A continuity clause[1] has become a customary inclusion in most professional indemnity and D&O policies. However, such clauses are generating some difficult legal and practical issues to deal with in the context of managing and resolving contested claims for indemnity. In this article, we explore the rationale for continuity clauses and outline three specific, but not exhaustive, issues that have emerged. 

Rationale

The traditional purpose of a continuity clause is intended to operate as a write back for cover from the operation of a prior circumstances exclusion – indeed, it is common for continuity clauses to commence with the words ‘Notwithstanding the operation of the prior circumstances exclusion’ or something similar. Another formulation is to express this type of exclusion as being subject to the operation of the continuity clause.

Continuity clauses have sought, or have intended to seek, to balance the following competing factors:

  • Unfairness – there is a real risk of an insured ‘falling between two stools’ and having no insurance cover by reason of:
    •  The insured’s failure to notify known facts and circumstances that might give rise to a claim to a prior year insurer (Year 1 Insurer) in circumstances where:
      • There is no contractual deeming provision permitting the late notification of such facts and circumstances based on the Australian Hospital Care[2] line of authority and reliance on s54 of the Insurance Contracts Act 1984 (Cth) (ICA), which is a remedial provision; and/or
      • s40(3) of the ICA is effectively a ‘use it or lose it’ provision – that is, a failure to make a s40(3) notification prior to the expiry of the period of insurance is fatal to an insured’s indemnity claim. Further, it is well settled that s54 does not cure an insured’s failure to make a valid s40(3) notification[3];
    • the insured’s failure to disclose those same facts and circumstances to a subsequent insurer (Year 2 Insurer[4]) as part of a proposal or otherwise. If so, the Year 2 Insurer could rely on a prior circumstances exclusion and/or a potential non-disclosure and misrepresentation defence pursuant to s28(3) of the ICA to disclaim or reduce its liability[5].

This scenario produces the unsavoury outcome of an insured having no insurance cover, despite purchasing back to back insurance policies year on year and in most cases, with the same insurer.

  • Loyalty – continuity clauses incentivise an insured to stay with the same insurer(s) noting the obvious benefits of ‘continuity of cover’ with the same insurer(s) over consecutive policy periods.
  • Prejudice – this is really the flipside of the unfairness point above. That is, the inclusion of continuity clauses poses ‘moral hazard’ issues in the sense that an insured could theoretically be rewarded for its failure to notify the Year 1 Insurer by being put in a better position and notifying the Year 2 Insurer. An obvious example is where the Limit of Liability of the Year 1 policy is exhausted or partially eroded, which causes the insured to notify the Year 2 Insurer for the purpose of maximising the benefit of the uneroded Limit of Liability of the Year 2 policy.

To address this conundrum, it is typical for a continuity clause contained in a Year 2 policy to incorporate the terms, conditions, limitations and exclusions of the Year 1 policy. Further, it is not uncommon for such a clause to provide a mechanism for the Year 2 Insurer to reduce its liability by reference to any ‘prejudice’ suffered by that insurer, had the insured notified the Year 1 Insurer – this is not dissimilar to a s54 prejudice reduction.

Against this backdrop, we provide the following basic worked example of how a continuity clause should work…in theory:

