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Commercial Coverages:What Every Agent Should Know

A.D.Banker&Company

Introduction ..................................................................................................................................... 1

Part One: Surplus Lines, Reinsurance, & Terrorism ............................................................... 2

Chapter 1: Surplus Lines Insurance ........................................................................................... 3Glossary of Terms; History of Surplus Lines Market; Specialty Lines Insurance; Lloyd’s; Regulations of Surplus Lines; Nonadmitted and Reinsurance and Reform Act of 2010; Agent Concerns; Resources; Review Questions

Chapter 2: Reinsurance ............................................................................................................. 17Reinsurance Terminology; History of Reinsurance; Reasons for Reinsurance; How Reinsurance Works; Review Questions

Chapter 3: Terrorism Coverage ................................................................................................. 30Federal Terrorism Regulation; Definitions; Mandatory Offer of Coverage; Conditions of Coverage; How Terrorism Losses are Shared; Terrorism Insurance Coverage; Impacts of Terrorism on Insurers and Reinsurers; Review Questions

Part Two: Crime and Surety, Business Interruption & Equipment Breakdown ................... 43

Chapter 4: Crime and Surety Coverages .................................................................................. 44Definitions; Crime Insurance; Commercial Crimes Endorsements; Crime Policy Terms and Conditions; Suretyship; Crime and Bond Claim Examples; Review Questions

Chapter 5: Business Interruption Insurance............................................................................. 60Overview; Business Interruption Insurance Terminology; Business Income (and Extra Expense) Coverage Form; Endorsements and Optional Coverages; Contingent Extra Expense (CEE) Coverage; Delayed Completion Coverage; Ingress/Egress Coverage; Utility Services; Review Questions

Chapter 6: Equipment Breakdown Coverage........................................................................... 75The Policy; Review Questions

Part Three: Professional Liability ............................................................................................... 90

Chapter 7: Professional Liability Fundamentals ..................................................................... 91Introduction; Professional Relationship; Liability Coverage Forms; Review Questions

Chapter 8: Professional Liability Coverages ......................................................................... 107Errors & Omissions (E&O) Liability Insurance; Directors & Officers (D&O) Liability Insurance; Employment Practices Liability (EPL) Insurance; Cyber Liability Insurance; Identity Fraud Insurance; Review Questions

Chapter Review Answer Key ..................................................................................................... 150

Table of Contents

Commercial Coverages: What Every Agent Should Know

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Copyright 2014© A.D. Banker & Company®, L.L.C.

This course, seminar, or publication provides general information regarding the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. The publisher hereby expressly excludes all warranties. The information in this text is current as of the date of publication

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IntroductionThe world of commercial lines insurance is exciting ... or terrifying, depending upon an agent’s perspective. Those who work actively in commercial lines love the prospect that today just might be the day they write insurance for a business class they have never encountered before. On the other hand, agents who spend most of their time working in personal lines or with small commercial lines accounts might shudder at the prospect of insuring a logging company or an account with a $500,000 annual workers’ compensation insurance premium.

All agency owners, producers, and customer service representatives have their own personal preferences when it comes to writing and servicing commercial lines accounts. Some agents avoid clients who work in the construction industry; others actually prefer working with roofers and builders. Some agents feel more comfortable with commercial lines clients who own small, local businesses while many other agents enjoy working with large, national corporations. Still other agents only work in niche markets, such as aviation or trucking.

Despite an agent’s preferences with respect to types of clients or insurance products, at some point in time, he or she will be faced with a client’s need for coverage about which the agent knows little or nothing. What does an agent do the first time a client opts to buy terrorism coverage rather than reject it? What does an agent do when his biggest personal lines client establishes a new business and none of the agent’s carriers want to write coverage? Does the agent refer the client elsewhere or does he dip his toes into the water of the surplus lines marketplace?

In this course, we share information about eight different commercial lines topics that often baffle many insurance agents. On the other hand, some agents actually specialize in writing these types of coverage—which is precisely what makes commercial lines so exciting ... or terrifying. Our goal is to provide you with information on insurance topics about which you might not have experience or to help you brush up on topics about which you are familiar. We also provide you with links to sources with whom you will be able to conduct further research.

In Part One, we discuss reinsurance, terrorism coverage, and the surplus lines marketplace—areas that every agent working in commercial lines encounter at some point in time. In Part Two, we review three particular types of property coverage: crime and surety bonds, business interruption insurance, and equipment breakdown coverage. And in Part Three, we tackle several types of professional liability coverage: errors and omissions (E&O), directors and officers (D&O), employment-practices liability (EPL), cyber liability, and identity fraud.

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Part OneSurplus Lines, Reinsurance, & Terrorism

In this first section of the course, we address three topics that are central to commercial lines. In fact, agents in personal lines should probably also study the topics of reinsurance and surplus lines, as well, since they are not specific to commercial lines.

In some ways, the surplus lines marketplace works very differently than the standard marketplace does. However, the insurance products sold in this marketplace are not completely different from what an agent might be used to selling. In Chapter One, we explain why the surplus lines market is needed and highlight how it is both similar to, and different from, the standard market.

Although most agents never have any personal dealings with a reinsurance transaction, each of the carriers it represents has purchased reinsurance. And each of those reinsurance contracts has a direct effect on the carrier’s underwriting guidelines—as well as numerous other areas of operations. Knowing how reinsurance works will help an agent gain a clearer understanding of precisely why certain carriers have the procedures and perspectives they do. In Chapter Two, we will help agents gain that understanding.

Any agent who has sold a commercial lines property product during the past decade or so has offered terrorism coverage to a client. However, many agents do not have a clear knowledge of the precise nature of terrorism risk or why, exactly, they are required to offer terrorism coverage and obtain the signature of a client who rejects it. In Chapter Three, we provide a framework for the agent to understand the Terrorism Risk Insurance Act and how it affects the insurance-buying public.

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Chapter 1 Surplus Lines Insurance

Most property and casualty insurance agents write standard insurance for “ordinary” clients. Personal lines agents spend the majority of their time writing homeowners, auto, umbrella, and some inland marine insurance. On occasion, they also write insurance for mobile homes, motorcycles, motor homes, boats, and other recreational vehicles. Commercial lines agents spend the majority of their time writing businessowners policies, commercial property, general liability, and business auto insurance. Many will also write workers’ compensation, professional liability, bonds, and other lines of insurance as needed by their clients. But what do these agents do when their ordinary clients want to purchase insurance their insurance carriers will not sell?

For example, Amelia works at the local insurance agency and one of her clients refers his best friend, who just opened a dog grooming business. The new insurance prospect, Fred, has never owned a business and has never worked as a dog groomer. Still, he wants (and needs) property insurance for his business personal property, general liability insurance, and professional liability insurance. Unfortunately, none of the insurance companies Amelia represents will write this risk because of Fred’s inexperience in the dog grooming business and his establishment of a new company that has no prior loss experience. Amelia can tell Fred she is unable to help him with the placement of his insurance or … she has the option of submitting his application for insurance to one or more surplus lines insurance carriers.

Later in this chapter, we will discuss some of the major concerns insurance agents have when working with clients in these situations and when procuring or placing surplus lines insurance. Agents should understand that in order to work successfully in the surplus lines market, knowing how it differs from the standard insurance marketplace is crucial—not only to protect the best interests of the client but also to protect the insurance agent from E & O claims.

Surplus lines insurance is available for three general types of risks that are unacceptable to insurance companies in the standard insurance marketplace. In most states, a risk must actually have been declined by one or more standard insurers before surplus lines insurance can be written. Some classes of business are exempted from this diligent search requirement, such as an explosives manufacturer, because it is clearly understood that standard insurers are unwilling to assume the extraordinarily high exposure this business presents.

The particular reasons a risk might not be eligible for insurance in the standard marketplace differ but can categorized into three general types:

1. Distressed risks exhibit undesirable characteristics, such as an older dwelling that fails to meet underwriting criteria, a business with a long history of third party liability claims, or a home located 250 feet from the seacoast.

2. High-capacity risks require insurance limits in excess of those an insurer is able to write, usually due to lack of underwriting capacity or lack of reinsurance cover. Examples include a contractor needing $1 billion of general liability coverage or an 80-story skyscraper needing property coverage.

3. Unique risks demand coverage types an insurer is unable to provide because they have no previous loss experience that can be analyzed (i.e., a brand new business), because an insurer doesn’t have the appropriate form or rate filings with the state for that class of business, or for other administrative reasons.

In this chapter, we will discuss what surplus lines insurance is … and is not. We will also provide the following information:

• A glossary containing basic surplus lines terminology• A brief history of the surplus lines market

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4 COMMERCIAL COVERAGES: WHAT EVERY AGENT SHOULD KNOW

A.D. Banker&Company©

• Licensing of surplus lines producers, brokers, and insurers• Premium taxation of surplus lines insurance• Information about the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA)• How surplus lines policies are solicited and written• Concerns of retail agents with respect to surplus lines insurance

Glossary of TermsAdmitted insurer – An insurance company licensed to transact insurance business in the jurisdiction in which the insured is located and that has submitted its applications, policy forms, endorsements, and pricing to the jurisdiction for approval by the department of insurance.

Nonadmitted insurer – An insurance company that, while licensed to transact insurance business in the jurisdiction in which the insured is located, has not submitted its applications, policy forms, endorsements, and pricing to the jurisdiction for approval by the department of insurance.

Excess and surplus (E&S) lines insurance – Any type of insurance coverage than cannot be written by an admitted insurer in the jurisdiction in which the insured is located.

Specialty insurance – Lines of insurance written on unusual or high risks that must be provided by insurance carriers with special expertise and experience in underwriting and rating these risks. Examples of specialty lines of insurance include aviation, ocean marine, and professional liability. Specialty lines of insurance may be written on an admitted or nonadmitted basis.

Surplus lines insurance – Lines of insurance that do not need to be filed with state insurance departments in order to offer coverage and that is only offered by nonadmitted insurers. Surplus lines insurance is not encumbered by the same form and rating filing regulation that applies to admitted insurance. Types of risks covered by surplus lines insurance are generally those with adverse loss experience, those that are unusual or unique risks, and those for which the standard market lacks capacity.

Alien insurer – An insurer formed or established under the laws of another country.

Intermediary – One who acts as a mediator or an agent between two parties.

Retail agent – An insurance agent who acts as an intermediary between the insurance applicant and the insurance marketplace. Retail agents may work with wholesale brokers, managing general agents, or directly with surplus lines insurers to secure coverage on behalf of an insured.

Wholesale agent or broker – An insurance agent or broker who acts as an intermediary between retail agents and insurers. The wholesale agent or broker does not deal directly with individual insureds. In surplus lines insurance, wholesale agents and brokers do not have binding authority.

Managing general agent (MGA) – A wholesale intermediary that is authorized to accept insurance placements from retail agents on behalf of an insurer. MGAs selling surplus lines insurance have binding authority and are generally permitted to appoint agents and brokers, provide underwriting and administrative services, and quote, bind, and issue policies on behalf of the nonadmitted insurers they represent. An MGA, in many respects, is another office or branch of an insurance company and does not deal directly with individual insureds.

Wholesaler – Wholesaler is a generic term that refers to one who acts as an insurance intermediary between retail agents and insurers. A wholesaler may be a wholesale agent or broker, an MGA, or both.

Premium tax – A tax that is imposed by each state or jurisdiction on gross written insurance premiums written by insurance companies in that state. Gross written premium (GWP) is premiums before ceded reinsurance but after salvage and subrogation.

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CHAPTER 1: SURPLUS LINES INSURANCE

History of Surplus Lines MarketAlthough many people mistakenly believe the surplus lines market is unregulated, and although it is a segment of the insurance industry that is far less regulated than any other segment, insurance regulation actually spurred the creation of the surplus lines market.

Before 1835, when a tragic fire destroyed much of New York City’s business district, including the New York Stock Exchange and much of Wall Street, most property (fire) insurance companies only sold insurance locally. Until that point in time, many states had been taxing the premiums of insurance policies written by out-of-state insurers to dissuade them from writing business. Their purpose was to provide domiciled insurers with an advantage when writing insurance coverage.

The Great Fire of New York generated between $15 and $20 million of damage (in dollars at that time) and bankrupted nearly 90 percent of the local fire insurance companies in New York because they were destroyed by direct and indirect damage from the fire. It became immediately apparent that spreading risk geographically would be more advantageous than limiting the insurance marketplace to local insurers.

Insurance companies in Hartford, Connecticut and Philadelphia, Pennsylvania began experimenting with different distribution channels and founded the agency system, which began flourishing in the 1850s. Within ten years, the agency system had largely replaced the local distribution systems that had been favored in the past. Dozens of insurers became licensed in other states and insurance agencies were established to handle the increasing volume of insurance being sold.

Competition became fierce. This, in turn, generated premium reductions that would ultimately be unable to generate the reserves necessary to cover catastrophic losses … like the Great Fire of New York. Insurance companies recognized this danger and banded together to assure that competition would not erode premium rates to the point insurers and consumers would be financially devastated in the event of another disastrous loss.

The National Board of Fire Underwriters was founded in 1866 and was comprised of 75 member insurance companies. The Board was responsible for establishing local rating bureaus around the country that would set uniform rates for adoption by all insurers. These bureaus collected data concerning loss experience and then distributed recommendations for standardized insurance rating and policy language. However, many insurers preferred open competition and refused to adopt standardized policies and rates.

During this period of turmoil, several states enacted legislation for the protection of consumers. New York and Massachusetts were the first to establish insurance laws and insurance company capitalization requirements.

Capital requirements for insurance companies are calculated based on a method developed by the NAIC to establish the minimum amount of capital required by an insurer to support its operations and write insurance coverage.1 Although the first regulated capital requirements only mandated an insurer to have $100,000 of cash and easily liquidated assets to conduct operations and respond to claims, they were a step in the right direction. Capital requirements are based on four categories of risk faced by the insurer, which are represented as a ratio of the total amount of liquid assets, or capital, the insurer has on hand:

1. Asset risk – the risk of poor investment performance of one or more of the insurer’s assets2. Credit risk – the risk of loss to the insurer because of the default in payment by policyholders,

reinsurers, and/or other creditors3. Underwriting risk – the risk that the premiums generated by issued insurance will not be adequate to

pay future claims and claims expenses4. Off-balance sheet risk – the risk that certain items not contained on the balance sheet will grow at

unanticipated rates, i.e., premiums, contingent liabilities, etc.State regulation of insurance eventually caught on and, by the 1880s, more than half the states had established insurance departments that were run by a commissioner or superintendent. By the early 1900s, the state legislature of New York formed a committee that confirmed the utilization of insurance rating bureaus as the best method of protecting the public from insurers charging inappropriate rates and using unscrupulous policy

1 (International Risk Management Institute, Inc. n.d.)



language. The standardization of policy language, forms, and rates assisted a great portion of the insurance-buying public—and most insurers. It did, however limit the ability of certain insurance companies to insure risks that required creativity to respond to the particular needs of their clients.

The demand for continued freedom to design insurance products and pricing for particular risks is what created the surplus lines marketplace. Because the National Association of Insurance Commissioners (NAIC) became concerned about insurance companies operating without regulation, it advocated for the creation of laws in each state that would prevent insurers from transacting insurance business in states in which they were not licensed. If a state followed the NAIC’s recommendations, it would have resulted in admitted carriers in that state being unable to insure certain classes of businesses and/or charging appropriate premiums due to the requirements of form and rate standardization. It would also have resulted in certain risks being unable to obtain insurance—some of which was required by insurance legislation.

At the time, Lloyd’s was an alien specialty insurer doing business in many states and most of the insurance regulations in place at the time did not affect how it operated in the United States. Because of its successful operation as a nonadmitted, alien, specialty insurer, Lloyd’s did not want to become an admitted carrier and alter the way it conducted insurance business in this country.

The legislature of the state of New York understood the need for a market for specialty lines of insurance and was the first to enact surplus lines insurance laws. Essentially, these laws imposed regulatory responsibility on the surplus lines broker or producer rather than on the insurer. Unfortunately, most other states did not share New York’s belief that the standard insurance market was unable to handle the needs of all consumers.

