Insurance Requirements in Commercial Contracts (Part 5)

In the final part of our series, we will address certificates of insurance.  In Part 1, we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention.  In Part 3, we explained the difference in Loss Payee versus Lender Loss Payee status.  In Part 4, we discussed theft and crime coverage.

Business lawyers and deal makers are often given a Certificate of Insurance, which was typically prepared by the counterparty’s insurance broker on a standardized form (such as the Acord 25 form for liability insurance and the Acord 27 for property insurance).

Certificates of insurance should be considered, at most, to be a snapshot in time. They are a document that evidence that on a particular day, a particular insured had the insurance in place which is generally described on the certificate. However, the certificate will typically not note important exclusions. It will not discuss the deductible on the policy or whether it is actually a self-insured retention. And, if the insured cancels the insurance the very next day (or alters the coverage limits), the certificate holder will typically have difficulty finding out that the certificate represents a policy which is no longer in effect.  

Additionally, the “boilerplate” on these forms should be carefully read and considered by anyone who receives one. Certificates of insurance typically state that they are issued only for information purposes, and that they confer no rights. Certificates of insurance are not contracts, and they are especially not insurance contracts. Certificates of insurance, as the disclaimers plainly state, do not change the coverage that the actual policy provides.  

Because of this strong disclaiming language, and the fact that the certificates are usually prepared by the insurance broker, the certificates are unlikely to be binding on the insurer. When in doubt, also request a certified copy of the actual policy; do not rely on a certificate of insurance. If a counterparty balks at producing the actual policy, be concerned.

 Conclusion

This series was intended to shed some light on insurance provisions commonly encountered by transactional lawyers or deal makers when reviewing commercial agreements.  These are just a few of the commonly-encountered insurance provisions that commonly occur.  Often, the language used in commercial contracts (whether they be financing agreements, contracts, leases, or other documents) does not actually provide for the risks which the parties sought to cover or require insurance for. Poorly worded insurance clauses can cause confusion, can require commercially-unavailable insurance, or can simply frighten away customers with unnecessary requirements. If clients or counsel are unfamiliar with insurance, they should seek assistance from their own insurance brokers or an insurance lawyer.

Insurance Requirements in Commercial Contracts (Part 4)

Welcome to Part 4 of the Insurance Requirements in Commercial Contracts series.
 
In Part 1, we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention.  In Part 3, we explained the difference in Loss Payee versus Lender Loss Payee status.  Today's blog post is about theft and commercial crime coverage.

A secured lender may wish to require the borrower to obtain coverage for “theft” of the property (equipment, inventory, etc.) which secures the loan. Otherwise, the personal property could be stolen and the secured lender would be left without any collateral securing the financing.  

Ordinary property coverage will typically cover many types of theft, subject to exclusions and any special terms of the policy. At the same time, the insurer may require the insured (i.e., the borrower) to have certain physical security measures in place before writing the insurance, such as fences, locked gates, security cameras, or a monitored burglar alarm. The underwriter of the insurer will typically, either prior to writing the policy or shortly after inception, verify the existence of these physical security measures. These physical security measures not only assist the insurer in helping to prevent a claim, but ultimately also inure to the benefit of the lender who will be protected when the borrower maintains physical possession and custody of the items securing the loan. However, in many cases these policies will contain an exclusion for employee theft. This is significant because, by some estimates and depending on industry, up to 80% of workplace crime is the sort of insider theft/white-collar fraud conducted by a company’s own employees. 

A commercial crime policy, often described as a fidelity bond or fidelity insurance, is designed to insure against criminal acts of a company’s own employees, as well as certain other criminal acts by non-employees. This policy is directly squarely at the theft of money, marketable securities, embezzlement, certain computer crimes, forgery, and other crimes which businesses are sometimes targets of and victims of. Dedicated crime coverage will also often cover other situations where a business is the victim, such as the receipt of counterfeit money or a financial loss which is the result of a forgery or facsimile signature. 

Like many types of insurance, a crime policy also serves as a type of credit enhancement to a lender. If a borrower already has a crime policy (or is required to obtain one) the borrower will be better able to weather an unpredicted criminal event and thus be better able to have the cash flows to service its debt obligations. 

While a crime policy will cost additional premium, it will provide much broader coverage in the event of criminal acts, particularly by “insiders” of the company such as employees, management, and often officers of the company. When drafting or insisting on contract terms which require the provision of “theft” insurance, the parties need to clarify whether the financing documents only require ordinary property coverage, or also require a commercial crime policy or fidelity bond.

Later this week we will probably post Part 5, the final installment of our series on insurance provisions in commercial contracts.

Will North Carolina follow Tennessee's memo on captive reinsurance transactions?

On October 22, the Tennessee Department of Commerce and Insurance adopted a memo which provides guidance to captive insurance companies domiciled in Tennessee regarding the credit obtained for reinsurance from unauthorized reinsurers. This is significant, not only because Tennessee and North Carolina are adjacent states (which to some degree compete against each other for captive insurance domestications and formations), but also because the statutory language of the North Carolina General Statutes and the Tennessee Insurance Code are identical.