  • Policies – the same insurer issues the same Policy wording to the same insured for Year 1 (ie the ‘Year 1 Insurer’) and Year 2 (ie the ‘Year 2 Insurer’) with each Policy having a Limit of Liability of $5 M for any one ‘Claim’ and in the aggregate;
  • Year 1:
    • The Year 1 Policy Limit is eroded by $4 M for Claim A leaving an uneroded portion of that Limit of $1 M.
    • During the currency of the Year 1 policy, the insured becomes aware of facts and circumstances that might give rise to a claim (Claim B) but fails to notify those facts and circumstances to the Year 1 Insurer before the expiry of the Year 1 policy.
  • Year 2:
    • During the currency of the Year 2 policy, a third party plaintiff serves on the Insured court papers making Claim B and seeking compensation of $5 M. On receipt of those papers, the Insured promptly notifies the Year 2 Insurer under the Year 2 policy and seeks cover under that policy.
    • The Year 2 Insurer relies on the prior circumstances exclusion by reason of the insured’s failure to notify the known fact and circumstances in Year 1. However, the insured enjoys the benefit of the continuity clause, which writes back cover from the operation of that exclusion but subject to the terms, conditions, limitations and exclusions of the Year 1 policy. One such limitation would ordinarily be regarded as the remaining portion of the Limit of Liability.
    • As the Year 1 Policy Limit of $5 M has already been eroded by $4 M for Claim A, the Year 2 Insurer is only be obliged to pay $1 M in respect of Claim B representing the uneroded portion of the Year 1 Policy Limit. That is, had the insured notified circumstances to the Year 1 Insurer, the ‘prejudice’ suffered by the Year 2 Insurer represents its putative inability to rely on the erosion of $4 M for Claim A under the Year 1 Policy Limit for the purpose of reducing its exposure for Claim B.

This is only one just example directed to the erosion of Policy Limits but what it serves to illustrate is that the insured is effectively put into the same position had it notified circumstances to the Year 1 Insurer consistent with balancing the three competing factors outlined above.  

Issues

In a perfect world, continuity clauses work best when the same insurer issues the same wording to the same insured year on year – that is, the only thing that changes is the period of insurance. However, it seldom works like this in the real world, especially on significant D&O and PI programmes for the big corporates with changes to policy wordings and the composition of towers. In particular, it is common for insurers and underwriters to come off risks altogether, to change positions on towers (eg moving from the first excess layer to the fifth excess layer and vice versa) or to adjust their line sizes and participations across different years of account.  

The decision of CIMIC v AIG [2022] NSWSC 999 brought to fore some of the legal and practical issues concerning continuity clauses that have been bubbling away for some time. While this judgment is the subject of an appeal and dealt with a smorgasbord of insurance law issues (which is beyond the scope of this paper to canvass), the decision highlights that the proper working out of a continuity clause may not always reflect the contracting parties’ underwriting intent. Adopting some of the defined terms above, set out below are three specific issues canvassed in this decision relevant to continuity clauses:

Issue

Discussion

Whether continuity clauses waive or modify (impliedly or otherwise) an insurer’s innocent non-disclosure and misrepresentation rights.

There is an obvious tension here given a continuity clause is really designed to excuse an insured’s innocent failure to notify or disclose to the Year 2 Insurer the facts and circumstances known to the insured during the Year 1 policy period.

In CIMIC, Peden J (at [158]) stated that:

‘I consider the better construction of [the continuity clause] that it does not amplify the Insured’s rights or support a construction of cl7.1 that narrows the Insurer’s s28(3) IC Act rights as suggested by CIMIC.’ (underlining added)

Clause 7.1 of the policy in question waived the insurer’s non-disclosure and misrepresentation rights in respect of non-Side C losses but there was a dispute as to whether such rights were waived or modified for Side C losses including by reference to the continuity clause.

Her Honour’s findings were relevantly as follows (at [181](1) and (2)):

  • The insured is entitled to make the relevant non-Side C claims under the Year 2 Policy by reason of the continuity clause. This was because the insured was aware of the facts that might give rise to a claim in the prior policy period but failed to notify those facts to the Year 1 insurer; and
  • The Year 2 Insurers are entitled to rely on any pre-inception non-fraudulent non-disclosure or misrepresentation (if otherwise made out) in relation to the Side C claims for the purposes of a s28(3) reduction in liability. In other words, notwithstanding the existence of the continuity clause, the insurer’s s28(3) rights effectively trumped continuous cover in respect of the Side C losses.

Whether the erosion of the Year 1 Policy’s Limit is to be factored into any reduction of the liability of the Year 2 Insurer.

