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1. Insurance is "a risk-distribution arrangement for the compensation of loss that is entered into by one party as its business" a. The principal sellers of insurance are stock companies (owned by SHs) and mutual companies (owned by insureds)
2. Insurance exists because people are risk averse. This means that, all else equal, people prefer to reduce variance even at the cost in a slight diminution in expected value (due to the payment of administrative costs as part of the premium) a. Explanations of risk aversion: diminishing marginal utility of wealth
3. Functions of insurance: a. Risk transfer from relatively risk averse (insured) to relatively risk neutral (insurer) i. Insurer does not experience diminishing marginal utility of wealth. For a corporation, wealth is utility b. Risk pooling (diversification): By insuring a large number of insureds posing homogenous and independent risks, an insurer can reduce the variance in its expected losses to a very small range i. Law of large numbers: the average obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed
1. A consequence of this theorem is that highly unpredictable individual events may be highly predictable in the aggregate ii. Dynamics of insurance markets:
1. The smaller the pool of insureds, the higher the premium that is required to insure the risk
2. If premium is calculated correctly, the insured's expected value remains the same (minus administrative costs), but variance is eliminated c. Risk allocation: Insurers attempt to set a premium that is proportional to the degree of risk posed by each insured. i. Insurers thereby create incentives for insureds to optimize the degree of risk they pose
4. Social functions of insurance: a. Insurance affects norms b. Acts as a surrogate regulator or instrument of governance i. E.g., drivers who cannot obtain liability insurance because of their accident records are effectively prohibited from driving c. Insurance has a redistributive effect i. Redistributes wealth from the lucky to the unlucky d. Because of social role, insurance necessarily subject to regulation beyond that of other private activity i. Solvency regulation is crucial to maintain the market
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ii. Mutual insurers that run large surplus are required to rebate money to insureds II.
ADVERSE SELECTION & MORAL HAZARD
Adverse Selection and Moral Hazard are two market dynamics resulting from asymmetrical information benefitting the insured; each dynamic creates inefficiency in insurance markets.
5. Adverse Selection: A dynamic that can occur in an insurance market where (a) individuals present different levels of risk; and (b) there is asymmetrical information benefitting the insured, such that (c) high-risk individuals are more likely to seek coverage than low-risk individuals. a. This dynamic drives up premiums, which causes low-risk individuals to exit market, further driving up premiums i. Cost of coverage becomes increasingly expensive, pool of insureds becomes increasingly small ii. Market can unravel completely Insurance does not work well when the insured's behavior affects its risk:
6. Moral Hazard is "the tendency of any insured party to exercise less care to avoid an insured loss than would be exercised if the loss were not insured." a. Essentially, the concern is that insurance may skew incentives, either allowing the insured to completely externalize the cost of a loss and thus become loss-neutral, or by allowing the insured to claim a profit from a socially destructive activity (if the amount of recovery exceeds the insured interest) i. Deductibles can make sure that the risk of loss is not completely externalized ii. Increased monitoring can reduce the risk of moral hazard
1. If insurers had perfect ability to monitor insureds, insurance would not be plagued by moral hazard To combat Adverse Selection and Moral Hazard, insurers seek to obtain more information about insureds (underwriting) - or to cause insureds to internalize some of their losses (experiencerating, use of deductibles, and dollar-limits on coverage). Adverse Selection must not be overstated. Applicants may incorrectly estimate their own risk. And if especially risk averse, applicants may remain in the insurance pool even if they are charged more for coverage than perfect actuarial calculations would dictate. The result may be a tolerable level of cross-subsidization within the risk pool. Moral Hazard exists to varying degrees for different forms of insurance. E.g., given drivers' instinct for self-protection, auto liability insurance probably does not significantly influence driving behavior.
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What is distinctive about insurance contracts that make them worthy of their own course?