Over the next few decades, the surplus lines insurance market operated under a black cloud, often being misunderstood and under-utilized. By the 1960s, when standard insurers were unable to provide coverage for many emerging risks on their own standard policy forms and/or with filed rates, the volume of business being written in the surplus lines market began growing appreciably. A number of U.S. insurers established surplus lines subsidiaries to handle the risks they were unable to handle, or handle profitably, in their admitted insurance operations.

The ability of surplus lines carriers to insure unusual or adverse risks on forms of coverage that provide the unique terms and conditions required, and at pricing that is adequate for each risk posed to an insurer, is tremendously beneficial to insurance professionals and consumers. Many believe that the more the surplus lines marketplace is regulated, the less freedom it will have to continue providing the services that are responsible for its strength.

Specialty Lines InsuranceSpecialty lines of insurance are those providing insurance coverage on risks that are unusual and difficult to insure because of their uniqueness and/or because they pose extraordinary risk to the insurer. Examples of risks that require specialty lines of insurance include parasailing operations, guides and outfitters, amusement parks, rifle ranges, professionals requiring medical malpractice coverage, and kidnap/ransom insurance.

Most insurance companies do not insure the unusual or high-risk client because their policy forms and language does not adequately protect the client’s exposures and they cannot be certain they are collecting adequate premium for all known and unknown exposures. Only insurers that specialize in these classes of business—because they have large pools of risk units from which to collect statistical data, loss experience, and premiums—are able to draft appropriate policy language and rate the risks accurately.

Professional liability insurance is the classic example of specialty lines insurance. A surgeon, an architect, and an insurance agent all possess significant professional liability exposures. Some exposures are shared by all three professions and others are vastly different. The professional liability policies issued to each of these individuals are highly specialized and written by insurers with expertise and experience specific to the individual professions—and professionals. One insurer may only write medical malpractice. Another insurance company may write professional liability coverage for architects but not for insurance agents.

Specialty lines of insurance may be written by admitted carriers or surplus lines carriers. Estimates of the size of the specialty lines business in the United States range from $15 billion to $50 billion.

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Lloyd’sLloyd’s (also known as Lloyd’s of London) is an organization that provides both specialty and surplus lines insurance worldwide. Most consumers, and many insurance professionals, believe Lloyd’s is an insurance company—which is not accurate.

Lloyd’s is an insurance market with over 80 syndicates that underwrite risks. It also utilizes more than 50 MGAs to broker and issue business on its behalf. A Lloyd’s syndicate consists of one or more members that provide the funds to underwrite the risks it undertakes. Syndicates operate on a continuing basis, usually for several years. (Technically, a syndicate operates on an annual basis and chooses to continue insuring a risk, or not, at each policy anniversary.) Members are not obligated to participate in future syndicates.

Typically, the providers of capital for a syndicate support it for a number of years; therefore, they operate in a fashion similar to insurance companies. The individual members review applications for insurance and make decisions about whether they choose to participate in sharing a risk and if so, to what extent.

The Corporation of Lloyd’s oversees the Lloyd’s marketplace and its syndicates, providing support and ensuring its efficient, professional, and reputable operation. Lloyd’s describes itself this way:2

Lloyd’s is the world’s specialist insurance market. Unlike many other insurance brands, Lloyd’s is not a company; it is a market where our members join together as syndicates to insure risks. As of 31 December [2011] Lloyd’s was made up of 88 syndicates, full details can be found in Lloyd’s 2011 Annual Report.

Much of Lloyd’s business works by subscription, where more than one syndicate takes a share of the same risk. Business is conducted face-to-face between brokers and underwriters in the Underwriting Room.

When we talk of Lloyd’s, we’re really referring to two distinct parts. The market, which is made up of many independent businesses, and the Corporation of Lloyd’s, which is there – broadly speaking – to oversee that market. These parts are distinct, but far from independent. Both work closely to maintain high standards of performance across the market.

Lloyd’s provides insurance on an admitted and nonadmitted basis for seven major categories of insurance: liability, property, marine, energy, non-standard auto and company fleet auto, global aviation, and reinsurance. Because Lloyd’s provides insurance in over 200 countries worldwide, and for a wide variety of risks, its global diversification continues to contribute to its financial strength and capacity for surplus lines insurance and reinsurance.

Lloyd’s was established in a coffee house in London in the 1600s, where Edward Lloyd catered to the captains of ships, merchants, and the wealthy—all of whom engaged in the business of insuring ships and their cargoes. Each individual who assumed a share of a marine risk signed his name, one beneath another, on the insurance policy. This custom gave birth to the term underwriter.

After Edward Lloyd died, the coffee house carried on operations as a hub for the underwriting of marine insurance and, by the late 1800s, elected a committee, and moved to a new location. The Society of Lloyd’s was incorporated in 1871, and became the underpinning of the marketplace that operates today.

Regulation of Surplus LinesInsurance companies licensed to do business in the United States on an admitted basis are regulated differently than surplus lines (nonadmitted) insurers are. Admitted carriers are subject to state regulation with respect to solvency, rating, policy forms, market conduct, subsidiaries and affiliates, investments, capital, reserves, and other financial matters. In addition, insurers admitted to do business in a particular jurisdiction (i.e., each of the 50 states, the District of Columbia, Puerto Rico, and the U.S. territories and possessions) are required to contribute to the guaranty fund of the state or jurisdiction, which is used to pay claims if any of the licensed insurers becomes insolvent.

Surplus lines laws, however, have little control over the rate and form filing of nonadmitted insurers. In fact, surplus lines laws concentrate more on requirements of surplus lines brokers than of surplus lines insurers. In most states, surplus lines brokers are required to determine that a nonadmitted insurer meets the state’s

2 (Lloyd’s n.d.)



requirements pertaining to financial condition before placing surplus lines insurance. All 50 states, the District of Columbia, and all other American jurisdictions have enacted surplus lines legislation.

Most insurance companies that operate as nonadmitted carriers do so by choice rather than because of an inability to secure a license to transact insurance business in a particular state. This choice allows them to offer more flexibility with the coverages they offer; it also allows them more flexibility when pricing risks. It is important for agents to understand that each state has in place legislative requirements with respect to the financial solvency and capital requirements of insurers that secure licenses to transact business within their jurisdictions whether they are admitted or nonadmitted.

Nonadmitted and Reinsurance and Reform Act of 2010Before the Nonadmitted and Reinsurance Reform Act of 2010 (NRRA) became law in 2010—it is contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)3 —state regulation of surplus lines brokers and insurers, including licensing, differed greatly. With enactment of the NRRA, however, the states became subject to compliance with certain uniform federal requirements.

The purpose of surplus lines insurance is to supplement the standard insurance market; it is not to compete with the standard marketplace. Toward this end, most surplus lines legislation requires surplus lines brokers to conduct a diligent search of admitted carriers willing to write business before placing it with a surplus lines insurer.

Most jurisdictions publish export lists, which are lists containing types of insurance and risks the standard insurance market chooses not to insure. If a risk appears on an export list (i.e., amusement parks, aviation risks, and demolition contractors), a surplus lines broker does not need to conduct a diligent search because the regulatory authority has confirmed no standard market exists for the risk. Export lists are updated on a regular basis.

Broker LicensingAs previously mentioned, most surplus lines legislation concentrates on brokers. Per requirements of the NRRA, the states are now required to participate in the NAIC’s electronic National Insurance Producer Registry (NIPR) for the purpose assuring the uniformity of licensing requirements for surplus lines brokers in all jurisdictions. If a state did not begin participating in the NIPR by July 21, 2012, it may not collect any fees relating to the licensing of an individual or entity as a surplus lines broker. If the state chooses to participate in the database at a later date, collection of fees will be permitted at that time.

Home StateA surplus lines broker is only required to be licensed in the home state of the insured. The NRRA defines home state as being the state in which an insured maintains its principal place of business (if the insured is a business) or its principal residence (if the insured is an individual). If 100% of an insured risk is located outside the state where the insured’s principal place of business or residence is located, then the home state will be determined by the state to which the greatest percentage of the insured’s taxable premium for that insurance contract is allocated. For example, if the surplus lines broker is located in Kansas and the insured is located in Massachusetts, the broker must be licensed in Massachusetts to sell surplus lines insurance on that risk.

Insurers are permitted to transact surplus lines insurance in U.S. jurisdictions if they meet requirements of the jurisdiction in which they are licensed—in most cases, this will be the insured’s home state. This jurisdiction—the home state—is the only one able to regulate the surplus lines transaction and to collect premium taxes. Requirements of the surplus lines insurers include the financial criteria necessary for inclusion on a state list of eligible surplus lines insurers. Because the NRRA declared that surplus lines transactions are only subject to regulatory requirements of the insured’s home state, each state has its own insurance company licensing requirements—so long as they do not violate the NRRA.

3 (Chadbourne & Parke, LLP 2011)

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Eligibility Standards of Nonadmitted InsurersOne of the NRRA’s prohibitions prevents the states from requiring U.S. domiciled surplus lines insurers to meet eligibility standards other than those that conform to the NAIC’s Nonadmitted Insurance Model Act unless the state has adopted nationwide uniform requirements, forms, and procedures that comply with the NRRA. The NRRA also prohibits the states from preventing surplus lines brokers from placing nonadmitted insurance with, or procuring nonadmitted insurance from, any alien nonadmitted insurer on the NAIC’s Quarterly Listing of Alien Insurers.4 States are permitted to allow placement of surplus lines insurance with alien insurers not on the list but are not permitted to refuse placement with insurers on the list.

The International Insurers Department (IID) of the NAIC has received financial statements from the insurers contained in the Quarterly Listing. It has also received from those insurers copies of auditors’ reports, the names of their U.S. attorneys or other legal representatives, and details of their U.S. trust accounts with the IID. Based on these requirements, the NAIC states the insurers “appear to fulfill the criteria set forth in the International Insurers Department Plan of Operation for Listing of Alien Nonadmitted Insurers.” The NAIC does not endorse these insurers or guarantee their solvency.

Direct Placement/Independently Procured PlacementWhen a risk wishes to purchase surplus lines insurance, it may choose to be represented by a retail agent or surplus lines broker, or it may seek coverage directly with a surplus lines insurer. The process of a risk going outside the home state to purchase surplus lines insurance without the assistance of a broker or agent licensed in its home state is called direct placement or independently procured placement. Direct placement may only be conducted if certain criteria are met:

• The risk does not use a resident agent or surplus lines broker to gain access to the nonadmitted carrier

• The nonadmitted carrier conducts no activity in the insured’s state with respect to making the insurance contract or in its performance of the insurance contract

• The transaction takes place outside the insured’s home state

Exempt Commercial PurchaserThe NRRA introduced the term exempt commercial purchaser and defines such a party as being any person purchasing commercial insurance and, at the time of placement, meets the following requirements:

• Employs or retains a qualified risk manager to negotiate insurance coverage• Has paid aggregate nationwide commercial property and casualty insurance premiums in excess

of $100,000 in the immediately preceding twelve months, and• Meets at least one of the following criteria:

◦ Has a net worth in excess of $20 million (that amount may be adjusted) ◦ Generates annual revenue in excess of $50 million (that amount may be adjusted) ◦ Employs more than 500 full-time or full-time equivalent employees per individual insured or

is a member of an affiliated group employing more than 1,000 employees ◦ Is a not-for-profit organization or a public entity that generates annual budgeted expenses of

at least $30 million (that amount may be adjusted) ◦ Is a municipality with a population greater than 50,000

The amounts shown in the preceding paragraph must be adjusted in future years. Beginning on January 1, 2015, and every five successive years on January 1st, the amounts must be adjusted to reflect the percentage change, for all urban consumers, for that 5-year period in the Consumer Price Index (CPI) for All Urban Consumers published by the Bureau of Labor Statistics of the United States Department of Labor.

4 (National Association of Insurance Commissioners 2011)



If a client is an exempt commercial purchaser, a broker is not required to conduct a diligent search of the admitted market, and may place coverage directly in the surplus lines market, if:

• The procuring or placing broker has disclosed to the exempt commercial purchaser that similar insurance may or may not be available in the admitted market and, if available, may provide greater insurance protection with more regulatory oversight, and

• The exempt commercial purchaser has subsequently requested in writing that the broker procure insurance from, or place coverage with, a nonadmitted insurer

All other requirements have remained unchanged.

Premium TaxesIndividuals and businesses in the United States pay a variety of taxes, including income tax, excise tax, sales tax, property tax, capital gains tax, Social Security and Medicare tax, and unemployment tax. Insurance premium tax is a form of corporate income tax payable by insurance companies, although some states do assess insurance companies a corporate income tax and then permit a deduction for insurance premiums paid.5

Because premiums charged by admitted insurers are taxed to the insurers themselves, most insurance agents and policyholders do not even realize they exist. The states charge insurance premium tax at various rates, usually around 2%—like Florida, North Carolina, and Missouri do. Some states, however, charge higher and lower rates; Texas charges 1.6%, and Mississippi charges 3%. Some states vary the tax rate by line of insurance; for example, life and health premiums are taxed at a different rate than property and casualty premiums are taxed.

When nonadmitted or surplus lines insurance is written, however, the insurance company is not taxed; instead, the surplus lines broker or the policyholder is taxed. For this reason, surplus lines taxes are more transparent to the agent and policyholder. If the services of a surplus line broker are utilized to procure or place surplus lines insurance, the broker is taxed and, typically, passes the tax along to the policyholder. If the surplus lines purchase is a direct placement, the policyholder is taxed. Surplus lines tax rates often differ from the tax rates charged to admitted insurers. For example, California’s premium tax for property and casualty insurance is 2.35% but its surplus lines tax is 3%.

If an insurer is licensed to do business in one state and all its policyholders and their operations are contained within that state, premium taxation is simple. However, because state insurance regulations about premium taxation differ greatly, complications concerning premium taxation arise when an insurer transacts business in multiple states. These complications multiply even more significantly when policyholders operate in multiple states.

The surplus lines industry has long wished for uniformity among the states with respect to premium taxation and other insurance regulations. Before enactment of the NRRA, surplus lines premium taxes were allocated to the states based on a percentage of the risk that was located in each state. This meant that if a policyholder conducted operations in three different states, the tax rules and laws of each of the three states applied based on the policy premiums allotted to them. Because each state had its own regulations, calculating and collecting the taxes was not only difficult it could also be downright contentious.

Although it is known for developing model legislative acts for adoption by all the states, the National Association of Insurance Commissioners has been unable to achieve success with the development of an acceptable model act for the streamlining of regulation and taxation of multistate surplus lines insurance transactions. The NAIC proposed the Nonadmitted Insurance Multistate Agreement (NIMA) as an alternative to the Surplus Lines Insurance Multi-State Compliance Compact (SLIMPACT), which was created by a group of brokers, insurers, trade associations, stamping offices, and regulators to handle the taxation of multistate surplus lines transactions.

Neither plan has found much support by the states for their attempts to simplify multistate taxation of surplus lines insurance. Although the NAIC and four states support NIMA, the National Conference

5 (Casey 2009)

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of Insurance Legislators (NCOIL) and nine states support SLIMPACT. A number of the larger states (California, New Jersey, New York, Pennsylvania, and Texas) have decided to opt out of participation in any multistate tax sharing agreement or compact.

The reasons for the lack of support for NIMA and SLIMPACT include:• Some states will lose money if they participate• Voluntary state tax sharing agreements have not been successful in the past• Certain costs of the tax sharing agreements will be borne by policyholders and the states

The NRRA imposed regulations on the allocation of nonadmitted insurance premium taxation. It allows, but does not require, the states to enter into a compact or to otherwise establish procedures to allocate among the states the premiums paid to an insured’s home state. Each state is expected to adopt nationwide uniform requirements, forms, and procedures that provide for the reporting, payment, collection, and allocation of premium taxes for nonadmitted insurance that comply with the NRRA. Annual allocation reports may be required of surplus lines brokers and policyholders by the states participating in multistate compacts or agreements. These reports will be submitted to an insured’s home state and should include details of the portion of the nonadmitted insurance policy premium(s) attributable to the property, risks, and exposures in each state.

If a state does not elect to participate in a multistate agreement or compact, no state other than the home state may require any premium tax payment for admitted insurance. Essentially, the state will be permitted to retain 100% of the premium taxes for risks that declare it as home state, regardless of the percentage of an insured risk that is located in other states.

