This article is the third in a series of three articles addressing the potential pitfalls embedded in policies written with claims-made coverage triggers. My purpose in pointing out the many dangers lurking within the language of claims-made policy forms in this series is simple.
The goal of insurance is to assure that insurers make a profit, while at the same time, their policies should provide a reasonable expectation that their policyholders will be protected against a given hazard. Yet, when policies contain language that creates uncertainties, the costs and expenses are increased for insureds and insurers alike. Uncertainty increases unnecessary litigation, from which neither party gains. Uncertainty can turn a single claim against the insured into four additional lawsuits, which, again, benefits no one. And finally, the uncertainty resulting from ambiguous language within claims-made policy forms can doom any insurer's program of coverage because, in the long run, the program becomes actuarially unsustainable, an outcome that is harmful to all.
This article takes a look at extended reporting periods, other dangers in the conditions section (mergers and acquisitions, hammer clauses, and allocation clauses), and the workers compensation claim exclusion. If you haven't already, see my March 2019 and April 2019 articles addressing previously discussed pitfalls of claims-made policies.
Problem #7: the Dangers Inherent in Extended Reporting Provisions
Extended reporting provisions (ERPs) in claims-made policy forms have existed for a long time. ERPs were once considered to provide a type of "retirement coverage" under which the insureds would have coverage for claims made against them during the extended reporting period term, provided the claims arose from wrongful acts that took place prior to the expiration of the policy. In other words, even when one is retired, he or she can still be sued "tomorrow" (i.e., during their retirement) for something they did "yesterday." ERPs addressed this so-called "retirement exposure." Unfortunately, ERP provisions have gotten more complicated since that time.
Circumstances under Which an ERP Is Available
Currently, some claims-made policies distinguish between an ERP that, on the one hand, may be triggered due to a cancellation or nonrenewal of coverage and, on the other hand, an ERP that is provided when one's business or company is acquired. The latter, known as "runoff provisions," provide the same coverage as ERP provisions but are only triggered when the insured is acquired, rather than retiring, going out of business, or having their coverage canceled or nonrenewed.
Price of the ERP
The vast majority of claims-made policies specify the price the insured must pay for an ERP—typically a percentage of the expiring policy premium. In addition, some policies may even provide coverage options for several different ERP terms (e.g., 2 years, 3 years, or 5 years) in addition to the standard 1-year ERP option.
There are, however, a small handful of claims-made policies that do not specify a premium for the ERP endorsement provided by the policy. Instead, the policy only states that premium will be calculated "in accordance with the rates and rules in effect at the inception of the policy." Thus, at the inception of the policy, there would be no way to know what premium would be charged when an insured seeks to buy an ERP in the future.
This is substandard language because, as already noted above, the vast majority of claims-made policy forms provide a 1-year ERP (or longer) for a specific premium, which is nearly always quoted as a percentage of the expiring policy's premium. This approach eliminates a certain degree of uncertainty for the insured, as opposed to the policies that do not specify a percentage for the ERP.
The figure below provides representative substandard wording of an ERP provision.
SUBSTANDARD LANGUAGE: ERP PREMIUM NOT STATED AT THE INCEPTION OF A POLICY
B. Optional "extended reporting period"
1. If this Policy is canceled or non-renewed by either us or by you, then the first of you named on the Declarations shall have the right to purchase an optional "extended reporting period". Such right must be exercised by you within sixty (60) days of the termination of the policy period by providing: a. written notice to us; and b. with the written notice, the applicable additional premium which will be calculated in accordance with the rates and rules in effect on the inception date of this Policy.
ERP Election and Application
Another aspect of ERPs that varies from insurer to insurer is the time limit within which an insured must notify the insurer of its election to purchase the ERP. A small minority of forms require the insured to make this election prior to the expiration of the policy, whereas most others permit the insured to make this decision up to 30 or 60 days postexpiration.
Furthermore, insureds should not assume that multiyear ERP options are automatically provided in every policy. This is not the case. In fact, a larger proportion of insurer forms offer only a 1-year option than do those that provide additional options, such as 2 years, 3 years, and 5 years.
Ensuring ERP Limits Are Adequate To Cover Claims in Multiple Years
Another critical point to recognize is that EPRs are an incomplete solution to the need for postretirement coverage (or any postpolicy coverage for that matter). Recognize that, under an ERP, the insured is obtaining just one limit of liability, and that limit must provide coverage over at least a year, and perhaps more, in the event the insured obtains a 2-, 3-, or 5-year ERP. Thus, during the extended reporting term, multiple claims could potentially be made against the insured, thus significantly reducing or even completely extinguishing whatever limit was initially purchased. At that point, it may be difficult (or even impossible at a reasonable premium) to secure an additional ERP that replenishes the original limits.