Both Tennessee Insurance Code § 56-13-112 and North Carolina General Statute § 58-10-445 explain that: 

Any captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to reinsurers complying with this Chapter. If the reinsurer is licensed as a risk retention group, then the ceding risk retention group or its members must qualify for membership with the reinsurer. The Commissioner shall have the discretion to allow a captive insurance company to take credit for the reinsurance of risks or portions of risks ceded to an unauthorized reinsurer, after review, on a case-by-case basis. The Commissioner may require any documents, financial information, or other evidence that will allow an unauthorized reinsurer to demonstrate adequate security for its financial obligations.

In addition to reinsurers authorized by this Chapter, a captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to a pool, exchange, or association to the extent authorized by the Commissioner. The Commissioner may require any documents, financial information, or other evidence that such a pool, exchange, or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that in the Commissioner's judgment are necessary and proper to provide adequate security for the ceding captive insurance company and for the protection and benefit of the public at large.

 

 The memo from the Tennessee Department of Commerce and Insurance provides a regulatory gloss on the statute. It goes on to state that “Tennessee captives seeking to enter into a reinsurance contract with the same unauthorized reinsurer should likewise include the details of the proposed reinsurance agreement and its proposed business plan or submit a change of business plan.” This obviously has large implications for the risk pools operated by many captive managers.

The Tennessee memo then lays out five factors which it claims will be used in deciding whether to grant credit for reinsurance purchased from unauthorized reinsurers. These factors are:

• “The policy issued to the original named insured is issued by a traditional admitted domestic insurance carrier acting as a front.
• The reinsurance agreement is made upon secured collateral. This includes reinsurance agreements made on a funds withheld basis, via a domestic U.S. trust, or via a letter of credit issued by a reputable U.S. based financial institution.
• The reinsurance agreements are obtained from an accredited reinsurer as defined by Tenn. Code Ann. §56-2-208.
• Reinsurance is obtained from a reinsurer that is highly rated by a reputable rating agency.  
• The reinsurer has a paid in unencumbered capital and surplus of at least $20,000,000 and agrees to submit to Tennessee copies of its audited annual financial statements as well as copies of any examination report conducted by its home domicile.”

Two additional factors are also explained: Tennessee will provide additional weight to a reinsurer if it is “domiciled in a jurisdiction with a solid reputation for providing accountability and oversight to its insurers” and the Department will give weight to the “experience and reputation of the captive manager and other service providers selected by the captive owner.”  These factors, of course, beg the question as to what qualifies as a domicile with a "solid reputation."  Does this exclude all off-shore domiciles?  Will Tennessee consider any on-shore domiciles other than itself to be qualified?

This memo continues that “some captives choose to participate in reinsurance exchange pooling arrangements structured in any number of ways. When such pooling arrangements include scenarios where a Tennessee captive insurance company cedes risk to an unauthorized reinsurer, the Department will give the greatest weight to arrangements where the ceded premium is held in a domestic U.S. trust, or where all pool participants are managed by the same captive manager. Any type of proposed pooling arrangement should include information sufficient to satisfy the Department that adequate controls are present and that the pooling arrangement, and its participants, possesses sufficient liquidity and accountability.” 

The memo concludes by stating that the Department of Commerce and Insurance retains its discretion to grant credit for reinsurance on a case by case basis.

This memo is important because it applies a regulatory interpretation to statutory language that is identical to North Carolina’s captive insurance law.  It will be interesting to see whether North Carolina's Department of Insurance reacts in any way to this memo.  Even if North Carolina's regulators do not adopt the Tennessee memo outright, would they consider compliance with it as a "plus factor"?  Conversely, depending on whether Tennessee construes its policy memo narrowly or broadly could have implications for North Carolina's captive insurance industry.      

Insurance Requirements in Commercial Contracts (Part 2)

In this second post in the series, I hope to shed some light on the difference between an insurance policy with a deductible compared to one with a self insured retention ("SIR") and how that impacts business contracts. 

I have often heard people ask what is the difference in an SIR versus a deductible.  Confusion on this topic can have real-world impact when it comes to obtaining coverage under commercial contracts.

In Part 1, we discussed that bargaining for additional insured status may not always be equal to a stand-alone insurance policy.  Let's presume that a business bargained for additional insured status on a CGL or other liability policy.  The business then assumed it has coverage to defend and indemnify it against third-party tort claims, as if it had purchased its own insurance. However, if the liability policy is subject to a SIR rather than a traditional deductible, then the business will not obtain any coverage until the SIR is satisfied.  Further, the law is unsettled (depending on jurisdiction) as to whether only the primary named insured is permitted to satisfy the SIR or whether an additional insured can make a voluntary payment to satisfy the SIR, thus obtaining the coverage it (believed) it bargained for in an indemnity agreement or commercial contract. 