Stamping OfficesSurplus lines stamping offices were established by surplus lines brokers as a form of self-regulation within the surplus lines insurance industry. According to the National Association of Professional Surplus Lines Offices, Ltd. (NAPSLO):6

By offering the public a greater level of protection, the industry also achieved a greater level of success and acceptability. The E&S broker community was able to create a self-governing dynamic which provides consumer protection to those with E&S insurance needs without changing the marketplace’s essential character, simultaneously avoiding a traditional regulatory approach. The fourteen states with Stamping Offices are Arizona, California, Florida, Idaho, Illinois, Mississippi, Minnesota, Nevada, New York, Oregon, Pennsylvania, Utah, and Washington.

These stamping offices prevent ineligible insurers from transacting surplus lines insurance in their states and they monitor the financial solvency of eligible insurers. In addition, stamping offices monitor documents and policies submitted through them for the proper use of white-listed insurance companies and policy terms and language.

Before the stamping offices were created, many inadvertent clerical and regulatory mistakes generated fines and other penalties. Because the stamping office is an intermediary, it is able to offer information and advice before a licensee is fined or before it becomes vulnerable to a loss of license. According the NAPSLO, the fourteen state stamping offices review approximately eighty percent of all surplus lines placements in the U.S.

Stamping offices perform certain functions—although the stamping office in each state does not necessarily perform each of the following:

• Receives affidavits that contain required information about each surplus lines insurance placement

• Receives and reviews copies of all surplus lines policies written• Reviews the affidavits for accuracy, records information in a database, and reports to the state

insurance department

6 (National Association of Professional Surplus Lines Offices, Ltd. n.d.)



• Compiles statistical data• Provides technical assistance with respect to the transaction of surplus lines insurance, sometimes

in the form of education to surplus lines brokers and policyholdersMost stamping offices are non-profit organizations funded by the stamping fees they charge, which are a percentage of the surplus lines policy premium.

For example, if a surplus lines policy premium is $1,000, the surplus lines tax is 3% (or $30), and the stamping fee is 2% ($20), the surplus lines broker will be required to pay $50 in taxes and fees to the state in addition to the $1,000 premium to the surplus lines insurer.

If a surplus lines policy is written through direct placement, the insured will be required to pay any applicable taxes and stamping fees.

Surplus Lines AffidavitA surplus lines affidavit is required by most states when a surplus lines policy is written.7 Some states require the affidavits to be filed electronically instead of on paper and other states have substituted other requirements for the affidavit. For example, Maryland requires the affidavit to be filed within 45 days after the last day of the calendar quarter in which the policy was placed. North Dakota requires an affidavit to be filed within 60 days of a surplus line policy’s effective date. A few states simply require the surplus lines broker to keep an affidavit or equivalent form on file for a certain number of years after the surplus lines transaction.

The surplus lines affidavit is, essentially, a disclosure to the policyholder and an affirmation to the state that the producer, surplus lines broker, and surplus lines insurer have complied with the state’s surplus lines insurance regulations. Affidavits require the signatures of the insured, the producer, and/or the surplus lines broker to be notarized. Each state’s affidavit contains specific verbiage; in general, the forms include the following information:

• Name and address of the insured risk, along with the policy number or type of policy• Name, address, and license number of the surplus lines producer

• Name, address, and license number of the writing producer• A statement affirming that a diligent search was made by the producer for coverage in the

admitted market and such coverage was unavailable • The insured was advised by the producer that admitted coverage was not available and that the

nonadmitted insurer is not a member of the state’s guaranty associationIn addition to the information shown above, some states also require the following information on their affidavits:

• The names of a minimum of 2 or 3 admitted insurers that declined to write coverage• The reason coverage was declined in the admitted market• The amount of insurance purchased• The policy dates and premium• Commissions to the producer and/or surplus lines broker• Amounts of surplus lines taxes and/or stamping fees• Whether policy is new or renewal

Agent ConcernsIt is nine in the morning and Arnie Agent is excited. He has a three o’clock appointment with a referral from one of his best commercial lines clients. The referral owns a large house in one of the most prestigious sections of town, four cars, and a trendy restaurant. Dollar signs appear in Arnie’s mind; if he acquires this new client, his sales bonus for the month will be made.

7 (Dearie 2012)

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At four o’clock, Arnie is no longer excited. The referral, Buddy, is a great guy. Unfortunately, Buddy has a few insurance issues. Both his teenagers have multiple speeding tickets on their driving records. He and his wife have never had a homeowners claim … but the family dog is a pit bull. And his business. Wow. Buddy’s restaurant is a mess. It is being sued by a patron who claims she contracted food poisoning from a bacon and Swiss omelet the restaurant served. An employee is suing because she claims a fellow worker committed sexual harassment. And that little electrical fire last winter did not help, either. The current insurer has issued a non-renewal notice for loss history.

What can Arnie say? What can Arnie do?

The first thing Arnie should do is decide whether or not he wants Buddy as a client. Will his relationship with the client who referred Buddy suffer if he declines to assist Buddy with his quest for insurance? Does Arnie think Buddy is a poor risk, or just one with a spate of bad luck? Most agents in Arnie’s shoes are not going to want to take Buddy on as a client, regardless of the relationship with the client who referred him. But if an agent did want to take Buddy on, he or she should be able to find coverage for most of Buddy’s insurance needs in the surplus lines market.

But what if Buddy’s situation were different? What if his kids were good drivers? And his dog was a Golden Retriever? And the only reason the insurance policy covering his restaurant was being non-renewed was a $15,000 grease fire? Might Arnie be willing and able to be Buddy’s new insurance agent? He probably would.

Arnie would be able to write all Buddy’s policies, except the restaurant, in the standard marketplace. To secure insurance on the restaurant, Arnie will need access to nonadmitted insurers. If he forms a relationship with a good wholesaler, that business partner will provide Arnie with the guidance he needs as he navigates the waters of his first surplus lines placement.

Reputable surplus lines brokers and MGAs provide retail agents with sample policies, forms, and endorsements so agents can familiarize themselves with policy language and coverage terms before coverage is bound. They search for multiple carriers to be sure they secure the best coverage terms and pricing. They provide marketing materials and assistance. They only provide quotes with nonadmitted carriers that have strong financial ratings. They also educate retail agents with respect to the insurance laws that apply to surplus lines transactions.

One of the most important thing retail agents need to know is this: retail agents do NOT have binding authority when writing surplus lines insurance. In fact, the only surplus lines brokers that have binding authority are MGAs. Quite often, the surplus lines broker has to submit the retail agent’s request to the nonadmitted carrier in the same fashion the retail agent undertakes when writing insurance with an admitted carrier.

Retail agents should always make sure they allow themselves, and their clients, ample time to complete and submit applications and required paperwork. Waiting until the last minute when submitting a surplus lines transaction usually results in negative consequences.

Another consideration is the issuance of certificates of insurance. Because retail agents do not have binding authority, many nonadmitted insurers and wholesalers do not permit retail agents to prepare certificates of insurance. Instead, they require that all such requests be submitted to the wholesaler for issuance. Agents should be sure to determine, in advance of binding coverage, how a wholesaler wishes to handle the issuance of certificates of insurance. If the wholesaler will, in fact, issue these documents, policyholders should be notified that the retail agent needs some lead-time before being able to produce them.

In most states and jurisdictions, the wholesaler is not responsible for explaining policy coverages, terms, endorsements, conditions, etc. beyond what is required for them to put on their proposals, quotes, and offers of coverage. They should always provide the retail agent with sample policies, forms, and endorsements upon the retail agent’s request and are usually happy to discuss any concerns the agent might have.

Sometimes, the wholesaler is unable to secure coverage on the same terms that were requested on the insurance application. It is for this reason, retail agents should be sure to confirm that the coverages quoted and offered match the terms requested. Most wholesalers include language on their quotes and proposals that state this fact, but retail agents should always compare what they receive—both quotes and policies—with what they request.



Although most states require wholesalers to obtain financial information about the nonadmitted insurers with whom they place coverage, retail agents should still protect themselves by hopping online to the A.M. Best Company’s website to verify a nonadmitted carrier’s financial rating. The wholesaler will also provide retail agents with details about the premium taxes, stamping fees, and any other costs to be charged the client in addition to the policy premium.

Premium taxes must be paid to the state, and must be paid within a certain number of days. Failure of the surplus lines broker to pay taxes on a timely basis results in a fine to the surplus lines broker. When financing a surplus lines policy, the taxes and stamping fees are usually required up-front and in addition to the down payment for the policy premium. In some states, if the policy is cancelled mid-term, no refund of the premium taxes and/or stamping fees is made.

When surplus lines insurance is written, a minimum earned premium will be required. In many cases, the minimum earned premium is 25% of the policy premium.

For example, assume a surplus lines policy with a $1,000 premium is issued, and the minimum earned premium is 25%. If the named insured requests cancellation of the policy, the insurer will retain $250 of the premium, regardless of the date of cancellation—even if it is the same day coverage is issued.

As the risk to the insurer increases, so too, does the minimum earned premium. It is quote common for issuers of special event policies to require a minimum earned premium of 100%—which translates to payment in full, without any type of refund available.

As mentioned previously, nonadmitted insurers are not members of a state’s guaranty association. Therefore, if they become insolvent, their policyholders are not protected by the state’s guaranty fund. Because state guaranty funds limit recovery when an insurer becomes insolvent, and because many national or alien nonadmitted carriers are actually stronger financially than smaller, regional insurers, this issue isn’t as worrisome as it once was.

An insurance company’s financial rating is more important in determining its solvency than its status as an admitted or nonadmitted insurer is. A nonadmitted carrier with an A+ rating by A.M. Best is more financially solvent than an admitted carrier with a B rating is. Other firms that provide insurance company financial ratings in addition to A.M. Best include Standard & Poor’s, Moody’s, and Weiss Ratings.

In closing, retail agents should be alert for conditions in surplus lines insurance that are not found in insurance issued in the standard market. Because nonadmitted insurers have much latitude with respect to issuing endorsements that modify policy language or exclude coverage, special care should be taken to review all policies, forms, and endorsements before recommending coverage to the insured and submitting a bind order to the wholesaler.

For example, many surplus lines general liability policies contain a classification limitation endorsement.8 This endorsement limits coverage to the classifications noted in the policy. If the insured has an operation or acquires an operation or exposure for which a rate classification does not appear on the policy’s Dec page, the coverage will not apply.

Another example of an endorsement not found in the standard insurance marketplace involves workers’ compensation insurance. Many surplus lines workers’ compensation policies contain an audit provision that only provides for an additional audit premium and not a refund audit premium—meaning that if the insured’s actual payroll is less than anticipated, the insured does not receive a refund after the audit is completed.

One final note with respect to working with wholesalers: Retail agents should be sure to obtain an E & O certificate of insurance from them. Wholesalers will surely request certificates from retail agents as a form of protection; retail agents should secure the same form of protection for themselves. If a wholesaler is unable or unwilling to provide a certificate of insurance for errors and omissions liability insurance, perhaps it is not the wholesaler to be working with.

8 (Malecki 2011)

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ResourcesFor students wishing to research surplus lines insurance further, the following Internet resources have been provided: American Association of Managing General Agents and National Association of Professional Surplus Lines Offices, Ltd.

Chapter 1 Review Questions

1. Which of the following is NOT one of the categories of risk that generally are ineligible for insurance in the standard insurance marketplace?a. Distressedb. High-capacityc. Preferredd. Unique

2. What type of insurer has not submitted its applications, policy forms, endorsements, and pricing to the jurisdiction for approval by the department of insurance?a. Admittedb. Nonadmittedc. Aliend. Intermediary

3. What type of insurance agent is permitted to bind surplus lines insurance?a. Writing agentb. Intermediary agentc. Wholesale agentd. Managing general agent

4. Which of the following is NOT a specialty line of insurance?a. Aviationb. Homeownersc. Medical malpracticed. Professional liability

5. In what state must a surplus lines broker be licensed?a. The broker’s state of residencyb. The state in which the insurer is domiciledc. The insured’s state of residencyd. The insured’s home state

6. What state is responsible for charging surplus lines insurance premium taxes?a. The insured’s home stateb. The surplus lines broker’s state of residencyc. The producer’s state of residencyd. The insurance company’s state of domicile

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Chapter 2Reinsurance

Because reinsurance transactions take place between insurance companies—and do not involve policyholders and agents directly, most producers and agents possess a rudimentary understanding of reinsurance—if they understand it at all. Despite an insurance professional’s [lack of] awareness of reinsurance, it is a crucial component of the insurance industry and affects every aspect of an insurance company’s operations. Virtually all insurance companies, including property and casualty insurers, purchase and/or sell reinsurance.

In very basic terms, reinsurance agreements transfer the risk of loss between two insurance companies. For example, ABC Insurance Company sold a homeowners policy to Bud. Bud’s policy provides $500,000 of insurance for the dwelling and $1,000,000 of personal liability coverage. If ABC Insurance Company does not purchase reinsurance, it will be solely responsible for the payment of all losses covered by the policy. In other words, if Bud’s house were destroyed in a fire, ABC must come up with the $500,000 to pay Bud. Similarly, if Bud’s neighbor broke his neck when diving into Bud’s backyard swimming pool and was later awarded a $2,000,000 judgment against Bud, ABC would be solely responsible for paying $1,000,000 and the defense costs.

On the other hand, if ABC does purchase reinsurance, it will only be responsible for a portion of Bud’s losses and the reinsurer will be responsible for a portion of the losses. The reinsurance agreement specifies which company pays what portion of a covered loss. (In some cases, the reinsurer is not responsible for any portion of a loss.)

This chapter does not delve deeply into the topic of reinsurance—a single chapter could not possibly address all its technicalities and repercussions. It does, however, shed light on the basics of reinsurance, how reinsurance affects the insurance industry, and, in particular, how individual insurance companies are affected by reinsurance. A glossary of basic reinsurance terms leads off the discussion.

Reinsurance TerminologyThis section provides the student with only the most basic of reinsurance terms. For a more thorough list of terms, this hyperlink to Reinsurers Association of America will take you to its glossary.1

Admitted or Authorized Reinsurance – Reinsurance purchased from a reinsurer licensed or authorized to transact business in the jurisdiction of the reinsurance transaction.

Alien Insurer – An insurance company domiciled outside the United States.

Association (also Pool or Syndicate) – An organization of insurers or reinsurers through which pool members underwrite particular types of risks and share premiums, losses, and expenses in agreed amounts.

Broker – An intermediary that facilitates the purchase of reinsurance between the reinsurer and the purchasing insurer, called the ceding company. The broker usually represents the ceding company and receives commission and/or other fees for placing the reinsurance business and any other services provided.

Capacity – Capacity has two separate meanings: (1) The largest amount of insurance or reinsurance available from an insurance company (or market). (2) The largest premium volume an insurance company (or market) is able to write based on its financial position.

Catastrophe Reinsurance – A form of reinsurance that indemnifies the ceding company with respect to multiple losses arising from one or more disasters.

Cede – The transference of some, or all, of an insurance company’s risk to another insurance company through a reinsurance agreement or agreements. The buyer of reinsurance is the cedent (ceding company) and the seller of reinsurance is the reinsurer.1 (Reinsurance Association of America 2007)

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COMMERCIAL COVERAGES: WHAT EVERY AGENT SHOULD KNOW


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Cedent (also Ceding Company, Reassured, or Reinsured) – An insurance company that purchases reinsurance for the purpose of obtaining contractual indemnification for all, or a designated portion, of the risk associated with insurance policies it issues.

Ceding Commission – An amount deducted from the reinsurance premium to compensate the ceding company for its premium taxes and acquisition and overhead costs.

Cession – The portion of insurance that is ceded by the ceding company to the reinsurer.

Direct Writing Reinsurer – A reinsurance company that uses its own personnel to acquire business and that does not typically accept reinsurance business from a broker or intermediary.

Excess of Loss Reinsurance (also Non-Proportional Reinsurance) – A form of reinsurance that only indemnifies the ceding company for losses in excess of a specific retention. Excess of Loss Reinsurance (XL) includes various types of reinsurance including catastrophe reinsurance.