This inherent limitation of ERPs becomes extremely important when one company is acquired by another. In such a situation, the buyer of the company would be forced to contact the seller of the company, years after the transaction was concluded, to inform the seller that there are no additional limits available under the ERP that was originally purchased to cover claims made against the seller for wrongful acts that arose prior to being acquired. In this situation, the seller must now provide funds to purchase additional ERP limits (which is normally an express condition found within the original sale agreement).
Automatic Coverage for Newly Acquired Companies
A related concern involving acquisitions is whether an insured can negotiate with its insurer to simply pick up the exposure of any companies the buyer acquires. In other words, if Company A the buyer, is a well-managed, profitable company with a loss-free track record, good management, and solid operations, obviously any underwriter would like to insure them. When an application from Company A indicates that it is purchasing Company B, which also has the same qualities of an excellent track record, loss history, and management, why is it that Company B is suddenly considered a poor risk? Often the answer is "That's the way it's always been done."
Yet, unfortunately, if everyone thought like that, we'd still be communicating with smoke and drums! It would appear that if Company A is buying Company B, and both are "good writes," Company B could reasonably be automatically covered and scheduled as an additional named insured under Company A's policy, and with prior acts coverage (for Company B's acts prior to it being acquired by Company A).
Problem #8: Other Dangers in the Conditions Section
Merger and acquisition language, also known as change in control language, is usually found in the conditions sections of claims-made policy forms. However, sometimes a policy's definition of "insured" may also contain acquisition/change in control wording, so broker beware. Regardless of where merger and acquisition/change in control language is found within a claims-made policy, a substantial coverage gap can arise when there is a conflict between such language and an insured buyer's intent to cover the prior acts of a company it is acquiring.
Covering the Prior Acts of the Acquiree
A common pitfall associated with merger and acquisition/change in control language occurs when, for example, Company A acquires Company B. Simply scheduling the name of Company B as an additional named insured, together with Company B's retroactive date on Company A's policy, will not provide coverage for Company B's wrongful acts that took place before the acquisition was completed. This is because the standard policy language pertaining to merger and acquisition/change in control situations states that the acquiring company's policy (in this instance, Company A) excludes coverage for any wrongful act that took place prior to the transaction date of any merger and acquisition.
Therefore, and in addition to adding an endorsement affirmatively covering the acquired company's acts prior to being acquired, yet another endorsement to Company A's merger and acquisition/change of control provision is also required to void the policy's standard change in control provision that excludes coverage of any acquired company's prior acts.
Coverage disputes associated with merger and acquisition/change in control language have already been ruled on by various appellate courts, nearly all of which have denied coverage of an acquiree's prior acts, given the fact that such coverage conflicts with the merger and acquisition/change in control provision. Such courts noted that the merger and acquisition/change of control section was not also endorsed to provide coverage of prior acts and, therefore, supersedes the endorsement that affirmatively covers the acquired company's prior acts.
"Hammer clauses," another provision commonly found in the conditions section of claims-made policies, have been around for a long time. A standard "hammer clause" requires an insurer to seek an insured's approval prior to settling a claim for a specific amount. However, if the insured does not approve the insurer's recommended settlement figure, the hammer clause states that the insurer will not be liable for any additional monies required to settle the claim or for the defense costs that accrue from the point after the insurer made its settlement recommendation.
For example, assume an insurer suggests an insured settle a claim for $100,000. The insured refuses and, ultimately, the claim settles for $200,000. In addition, another $50,000 in defense costs are incurred from the time of the insured's initial refusal to settle and the eventual settlement. In this situation, the insured will be responsible for both the additional $100,000 in settlement costs as well as the additional $50,000 in defense costs, for a total of $150,000. The insurer is only responsible for the $100,000 settlement offer that was originally proposed.
A "softer" alternative to the standard "hammer clause" (known as a "coinsurance hammer clause") provides for a sharing of defense and indemnity costs (between the insured and the insurer) incurred after the insured refuses to consent to a settlement proposed by an insurer. The most common sharing percentage is 50/50 but can sometimes go higher (e.g., 80 insurer/20 insured). The effect of such clauses is to reduce the amount of additional indemnity and defense costs that an insured could potentially incur if it refuses to consent to a settlement amount recommended by an insurer.
