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Pro rata condition in insurance policy held ineffective

In a judgment involving compensation under an insurance policy, the Supreme Court of Poland has held that a pro rata provision was invalid because it was disadvantageous to the insured and was included in the insurance conditions unilaterally by the insurer as the party with the stronger contractual position.

Supreme Court of Poland judgment of 28 May 2019, case no. II CSK 454/18

The judgment is important for two reasons. First, the Supreme Court questioned the permissibility of an insurer’s inclusion of a pro rata condition. Second, in this case the insured was a company, meaning that the provision in question did not fall under regulations on abusive clauses in consumer contracts.

Pro rata condition of average with underinsurance

The case involved compensation for loss of property due to a fire. The plaintiff was the owner of a park and palace complex, where it operated a hotel and restaurant. The plaintiff had taken out insurance against fire and other risks for the buildings, other structures, machinery, equipment, and fixtures on the property.

The insurance policy provided a separate sum insured for each category of property. The sum insured for the fixtures corresponded to the cost of purchase or production of items of the same type and capacity, plus costs of transport and installation. Thus the replacement value was insured.

Additionally, the general conditions of the insurance included what is known as a “pro rata condition of average,” i.e. a provision indicating that if the sum insured, in a fixed amount (according to the replacement value) is lower than the actual value on the date of the loss—in other words, the item was underinsured—the amount of compensation will be reduced pro rata to reflect the underinsurance, i.e. multiplying the amount of the loss by the fraction of the sum insured divided by the value of the insured item on the date of the loss. The pro rata condition would apply only if the value of the insured item on the date of the loss exceeded 120% of the sum insured for that item.

After issuance of the insurance policy, a fire occurred at the property in which a portion of the palace burned and some of the fixtures in that building were wholly or partially destroyed. During the claim adjustment process, the value to rebuild the fixtures was determined to be 139% of the sum insured. Thus the items were found to be 28% underinsured, and the compensation was set at an amount reduced pro rata to reflect the degree of underinsurance.

To summarise the litigation in the lower courts, the insured filed suit demanding the difference between the sum insured and the amount of compensation set by the insurer. The regional court upheld the claim, but the court of appeal granted the insurer’s appeal and denied the claim. The court of appeal shared all of the factual findings made by the regional court, but rejected its legal ruling that it was impermissible for the insurer to apply the pro rata condition in the event of underinsurance.

The insured filed a cassation appeal with the Supreme Court of Poland, disputing the infringement of substantive law relied on by the insurer in its appeal, including Civil Code Art. 824 §1 (damages cannot exceed the loss) and Art. 805 §1 (the nature of an insurance contract), also in connection with Art. 3531 (freedom of contract and its limitations).

Two-stage reduction of compensation not allowed

The Supreme Court agreed with these allegations. It held that generally it may be permissible to include in an insurance policy a pro rata condition in the case of underinsurance, but in the circumstances of this case the manner in which the provision was included was impermissible.

The court held that the pro rata condition cannot result in a two-stage reduction of compensation. It was not permissible to have a first stage consists of reducing the extent of the loss and the compensation to the amount of the sum insured, followed by a second stage where the compensation was further reduced pro rata to reflect the degree of underinsurance of the insured item compared to its actual value on the date of the loss. According to the findings made in the case, this was how the general conditions of insurance were interpreted and applied by the insurer in the claim adjustment procedure—although, in the Supreme Court’s view, the provision of the policy introducing the pro rata condition was not worded unequivocally.

The court held that under the circumstances of the case, this solution was unacceptable. According to the insurance policy, if the sum insured were set properly (equal to the value of the insured item), the insurer should be prepared to pay compensation equal to the sum insured if the insured item is totally destroyed (total loss), or in an amount close to the sum insured if the degree of partial loss is close to a total loss.

As the insurer had taken this obligation into account when setting the premium, it was unfair for the insurer to apply a two-stage reduction of the compensation paid out under the policy. In the court’s view, this solution was inconsistent with the nature of an insurance contract, which consists of a link between the amount of the sum insured and the premium. This inconsistency resulted in the invalidity of the terms of the general conditions of insurance providing that in the event of underinsurance, the underinsured would receive—regardless of the extent of the loss—compensation in an amount equal to the percentage of the sum insured corresponding to the ratio of the sum insured bears to the value of the insured item (Civil Code Art. 58 §1 in connection with Art. 3531). This invalidity did not affect the rest of the insurance contract.

Significantly, the Supreme Court also pointed out that the earlier case law did not absolutely exclude the permissibility of applying a pro rata condition in the case of underinsurance. The views expressed in the recent cases restricting this possibility applied to provisions in contracts with consumers, covered by the regulations on prohibited clauses, or in dealings with individual business operators (to whom the regulations on prohibited clauses apply as relevant, under Civil Code Art. 805 §4). Disagreeing with the insured, the Supreme Court stated that there was no basis for holding the pro rata conditions reserved by insurers as impermissible in every case. The court also stressed that the peculiar nature of insurance law draws on a long insurance tradition and respect for common principles and values adopted across numerous European legal systems. The court aptly pointed out that in this tradition, the pro rata condition is a recognised rule in the case of underinsurance, as reflected for example in Art. 8:102(2) of the Principles of European Insurance Contract Law (the insurer “shall be entitled alternatively to offer insurance on the basis that the indemnity to be paid shall be limited to the proportion that the sum insured bears to the actual value of the property at the time of the loss”).

Conclusions for insurers

The Supreme Court of Poland did not hold that it is impermissible in every case for insurers to include a pro rata condition in their policies. The court did indicate, however, that the insurer must first and foremost comply with its informational and advisory obligations in relation to determination of the sum insured. The insurer must display due care in performing these obligations. Similarly, it must ensure the essential clarity, understandability, transparency and predictability of results of a provision introducing a pro rata condition with respect to the amount of the loss the insurer will be required to pay.

Dr Marta Kozłowska, adwokat, Dispute Resolution & Arbitration practice, Wardyński & Partners