Facultative Certificate of Reinsurance – A contract that formalizes a reinsurance cession on a particular risk.

Facultative Reinsurance – The reinsurance of individual risks whereby the reinsurer may accept or reject each individual risk offered by the ceding company. The reinsurer is under no obligation to accept a risk and the ceding company is under no obligation to offer risks to the reinsurer.

Facultative Treaty – A reinsurance contract that describes how the subjects of facultative reinsurance will be handled. The ceding company has the option of offering to cede and the reinsurer has the option of accepting or declining each offer.

Foreign Insurance Company – An insurance company domiciled in the United States but in a state other than the jurisdiction involved in the transaction.

Incurred But Not Reported (IBNR) – A term that refers to losses that have occurred but have not yet been reported to either the ceding company or the reinsurer. These losses have a significant impact on loss reserves and loss adjustment expenses. (It is understood by all parties to a reinsurance contract that an unspecified number of losses will be reported well after they occur—especially liability losses.)

Incurred Loss (also Loss Incurred) – A calculation of outstanding losses at the beginning of a reinsurance period, plus any paid and/or outstanding losses reported during the reinsurance period, minus any outstanding losses at the end of the reinsurance period. (The date of loss or the original policy has nothing to do with these loss calculations.)

Insolvency Clause – A reinsurance policy provision requiring reinsurance to be paid directly to the company or its liquidator without reduction in the event the reinsurer becomes insolvent. This provision is required by most state insurance regulators as part of their efforts to monitor insurer solvency.

Letter of Credit (LoC) – A financial instrument obtained from a bank that guarantees the availability of funds to be collected in the future under a reinsurance contract. Letters of credit are often required of alien insurers by insurance regulators.

Line of Business – The general classification of a type of insurance as designated in the insurance industry, such as homeowners, workers’ compensation, etc.

Loss Adjustment Expense (LAE) – The expense incurred by a ceding company in the defense, cost containment, and settlement of claims.

Net Retained Liability – The amount of insurance a ceding company does not reinsure in any way and keeps for its own account. This is also referred to as the ceding company’s “retention.”

Net Loss – The amount of loss sustained by a ceding company after making deductions for all recoveries, salvage, and claims against reinsurers. Details of the definition of net loss are contained in the reinsurance agreement.

Non-Admitted Reinsurance – Reinsurance purchased from a reinsurer that is not licensed or authorized to transact business in the jurisdiction of the reinsurance transaction.


CHAPTER 2: REINSURANCE 19

Obligatory Treaty – A reinsurance agreement that requires the ceding company to cede business and the reinsurer to accept it. The agreement states the subject of the business to be ceded.

Placement Slip (also Binder, Confirmation, Slip, or Cover Note) – A temporary reinsurance agreement that states certain terms and conditions of reinsurance that has been effected. A formal reinsurance contract replaces a placement slip.

Portfolio – A term that defines a body of insurance policies in force (premium portfolio), outstanding losses (loss portfolio), or insurance company investments (investment portfolio). If all new and renewal insurance of a ceding company is reinsured, it is referred to as a running account reinsurance with portfolio transfer (or assumption).

Portfolio Reinsurance – The transfer of a portfolio via a cession of reinsurance. The only policies reinsured are those in force—not new business and not renewals. The premium portfolio and/or the loss portfolio may be reinsured.

Portfolio Return (also Return Portfolio or Return of Unearned Premium) – If the reinsurer is no longer liable under a pro rata reinsurance agreement for losses that occur after the termination of a reinsurance treaty, the total unearned premium reserve is usually transferred to the ceding company.

Primary – In reinsurance, this term may be used to describe an insurer, insured, policy, or insurance. When used, it has separate and distinct meanings:

• Primary Insurer is the ceding company• Primary Insured is the policyholder insured by the primary insurer• Primary Policy is the initial policy issued to by the primary insurer to the primary insured• Primary Insurance is the insurance provided by the primary policy issued to the primary insured by

the primary insurer; primary insurance is often called underlying insurance.Pro Rata Reinsurance (also Quota Share, Proportional, Participating, or Surplus Reinsurance) – A general term that describes all types of reinsurance whereby the reinsurer assumes responsibility for a pro rata share of the ceding company’s premiums and losses.

Quota Share Reinsurance – A type of pro rata reinsurance whereby the reinsurer indemnifies the ceding company for a stated percentage of each loss covered by the reinsurance contract. The ceding company pays the reinsurer the same percentage of its premiums for the insurance subject to the reinsurance agreement.

Rating – Most reinsurance is priced using one, or both, of two different rating methods. The methods can be used individually or in a combination; each contains specific subsets of rate formulas.

• Experience Rating (also Loss Rating) is based on the ceding company’s historical loss experience.• Exposure Rating is based on analysis of the exposures contained in the book of business per

business industry. This method does not take the actual loss history of the ceding company into consideration; instead, it uses industry “averages” for the exposures contained in the industries of insurance subjects within lines of business.

Reinsurance – The transaction whereby the assuming insurer, in consideration of premium paid, agrees to indemnify the ceding company against all or part of the losses the latter may sustain under the policy or policies it has issued.

Reinsurance Premium – The consideration the ceding company pays the reinsurer for the coverage provided by the reinsurer.

Reinsurer – The insurance company that assumes some or all of the insurance or reinsurance risk written by another insurance company.

Reserve – An amount established to provide payment for a future obligation; i.e., claims reserve.

Retention – The amount of risk a ceding company keeps for its own account or the account of others. The retention is not reinsured.



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Retrocede – The transference of some, or all, of a reinsurer’s risk to another reinsurer through a reinsurance agreement or agreements. The buyer of reinsurance is the retrocedent (ceding reinsurer) and the seller of reinsurance is the retrocessionaire.

Retrocedent – A reinsurer that underwrites and issues reinsurance contracts to a primary insurance company or a reinsurer and then contractually obtains reinsurance from a retrocessionaire.

Retrocession – The reinsuring of reinsurance.

Retrocessionaire – A reinsurer that accepts the transference of some, or all, of a reinsurer’s risk via a reinsurance agreement or agreements.

Risk – A term describing the uncertainty of loss, chance of loss, or the variance of actual from expected results as it relates to insurance provided by an insurance or reinsurance contract. Risk also refers to the subject of insurance (i.e., a car, a business, a human life).

Risk Transfer – The transference of insurance risk from the ceding company to the reinsurer under a reinsurance agreement. In order for a ceding company to receive credit for reinsurance (both statutorily and under generally accepted accounting practices), it must achieve a threshold of both underwriting risk and timing risk.

Subrogation – A contractual transfer of rights from one party to another; specifically, after an insurance company has made a loss payment, the transfer of rights of recovery from the party receiving payment to the insurer making payment.

Target Risk – Certain risks in property reinsurance that are excluded from reinsurance treaties and that, if reinsured, are reinsured under facultative reinsurance agreements. Examples of target risks include certain bridges, tunnels, fine arts collections, and other property of high value and/or high exposure.

Treaty – A reinsurance contract.

Unauthorized Reinsurance – Reinsurance placed with a reinsurer that is not authorized to conduct business in the jurisdiction in which the reinsurance transaction takes place.

Underlying – The amount of existing insurance, or reinsurance, that applies to a loss before the next highest layer of insurance or reinsurance is attached.

Underwriting Capacity – The maximum amount of money an insurer or reinsurer is willing to risk in a single loss on a single risk or within a given period of time. Underwriting capacity may also be imposed by law or by regulatory authority.

History of ReinsuranceAlthough the first documented reinsurance contract was effected in 1370—when an underwriter contracted with two individuals to reinsure a ship during a portion of its voyage from Genoa, Italy to Bruges, Belgium—the first reinsurance company was not established until the mid-1800s.2 A number of disastrous fires took place in Europe and the United States during the mid to late nineteenth century; the manner in which these disasters affected insurance companies and, ultimately, their policyholders, provided the impetus for the establishment of reinsurance companies.

In 1842, one of the largest fires in Germany destroyed approximately one-fourth of the inner city of Hamburg. The fire raged for four days, destroyed numerous buildings, killed over 50 people, and left 20,000 people homeless. It took forty years for the city of Hamburg to rebuild.

Because the extensive damage (estimated to be more than $35 million at the time) bankrupted a number of insurers, insurance companies in Germany began to establish subsidiary insurers to handle the surplus business of their parent companies. In 1846, the Cologne Reinsurance Company was established and, for a variety of reasons, mostly financial, it did not execute its first reinsurance treaty until 1852. The next two European reinsurers to be founded are still in existence. Munich Reinsurance Company (Germany) was founded in 1880 and Swiss Reinsurance Company Limited (Switzerland) was founded in 1863.

2 (Kopf n.d.)



Catastrophic fires in the United States also prompted reinsurance to be transacted in this country, although American reinsurance companies had not yet been established. In October 1871, a horrendous fire in Chicago destroyed over 12,000 buildings and generated property losses of approximately $165 million. In November of the following year, a fire in Boston destroyed over 700 homes and caused approximately $75 million in losses. Roughly one-half the insurance in place on the destroyed property in Boston was insured by Massachusetts domiciled insurers—many of whom went into liquidation because of the fire. After the Chicago fire, the insurance commissioners of all the states began discussing seriously the need for U.S. insurers to purchase reinsurance on a routine basis; the Boston fire served to reinforce this opinion.

The United Fire Reinsurance Company of Manchester, England began operating in the United States in April of 1882 as a nonadmitted reinsurer. Just before the turn of the century, the states began to license foreign reinsurers as admitted reinsurers on a regular basis.

Two additional catastrophic fires took place in the U.S. and spurred significant awareness of the need for reinsurance. The Great Baltimore Fire (1904) raged for two days and destroyed a major portion of the center of the city, encompassing property located in an area of approximately 140 square acres. The fire caused more than $150 million in damage and was responsible for implementing national standards for fire hydrant and fire hose connections. A lack of such standardization is directly responsible for the two-day duration of the fire.

The San Francisco fire (1906), which was sparked by a momentous earthquake, caused approximately $350 million in fire losses—of which about 60 percent were insured. Over 30 separate fires destroyed roughly 25,000 buildings in an area containing 490 city blocks. It is reported that many of the fires were set deliberately when residents learned that although property insurance did not pay for losses resulting from the peril of earthquake, it did pay for loss caused by fire. Of the $235 million in losses that were insured, about 80 percent of the losses received claim payments.

The San Francisco Chamber of Commerce commissioned an insurance report after the fire with respect to the insurance consequences of the tragedy. The report revealed that many of the primary insurers who were unable to pay their claims in full were able to pay their reinsurance claims fully.3

In 1914, the Pilot Reinsurance Company of New York was incorporated to write reinsurance in fire, marine, and allied lines of insurance. However, until the 1950s, most U.S. reinsurance was written by a department within a direct writing insurance company rather than by a reinsurance company:4

• American Central Life established a reinsurance division in 1904• Lincoln National wrote its first reinsurance treaty in 1912• North American Re (parent company is Swiss Re) was founded in 1923• Transamerica began accepting reinsurance in 1930

In the 1950s and 1960s, a number of reinsurance companies joined the reinsurance market in the United States:5

• 1953 – CNA began selling reinsurance• 1959 – Munich American Reassurance Company was founded• 1965 – Phoenix Mutual began selling reinsurance• 1967 – General Reassurance Company was founded• 1969 – Transamerica began selling reinsurance and soliciting it directly

American insurance companies are permitted to purchase reinsurance from foreign companies because reinsurers conducting business globally have more diversification and are viewed as having greater financial strength than reinsurers who conduct business in one specific geographic area have. In recent years, A.M. Best has reported the 10 largest reinsurers in terms of gross written premiums:6

3 (Kopf n.d.)4 (Holland 2008)5 (Holland 2008)6 (Wade 2011)



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• Munich Reinsurance Company (Germany)• Swiss Reinsurance Company (Switzerland)• Hannover Rueckversicherung AG (Germany)• Berkshire Hathaway, Inc. (United States)• Lloyd’s (United Kingdom)• SCOR S.E. (France)• Reinsurance Group of America, Inc. (United States)• Allianz S.E. (Germany)• PartnerRe, Ltd. (Bermuda)• Everest Re Group, Ltd. (Bermuda)

Reasons for ReinsurancePrimary insurers, also called direct insurers, need reinsurance to address several needs. The major reasons are to protect themselves in the event of catastrophe and to limit the amount of annual losses for which it must be responsible. Reinsurance also provides a number of accounting benefits with respect to an insurer’s financial statements.

According to Swiss Re, primary insurers benefit from reinsurance in the following ways:7 • Catastrophe risks are passed on to the reinsurer(s)• Balance sheet risk, in the form of random fluctuation, risk of change, and risk of error, are passed on

to the reinsurer(s)• The balance of the primary insurer’s portfolio is improved through the reinsurer’s assumption of risk

for policies issued at large limits of liability and policies with high exposures• Underwriting capacity is increased by the reinsurer(s)’s acceptance of a portion of the primary

insurer’s risks and providing additional reserves• The primary insurer’s available capital is increased when equity is freed after the reinsurer assumes a

portion of the primary insurer’s risk• The primary insurer receives additional services from the reinsurer(s), including:

◦ Underwriting data obtained from global sources ◦ The assessment and evaluation of special risks ◦ Loss prevention consulting ◦ Support with loss adjustment ◦ Actuarial support and assistance ◦ Training ◦ Assistance with capital investment, recruitment of management, mergers and acquisitions, etc.

For example, if a primary insurer purchases facultative reinsurance, it will have the capacity and resources to insure larger commercial accounts it might not otherwise be able to insure, such as a car manufacturer or a national retail store chain. A primary insurer will also be able to secure more effective protection against the consequences of products liability claims if it has purchased facultative reinsurance. When purchasing excess of loss reinsurance, a primary insurer will pass along the catastrophe risks associated with hailstorms, hurricanes, earthquakes, floods, air and marine accidents, etc. (More about these types of reinsurance later in the chapter.)

The basics of reinsurance, and all insurance for that matter, are associated with mathematical calculations and formulas—specifically, the law of large numbers. Also called Bernoulli’s Law, or Ars Conjectandi (The Art of Conjecture), the law of large numbers was proven by Jacob Bernoulli in 1705. In simple terms, the mathematical premise states that as the number of units in a group increases, the more likely it is to predict a particular outcome.

7 (Swiss Reinsurance Company 1996)



In other words, the more often you do something, the better your chances are of predicting what the outcome will be.

For example, if Ed flips a coin, the odds are 1 in 2 that the coin flip will turn up heads. If Ed flips a coin 100 times, he has a greater chance of getting heads half the time than if he only flipped the coin 5 times.

Insurance companies use the law of large numbers as their foundation of statistical expectation of loss when calculating insurance premiums. Insurance companies can predict, with reasonable accuracy, the probability that actual loss experience will equal expected loss experience.8 This is the major reason insurance companies prefer to write particular types of insurance and avoid writing others.

For example, as an insurance company continues to write more and more auto policies, it will be able to predict the number of losses more accurately. However, if it only writes a single auto policy, its ability to predict losses is reduced drastically and, in fact, is actually handicapped.

Lines of insurance that involve relatively easy loss prediction include property, auto physical damage (i.e., collision and comprehensive coverages), and aviation hull. Because these types of losses are typically reported immediately after occurring, and are usually paid in a relatively short period of time, the amount and degree of loss can be calculated without much difficulty. These lines of insurance are referred to as short-tail business.

Long-tail business, on the other hand, involves lines of insurance that generate claims that may not be known until long after the actual loss occurs. Many types of liability insurance fall into this category, especially workers’ compensation, medical malpractice, and professional liability.

For example, a surgeon may be sued by a patient two years after performing a surgical procedure. During those two years, damages accrue and, if the surgeon loses the lawsuit, interest will be added to the claim. Because of inflation, any other costs associated with the claim will have increased, such as medical services and legal fees. In addition, social, legal, and other economic factors may combine to generate a much larger claim than anyone would have anticipated.

An insurer’s claims costs are generated by three factors:1. The total number of units insured2. Frequency (how many claims happen per unit insured)3. Severity (the average cost of each claim)

As previously discussed, the more number of units insured, the easier it will be for the insurer to predict the frequency and severity of losses.

