Insurance for Lawyers 201

Introduction to Advanced Risk Management

Review

• So far, we have been discussing the Insurance Service Office and the Commercial Package Policy.

• The CPP is a bundle of coverage parts.– Commercial General Liability– Special Liability Parts– Property Coverage– Business Income

Review

• The big distinction in insurance is between First Party and Third Party.– Keeping the distinction in mind helps avoid

confusion.– First Party Insurance pays the policyholder or its

designees.– Third party insurance pays people other than the

policyholder.• No cross-insured coverage

Review

• RTFP• There is no substitute for reading the policy– Certificates and indications do not mention the

exclusions.– Even without exclusions, there can be sub-limits

that can make coverage less valuable.– It’s the only way to know what is and what is not

covered by the insurance.

Excess and Umbrella

• These are not the same, even though clients and courts sometimes use these terms interchangeably.

• Insurance Companies contribute to the confusion: there are policies out there that are called Umbrellas even though they don’t cover anything that is not covered by the primary.

• In our discussion, I will refer to true umbrellas as such and to excess as such as well.

Umbrella

• Umbrellas serve three purposes:– Increased amounts of coverage under primary policies

(CGL, Auto, etc)– Replace primary coverage if aggregate exhausted– Broaden coverage for some risks not covered by primary

• Under an excess policy, if a risk is not covered by the primary, it’s not covered by the Excess.

• Umbrellas cover risks not covered by the primary, and not excluded by the Umbrella, but subject to a self-insured retention (typically $250,000)

Tower of Coverage

Excess

• Two basic policy forms exist:– Follow Form– Standalone

• Follow Form incorporates the underlying insurance into the excess policy:– In consideration of the payment of the premium and in reliance

upon all statements made in the application including information furnished in connection therewith, and subject to the terms, definitions, conditions, exclusions and limitations of this policy, the Insurer agrees to provide insurance coverage to the Insureds in accordance with the terms, definitions, conditions, exclusions and limitations of the Followed Policy, except as otherwise provided herein.

Excess

• A standalone policy contains all of the terms and conditions within its four corners.

• Some policies are hybrids, covering some risks on a Follow Form basis, and others as Standalone.

• Excess policy is triggered when the underlying insurance is reduced or exhausted.– Excess policy pays the amount of covered losses in excess of

the reduced coverage from the underlying insurance.– If primary is exhausted, the excess drops down and

becomes primary insurance, subject to a self-insured retained amount (usually $250,000).

Specific/Aggregate Excess

• Specific Excess is seen with Self-Insured Workers’ Compensation.

• Policyholder retains an amount, say $100K, per workers’ compensation claim.

• If a claim comes in that costs $150K, then the policyholder pays the SIR of $100K and the excess pays $50K.

• If ten claims come in for $99,000 each, the policyholder pays $990,000 because none of the claims exceeded the $100K per claim trigger.

Supported/Unsupported Umbrella

• Supported Umbrella sits excess of the insurance company’s primary policy.– Disadvantage: some companies do not want to

take on this large a share of the risks– Advantages:• Underwriting can be coordinated to avoid gaps• Claims handling can be expedited• Excess insurance company can reside confidence in the

information it receives regarding the primary risk and coverage

Umbrellas Are Variable…RTFP

• Some umbrella forms provide for Part A and Part B coverage. This does not mirror the CGL’s Part A and Part B. Instead, umbrellas that use this format are combination policies, in which Part A addresses coverage when the underlying policy covers the loss, and Part B addresses coverage when the underlying policy excludes the loss.

• Look carefully when reviewing ANY umbrella policy to understand whether and when it drops down, and what retention applies to a dropping down.

More Variations….• Ultimate Net Loss may include defense costs, a backhanded way of making

defense inside the limit.• The umbrella may have its own definitions of bodily injury, property

damage, personal injury, and advertising injury that may not line up exactly with the underlying policy. This creates headaches when trying to show that the underlying limits have been exhausted, but bear in mind that if the Umbrella covers an injury to “bodily injury” that is excluded from the CGL layer, then the Umbrella should drop down. The policyholder takes the hit for a larger self-insured retention, but the umbrella should respond.

• The umbrella may have a different trigger than the underlying policy: the excess is triggered by the wrongful act rather than the injury. Gaps may result. Moreover, if the policyholder has changed insurance companies, you might omit to give notice to the correct insurance company. Other policies adopt the trigger of the underlying policy. If that includes a claims made policy, pay attention to the retro dates of the policies (they should match).

