March 20, 2004

Background on risk management and insurance against SCO lawsuits

James Grimmelmann comments in LawMeme - Great Ideas Dept.: Open Source Insurance about news that Open Source Risk Management may counsel companies about managing the risk of being sued by SCO. Below are some comments I added to his posting. (Read more ... )

James, I took a look at OSRM's site, and thought about your comment that
it would not be likely to have sufficient capital to respond if many SCO
suits came in at once.

OSRM, from all I can see on their site, does not hold itself out as an insurer or even an insurance broker. Rather, it is a provider of fee-based risk management, consulting and training. Such companies take a fee from the ultimate customer in order to independently evaluate and advise regarding the management of risk, but do not sell or provide insurance coverage. I know of no real capital requirements to operate as a risk manager.

A risk manager may advise their clients about available insurance and introduce them to licensed brokers representing companies that offer such. A risk manager may advise a client to self-insure, or join with others similarly situated to form a risk pool, perhaps set up an offshore captive insurer owned by the pool members to which the risk may be transferred. They might even administer such a pool, acting as a third party administrator or "TPA". State regulation of TPAs varies.

If actual insurance were to be available, it would have to come from an actual insurer, which would need to have capital and/or reinsurance. I did not find anything on the OSRM site that indicated that any particular insurer was offering this type of coverage. That does not surprise me, because coverage like this is quite unusual, and there are very few players in the market.

This sort of coverage is *not* likely to be offered by a standard, licensed insurer with offices and agents in the prospective insured's state. Its the sort of non-standard coverage that would typically come from a "surplus lines" insurer licensed out-of-state or outside of the U.S. Most folks are familiar with the unusual types of insurance written by Lloyds of London, whose underwriters are an example of a S/L carrier. There are many others less well known, some that are subsidiaries of famous companies.

S/L carriers are not licensed or regulated by states (other than the state where they may be domiciled) so that buyers need to do due diligence. Risk managers are useful in that due diligence, because they are (usually) not compensated by the insurers with which the risk may eventually get placed.

Purchase of S/L coverage is typically through a specially licensed surplus lines broker, an insurance intermediary that takes a commission from the insurance company for the service of arranging insurance coverage for particular insureds with an insurer not licensed in the insured's state.

You've put your finger on the main challenge for any underwriter thinking about putting out a line on this type of risk ... lack of distribution of the potential hazard. If SCO starts a suit campaign, and only one or two insurers cover the whole waterfront, they will be hit hard.

Such can be handled much like "retroactive" coverage ... which is sometimes purchased *after* a disaster. In essence, the insured, who has already been sued or expects to be sued because of some known event, pays a premium that the insurer figures will cover the costs of defense, indemnity, its administrative costs and a margin for profit. The transaction may be beneficial to both parties because the insured can take a business expense deduction in the year the premium is paid (rather than over the ensuing years of defense and ultimate payout).

Unlike the insured, the insurer *is* allowed to deduct its actuarially justifiable reserve for all that anticipated expense and indemnification, in the year the premium is paid. If the likely main pay-out is several years away, the insurer may also be able to generate investment income on the premium paid by the insured over the years of defense. So, there are tax advantages for the customer in placing the risk into an insurer.

Either way, the coverage is likely to be expensive, if available at all. The more likely the coming lawsuits, the more expensive it will be. In some cases, the premium will equal the limits of coverage, so that it may be somewhat like a banking transaction. Under IRS rules, there must be sufficient transfer of risk to the insurer for the premium to be deductible, however.

One may ask: "but isn't the real value of such a policy in the insurer's coverage of defense expenses?" Good question. Many surplus lines policies provide that defense is "within the limits," so that payouts for defense costs reduce the remaining limit for indemnity. If one has a million dollar limit, and the insurer pays out $750k to defend, there may only be $250k left for any indemnity or settlement. Careful analysis of the policy language by an expert may reveal similar limitations.

Surplus lines coverage prices are also volatile, because they are not regulated. So, if a flurry of lawsuits hits the cover, the renewal may be *dramatically* more expensive. And, if the management of the insurer changes and decides it no longer has an appetite for that type of risk, the coverage may get prohibitively expensive or simply unavailable. It is not unusual to find that there are no other sources of the coverage at such times.

Insurers sometimes fail, become insolvent. In the US, all insurance insolvencies are handled under state insurance insolvency law, not federal bankruptcy law. Also, except in one or two states, surplus lines insurers are *not* covered by insurance guaranty funds, which act in a way like FDIC or FSLIC to pay some claims of insolvent insurance companies. Purchasers of insurance from a surplus lines carrier that becomes insolvent may have little recourse except to wait for their share in the insolvency proceeding in the insurer's home jurisdiction. If the insurer is domiciled in a jurisdiction outside the U.S., the insolvency laws may be less favorable to creditors (policyholders) than is the case in the U.S.

Even in the U.S., insurance insolvencies often take decades to liquidate, if the principal liabilities are disputed "long-tail" claims and the principal assets are reinsurance policies with reinsurers that are financially strained, insolvent or just plain stubborn. Reinsurers may be particularly stubborn about paying claims of insolvent insurance companies, because they cannot produce future business for the reinsurer.

When caveat emptor is the word of the day, independent advice is most valuable, so that a good risk manager may be worth the investment.

Douglas Simpson, J.D. "Unintended Consequences" at Posted by dougsimpson at March 20, 2004 09:25 AM | TrackBack