The way direct insurers calculate loss costs, however, does not always apply to reinsurers. Because the subject of reinsurance is often catastrophe and unique risks, less loss data is available to review and evaluate those types of loss. In addition, the total number of catastrophe and unique risks insured by reinsurers is far less than the total number of “normal” risks covered by direct insurers.

Delays in reporting losses negatively affect all insurance companies; however, reinsurers are the hardest hit by this factor. For example, ABC Insurance receives a notice of a general liability claim in January. Based on the information collected by its adjuster, it establishes a loss reserve. When the loss is ultimately paid three years later after litigation, it exceeds the primary policy’s limit of liability and the primary insurer’s reinsurance retention. It is only at that time that the primary insurer reports the loss to the reinsurer because, up until that time, the primary insurer believed it would retain all expenses related to the claim. Similar scenarios occur in the world of reinsurance all the time, which has a tremendous impact on pricing and the ability to pay claims.

How Reinsurance WorksThe first thing an agent must understand about reinsurance is that reinsurers have no direct contract with, or obligation to, policyholders of the primary insurance company. The only parties to a reinsurance agreement are the ceding company and the reinsurer. The only contractual duties and rights are those of the ceding company and reinsurer.

8 (International Risk Management Institute, Inc. n.d.)



24

The second thing an agent needs to know is that reinsurance transactions have no effect on the nature of the risks insured by the ceding company. This means the contract between the ceding company and the reinsurer has nothing to do with how the primary insurance policy’s terms, conditions, limits, and exclusions affect the policyholder and any other person insured by the policy.

The third item an agent should keep in mind is that reinsurance payments are only made by a reinsurer to a ceding insurer after it has made loss payments under its own policies and underlying reinsurance contracts. However, if the ceding company becomes insolvent and the reinsurance contract contains an insolvency clause, reinsurance may be paid to the ceding company’s receiver. Agents should also know that any payments made by a reinsurer to a ceding company will be considered an asset of the ceding company.

Forms of ReinsuranceTreaty ReinsuranceWhen reinsurance is written on a treaty, one or more lines of business are the subject of the reinsurance contract (the treaty). Treaties usually remain in force for long periods of time and renew automatically. They cover all risks contained in the subject line(s) of business unless specific exclusions are contained in the agreement.

For example, one reinsurance treaty might cover all auto physical damage risks in a ceding company’s book of business and another might cover all property and auto physical damage risks in a ceding company’s book of business. Another treaty might cover a ceding company’s workers’ compensation book of business.

Although treaty reinsurance does not require underwriting review of individual risks by the reinsurance underwriter, it does require an exhaustive review of the ceding company before the contract is effected. Concerns of the reinsurer before agreeing to enter into a treaty include the ceding company’s:

• Underwriting philosophy and practices• Risk management philosophy and practices• Claims management and settlement philosophies and practices• Historical experience• Engineering control• Management team, including the general background and experience of individual members• Business goals and objectives

Facultative ReinsuranceWhen facultative reinsurance is written, the subject of coverage is an individual risk. The ceding company and reinsurer negotiate coverage for a single particular policy. This type of reinsurance is generally purchased when a ceding company insures a risk that is excluded from treaty reinsurance, for amounts in excess of the limits of treaty reinsurance, and for unique and catastrophic risks.

Facultative reinsurance is usually more costly than treaty reinsurance because the reinsurer incurs more expenses during the process of individually writing risks. The pricing of facultative reinsurance, however, is far more apt to be appropriate for the risk because of the individual underwriting process. Because of its inherent nature to provide coverage for unusual risk exposures, facultative reinsurance presents far more opportunity for significant loss than treaty reinsurance does.

For example, a ceding company’s treaty may exclude coverage for pollution liability. When the ceding company has the opportunity to write a trucking company with a significant pollution liability exposure, it may negotiate facultative reinsurance to cover the risk.



Types of ReinsuranceRegardless of the general form of reinsurance (i.e., facultative or treaty), coverage may be written on a proportional or non-proportional basis. Each of these basic types of reinsurance may be further amended to include different methods of sharing losses between ceding companies and reinsurers.

Non-Proportional ReinsuranceWhen non-proportional reinsurance is purchased, losses are divided between the ceding company and reinsurer based on the actual amount of the loss. The reinsurance treaty defines the ceding company’s retention (also called a deductible, net retention, excess point, or priority) and the reinsurer is only liable for losses that exceed the ceding company’s retention.

For example, assume the ceding company’s retention is $250,000. If a $700,000 loss occurs, the ceding company pays the first $250,000 and the reinsurer pays the balance, or $450,000.

The reinsurance premiums for non-proportional reinsurance are based on the ceding company’s loss experience in previous years in addition to expected losses for the exposures insured.

Excess of Loss ReinsuranceThe most common type of non-proportional reinsurance is excess of loss (XL) reinsurance. When excess of loss reinsurance is issued, the reinsurance agreement specifies what lines of primary insurance are subject to the agreement and then focuses on the losses subject to the agreement—the amount of insurance issued by the ceding company (i.e., the limit of liability appearing on the primary policy) does not come into play with excess of loss reinsurance. The reinsurance agreement also specifies the ceding company’s retention, which may be referred to as a deductible, net retention, excess point, or priority.

Excess of loss reinsurance is subdivided into two basic types: per risk or per catastrophe. Working excess of loss per risk reinsurance applies to each individual claim incurred for each individual risk. Catastrophe excess of loss reinsurance applies to a catastrophic event that generates losses for multiple insured risks.

Excess of loss reinsurance allows a ceding company to keep more of its gross premiums than quota share reinsurance; however, it also leaves the ceding company vulnerable to all claims that fall below its retention.Example #1

Assume the ceding company insures a building for $2,000,000 and that single building suffers a total loss.

Quota Share Reinsurance Excess of Loss ReinsuranceCeding company’s quota 30% NACeding company’s retention NA $250,000Ceding company’s share of loss $600,000 $250,000

Example #2

Assume the ceding company insures three homes in a neighborhood in which a tornado strikes; the homes sustain damage as follows:

Home #1—$100,000Home #2—$50,000Home #3—$10,000



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Quota Share Reinsurance

Excess of Loss Reinsurance

Ceding company’s quota 30% 30%Ceding company’s retention NA NACeding company’s share of loss for Home #1 $30,000 $30,000Ceding company’s share of loss for Home #2 $15,000 $15,000Ceding company’s share of loss for Home #3 $3,000 $3,000Ceding company’s total share of all 3 losses $48,000 $48,000

Proportional ReinsuranceAlthough many types of proportional reinsurance exist, one component is common to all: the ceding company and reinsurer share premiums and losses of the reinsured book of business based on a ratio defined in the reinsurance agreement. Depending upon the reinsurance contract, the ratio may be the same for all risks covered (quota share reinsurance) or it may vary. For all types of proportional reinsurance, the reinsurance company’s share of premiums is directly proportional to its obligation to pay losses; meaning if a reinsurer is responsible for 90% of a risk, it will receive 90% of the premium and will pay 90% of the losses incurred by that particular risk.9

Quota Share ReinsuranceThe most common type of proportional reinsurance is quota share reinsurance. When quota share reinsurance is issued, the reinsurance agreement specifies what lines of primary insurance are subject to the agreement. It also specifies a fixed percentage (i.e., quota) of all policies subject to the agreement that will be assumed by the reinsurer. Liability, premiums, and losses are shared between the reinsurer and ceding company based on this quota.

The primary subject of quota share reinsurance is the amount of insurance. The reinsurer retains a quota of the risks insured—the premiums and the losses.

For example, a reinsured risk generates a primary policy premium of $1,000. Six months later, the risk sustains a $1,000,000 loss. The reinsurer will receive 80% of the original premium and will pay 80% of the loss—or $800,000. This of, course, is a very simplistic explanation of how the premiums and losses are shared. Other factors that will affect this process are the ceding company’s operating costs, portfolio profit, and the reinsurance commission. The reinsurance agreement may also specify a cap, or limit, on the reinsurer’s payments.

Quota share reinsurance is one of the most simple and cost-effective types of reinsurance. However, because such an agreement deals with all risks in the same fashion, the ceding company may be especially vulnerable on risks that are insured to a very high limit of liability. On the other hand, the reinsurer will also pay its quota of small losses the ceding company might prefer to retain.

Quota share reinsurance is especially beneficial for new insurance companies or those writing a new line of business for which they do not have loss experience and other loss data.

Reinsurance RegulationU.S. insurance companies are able to purchase reinsurance from domestic, foreign, or alien reinsurers. Solvency, however, has become a major concern to insurers worldwide in recent years and, in light of the downturn in the economy, reinsurers have been receiving much regulatory scrutiny. Because global reinsurers offer diversity and capacity that smaller reinsurers are unable to provide, purchasing reinsurance from them often greatly benefits a ceding company. However, if a reinsurer becomes insolvent, the consequences can be disastrous and far-reaching.

9 (Swiss Reinsurance Company 1996)



Until Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in July 2010, regulation of reinsurance was left largely to the states. Because state insurance regulation focuses on protecting consumers—and consumers are not parties to reinsurance contracts—it often did not address issues of concern to the consumer. Solvency is of great concern to consumers.

State and federal regulations pertaining to reinsurance focus on the financial strength and solvency of reinsurance companies. Ceding companies are permitted to obtain reinsurance from reinsurers who are licensed in the U.S. or who are licensed in other countries. Two different types of reinsurance regulation exist—direct and indirect.10 Direct regulation applies to reinsurance companies that are licensed in at least one U.S. state. Reinsurers licensed in the United States are subject to the same legislation as primary insurers.

Indirect reinsurance regulation focuses on the reinsurance transaction itself rather than on the reinsurer. It utilizes a system called credit for reinsurance. Credit for reinsurance legislation permits unlicensed reinsurers to do business with ceding companies in the United States if they show proof of adequate financial security. When unlicensed companies prove their accreditation, ceding companies may treat amounts due from reinsurers on their financial statements as either assets or reductions from certain liabilities. Credit for reinsurance is generally allowed if the unlicensed reinsurer establishes an acceptable U.S. trust fund or security, such as a letter of credit.

The Nonadmitted and Reinsurance Reform Act (NRRA) is a portion of the Dodd-Frank Act that addresses federal regulation of both surplus lines insurance and reinsurance. Part II of the NRRA concerns reinsurance and its primary objective is to limit the extraterritorial application of state laws. Under this federal legislation, the state of domicile now has primary authority over reinsurance. Some of the changes that went into effect in July 2011 include:11

• States may only apply credit for reinsurance rules to domestic ceding companies• Statement credit for reinsurance cannot be denied by a ceding company’s state of domicile if

the state of domicile is either NAIC accredited or has substantially similar financial solvency requirements

• New York and California have amended state regulations in response to NRRA reinsurance premium provisions and conform to NAIC model acts

• Reinsurer is defined as being “…principally engaged in the business of reinsurance; (ii) does not conduct significant amounts of direct insurance as a percentage of its net premiums; and (iii) is not engaged in an ongoing basis in the business of soliciting direct insurance… A determination of whether an insurer is a reinsurer shall be made under the laws of the state of domicile…;”12 this definition now makes a clear legislative distinction between primary insurance companies and reinsurance companies

• In order to obtain credit for reinsurance, a reinsurance agreement must include an insolvency clause specifying that if the ceding company becomes insolvent or is placed in liquidation, reinsurance claims must be paid directly to the ceding company’s receiver or liquidator.

Although many believe the Dodd-Frank Act will help the states create uniformity among insurance legislation, carriers, and regulators, its effect of preempting state authority has not been embraced by everyone in the insurance industry. According to an article in the Insurance Journal, “Federal oversight could be costly for companies because it involves maintaining higher capital reserves, having a plan for liquidation in the event of a failure, and other regulatory requirements.”13

10 (Massie 2010)11 (Clark 2011)12 (Chadbourne & Parke, LLP 2011)13 (Jengler 2012)



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Top 10 Global ReinsurersAccording to Standard and Poor’s, the global reinsurance sector has been tested by many factors in recent years, including catastrophe losses, low interest rates, a sluggish economic recovery in developed markets, and increased competitive pricing. Overall, S&P claims the reinsurance marketplace is stable, and cites the following as the top 10 global reinsurers:

1. Alterra Capital Holdings Ltd.2. Everest Re Group Ltd.3. AXIS Capital Holdings Ltd.4. Arch Capital Group Ltd.5. Partner Re Ltd.6. Endurance Specialty Holdings Ltd.7. Transatlantic Reinsurance Co.8. Allied World Assurance Co. Holdings AG9. Platinum Underwriters Holdings Ltd.10. Maiden Holdings Ltd.

Top 10 U.S. ReinsurersAccording to Property Casualty 360 (a National Underwriter website), it ranked the top 25 U.S. Reinsurers14 based on underwriting results and if their premiums assumed from non-affiliates were more than 55% of gross premiums OR if the terms reinsurance, reins, or re were part of their names. The following reinsurers ranked in the top ten:

1. National Indemnity Company 2. Swiss Reinsurance America Corporation (Swiss Re)3. Transatlantic Reinsurance Company (Transatlantic Re)4. Everest Reinsurance Company 5. Munich Reinsurance America, Inc. (Munich Re)6. QBE Insurance Corporation 7. Odyssey Reinsurance Company (OdysseyRe)8. Partner Reinsurance Company of the U.S. (PartnerRe)9. General Reinsurance Corporation (GenRe)10. American Agricultural Insurance Company

14 (Property Casualty 360 2012)


1. Who are the parties to a reinsurance contract?a. The reinsurer and the state division of insuranceb. The reinsurer and Dodd-Frankc. The reinsurer and the policyholderd. The reinsurer and the ceding company

2. What transfers the risk of loss between two insurance companies?a. Primary insuranceb. Direct insurancec. Reinsuranced. Subrogation

3. Which of the following is a form of reinsurance that only indemnifies the ceding company for losses in excess of a specific retention?a. Excess of loss b. Quota sharec. Facultative d. Treaty

4. Which of the following is NOT an activity of daily living (ADL)?a. Bathingb. Dressingc. Toiletingd. Walking

5. Which of the following is NOT a reason for a ceding company to purchase reinsurance?a. To pass catastrophe risk to the reinsurerb. To pass balance sheet risk to the reinsurerc. To decrease underwriting capacityd. To increase available capital

6. Which of the following statements is NOT true about reinsurance?a. Reinsurance changes the terms of the underlying insuranceb. Reinsurers have no direct obligation to policyholders of primary insurancec. Reinsurance has no effect on the nature of risks insured by the ceding companyd. Reinsurance payments are made after a ceding company has made loss payments

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Chapter 3Terrorism Coverage

When Americans hear the word terrorism, they think immediately of the hijacked aircrafts that crashed into the World Trade Center in New York City and the Pentagon in Washington, D.C. on September 11, 2001. Those tragedies resulted in the deaths of nearly 3,000 people and caused over $23 billion in insured property losses.

Americans also think about the explosion in the garage at the World Trade Center in New York City in February of 1993 (6 deaths and $770 million in property insurance losses) and the Oklahoma city bombing of a government building in April of 1995 (166 deaths and $179 million in property insurance losses).

What Americans do not realize, however, is that significant terrorist attacks have been taking place around the globe for a very long time. In fact, not a day goes by that a terrorist attack does not take place somewhere in the world. Neither do most Americans realize how many deaths, and how many billions of dollars in property losses, are attributable to these terrorist events. Terrorist attacks have a significant impact on the psychological and economic structure of a nation.