Still More Variations…• Umbrella same as Underlying• Umbrella omits some exceptions. E.g. auto, which is excluded from CGL, but umbrella

is often written to be excess of auto coverage. Other umbrellas omit exclusions in order to broaden coverage (e.g., pollution, dram shop, accidents outside the US and Canada)

• Umbrella uses less restrictive versions of underlying exclusions. Watercraft and aircraft; property in care, custody or control often excluded (absent an express agreement to insure, signed before the loss occurs), but this loosening of the policy is generally endorsed-out in the case of contractors’ policies.

• Umbrella uses more restrictive versions of underlying exclusions. Pollution is sometimes excluded but at other times is covered. RTFP

• Punitive Damages• Cross-liability exclusion• Broad as Primary endorsement• Contractors’ Limitation Endorsement• Following-form endorsements

Excess and Umbrella Final Thoughts

• Maintenance of Underlying Insurance– Some umbrellas will not drop down if required underlying coverage not maintained– Others respond “as if” it had been maintained, i.e., policyholder absorbs all payments

and costs that would have been covered– If defense is outside the limit, this can be very expensive, because defense costs

continue under the primary until the limit is met by indemnity payments.• Concurrency. Inception and expiration of underlying and excess/umbrella

should match. Otherwise the years will be confused and it will be challenging to find the trigger.

• Coverage Territory: often worldwide coverage so long as suit is filed in US or Canada

• Structuring the Liability Insurance Program– Layering. Buffers. Gaps.– Are the limits adequate?

• DON’T ADVISE ON LIMITS UNLESS PRESCRIBED BY LAW

Self-Insurance

• Fundamentally, no insurance at all.• When a risk is uninsured, it is said to be a

retained risk.• Risk retention can be accidental, as when the

risk was supposed to be covered but isn’t, and planned, as when a policyholder decides to pay for workers’ compensation losses up to $100K per claim.

Self-Insurance

• Self-Insurance is planned. – It reflects the policyholder’s tolerance for risk.– Self-insurance is generally not a solution for

policyholders exposed to catastrophic losses.– Some categories of loss are predictable. Slip-and-

fall losses are largely a function of the volume of foot traffic.

– A combination of self-insurance with targeted coverage on Black Swan events is a common goal.

Self-Insurance

• Can be as informal as “going bare” or as complex as hiring a TPA to administer claims, give notice to umbrella and excess layers.

• Loss control takes on special significance in a self-insured program.

• Some excess insurers simply will not write in excess of “nothing,” so policyholders sometimes purchase a million-dollar policy with a million-dollar deductible. The market for excess coverage over self-insurance is much narrower than the market for excess over primary coverage.

Self-insuranceSelf-Insurance Noninsurance

All or a part of a risk is retained, resulting in lower insurance premiums.

All or a part of a risk is retained, resulting in lower insurance premiums.

The plan is part of a conscious decision to retain losses.

There is no awareness of the retained exposure to loss.

It often involves the purchase of excess insurance over self-insured retention (SIR) levels.

There is no consideration of purchasing excess insurance.

SIR levels are periodically reviewed to establish the optimum arrangement.

There is no consideration of optimizing the arrangement.

There are predetermined methods of handling claims and paying losses.

There are no predetermined methods of handling claims and paying losses.

The plan includes a record-keeping and reporting system for claims and loss information.

There is no specific record-keeping system.

The plan offers a high degree of control over claims handling functions.

There is no preloss consideration of controlling claims handling functions.

It results in greater awareness and incentives for safety and loss control efforts.

It does not provide greater awareness of the potential

Self-Insurance

• Some self-insurance programs are limited by law (workers’ compensation, auto liability) or practical concerns.– Some clients may be uneasy with self-insurance.– In construction, the policyholder can include insurance

premiums in the cost of the work; but self-insured reserves and allowances may not be chargeable: it may be more profitable to buy insurance than to self-insure in these cases.

– Tax treatment of self-insurance may be troubling. Policyholder may take a contra-income charge (similar to an allowance for bad debts) but most of these advanced techniques call for tax counsel as well as risk management.

Large Deductible Plans

• Large Deductible Plans– Deductible amounts of $250,000 and more are in

this category.– Resembles self-insurance but • insurance company administers claims and • the program does not require state approval. • Frequently a component of construction insurance wrap-

ups.• Aggregate cap or “stop loss” provisions are often

included to prevent the deductibles from ruining the policyholder.

Large Deductible Plans

• Insurance company pays the loss even if the policyholder does not reimburse. – But RTFP: some “large deductible” endorsements actually create a

self-insured retention, which can have a major impact on wrap-up programs.

– When the plan has a true deductible, the insurance company will demand an escrow or other financial assurance that the deductible will be reimbursed.

– Often seen in conjunction with Retrospectively-rated programs.

