Winds of Change

Residual value insurance is regarded as archaic. Reforms being
drawn up, however, may bring it up to date

The diversification of the leasing industry, along with the
increased prevalence of operating leases, has led to the further
development of residual value insurance products on the

A residual value insurance policy is not the same thing as a
guarantee of residual value. The policies available to lessors have
frequently been very far from being guarantees, and offer the
insurer a number of potential opportunities to escape liability.
Lessors accepting policies without taking proper legal advice on
the substance of the policy have run the risk of purchasing a
worthless policy – or, at best, one where it may be at the
discretion of the insurer as to whether claims are paid.

Insurance contract law in the UK has frequently faced criticism
for being rather archaic.  While over the years there has been
a general evolution of contract law, the century-old Marine
Insurance Act 1906 remains the statutory basis for insurance law.
In July 2007, the Law Commission in England and Wales and the
Scottish Law Commission released a joint consultation paper
considering insurance contract law. It is hoped that the
culmination of this paper (and the three coming before it) will be
an Insurance Contracts Act which has been proposed for
incorporation into law in 2010.

Lessors face two main areas of exposure with residual value
insurance. First, all insurance policies are subject to a number of
terms which are implied into them automatically on the basis of
case law – of which the insured may be quite ignorant – unless
those terms are specifically excluded by agreement. Secondly, most
insurance policies are drafted in terms that a minor breach may
entitle the insurer to walk away from the policy.

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Implied terms

Unless excluded by agreement, an obligation of utmost good faith
is implied into insurance policies. The obligation continues
throughout the duration of the policy, including in relation to
claims. There is a separate obligation to disclose fully all
material facts without misrepresentation. Breach of either
obligation will allow the insurer to avoid the policy. The contract
will be treated as though it never existed, with the premium being
returned – clearly an attractive remedy for an insurer faced with
large losses. 

The insured has the obligation to disclose because the insured,
in theory, knows more of the facts relevant to assessing the risk
than the insurer. The difficulty the insured faces is knowing
exactly what is material; it will be deemed to know all facts which
it should have known but did not or those that it could have
ascertained with reasonable enquiry. The obligation is open ended
and allows the insurer to claim non-disclosure in many
unanticipated circumstances. This obligation can only be excluded
by agreement with the insurer stating that it is happy to rely on
its own risk assessment and what has been expressly disclosed in

Breach of policy terms

Many insurance policies contain a list of “conditions”. A breach
of condition by one party allows the other to terminate the policy.
Even though a term may relate to a trivial matter, it is open to
the parties to agree it is a condition (regardless of what a court
might think). An unsuspecting lessor might find its policy
unenforceable because it has, for instance, agreed a change to the
terms of a lease which, although immaterial to residual value
issues, will constitute a breach of a condition requiring it not to
vary the lease.

The future

These dangers may soon be negated for lessors taking out
residual value insurance if the Law Commissions follow through
their proposals. The Commissions have suggested the introduction of
a default regime applicable to all business insurance based on
generally accepted industry standards. The proposal is that any
insured should be entitled to be paid a claim if it can be proved
that, on the balance of probabilities, the event or circumstance
constituting the breach did not contribute to the loss. 
Businesses would be free to contract out of this default position
if they wished though. 

While still allowing business insureds to contract out of even
their most basic rights, this will be subject to sensible controls,
with the policy being written on the insurer’s standard
terms.  The ability of businesses to ‘contract out’ preserves
their freedom to contract. However, it is proposed that any insurer
would not be allowed to rely on a standard term to alter the
default rules if it meant that the policy cover was substantially
different to what the insured reasonably expected. This question
would be judged in the light of the way the policy was presented
when it was arranged. The proposed controls on standard term
contracts mean that an insurer must ensure that the business
insured’s ‘reasonable expectations’ of cover are not defeated.

Businesses would still have a duty of disclosure.  However,
it has been proposed that the test for materiality should no longer
be whether a fact would have an effect on the mind of a prudent
underwriter, but whether a reasonable insured would understand the
fact to be material to the underwriter in question.

Should the Commissions’ proposals be adopted, the statute would
provide significant protection for the business insured whilst
still retaining the freedom to contract.

The author is a partner at the law firm Watson Farley &