For example, a bomb exploded in the financial district of London in April 1993; it was responsible for one death and over $1 billion in insured property losses. Other major terrorist events outside the United States include:1

Date and Location Description Insured Property Losses

Madrid, Spain – 12/2006 Bomb exploded in garage at Barajas airport and killed 2 people $71 million

Colombo, Sri Lanka – 07/2001 Rebels destroyed 3 airliners, 8 military aircraft, and damaged 3 civilian aircraft $491 million

London, U.K. — 02/1996 IRA bomb explodes in South Key Docklands and killed 2 people $319 million

Manchester, U.K. – 06/1996Irish Republican Army (IRA) car bomb exploded near a shopping mall and killed 20 people

$917 million

Buenos Aires, Argentina – 03/1992 Bombs exploded in the Israeli embassy and killed 24 people $47 million

London, U.K. – 04/1992 Bomb exploded in financial district and killed 3 people $826 million

Irish Sea, Atlantic Ocean – 06/1985 Bomb exploded on board an Air India Boeing 747 and killed 329 people $199 million

Zerqa, Jordan – 09/1970 Hijacked aircraft were dynamited on the ground at an airstrip in the desert $157 million

After the attacks on the United States in September 2001, American financial and lending institutions recognized the potential for catastrophic loss posed by terrorist attacks and began requiring certain borrowers to purchase terrorism insurance. Unfortunately, most insurers began issuing terrorism exclusions after the attacks, which lead to a huge predicament—for a number of reasons.2

Because lenders were unable to secure the collateral on loans from loss against terrorism, they refused to issue many loans. The resulting loss of jobs in the construction and other business industries that relied on securing business loans created an enormous strain on the U.S. economy. In addition to the massive disturbance created in the U.S. insurance and global reinsurance markets by the September 11, 2011 terrorist attacks, the U.S. financial infrastructure became threatened. Congress responded by passing the Terrorism Risk Insurance Act

1 (Hartwig, Terrorism Risk: A Reemergent Threat 2011)2 (Dwight Jaffee and Thomas Russell 2009, Dwight Jaffee and Thomas Russell 2009)

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CHAPTER 3: TERRORISM COVERAGE 31

(TRIA) of 2002. However, that federal regulation and its ensuing extensions did not make the problem go away; it simply alleviated it for a while.

Terrorism is not going away. In fact, it is actually becoming more widespread. At present, what makes terrorism such a difficult risk to insure is that it is nearly impossible for an insurer to evaluate terrorism in the same manner it assesses other insurable perils.

An insurance company asks itself the following questions and uses certain steps to evaluate a risk and determine if it is insurable:

• Is the risk measurable? This means the insurer wants to be able to calculate frequency (how many losses are likely to occur) and severity (the largest cost) of potential losses. For example, the perils of collision and comprehensive on an auto policy are the easiest type of risk to measure because insurers have a wealth of data and claims history to review to help them measure anticipated frequency and severity. On the other hand, professional liability insurance risks are difficult to measure for a number of reasons. First, fewer losses have occurred, so less information is available for review and evaluation. Second, it is more difficult to anticipate what will cause a professional liability loss and, if a loss occurs, it can be years before the insurer receives notification that it did occur.

• How many exposure units are in the group and how many of those units are likely to sustain a loss? Ideally, the number of exposure units should be large and the number of units likely to sustain loss should be small. Using the examples in the previous paragraph, insurers have a far larger pool of exposure units in the auto insurance market than they do in the professional liability market.

• Are losses apt to be accidental and random? Using the examples given for auto and professional liability insurance, it is quite clear the overwhelming majority of auto and professional liability losses will be accidental and random.

Unfortunately, the answers to these questions are not favorable with respect to the peril of terrorism. Because few terrorist attacks have occurred in the United States, American insurers have insufficient data to study in order to calculate loss costs, especially those pertaining to frequency and severity. The terrorist attacks that have occurred on U.S. soil have affected concentrated geographic locations, causing considerable damage to those particular areas from both economic and emotional standpoints.

But how do insurers predict where future terrorist attacks will take place? Simply put: they cannot. They can guess where they might occur based on certain factors, but not with any kind of certainty.

If it is impossible for an insurer to anticipate where a loss happens (i.e., what property will be damaged), how can the outcome be calculated?

Because most terrorist attacks are not accidental, they really do not meet the definition of pure risk—which is an element all insurable risks must possess. Terrorist attacks are not accidental—they are planned and executed carefully.

All these factors require terrorism insurance to be designed differently than other insurance products have been designed. These factors affect primary insurers and reinsurers, which we will discuss later in the chapter.

One final issue for agents to keep in mind when talking about terrorism insurance is that very few eligible policyholders in the United States are buying terrorism insurance. In fact, it is estimated that less than 25% of eligible insureds have purchased terrorism coverage. One major reason for this phenomenon is the fact that consumers located in suburbia and rural areas do not believe themselves to be likely targets of terrorism—so they do not buy coverage. Which leaves the consumers most at risk as the only purchasers of coverage—a condition known as adverse selection.3

How does a property insurer calculate the risk of a terrorism loss to one building, let alone a number of buildings in the same area? Even more daunting is the ability of a workers’ compensation insurer to calculate the risk of loss to the employees of an insured because of a terrorist attack. Keep in mind that workers’ compensation coverage insures all work-related injuries, including medical expenses, lost wages, rehabilitation … and terrorism.

3 (Insurance Information Institute 2011)



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American insurers have studied the terrorism programs developed in other countries to help solve some of these issues. Spain has a privately managed but government-sponsored program that provides insurance for bodily injury, property damage, and business interruption resulting from all kinds of catastrophes—both natural and human. It was established in 1941 and, after the Islamic terrorist bomb attacks in 2004, simply reinforced the need for the program. The U.K. established a reinsurance pool for terrorism insurance in 1993 because of actions taken by the Irish Republican Army. Other countries that established terrorism programs since September 2001 include Australia, Austria, Belgium, France, Germany, and Switzerland.

Although the United States hasn’t experienced any terrorist attacks on its soil since September 11, 2001, the 9/11 attacks rank second in the list of the five most costly catastrophes in the United States.4 Hurricane Katrina in August 2005, which resulted in $41 million of property losses alone, was responsible for the single most costly U.S. catastrophe. In terms of 2010 dollars, the Insurance Information Institute estimates losses from the September 2001 attacks to be in the vicinity of $40 billion.

Type of Loss Losses in $ Billions % of All LossesBusiness Interruption $13.5 33%

Property other than World Trade Center $7.4 19%Other Liability $4.9 12%

Property at World Trade Center $4.4 11%Aviation Liability $4.3 11%

Workers’ Compensation $2.2 6%Life Insurance $1.2 3%

Event Cancellation $1.2 3%Aviation Hull $0.6 2%

* Losses shown do not include 2010 settlement of over $650 million to compensate approximately 10,000 Ground Zero workers

** Losses and percentages are approximates due to rounding of numbers and have been rounded to 2010 dol-lars using inflation calculators of the Bureau of Labor Statistics

Federal Terrorism RegulationThe Terrorism Risk Insurance Act of 2002 (TRIA) was enacted on November 26, 2002 in direct response to the terrorist attacks in New York City and Washington, D.C. on September 11, 2001. After the terrorist attacks, Congress made a number of determinations:

• The ability of American individuals and businesses to purchase P&C insurance is critical to economic growth in the United States.

• P&C insurers are important financial institutions and their products enhance economic stability in the U.S.

• The insurance industry’s ability to provide insurance for the unprecedented financial risks of potential acts of terrorism in the U.S. can be a major factor in recovering from acts of terrorism and the stability of the U.S. economy.

• Widespread financial uncertainty resulted from the September 11, 2001 attacks, including the lack of information necessary for insurers to predict the frequency and severity of future terrorist attacks.

• The insurance industry’s decision to exclude coverage for terrorism, or to increase drastically the premiums for such coverage, may seriously hamper certain segments of the U.S. economy.

As a result of its findings, Congress decided to provide temporary financial compensation to insured parties for the purpose of stabilizing the U.S. economy during its crisis of recovery from the terrorist attacks. TRIA was intended to respond to the chaos the 9/11 terrorist attacks caused in the insurance industry as well as to assure that commercial property and liability insurance would continue to be able to provide coverage for the peril of terrorism.

4 (Hartwig, Terrorism Risk: A Reemergent Threat 2011)



TRIA was a temporary program that allowed the federal government to share in terrorism losses with private insurers in the event a certified act of terrorism took place. Basically, TRIA was a reinsurance program backed by the federal government that required insurers of certain commercial property and casualty risks to participate in the Terrorism Risk Insurance Program (The Program). Primary and excess insurance companies were required to participate, including admitted, nonadmitted, and captive insurers. The Department of the Treasury administers TRIA through The Program.

TRIA expired on December 31, 2005 and was extended for two years, with changes, under the Terrorism Risk Insurance Extension Act of 2005 (TRIEA). It was extended with changes a second time, in 2007, under the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) and is scheduled to expire on December 31, 2014.

Definitions

Act of TerrorismThe Program only covers losses for acts of terrorism that meet certain criteria. An act is considered a terrorist act only if:

• It is certified as terrorism by the Secretary of the Treasury, the Secretary of State, and the Attorney General of the United States

• It is a violent act, or an act dangerous to life, property, or infrastructure• It results in damage within the United States, or to a U.S. air carrier, a U.S. flagged vessel, or on

the premises of a U.S. mission• It is committed by an individual or individuals as part of an effort to coerce the civilian

population of the United States, to influence the policy of the U.S. government, or to affect the conduct of the U.S. government

Before the 2007, only foreign acts of terrorism where certified as covered under the Program. Domestic acts of terrorism are now included because it was established that it is nearly impossible to determine if American citizens might be acting on behalf of foreign interests.

Two restrictions apply to an act of terrorism. The Program does not consider an act to be terrorism if:• The act is committed as part of a war declared by Congress, or• The property and casualty insurance losses resulting from the act are less than $5 million

An exception exists for workers’ compensation insurance losses: acts of war may be certified as acts of terrorism for the singular objective of providing insurance to cover them.

Insured LossA loss covered by the Program is any loss that results from an act of terrorism (including an act of war in the case of workers’ compensation insurance) that is covered by primary or excess P&C insurance not otherwise excluded, if the loss:

• Takes place within the United States• Occurs to a U.S. air carrier• Occurs to a United States flag vessel or a vessel based principally in the U.S., on which U.S.

income tax is paid, and whose insurance is subject to U.S. regulation—regardless of where the loss occurs

• Occurs at the premises of any U.S. mission



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InsurerInsurers subject to the Program are any of the following entities:

• One licensed or admitted to transact primary or excess insurance business in any U.S. state• One not licensed or admitted to transact primary or excess insurance business in any U.S. state if

it is an eligible surplus lines carrier listed on the NAIC’s Quarterly List of Alien Insurers, or any subsequent publication

• One approved for the purpose of offering P&C insurance by a Federal agency in connection with maritime, energy, or aviation activity

• A state residual market insurance entity or state workers’ compensation fund• Any entity described by TRIA to the extent provided under Section 103(f) of the Act• One that receives direct earned premium for any type of commercial P&C insurance other than

those excepted in the Act• One that meets any other criteria prescribed by the Secretary of the Treasury

Insurer DeductibleInitially, the insurer deductible was 1% of its direct earned premiums in 2000. Language in the Act increased the deductible through 2005. Amendment of TRIA in 2005 increased the insurer deductible to 20%. The 2007 amendment kept the deductible percentage at 20 through 2014.

PersonWhen used in the Act, the word person means an individual, business, non-profit organization, trust, estate, any state or political subdivision, or any other governmental unit.

Property and Casualty (P&C) InsuranceOnly commercial property and casualty insurance is covered by The Program; personal lines of insurance, and life insurance, are not included. Surety insurance was covered during the first three years of the program but is no longer included. In addition, regulations specifically exclude from The Program the following types of insurance:

• Federal crop insurance• Private crop or livestock insurance• Private mortgage insurance• Title insurance• Financial guaranty insurance issued by a monoline financial guaranty insurance corporation• Health insurance• Life insurance, including group life insurance• Flood insurance provided under the National flood Insurance Act of 1968• Reinsurance and retrocessional reinsurance• Commercial auto insurance• Burglary and theft insurance• Surety insurance• Professional liability insurance• Farm owners multiple peril insurance

The Department of the Treasury defines the types of insurance covered by the Program as lines of insurance for regulatory financial reporting. When insurance companies report annual written and earned premiums on their NAIC Annual Statements, they do so under these lines of insurance. The lines that are included in the program are:



• Fire• Allied lines• Commercial multiple peril, broken down as liability and non-liability• Ocean marine• Inland marine• Workers’ compensation• Other liability, excluding professional liability• Products liability• Aircraft• Boiler and machinery

Mandatory Offer of CoverageTRIA requires insurance companies to offer terrorism insurance coverage under the same terms and conditions it offers other P&C insurance. However, insurers are not required to provide coverage for chemical, nuclear, biological, or radiological (CNBR) acts of terrorism if the CNBR peril is excluded in the policy—regardless of the cause of the CNBR damage.

Federal regulations do not require policyholders to purchase terrorism insurance; however, certain states require its purchase on workers’ compensation policies. If an insured declines to purchase terrorism insurance, an insurer may issue a terrorism exclusion endorsement or offer limited types of terrorism insurance. TRIA does not regulate the pricing of terrorism insurance; the establishment of rates is subject to state insurance legislation.

Conditions of CoverageIn order for Federal terrorism insurance payments to be made, certain conditions exist:

• Any person that suffers a terrorism loss must file a claim with the insurance company• The insurance company must have provided “clear and conspicuous disclosure to the policyholder

of the premium charged for insured losses covered by The Program and the Federal share of compensation for insured losses under The Program”

• The insurance company must process the claim according to appropriate business practices and procedures prescribed by the Secretary of the Treasury

• The insurance company must submit to the Secretary of the Treasury, following established procedures: ◦ A claim for payment of the Federal share of compensation for the insured loss ◦ Written certification of the underlying claim and all payments made for insured losses ◦ Certification of its compliance with TRIA

How Terrorism Losses are SharedThe Federal government was originally responsible for 90% of insured terrorism losses that exceed the insurer deductible—subject to other provisions of the Act. This percentage was changed in 2005 to 85%. If any other Federal program provides compensation for terrorism losses, no duplication of federal funding will take place. An insurer’s share of terrorism losses includes five elements:

1. The insurer deductible2. The insurer’s share of losses in excess of the deductible3. The Program trigger4. An annual cap on aggregate insured losses paid under The Program5. An insurance marketplace aggregate retention



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Insurer DeductibleAn insurer’s terrorism deductible is currently 20% of its direct earned premiums from all covered lines of commercial P&C insurance. This deductible has nothing to do with the terrorism insurance it sells, because it is based on all written premiums, not just the premiums written for terrorism coverage. An insurer may reinsure some of its insurer deductible. If a loss from a certified act of terrorism occurs, an insurer is responsible for 100% of that loss that falls beneath its insurer deductible.

Insurer’s Share of Losses in Excess of the DeductibleUnder the original language of the Act (TRIA of 2002), the Federal share of covered terrorism losses, after the insurers’ deductibles, was 90%. This translated into insurers being responsible for 10% of insured terrorism losses after the insurers’ paid their deductibles—which is, in effect, a copayment.

The current percentages reflect a change that was implemented when The Program was extended in 2005 under TRIEA, and the percentage remained unchanged during the 2007 extension under TRIPRA. The insurers’ share of covered terrorism losses in excess of the deductible is now 15% and the Federal share is 85%.

Program TriggerThe first extension of TRIA inserted language that effected a change effective March 31, 2006. The change postponed Federal payment of terrorism losses until a “floor” level of covered losses is reached. The Program trigger of $50 million was established and mandated that the Federal government would not make payment for any terrorism insurance losses until the total insured losses within the insurance industry exceeded $50 million. That trigger was increased to $100 million in 2007 and will continue at that level until The Program expires in December 2014.

Essentially, the Federal government will make no terrorism loss payments until the aggregate of all insurance industry terrorism losses reaches $100 million.

Annual CapAlthough federal legislation no longer allows health insurance to limit annual benefits, TRIA contains an annual limit on payments for terrorism losses by both the Federal government and insurers who have paid losses up to their deductibles. Once the federal government or any insurer has paid $100 billion in insured terrorism losses within a Program year, it will not be liable for additional payments under the Act.

If the annual aggregate insured losses is estimated to exceed $100 billion, or actually exceeds $100 billion, the Secretary of the Treasury must inform Congress that the annual cap has been achieved. Neither extension of TRIA adjusted the annual cap.

Insurance Marketplace Aggregate Retention The insurance industry is required by TRIA to pay for a certain portion of terrorism losses before the federal government begins paying. Insurer deductibles and copayments represent this share. The amount of aggregate marketplace payments was originally established at $10 billion in 2003 and increased to the current level, which is $27.5 billion.

