Part One: Foundations of Insurance Law and Regulation I. The Role of Information a. Core Insurance Concepts i. Risk Aversion – quantifies the premium that an individual or organization is willing to pay to avoid a given risk. Schwarcz’s Hypothetical: choice between paying $80 or facing a five percent chance of paying $1500 (expected value is $75): 1. Risk Averse Person – chooses the $80, even though the expected value is only $75. He is willing to pay the $5 premium over the expected value to be sure that he is covered against the loss. 2. Risk Neutral Person – chooses to face the loss. The expected value is less than the cost of insurance, so a risk neutral person would not want to pay $80 to avoid it. (A gambler would also choose this option). ii. Risk Aversion increases with the amount of the risk – people tend to be more averse to risks where the risk of loss is greater. (If it was $800 for a guarantee against a 5% likely, $15,000 loss, more people would be likely to opt for the insurance). iii. Risk Transfer – the act of buying insurance is a form of risk transfer. You pay somebody else to take on your risk. This is the insurance business. Insurance companies are in the business of transferring risk. iv. Risk Spreading – Insurance companies make their money by taking on other people’s risks in large numbers. Consider insuring one person against a $15,000 loss, where the loss is 5% likely. The insured pays you $800. You now have a 95% chance of making $800, but a 5% chance of being out $14,200. If, however, you take on a thousand such bets, you can become more and more assured that 5% of the losses will happen. Thus you can expect to pay $750,000 in claims, and can expect a $50,000 profit. v. Risk Reduction – Insurance also has the effect of reducing risk for policyholders, which in turn creates moral hazard. vi. Risk Allocation – Part of the job of insurance companies is to allocate risk. The riskier the policyholder, the higher the premium that policyholder should pay. The problem lies when policyholders do not accurately disclose their riskiness. This is the problem of adverse selection. b. The Law of Warranties, Misrepresentation, and Non-Disclosure i. Vlastos vs. Sumitomo Marine & Fire Ins. Co. – Fire occurred in a commercial building that Vlastos owned. Vlastos was denied recovery by the insurance company because she had warranted that the sole occupant of her third floor would be a janitor. ii. No Warranties – in insurance, misrepresentation law will govern a policyholder’s misrepresentation or nondisclosure, even if the insurance tries to invoke the stronger protection of warranty. iii. Voidability of Insurance Contract – Insurance contracts are voidable as a result of a policyholder misrepresentation only if: 1. The misrepresentation is material and fraudulent; II. 2. there is actual reliance by the party seeking to void the contract; 3. and the reliance was reasonable. iv. Materiality defined – materiality can be interpreted as increase in hazard or as contributor to loss. v. Scienter – some states add a scienter requirement, or reduce the remedy if there is no scienter. vi. Policy – The Role of The Agent - the strict application of misrepresentation rules when agents fill out applications may help respond to the risk of post-claim underwriting. The Role of Contracts a. Contract Law Foundations i. Formation – contracts are formed via mutual assent between contracting parties, typically through offer and acceptance. ii. Interpretation – contracts are interpreted on the basis of party intent, which is generally ascertained based on the objectively reasonable meaning of the parties’ actions and writings. iii. Extrinsic Evidence – cannot be used to contradict or supplement a final, complete written contract. (This is the parol evidence rule). 1. Some courts - Extrinsic evidence cannot be used to interpret a final and complete written contract unless the written contract is ambiguous. b. Interpreting Insurance Policies i. Formation of Insurance Policies – insurance policies are typically formed by an insurer sending policy after application, and policyholder retaining policy. 1. *Binder – a temporary policy that can span a gap between an insurance application and final policy. Binders are not subject to the parol evidence rule because they are not fully integrated agreements. ii. Contracts of Adhesion – Insurance contracts are essentially “super” contracts of adhesion. Contracts of adhesion are characterized by: 1. Standard forms 2. Complex, non-transparent terms 3. “Take it or leave it” offers 4. Inequality of bargaining power. iii. Rules of Interpretation – insurance contracts, and contracts of adhesion generally, are frequently subject to two interpretive doctrines: 1. Contra proferentem – the common law rule by which ambiguities are construed against the drafter of a contract. 2. Reasonable expectations – common law doctrine in which ambiguities are construed based on the reasonable expectations of the parties. c. Contra proferentum – the core rule of insurance interpretation. Numerous arguments can be made to determine whether a policy is ambiguous coverage it provides. i. Vargas v. [insurance company] 1. Plaintiffs’ airplane crashed on a trip to the Caribbean. They had an aviation insurance policy which applies “only to occurrences, accidents, III. or losses which happen within the USA, its territories, or possessions, Canada, or Mexico.” 