Captives• Insurance company owned by one or more parents that insures only the

parents. – Similar to mutual insurance but much smaller and policyholder-owners

contribute the captive’s capital– Captive can be owned by a single company = “Pure” Captive. Alternative is a

“Group” Captive– Can be “direct” or “indirect.” Direct captives issue policies to their policyholders

and frequently reinsure their exposures. Indirect Captives are reinsurers.• D. Risk Retention Groups are a special form of captive in which all

of the owners must be policyholders, and all policyholders must be owners. RRG and the closely-allied Risk Purchasing Groups are part of the federal response to the “Tort Crisis” and covered by the Liability Risk Retention Act of 1986. Statute permits an RRG licensed in one State to cover risks in all States.

Captives• Pros:

– Control– Tailoring coverage to the owner’s needs– Cost stabilization: cost of insurance does not rise due to hard market conditions– Taxation. Captives enable access to a variety of tax advantages tied to the

timing and recognition of expenses. Calls for its own presentation..• Cons

– Expensive to set up– Required capital must be maintained. – Requires management attention. Captives must be run like true insurance

companies.– Some captives accept business from non-parents in order to satisfy Treasury

Regs on deductibility of premiums paid to captives. This practice has been known to result in the captive failing financially due to the less-controlled risks introduced by the outsider.

Reinsurance

• A way for an insurance company to spread the risk around is to purchase insurance from another company to cover part of a loss.– Important for catastrophic exposures.– Reinsurance companies are often “offshore.”– May permit an insurance company to offer higher

limit of liability than permitted by company practice or state controls.

Reinsurance

• Two Types of Reinsurance– Treaty or Cession: the seller of reinsurance

commits to take on an agreed percentage of risks that are covered by the treaty.• Individual risks are not rated, but are accepted

automatically.

– Facultative: seller of reinsurance evaluates each policy on its own merits.

• Ceding company retains a percentage of the premium as a commission.

Reinsurance

• In keeping with the role of reinsurance as insurance for insurance companies, two coverage extensions are available:– ECO:

• the costs related to a "declaratory judgment" ruling if a coverage dispute develops with an insurer

• or a bad faith award (including punitive damages) against the insurer resulting from its alleged improper claims handling practices.

– XPL: excess of policy limits—pays losses in excess of policy limits

Reinsurance

• Proportional– Quota share: ceding company transfers the agreed

percentage of each policy covered by the treaty.– Surplus share: ceding company transfers a percentage

of each policy in excess of a retained.• Nonproportional– Excess of Loss insurance indemnifies the primary

insurer for losses in excess of a stated retention.– The limits can be per occurrence, per risk, or

aggregate.

Reinsurance

• The beneficiary of the reinsurance policy is the insurance company that wrote the underlying layer.

• Policyholder has no privity of contract with the reinsurance company and therefore cannot maintain an action.

• “Cut-through” or “Direct Access” terms can be endorsed onto the reinsurance policy but for a price.

Fronting

• Used by non-admitted insurers to issue policies on New York objects and activities.

• Policyholder actually purchases the coverage from an admitted insurance company that would not touch the risk…

• Company cedes (reinsures) the risk, or most of it, to the non-admitted insurance company.

Fronting

• Can be used by a company that needs insurance services but not insurance coverage. – Policyholder promises to indemnify insurance company for

any losses incurred. – Functionally similar to a policy where the limit of liability is

equal to the dediuctible. – For example, one can do this with Equipment Breakdown

Insurance in order to obtain the boiler inspection services these companies provide.

– Also may obtain loss control services, claims management, crisis services and like add-ons to the basic core insurance services (defense and indemnity).

Fronting

• Can be used by self-insurers to provide legal evidence of insurance.

• Gives the policyholder access to a broader market for excess insurance, because the primary layer is written by a “real” insurance company.

• Can conceal the financial weakness of the real insurance company

Fronting

• In New York, use by non-admitted insurance companies should cease.

• This is because the “Free Trade Zone” in New York has undergone tremendous expansion.

• Any commercial lines policy that generates $50,000 in annual premium or $25,000 for any coverage part or line of coverage, may be sold directly on a surplus lines basis.

• Henceforth, Fronting should be scrutinized carefully.

Retrospectively-rated Policies

• “Rating” is the process of determining the price to be paid for the coverage.– Ratings are normally based on the nature of the

policyholder’s business and its volume.– Insurance company is always going to charge less

for sheep herders than for people who blow things up.

– Multiply the two factors together and you calculate the “deposit premium” that is subject to audit.

Retrospectively-rated Policies

• These are different because the deposit premium gets adjusted based on the actual loss experience encountered.