If losses resulting from a terrorist act total less than $27.5 billion, the federal government will apply a surcharge to the premiums paid by commercial lines policyholders covered by the Act. The surcharge may not exceed three percent of applicable premiums. If losses exceed the threshold of $27.5 billion, the Secretary of the Treasury has discretion about how to recoup funds.

Terrorism Insurance CoverageBefore the September 11, 2011 terrorist attacks on the United States, exclusions for acts of terrorism were seldom found in insurance policies sold in this country. However, immediately after the attacks, insurance companies took steps to exclude coverage in policy language and endorsements for the peril of terrorism.



The enactment of TRIA was a directive to insurers that terrorism coverage must be offered to certain commercial lines insurance policyholders. As previously mentioned, terrorism insurance mandates do not apply to personal lines insurance, reinsurance, or any type of life insurance.

Fire Following TerrorismIn addition to federal mandates pertaining to terrorism insurance, state law has been enacted to address coverage for acts of terrorism. More than thirty states have enacted legislation requiring all property policies sold in the state to be based on the 1943 New York Standard Fire Policy (SFP).5 The SFP does not exclude loss caused by fire following an act of terrorism and, before, 2003, did not allow an exclusion for fire following an act of terrorism. Because the exclusion was not allowed, policyholders who rejected terrorism coverage in writing still had coverage for losses caused by fire following an act of terrorism.

After 2003, the majority of the states that did not permit SFP exclusions for fire following terrorism amended state law to allow them under certain conditions. Essentially, once those laws were enacted, policyholders declining terrorism coverage in writing would have no coverage for the peril of fire following an act of terrorism. In the remaining states that do not have statutes pertaining to the SFP, or with SFPs that specifically exclude the peril of fire following an act of terrorism, no terrorism coverage is provided for loss caused by fire following terrorism.

Nuclear, Biological, Chemical, and Radiological (NBCR) ThreatThe current federal terrorism regulation (TRIPRA) allows private insurers to exclude coverage for terrorist acts that use nuclear, biological, chemical, or radiological weapons. Many people use the terms dirty bomb or weapons of mass destruction when discussing the NBCR threat, however, it is not entirely accurate or encompassing enough.

The Centers for Disease Control and Prevention (CDC) defines a dirty bomb as “a mix of explosives, such as dynamite, with radioactive powder or pellets. When the dynamite or other explosives are set off, the blast carries radioactive material into the surrounding area.” Although most people believe the radioactive material released by a dirty bomb might cause the most damage, the CDC says it would likely only affect the people closest to the site of the explosion. Of course, anyone inhaling radioactive dust and smoke might be injured but the direct damage from the explosion is more apt to cause significant injuries and damage.

According to the FBI’s website,6 weapons of mass destruction (WMD) are defined in 18 U.S.C. §2332a as:

• Any explosive destructive device defined in Code• Any weapon designed or intended to cause death or serious bodily injury through the release,

dissemination, or impact of toxic or poisonous chemicals• Any weapon involving a biological agent, toxin, or vector as defined in Code• Any weapon designed to release radiation or radioactivity at levels dangerous to human life

The FBI website goes on to say that the phrase weapons of mass destruction often refers to the group of weapons that use chemical, biological, radiological, nuclear, and explosive components to do harm and that have a major impact on the safety of people, property, and infrastructure. Many experts on terrorism report that the damage and destruction caused by NBCR weapons would be devastating. Furthermore, these experts unanimously agree that the potential for an attack using NBCR weapons is likely within the next few years:

• “It is estimated that in New York a large NBCR event could cost as much as $778.1 billion, with insured losses for commercial property at $158.3 billion and for workers’ compensation at $483.7 billion. A loss of this magnitude is more than three times the size of the commercial property/casualty industry’s claims-paying capacity.”7

5 (Hartwig, Terrorism Risk: A Reemergent Threat 2033)6 (Federal Bureau of Investigation n.d.)7 Graham Allison 2008)



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• “The Commission further believes that terrorists are more likely to be able to obtain and use a biological weapon than a nuclear weapon.”

• “The U.S. Intelligence Community determined that the most probable WMD scenarios involve the use of toxic industrial chemicals, biological toxins/poisons, or radioisotopes fabricated into and improvised dispersal device. The use of chemical warfare agents, biological warfare agents, and improvised nuclear devices are other possibilities—though less likely—scenarios due to the difficulties in obtaining the necessary materials, technologies, and expertise.”8

According to the U.S. Government Accountability Office (GAO), the reason most P&C insurers exclude or significantly restrict coverage for NBCR risks is that they view these risks as being an inherent component of the existing exclusions for the nuclear and pollution perils. Of the commercial policyholders the GAO interviewed for its 2008 report on terrorism coverage, most said they did not have NBCR coverage because it was not offered by their insurance companies. They also said that when coverage was offered, either the cost was prohibitive or they did not want the coverage.9 Some policyholders reported they had formed captive insurers for the purpose of self-insuring the NBCR risk.

It should be noted that most workers’ compensation insurers do offer coverage for the NBCR risk because state insurance regulations do not allow them to exclude it. (Note: most state regulations require workers’ compensation policies to cover all causes of loss.)

Since the 2008 GAO report, a 2010 report by Guy Carpenter10 indicated that more than 80% of reinsurers at that time were actively seeking new or expanded terrorism insurance and “emphasizing the imbalance between supply/demand in the marketplace.” The report also indicated that roughly two-thirds of the reinsurance markets were offering coverage for NBCR risks.

Aviation Insurance for Acts of TerrorismAfter the September 11, 2001 terrorist attacks, aviation insurers immediately issued total exclusions of coverage for acts of war and terrorism. Because airlines must purchase insurance for passenger and third party liability in order to secure landing rights, and as conditions of some of their leases, this withdrawal of coverage created havoc in the aviation marketplace.

The Federal Aviation Administration (FAA) stepped in to help airlines fill this coverage gap by issuing insurance for third party war liability risk.11 A number of programs were subsequently established under the Homeland Security Act of 2002 and federal legislation mandated war risk insurance to include hull damage and passenger liability coverage.

The FAA’s Aviation Insurance Program directly insures airlines for war risk losses that arise out of the operation of an aircraft for damage to the hull, baggage, and cargo and includes passenger and third party liability. Coverage is also provided to those with ownership interest in an aircraft, such as lessors, lenders, and lienholders if the insured has a written agreement with the other insured party requiring aviation insurance.

The typical aviation policy contains exclusions for a number of perils, including war, invasion, acts of foreign entities, hostilities, revolution, insurrection, military or usurped power, hostile detonation of any weapon of war, acts of political or terrorist purposes, malicious acts of sabotage, and hi-jacking and unlawful seizure of an aircraft or crew in flight. An aviation policy also typically excludes coverage if an aircraft is not in the control of the insured because of any of the other excluded perils.

Most aviation policies offer buyback endorsements for additional premiums; however, not all excluded perils can be bought back. Some carriers permit insureds to buy war coverage for the hull without buying coverage for war liability.

8 (Federal Bureau of Investigation n.d.)9 (United States Government Accountability Office 2008)10 (Guy Carpenter 2010)11 (Hartwig, Terrorism Risk: A Reemergent Threat 2011)



Impacts of Terrorism on Insurers and ReinsurersAccording to the National Counterterrorism Center,12 more than 10,000 terrorist attacks occurred worldwide in 2011. These attacks resulted in more than 12,500 deaths. This number of 2011 terrorist attacks was nearly 12% lower than the number of attacks that took place worldwide in 2010. Although the overall number terrorist attacks has been decreasing in recent years, there’s no guarantee it will continue to decrease or that the U.S.—which traditionally has experienced fewer terrorist attacks than other countries—won’t be the target of future attacks.

The Near East and South Asia currently experience the most number of terrorist attacks (more than 75 percent of the worldwide total in 2011) and “Africa and the Western Hemisphere experienced five-year highs in the number of attacks, exhibiting the constant evolution of the terrorist threat.”13 The majority of the terrorist attacks in the Western Hemisphere in 2011 occurred in Colombia.

The continued inability of insurers and reinsurers to gauge the frequency and severity of acts of terrorism continues to add much volatility to the global market for terrorism insurance. A report issued by the Insurance Information Institute says, “Many insurers continue to question whether terrorism risk is insurable. Large segments of the economy and millions of workers are exposed to significant terrorism risk, but the ability to determine precisely where or when the next attack may occur is limited.”14

In a Congressional hearing in February 2011, Homeland Security Secretary Janet Napolitano said the terrorist threat to the United States may have been at its most “heightened state” [at that time] since the terrorist attacks on September 2011. Leon Panetta, director of the CIA, said in June 2011 that the potential for a significant cyber terrorism attack continues to mount. And of course, homegrown terrorists and domestic terrorism pose threats of untold proportions to the United States and Europe.

Because more and more policyholders are declining to purchase terrorism coverage, insurers have fewer and fewer dollars reserved to pay terrorism claims, even when considering the backing of the federal government. As a result, terrorism insurance rates are no longer decreasing, as they had been doing.

Despite these facts, Guy Carpenter & Company, LLC, a global risk and reinsurance specialist, recently reported that the reinsurance industry and government terrorism programs continue to provide “adequate terror cover.”15 The fact that few major terrorism losses have occurred in recent years increased capacity in the reinsurance marketplace. Guy Carpenter also reported that most reinsurance companies anticipate continuing to write terrorism insurance, especially in global terror pools.

According to research conducted by AON, the current consensus among insurers is that if TRIPRA expires in 2014—meaning the federal government no longer continues reinsuring terrorism insurance—more than 85% of insurers will not insure terror risk.16 Although expiration of TRIPRA would certainly result in an increase in specialty standalone terrorism insurers, the capital they bring to the market would not be even close to the $100 billion of reinsurance capital provided by federal regulations.

The fate of terrorism insurance is an ongoing landscape of uncertainty and may change at any moment.

12 (National Counterterrorism Center 2012)13 (National Counterterrorism Center 2012)14 (Hartwig, Terrorism Risk: A Reemergent Threat 2011)15 (Guy Carpenter & Company, LLC 2011)16 (Insurance Journal 2013)



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NAIC Terrorism Disclosure Form 1

POLICYHOLDER DISCLOSURENOTICE OF TERRORISMINSURANCE COVERAGE

You are hereby notified that under the Terrorism Risk Insurance Act, as amended, that you have a right to purchase insurance coverage for losses resulting from acts of terrorism, as defined in Section 102(1) of the Act: The term “act of terrorism” means any act that is certified by the Secretary of the Treasury—in concurrence with the Secretary of State, and the Attorney General of the United States—to be an act of terrorism; to be a violent act or an act that is dangerous to human life, property, or infrastructure; to have resulted in damage within the United States, or outside the United States in the case of certain air carriers or vessels or the premises of a United States mission; and to have been committed by an individual or individuals as part of an effort to coerce the civilian population of the United States or to influence the policy or affect the conduct of the United States Government by coercion.

YOU SHOULD KNOW THAT WHERE COVERAGE IS PROVIDED BY THIS POLICY FOR LOSSES RESULTING FROM CERTIFIED ACTS OF TERRORISM, SUCH LOSSES MAY BE PARTIALLY REIMBURSED BY THE UNITED STATES GOVERNMENT UNDER A FORMULA ESTABLISHED BY FEDERAL LAW. HOWEVER, YOUR POLICY MAY CONTAIN OTHER EXCLUSIONS WHICH MIGHT AFFECT YOUR COVERAGE, SUCH AS AN EXCLUSION FOR NUCLEAR EVENTS. UNDER THE FORMULA, THE UNITED STATES GOVERNMENT GENERALLY REIMBURSES 85% OF COVERED TERRORISM LOSSES EXCEEDING THE STATUTORILY ESTABLISHED DEDUCTIBLE PAID BY THE INSURANCE COMPANY PROVIDING THE COVERAGE. THE PREMIUM CHARGED FOR THIS COVERAGE IS PROVIDED BELOW AND DOES NOT INCLUDE ANY CHARGES FOR THE PORTION OF LOSS THAT MAY BE COVERED BY THE FEDERAL GOVERNMENT UNDER THE ACT.

YOU SHOULD ALSO KNOW THAT THE TERRORISM RISK INSURANCE ACT, AS AMENDED, CONTAINS A $100 BILLION CAP THAT LIMITS U.S. GOVERNMENT REIMBURSEMENT AS WELL AS INSURERS’ LIABILITY FOR LOSSES RESULTING FROM CERTIFIED ACTS OF TERRORISM WHEN THE AMOUNT OF SUCH LOSSES IN ANY ONE CALENDAR YEAR EXCEEDS $100 BILLION. IF THE AGGREGATE INSURED LOSSES FOR ALL INSURERS EXCEED $100 BILLION, YOUR COVERAGE MAY BE REDUCED.

Acceptance or Rejection of Terrorism Insurance Coverage

_____ I hereby elect to purchase terrorism coverage for a prospective premium of $_____________.

_____ I hereby decline to purchase terrorism coverage for certified acts of terrorism. I understand that I will have no coverage for losses resulting from certified acts of terrorism.

______________________________________ _____________________________________

Policyholder/Applicant’s Signature Insurance Company

______________________________________ _____________________________________

Print Name Policy Number

______________________________________

Date

© 2007 National Association of Insurance Commissioners



NAIC Terrorism Disclosure Form 2

POLICYHOLDER DISCLOSURENOTICE OF TERRORISMINSURANCE COVERAGE

Coverage for acts of terrorism is included in your policy. You are hereby notified that under the Terrorism Risk Insurance Act, as amended in 2007, the definition of act of terrorism has changed. As defined in Section 102(1) of the Act: The term “act of terrorism” means any act that is certified by the Secretary of the Treasury—in concurrence with the Secretary of State, and the Attorney General of the United States—to be an act of terrorism; to be a violent act or an act that is dangerous to human life, property, or infrastructure; to have resulted in damage within the United States, or outside the United States in the case of certain air carriers or vessels or the premises of a United States mission; and to have been committed by an individual or individuals as part of an effort to coerce the civilian population of the United States or to influence the policy or affect the conduct of the United States Government by coercion. Under your coverage, any losses resulting from certified acts of terrorism may be partially reimbursed by the United States Government under a formula established by the Terrorism Risk Insurance Act, as amended. However, your policy may contain other exclusions which might affect your coverage, such as an exclusion for nuclear events. Under the formula, the United States Government generally reimburses 85% of covered terrorism losses exceeding the statutorily established deductible paid by the insurance company providing the coverage. The Terrorism Risk Insurance Act, as amended, contains a $100 billion cap that limits U.S. Government reimbursement as well as insurers’ liability for losses resulting from certified acts of terrorism when the amount of such losses exceeds $100 billion in any one calendar year. If the aggregate insured losses for all insurers exceed $100 billion, your coverage may be reduced.

The portion of your annual premium that is attributable to coverage for acts of terrorism is __________, and does not include any charges for the portion of losses covered by the United States government under the Act.

I ACKNOWLEDGE THAT I HAVE BEEN NOTIFIED THAT UNDER THE TERRORISM RISK INSURANCE ACT, AS AMENDED, ANY LOSSES RESULTING FROM CERTIFIED ACTS OF TERRORISM UNDER MY POLICY COVERAGE MAY BE PARTIALLY REIMBURSED BY THE UNITED STATES GOVERNMENT, MAY BE SUBJECT TO A $100 BILLION CAP THAT MAY REDUCE MY COVERAGE AND I HAVE BEEN NOTIFIED OF THE PORTION OF MY PREMIUM ATTRIBUTABLE TO SUCH COVERAGE.