In CIMIC, Peden J (at [179] - [180] and [181(3)]) ruled that the insurer was not permitted to obtain the benefit of the erosion under the prior year limit. Specifically, her Honour stated at [180]:

‘…the proper construction is that payment for a cl5.3 [continuity] claim is made under the [Year 2] Policy, but applying the [Year 1] terms, including the [Year 1] Limit of Liability, without regard to payments that had in fact been paid pursuant to the [Year 1] Policy…’ (underlining added)

Applying her Honour’s reasoning to our example set out above, the Year 2 Insurer would not be able to assert that the $4 M payment for Claim A under the Year 1 Limit (notionally) eroded the Policy Limit of the Year 2 Limit by the same amount and therefore, the Year 2 Insurer was only obliged to pay out $1 M for Claim B. In other words, the moral hazard issue would not be extinguished.

Whether the existence of a continuity clause in a Year 2 Policy, coupled with the existence of a contractual deeming provision in the Year 1 policy, entitles the Year 2 Insurer to bring a contribution claim against the Year 1 Insurer based on dual or double insurance.

Dual insurance applies where more than one policy responds to the same loss and if so, an insurer is entitled to seek equitable contribution from the other insurer.

In CIMIC, the Court found that:

  • an internal file note regarding suspected bribery was a circumstance which could have been notified by the insured before the inception of the Year 2 Policy
  • If the insured had done so, the Year 1 Insurers could have been liable for the losses later incurred by the insured; and
  • AIG (as one of the Year 2 insurers) was entitled to equitable contribution of 50% from the two of the Year 1 insurers (Swiss Re and Berkeley) and to rely on s54 to cure the late notification.

In this respect, the existence of a deeming provision in the Year 1 policy was pivotal as this provided the pathway for a late notification of circumstances to be made to the prior year insurers in reliance on s54 and the Australian Hospital Care authority referred to above – that is, the omission to notify the Year 1 Insurer could be cured.

If this determination survives the appeal process, it will be a game changer for the industry and have significant ramifications for financial lines insurers in the underwriting and pricing of risks on the one hand, and the management and reserving of claims on the other hand. As things presently stand, the question is no longer ‘which Policy year applies?’ but rather ‘how many Policy years apply?’ This would seem to be a novel outcome in the context of claims made policies but contribution claims between different years of account may become more prevalent and extend the tail further on long tail claims.

Further, leaving aside dual insurance claims, the CIMIC decision also highlights that more than one year of account may be exposed to different losses flowing from the same subject matter.

 

While these discussion points are not intended to be exhaustive, it provides a flavour of some of the issues that have emerged so far.

Conclusion

While there are obvious benefits to continuity clauses, insurance industry participants should consider the consequences of the CIMIC decision and review Policy wordings to ensure that they are fit for purpose and reflect the relevant underwriting intent. Otherwise, they may lead to unwelcome surprises for insureds, brokers, insurers and reinsurers alike.

Further information / assistance regarding the issues raised in this article is available from the author, Michael Polorotoff, Partner or your usual contact at Moray & Agnew.

[1] Also known as continuous cover clauses.
[2] FAI Insurance v Australian Hospital Care [2001] HCA 38.
[3] Gosford City Council v GIO General [2003] NSWCA 34. A helpful survey of the key authorities on this issue is set out in Uniting Church v Allianz [2023] FCA 190 at [542] – [553] per Lee J.
[4] This also extends to a renewing insurer.
[5] Having said that, it is common for continuity clauses to include a carve out to the effect that an insured cannot rely on such clauses if there has been a fraudulent non-disclosure or misrepresentation.
 

The content of this publication is intended to provide a summary and commentary only. It is not intended to be comprehensive nor does it constitute legal advice, and has been prepared based on applicable legislation at the date of publication. You should seek legal advice on specific circumstances before taking any action.

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