Deductibles and SIRs are often conflated; the differences are poorly understood by those outside of the insurance industry as well as the practical implications. Two policies can have a $1 million limit, with the only difference between the two policies being that one has a $100,000 deductible and the other a $100,000 SIR. Under an SIR policy, the $1 million of insurance only becomes payable after the $100,000 SIR is exhausted by the insured. In contrast, the deductible policy will typically immediately respond. Also, depending on the terms, the typical SIR policy will entrust the direction of the defense, appointment of counsel, and payment of legal defense costs with the insured, while the insurer typically retains control of directing the defense, appointing counsel, and paying defense costs under a deductible policy.

These simple distinctions have stark real-world implications.

First, under an SIR policy, no insurance coverage is required to respond until after the policyholder pays the full amount of the SIR. If the policyholder has cash constraints, is undercapitalized, or enters bankruptcy, it may not be able to ever exhaust the SIR (and thus there will be no requirement of the insurer to ever provide coverage to the policyholder or to any additional insureds).

Second, under a deductible policy, a policyholder is entitled to a defense (i.e., the insurer paying for an attorney and expert witnesses) as an additional insured. Similarly, the insurer immediately has a duty to defend. However, under most SIR policies, the insurer is not obligated to provide a defense and the insured(s) have to pay their own defense costs (which includes attorney's fees, expert witness fees, and other defense costs). Any business which has defended many lawsuits will know that the dollar value of defense costs can be significant and can, in many cases, exceed the costs to settle the lawsuit. The duty to defend typically does not arise under an SIR policy until after the SIR has been exhausted.

Third, as an additional insured under an SIR policy, your business's ability to obtain insurance coverage is predicated on the primary insured being able to pay the SIR. Even though you bargained to be an additional insured under the SIR, your business will receive no coverage until the SIR is satisfied. But wait . . . what if you volunteer to pay the SIR on behalf of the primary insured and thus trigger coverage? This offer of voluntary payment may not be enough; there is at least one case which prohibits the additional insured from satisfying the SIR in order to obtain additional insured coverage for itself.

Fourth, SIRs can change the way the total tower of insurance is calculated.  For example, a $1 million policy with a $100,000 deductible actually provides only $900,000 of indemnity from the insurer; the policyholder pays $100,000 and the insurance company pays $900,000.  However, a policy with $1 million in limits, subject to a $100,000 SIR, will often be written so that it provides for an insurance tower of $1,100,000; after the policyholder pays the first $100,000, the insurance policy is triggered and provides an additional $1 million for a total of $1,100,000.  If there is an excess policy sitting above in a tower of insurance, this difference can change when the excess policy has to respond. 

Without notice that a policy contains an SIR rather than a deductible, and without understanding the implications of each, a business cannot accurately plan for a loss situation.  Further, the difference between a deductible policy and an SIR policy often has major implications for the defense of any claims, as the deductible policy typically places the insurer in control of the claims, hiring of counsel, and management of defense of any lawsuits. 

Insurance Requirements in Commercial Contracts (Part 1)

This is the first post in a series regarding insurance terms that are commonly encountered (but sometimes, poorly understood) in commercial contracts.

Whether you are drafting business contracts, reviewing them, or are a party to them, you will encounter insurance clauses. Insurance requirements are common in commercial contracts and have been for decades.  This includes commercial leases, licenses, subcontractor arrangements, and merger or asset purchase agreements.

Some of these clauses were heavily negotiated, other times they seem like mere boilerplate which was lifted from a form book decades ago. Without an understanding of insurance law, you may bargain for terms in the agreement that do not actually provide the sought-after coverage to protect from a possible loss.

Whether you are drafting agreements or simply reviewing older contracts, it is important to understand insurance law or to work with an insurance broker or insurance lawyer. Without an understanding of common issues and pitfalls, a party may believe that insurance exists to provide financial security to a transaction, when actually no insurance exists or coverage would be speculative at best.

Outdated terms which no longer apply.
Older documents (or new documents based on old forms) may include outdated insurance provisions. For example the common CGL policy was renamed from “Comprehensive General Liability” to “Commercial General Liability” nearly thirty years ago, however some commercial agreements still have the old language. And if a client wants to be defended against personal injury lawsuits, it needs a policy which provides coverage for “bodily injury.” Under common insurance law and the modern CGL policy, “personal injury” means non-bodily injuries such as defamation, the tort of invasion of privacy, wrongful eviction, and advertising injury. Contractual language which requires a party to obtain an outdated product – a commercial impossibility – does nothing but unnecessarily strain the relationship between parties.

Requests for additional insured status.
A contract may require the counterparty to add your business as an additional insured. Anyone added as an additional insured must know the limitations to additional insured status. For example, the  ability to gain coverage is only derivative of the first named insured; an additional insured has zero coverage for any independent claim that does not involve the first named insured. Similarly, certain policies do not permit naming additional insureds, such as worker’s compensation policies. In other situations, because certain policies typically include insured vs. insured exclusions, naming a person or entity as an additional insured may actually serve to negate or reduce coverage rather than extend coverage in certain circumstances.