Using the figures in the previous example, and assuming a 50/50 sharing percentage, the insured would only be responsible for paying half of the additional $100,000 settlement and half of the additional $50,000 in defense costs, for a total of $75,000, versus $150,000, as noted above.
Buyers and brokers should seek policies containing the so-called soft hammer clause. Or, alternatively, it would be advantageous to request that their current policy be modified to provide a "soft" hammer if it contains a "traditional" hammer clause.
Another potentially troublesome condition found within claims-made policy forms is the so-called allocation clause. Until recently, such clauses were only found within directors and officers (D&O) liability policies. Allocation provisions specify the manner in which coverage will be "allocated" between covered and uncovered items. In D&O forms, the issue of allocation arises between covered/uncovered acts and covered/uncovered persons.
Allocation provisions are complex, and a complete discussion of such clauses is beyond the scope of this article. However, the key point to recognize is this: until recently, such provisions were restricted to D&O policy forms. However, within the past several years, allocation clauses have begun appearing within claims-made professional and errors and omissions liability policies. Therefore, buyers and brokers should be on high alert for the presence of these provisions and must understand the ways in which they can reduce or even preclude coverage under a wide variety of claim scenarios.
Problem #9: the Workers Compensation Claim Exclusion
One peculiar, yet potentially dangerous exclusion sometimes found within claims-made policies is one that I noticed within an environmental architect and engineer's professional liability policy. Surprisingly, the policy was offered by a well-known and respected managing general agent. The language I will discuss below has been appearing frequently in recent years.
Although virtually every type of insurance policy contains a workers compensation exclusion (except a workers compensation policy itself), the following exclusion is one of the most egregious I've ever seen. It is highly substandard, and frankly, there is no logic in having it appear in any policy. It states the following.
The Company shall have no obligation whatsoever under this policy to make any payment of any kind for either "damages," "claims expense," or any coverage or payment provided..., or pay, for any defense, for: …
M. any "claim" for bodily injury or death to any person, whether or not an employee of the "named insured," if benefits from the bodily injury or death are collectible or compensable under any workers compensation law or disability benefits law.
The logic of this exclusion completely escapes me. If an insured environmental architect or engineer's professional negligence is responsible for causing bodily injury to a claimant, and the claimant is collecting workers compensation benefits from his employer in conjunction with such bodily injury, why should coverage under the architect or engineer's professional liability policy bar coverage?
In the event the insured architect/engineer actually was negligent in causing the injury, the workers compensation insurer of the worker's employer should be entitled to subrogate against the architect/engineer's professional liability insurer and be reimbursed for any medical or lost-time benefits it paid the worker. On the other hand, if it turns out that the architect/engineer was not negligent in causing the injury, the architect/engineer should still be entitled to coverage for defense against any lawsuits filed by the injured worker, the injured worker's employer, and the employer's workers compensation insurer.
The fact that the injured worker may be receiving workers compensation benefits from his employer (who might not be the insured under the environmental engineer's professional liability policy) is not something that increases the hazard or reduces the insurability of the insured environmental engineer, meaning the rationale for this exclusion is shaky at best. Once again, broker beware.
Extended Reporting Provisions
Be aware of the particular circumstances under which a policy's ERP is actually available: cancellation, nonrenewal, going out of business, or retirement?
Know the specific premium for the ERP option(s) being offered at the inception of the policy, and request an actual premium quotation if one is not already stated.
Understand how soon—following policy expiration—the insured must elect to buy an ERP.
Recognize that an ERP's limit may not be adequate if it will be providing coverage over multiple years.
Identify the conditions under which ERPs will cover an acquired company's prior acts, and attempt to arrange "automatic" coverage with your underwriter for all such acquisitions.
Other Important Provisions within Conditions Sections
Spot conflicts between merger and acquisition/change in control provisions and endorsements whose intent is to cover an acquired company's prior acts. Endorse the change in control provisions in a manner that "voids" the exclusion found within such provisions that bar coverage for an acquired company's prior acts.
Negotiate "softer" hammer clauses if your policy contains a "standard" hammer clause, or select policies already containing "soft" hammer clauses.
Look for allocation provisions in professional and E&O policies, understand their significance, and know the ways in which they can restrict coverage.
The Workers Compensation Exclusion
Be familiar with the way in which the workers compensation exclusion can limit the extent of coverage otherwise provided by professional and E&O policies (particularly for exposures with more potential for bodily injury). Attempt to negotiate removal of this exclusion.
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