? Specific policy concerns raised by: moral hazard and adverse selection
? One other distinctive feature: the contracts often involve large losses, which means large contract disputes. A lot of money at stake, so the temptations for opportunism or strategic behavior or shirking are considerable o Significant temptation for claimants to file false claims o Significant temptation for insurers to deny valid claims
? Market forces put some pressure on insurers to pay claims, for fear of developing reputation of being unreliable
? "Post claim underwriting" - tendency for insurers to closely scrutinize contracts for prior misrepresentations after claims are lodged
? Offering lowball settlements to parties who are under duress - too risk averse to seek litigation - highly unequal bargaining power between individual who has suffered loss and insurance company
? The tort of insurance bad faith attempts to respond to "lowballing" concern. See Whiten v. Pilot Ins. Co., in which the defendant "pursued a hostile and confrontational policy calculated to force the appellant to settle her claim at substantially les than its fair value." The plaintiff in that case prevailed on a bad faith claim and was awarded significant punitive damages.
? Punitive damages are not available for contract claims but are available for tort claims. Hence, the necessity of treating insurance bad faith as a tort III.
WARRANTIES AND REPRESENTATIONS
7. Lord Mansfield established that the terms of an insurance warranty (1) must be strictly complied with, or policy is void; (2) can be enforced even if there is no demonstration of materiality. a. A warranty is theorized as a condition precedent to coverage b. This rule can be justified as a penalty default rule i. Provides a strong incentive for high-information party (insured) to disclose all relevant information (thus reducing adverse selection) ii. Provides a strong incentive for insured to comply with all terms of coverage, avoiding moral hazard iii. Reduces administrative costs, increases predictability, prevents judges from inquiring into materiality, when they may be ill equipped to do so (cf. business judgment rule) c. Why treat insurance contracts different from all other contracts? Substantial performance is the norm in contract law, on a hypothetical bargain theory. See, e.g., Jacob & Youngs v. Kent (Redding Pipe case).
8. By contrast, a representation is not theorized as a condition precedent to coverage. Hence, representations are not strictly enforced and not enforced if not material.
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9. The argument for strict approach to warranties is weaker when purchaser is not a sophisticated; where parties differ in their expectations as to the significance of representation; and where the breach of warranty does not even increase the risk of loss.
10. Judicial strategies to avoid harsh effects of warranty rule a. Construe warranty as representation, thus requiring materiality b. Construe warranty strictly against the insurer c. Interpret warranties that might relate to future facts ("promissory warranties") as relating only to present facts ("affirmative warranties"); see Vlastos d. Interpret the warranty as satisfied if there has been substantial compliance (but still refrain from inquiring into materiality)
11. Legislative action: virtually every state has legislation on the issue of insurance warranties; most have collapsed the distinction between representations and warranties. See discussion of various approaches at p. 16 a. Increase-of-the-risk test is common (approach to materiality)
12. Insurers may respond to weakening of warranty law by seeking to include substance of warranty in coverage provisions. In many jurisdictions, an insurer can achieve the same effect as would be achievable under strict warranty law by phrasing the term as a prerequisite to coverage. a. E.g., Omaha Sky Divers - construed a clause excluding coverage of loss "occurring while the aircraft is operated in flight by other than the pilot" as a coverage provision, defeating coverage without showing of materiality b. NY has attempted to distinguish: Warranties and representations apply to potential causes of loss, whereas coverage provisions apply to actual causes
13. Elements of misrepresentation: misstatement that is (1) knowingly false (2) material fact that (3) induces justifiable reliance. Objective test for reasonable insurer common.
14. Elements of fraudulent concealment: (1) knowing (2) failure to disclose (3) facts known to be material.
15. Misrepresentation after the loss. The major function of the prohibition against misrepresentation is to combat adverse selection, but the legislative reluctance to countenance forfeiture also pervades the field. VLASTOS V. SUMITOMO MARINE & FIRE INS. CO. (3d Cir. 1983) RULE:
If there is uncertainty as to whether a term is a representation or a warranty, contra proferentem requires that the term be construed as a representation, such that the term (a) will not be construed strictly against the insured, and (b) cannot be enforced unless it is material.
Insurer sought to avoid recovery on basis of contract term stating that applicant "warranted that third floor is occupied as janitor's residence," after demonstrating that third floor included massage parlor as well as janitor's residence. In this case, the court agreed that this is to be treated as warranty rather than representation, but - applying contra preferentum - concluded that the term did not unambiguously require that third floor be exclusively occupied by a janitor's residence. Therefore, insurer could not deny coverage.
