high inflation in the wake of challenges including Covid-19 and Brexit, policyholders and their brokers should proceed with caution in relation to declared values to avoid finding themselves caught short.

Amy Lacey is a Partner at Fenchurch Law