2. Plaintiffs’ also later signed an endorsement: “limits set forth in the conditions of this policy are extended to” cover flights to the Bahamas. ii. Potential sources of ambiguity 1. Multiple meanings of an individual word 2. Reading contract as a whole 3. Apparent purpose of contracting parties 4. Perfectability of contract language (in other words, if it was possible to draft the language more clearly). 5. Reasonable expectations of parties 6. Extrinsic evidence (if permitted by court under its version of parol evidence rule) 7. Unreasonable implications of language iii. Stone Container 1. Boiler and machinery policy covered accidents to specific machinery. Contained exclusions for losses caused by “explosions.” Additionally, an exception to the exclusion “for loss caused by or resulting from an explosion of an ‘object’ of a kind described below… Explosion of any (1) steam boiler; (2) electric steam generator; (3) steam piping; (4) steam turbine; (5) steam engine; (6) gas turbine, or (7) moving or rotating machine [if the explosion is] caused by centrifugal force or mechanical breakdown. d. Reasonable Expectations Doctrine i. Reasonable Expectations Doctrine – the objectively reasonable expectations of applicants and intended beneficiaries regarding the terms of insurance contracts will be honored even though painstaking review of the policy provisions would have negated those expectations. ii. Restatement (Second) Contracts, 211 – “where the other party has reason to believe that the party manifesting such assent would not do so if he knew that the writing contained a particular term, the term is not part of the agreement.” iii. Atwater e. Intermediaries i. Agency law – agents act on behalf of a person or a corporation (a principal) if: 1. The Role of Regulation Part Two: Specific Lines I. II. III. IV. V. VI. Property Life Health Disability Liability Auto General Liability Insurance (CGL and HO) -the insuring agreement -exclusions Expected or intended injury Business risks exclusion Claims Made Liability Insurance D&O Insurance. GLI excludes BI or PI “expected or intended from the standpoint of the insured.” - Subjective test that reqruies awareness of substantial probability or harm. Can conflict with victim compensation Can result in strategic pleading. Unigard – school / insurer alleged negligent fire, negligent failure to supervise, but no suit for intentional torts. - Intentional torts are much less important and negligence because of the structure of liability insurance. In this way liability insurance shapes the law in action. Liability insurance typically only covers occurrences, requiring an accident. o May be different burden of proof because in trigger. Issues arise when BI/PI expected / intended is different than BI/PI that occurs. o Default rule is often that injuries must be of the same type for exclusions to apply. Pg. 19 of the homeowners policy purports to apply “whenever bodily or property damage is expected or intended, irrespective of whether the ultimate is a different kind quality yor degree” – seemingly captures the Unigard situation. Unigard ultimately comes out in a manner that is favorable for the first party insurer of the school because the coverage can be severable. - If bodily injury or property damage is expected or intended by one insurer, that doesn’t necessarily invalidate coverage for another insurer. Hartford fire – subject to antitrust laws where they want to move CGL to claims-made system. Med mal is typically provided on a claims made basis. Corporation can’t indemnify for a derivative suit – so that’s what D&O insurance is for. - Side a exists for situations where the corp is in bankruptcy and cant indemnify, and for derivative suits in which the corp cannot indemnify by law. Side b is company indemnity and reimbursement by the insurer Side c is coverage for the entity itself. If the company is sued for a securities violation, d&o covers directors and officers, but side c covers entity. Alstrin illustrates the way that exclusions for claims based on criminal or deliberate fraud can go awry. Does D&O undermine securities regulation? - - Protect investors AND deter directors. Officers continually engaged in fraud will have higher D&O premiums; company has to factor in the cost of potential fraud when hiring directors and officers. o Fire D&Os o Insurer can police because they’re the ones exposed to risks Securities regulation deters to the extent that insurance companies price well, police well, and structure policies to preserve the deterrent effect of the law. In order to gauge the effectiveness of securities regulation, have to examine insurance companies. Notwithstanding D&O insurance, criminal penalties can apply, reputational penalties. Raytheon – prior and pending litigation exclusions - Securities claim, ERISA claim brought concurrently Rationale for PPL exclusion – information asymmetry between the company and the insurer (causes adverse selection) – the insurer doesn’t know about the exposure to additional claims on the same facts. Notice and Circumstances Provision Rationale - Adverse selection concerns Coverage limits are defined per occurrence – hence companies want to treat all claims arising out of a set of facts as arising in the same point in time. BABY’S POINT – encourages early reporting.