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NEILL V. NATIONWIDE MUT. FIRE INS. CO. (Ark.App. 2003) RULE:
Where facts are truthfully stated to an agent, but by fraud, negligence, or mistake, the agent misstated the information on the contract form, the company cannot avoid liability if the agent had actual authority and there was no fraud or collusion on the part of the insured.
The applicant signed a contract stating that he had no previous fire loss, although this was incorrect. The applicant claimed that he had not been aware of the misstatement in the contract. The court concluded that, although "a person is bound under the law to know the contents of the papers he signs and cannot excuse himself by saying that he did not know what the papers contained," the fact that the applicant signed certification information was not sufficient to avoid coverage. The court's theory may be that a signed document is conclusive proof that the applicant made a false material misstatement, but inconclusive as to whether the insurer's reliance on the misstatement was reasonable. The insurance company cannot reasonably claim to rely on a misstatement that its agent is responsible for.
1. Insurance companies need to be able to rely on their documents to set prices and predict losses. Is there really going to be a trial regarding the validity of every written contract signed by the applicant? For insurance to work, high-risk people must pay an actuarially fair price.
2. Who should bear the burden of avoiding predictable error in drafting? Arguably, the insurance company should. It is the repeat player, and thus is in the best position to achieve an optimal level of error-avoidance by modifying its practice. a. This argument is reinforced by concerns of post-claim underwriting. Insurers have an incentive to conduct a relatively cursory review at the time of application, and a more thorough review at the time of claim. b. Inquiry notice rule: If the insured furnished reasonably complete answers that could lead an insurer to the information it seeks through a diligent follow-up, there has been no misrepresentation or concealment. i. Is this better theorized as a holding that (1) there has been no misrepresentation or (2) that the insurer has not justifiably relied upon it?
MACKENZIE V. PRUDENTIAL INS. CO (6th Cir. 1969) RULE:
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If, after a contract is signed but before a policy is issued, an applicant for life insurance experiences a change in his health that is material to the contract, he has
a duty to divulge this change to the insurer, and failure to do so will constitute a material misrepresentation sufficient to void the policy. Policy considerations:
1. Is this a good rule? A rule that imposed no duty to disclose would merely create insurance against the risk that the facts would change during the application period. Is this such a bad thing, at least where the risk that develops is not one for which there is a moral hazard concern?
INSURANCE CONTRACTS: FORMATION & MEANING
1. Insurance contracts are, by and large, contracts of super-adhesion. This means that all insurance companies in the same area offer the same policy terms, usually not subject to individual negotiation. a. The argument for greater judicial and legislative regulation of these contracts is greater than for contracts that are individually negotiated.
2. Insurers have an incentive to pool data, if there is difficulty measuring the risk directly. a. Creates a broader, more statistically reliable database. i. Pooled data is only meaningful if the data is about the same thing.
1. To make predications about their expected losses based on pooled data, each insurer had to be promising to pay its policyholders on essentially the same terms ii. Development of contracts of super-adhesion; insurers compete over reliability and price but not over contract terms
3. Actuarial data is a natural monopoly. Ever increasing economies of scale, because data becomes increasingly useful the larger the pool.
4. Insurance Services Organization - an independent, for-profit corporation that prepares standard insurance contracts. Exempt from anti-trust laws.
5. Super-adhesion - not a bargaining power issue. Drafting and uncertainty costs exceed customization benefits for all players, including most profitable corporations. a. When customization does occur, it is typically through the attachment of endorsements to standard policies that change only the portion of standardized coverage that needs to be changed.
6. Much less standardization in life and health insurance policies, because there has long been fairly reliable data about mortality, which has reduced the need to standardize terms. a. Also, health insurance has historically been provided on a group basis through employers, so there is comparatively less need to aggregate data across insurers
7. Regulation also promotes standardization of terms
8. There is an argument that, because most insurance policies must secure regulatory approval before being marketed, and because statutes affect the content of insurance policies, the very idea of contractual intent should be disregarded, and interpretation should occur in view of the statutory and regulatory policies that dictate or constrain insurance policies. a. Taking the facts of an individual transaction into account often proves to be in tension with standardization in interpreting insurance contracts Page 6 of 20
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