_________________________________________________

Policyholder/Applicant’s Signature

_________________________________________________

Print Name

_________________________________________________

Date

Name of Insurer: ___________________________________

Policy Number _________________________________

© 2007 National Association of Insurance Commissioners


1. What is the major reason terrorism risks are so difficult to insure?a. Loss frequency and severity cannot be calculatedb. Because they occur outside the United Statesc. Acts of terrorism are illegald. TRIA makes insuring terrorism difficult

2. What is the major cause of Congress’ enactment of the Terrorism Risk Insurance Act of 2002 (TRIA)?a. President Obamab. The National Association of Insurance Commissionersc. The September 11, 2011 terrorist attacks on the United Statesd. The April 19, 1995 bombing of a federal building in Oklahoma City, Oklahoma

3. When is the Terrorism Risk Insurance Act scheduled to expire?a. It already expiredb. It is scheduled to run indefinitelyc. It is scheduled to run until June 15, 2013, per TRIEAd. It is scheduled to run until December 31, 2014, per TRIPRA

4. In order to be insured, an act must be certified as an act of terrorism by all of the following, EXCEPT:a. The Secretary of the Treasuryb. The Secretary of Statec. The Attorney Generald. The president

5. An act of terrorism would be covered by terrorism insurance if it occurred in all of the following locations, EXCEPT:a. Within the United Statesb. Outside the United Statesc. On a U.S. air carrierd. At a U.S. mission

6. P&C insurers must offer terrorism insurance under which of the following types of policies?a. Homeownersb. Life insurancec. Health insuranced. Workers’ compensation insurance

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Part TwoCrime and Surety, Business Interruption, and Equipment Breakdown

In this second section of the course, we address three types of property coverage that are often overlooked or misunderstood—by both consumers and producers. Because each business is unique, and each business industry involves particulars that are not shared universally, the three chapters in this section are general in nature rather than specific.

Although few business actually find themselves the victim of an armed robbery, they are still vulnerable to a number of criminal acts—most of which are caused by the dishonest acts of employees and other individuals. In this section, we will discuss the first party coverages available for property losses that result from criminal acts.

The other two topics of discussion in this section are time element coverages; they address consequential loss that results from direct damage to property, usually the insured’s property. If an insured business sustains property damage at one or more of its physical locations, the ensuing loss of income, along with the additional costs needed to get the business up and running at another location, often cripple the business, sending it spiraling into financial ruin if the business does not have adequate business interruption insurance in place.

Financial devastation is also a common occurrence when a business does not have appropriate coverage in place for the consequential losses that arise when its equipment and systems (i.e., heating, cooling, and communication) shut down due to mechanical failure.

Professional insurance producers are aware of the myriad exposures and hazards their commercial lines clients face and do their very best to point out the vulnerabilities a business faces on a daily basis. Insurance companies generally provide valuable assistance by making coverage checklists available by business industry so producers and clients are able to address the majority of the unique exposures a particular business is likely to face, in addition to the exposures the majority of businesses share. It is only after an exposure or hazard has been identified that a business can evaluate the risks it faces and make a decision about the best manner of protecting itself from the financial consequences of unexpected events.

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Chapter 4Crime and Surety Coverages

Crime insurance, also called fidelity insurance, protects businesses from the dishonest acts of employees and other persons. Surety bonds guarantee the fulfillment of contractual obligations, usually with respect to the performance of one of the parties to the contract.

Before discussing crime insurance and surety bonds in more detail, it is important to be familiar with terminology used within these respective areas of the insurance industry. Some of the following terms may have slightly different meanings outside the context of and crime insurance contracts and surety bonds.

Definitions

Crime InsuranceCrime insurance, also called fidelity insurance, protects organizations from the loss of assets and property due to business-related dishonesty and crime. Common crime and fidelity insurance claims involve employee dishonesty, embezzlement, forgery, robbery, safe burglary, computer fraud, wire transfer fraud, counterfeiting, and other criminal acts. Fidelity insurance also indemnifies banks, bankers, brokers, and financial or moneyed corporations or associations.

Surety BondsSurety bonds guarantee the fulfillment of one party’s contractual obligations and/or its contractual obligation to perform. Despite the fact that insurance companies issue surety bonds, surety bonds are not insurance contracts.

Unlike insurance policies, which anticipate losses occurring, suretyship does NOT anticipate losses occurring. In fact, the party issuing a surety bond will only issue one if it is relatively certain losses will NOT occur. As a result of this relative certainty (an insurer can never be absolutely certain a loss will not occur), premiums for surety bonds are correspondingly less expensive than those of insurance contracts.

BurglaryBurglary is theft of property from within a building by a person who commits forcible entry into, or exit from, the property of another while trespassing—without the owner’s permission. Visible signs of forced entry and/or exit must also exist. Most burglaries occur when a premises is unoccupied. An example of a burglary would be an individual who shatters the plate glass window of a jewelry store, grabs merchandise from within the store, and flees with the stolen items.

Counterfeit MoneyCounterfeit money is an imitation of money that is intended to deceive and be considered genuine. If a man uses a computer to design ten $100 bills, prints the bills, and then uses the bills to purchase a refrigerator, he has manufactured and used counterfeit money.

In this country, the U.S. Government is the only entity legally permitted to print paper currency and create coins. The following violations of United States Code are felonies and are overseen by the U.S. Secret Service, which is a subsidiary of the U.S. Department of the Treasury:

• Manufacturing counterfeit U.S. currency or altering genuine currency to increase its value

• Possession of counterfeit currency with fraudulent intent

• Mutilating, cutting, disfiguring, perforating, uniting or cementing together any U.S. bank bill, draft, note, or other evidence of debit with the intent to destroy it or render it unusable

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CHAPTER 4: CRIME AND SURETY COVERAGES 45

CustodianA custodian is the insured—or any of the insured’s partners, members, or employees—while having care and custody of property inside the insured premises. A custodian is NOT a person acting as a janitor or watchperson. For example, the cash register clerks working in a department store are the store’s custodians.

EmployeeAn employee is a natural person while in the service of the insured—and during the first 30 days immediately after termination of service for any reason other than theft or the commission of a dishonest act. An employee must be compensated directly by the insured via salary, wages, or commissions and be under the direction and control of the insured when performing services for the insured.

An employee is also any natural person furnished to the insured temporarily as a substitute for a permanent employee who is on leave—to meet seasonal or short-term work-related needs. Employees do not include such persons while having care and custody of property outside the “premises.” The following natural persons are also employees:

• Those leased to the insured under a written agreement between the insured and a labor leasing firm

• Trustees, officers, employees, administrators, and managers (other than certain independent contractors of an “employee benefit plan”)

• The insured’s directors or trustees while engaged in handling funds or other property of an employee benefit plan

• Former employees, partners, members, managers, directors, or trustees retained as consultants

• Guest students and interns except when having care and custody of property outside the premises

EmbezzlementEmbezzlement is the fraudulent conversion of another’s property by a person who is in a position of trust, such as an agent or employee. Embezzlement does not involve trespass; however, it does involve crimes committed by individuals who are on the property with the consent of the owner.

For example, the bookkeeper at a lawn care company opens a bank account under an assumed business name. She creates invoices and issues them to her employer from a fictitious supplier of lawn care products with the name of the fake business for which she opened the bank account. The bookkeeper then pays the invoices by issuing checks to the fictitious business and deposits them into the bank account she opened for the purpose of embezzling.

Employee Benefit PlanAn employee benefit plan is any welfare or pension benefit plan appearing on the policy’s declarations and that is also subject to the Employee Retirement Income Security Act of 1974 (ERISA) and its amendments. Examples of employee benefit plans include 401(k) plans, simplified employee pension plans (SEPs), profit sharing plans, and other types of pension plans, including defined benefit and defined contribution plans.

ForgeryForgery is the signing of another person’s name—or that of an organization for which one is not authorized to sign—with the intent to deceive. Forgery is not the signing of a person’s own name, in whole or in part, with or without authority, for any purpose, in any capacity.

For example, when a woman steals a car and signs the owner’s name when transferring the title to an unsuspecting buyer who believes the woman is the car’s owner, she has committed forgery. However, if she signed her own name, she would not have committed forgery, despite the fact that she stole the car.



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Fraudulent InstructionA fraudulent instruction is an electronic, telegraphic, cable, teletype, facsimile, or telephone instruction claiming to have been transmitted by the insured when, in fact, it was fraudulently transmitted by someone other than the insured without the insured’s knowledge or consent. Fraudulent instructions include written instructions (other than those previously mentioned) that were issued by the insured and were forged or altered by someone other than the insured without the insured’s knowledge or consent—and that claim to have been issued by the insured when they were not. Fraudulent instructions also include electronic, telegraphic, cable, teletype, facsimile, telephone, or written instructions initially received by the insured that claim to have been transmitted by an employee, but that were fraudulently transmitted by someone else without the insured’s, or an employee’s, knowledge or consent.

An example of a fraudulent instruction is an e-mail sent by an individual falsely claiming to be the recipient’s bank or financial institution and asking for personal information to update its security measures while really intending to steal the personal information and use it for criminal purposes.

FundsFunds are money and securities, such as paper currency and stock certificates.

LarcenyLarceny is a type of theft that involves personal property that is capable of being possessed and carried away. Larceny is a crime against the right of possession and each state addresses it differently. Degrees of larceny may be described by various jurisdictions and are based on the value of the property stolen, such as petty larceny or grand larceny.

Two elements are necessary for larceny to take place: (1) the intent to take the property without paying for or returning it and (2) the actual carrying away of property after trespassing. Examples of larceny include bicycle theft, theft of motor vehicle parts, and the theft of any property not stolen when using force, violence, or fraud. Embezzlement and forgery are not forms of larceny.

MessengerA messenger is the insured, a relative of the insured, or any of the insured’s partners, members, or employees, while having care and custody of property outside the premises. For example, when a company’s employee brings cash and checks to the bank to make a deposit, or travels from the post office to the place of employment with the mail, the employee is a messenger.

MoneyMoney is currency, coins, and bank notes in current use that have a face value. Money is also traveler’s checks, register checks, and money orders held for sale to the public.

Mysterious DisappearanceMysterious disappearance is loss of property for which the cause of loss cannot be determined. Mysterious disappearance is not theft—nor is it treated as theft under crime insurance policies. For example, if any type of property disappears and the insured does not know the time, place, and manner of its loss, the cause of loss will be mysterious disappearance.

Other PropertyOther property is tangible property that is NOT money and securities that has intrinsic value. Computer programs, electronic data, and property specifically excluded under the policy are not other property, either. Examples of other property include furniture and office equipment.



PremisesThe premises is the interior of that portion of any building occupied by the insured in which the insured conducts its business. For example, if an insured rents office space, the rented space is the insured’s premises. If the insured owns and occupies the entire building in which it conducts operations, the entire building and owned property is the premises.

RobberyRobbery is the unlawful taking of property from the care and custody of a person by force, the threat of using force, or causing fear of bodily harm. A person also commits robbery when unlawfully taking property from the care and custody of a person along with committing an obviously unlawful act witnessed by the victim. For example, if a person steps up to a pedestrian, grabs her purse, and says he will shoot her if she does not relinquish the purse, he commits robbery.

Safe BurglarySafe burglary is the unlawful taking of property from within a locked safe or vault by a person unlawfully entering the safe or vault—as evidenced by marks of forcible entry upon its exterior. Safe burglary is also the unlawful taking of an entire safe or vault from inside the premises.

SecuritiesSecurities are negotiable and non-negotiable instruments and contracts that represent either money or property. Securities include tokens, tickets, revenue, stamps in current use, and evidences of debt issued in connection with credit or charge cards—so long as the credit or charge cards are not issued by the insured.

TheftTheft is the act of stealing—or the felonious taking of personal property with the intent to deprive the rightful owner of it. Theft is a broad term that includes specific offenses, such as burglary, robbery, larceny, embezzlement, and forgery.

WatchpersonA watchperson is any person the insured retains specifically for the purpose of having care and custody of property inside the premises and who has no other duties. For example, a security guard hired to patrol the inside of the insured’s warehouse after hours is a watchperson.

Crime InsuranceStandard property insurance policies, if written on a special form basis, usually provide coverage for the peril of theft. However, all property policies include categories of property for which theft coverage is limited or specifically excluded.

For example, the ISO Building and Personal Property Coverage Form excludes coverage for accounts, bills, currency, evidences of debt, money, notes, and securities under the section, Property Not Covered. It is also important to note the Basic and Broad Causes of Loss forms do not include theft as a covered peril.

The Special Causes of Loss Form provides coverage for the peril of theft because theft is not excluded. However, the form specifically excludes:

h. Dishonest or criminal act (including theft) by you, any of your partners, members, officers, managers, employees (including temporary employees and leased workers), directors, trustees or authorized representatives, whether acting alone or in collusion with each other or with any other party; or theft by any person to whom you entrust the property for any purpose, whether acting alone or in collusion with any other party. This exclusion: (1) Applies whether or not an act occurs during your normal hours of operation; (2) Does not apply to acts of destruction by your employees (including temporary employees and leased workers) or authorized representatives; but theft by your employees (including temporary employees and leased workers) or authorized representatives is not covered.



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Crime insurance, also called fidelity insurance, provides coverage for a number of theft-related perils and protects businesses from employee dishonesty and other types of dishonesty—specifically the loss of money, securities, and other property. Typical crime insurance claims allege embezzlement, forgery, robbery, safe burglary, computer fraud, wire transfer fraud, counterfeiting, and other criminal acts.

Crime insurance also indemnifies banks, credit unions, financial or moneyed corporations or associations, bankers, and brokers for loss by theft-related perils. Commercial crime coverage forms may be added to the businessowners and commercial package policies or they may be written on a standalone basis.

As explained in the Definitions section of this chapter, theft is the act of stealing—or the felonious taking of personal property with intent to deprive the rightful owner of it. Burglary, robbery, larceny, forgery, and embezzlement are all types of theft. Other similar crimes, such as theft using computers and the issuance of fraudulent financial transactions, are also covered by crime insurance.

Crime insurance may be written on one of two different types of coverage forms. Although crime insurance is property insurance, its coverage forms can be likened to the two liability insurance coverage forms. The loss-sustained and discovery crime coverage forms are similar to the occurrence and claims-made forms of coverage used to write commercial general liability and professional liability.

• The loss-sustained form provides coverage for losses that occur and are discovered during the policy period OR that take place within the policy period and are discovered within one year of the termination of the policy period. It is similar to the occurrence form of liability insurance.

• The discovery form provides coverage for losses that are discovered during the policy period but that did not necessarily occur during the policy period. Discovery forms require the use of a retroactive date and are similar to the claims-made form of liability insurance.

In addition to being written on either of two types of policy forms, crime coverage forms are written for two different types of commercial enterprises.

• The Commercial Crime Coverage Forms (both loss-sustained and discovery) are designed for private businesses. The insuring agreements of these policies and forms contain one limit of insurance for all types of employee theft.

• The Government Crime Coverage Forms (both loss-sustained and discovery) are designed for government entities. They contain two different employee theft insuring agreements. One contains a separate loss limit that applies to each employee theft loss and the other contains its own loss limit for all losses occurring due to one employee.

Not all insurers use the ISO crime coverage forms; however, their policies usually provide similar coverage. The discussion in this chapter is based on the May 2006 edition of ISO’s Crime and Fidelity forms. The Commercial Crime Policy (Loss Sustained Form) offers eight types of coverage:

1. Employee Theft2. Forgery or Alteration3. Inside the Premises – Theft of Money and Securities4. Inside the Premises – Robbery or Safe Burglary of Other Property 5. Outside the Premises6. Computer Fraud7. Funds Transfer Fraud8. Money Orders and Counterfeit Money

The commercial crime policy includes separate insuring agreements for each of the preceding eight coverages. If the insured does not wish to purchase all eight coverages, coverage can be purchased separately for each of the above perils, or in any combination—none is mandatory.



1. Employee TheftThe first of the eight coverages provided by the crime coverage forms is Employee Theft, which is also referred to as employee dishonesty coverage. Employee theft covers loss of, or damage to, money, securities, and other property when committed by an employee—whether acting alone or in collusion with others AND that results directly from theft. Coverage does not require the employee to be guilty of committing a crime. Examples of employee theft include an employee stealing money from the cash register or several employees stealing office supplies. Income that is not considered “earned” includes interest, dividends, retirement income, Social Security benefits, unemployment benefits, alimony, and child support.

2. Forgery or AlterationThe second of the eight coverages provided by the crime coverage forms is Forgery or Alteration. Forgery or Alteration insures against the forgery or alteration of checks, drafts, promissory notes, and similar items regarding the payment of a sum of money that is made or drawn by the insured or someone acting on behalf of the insured. Someone other than an employee must commit the dishonest act because employee theft is included under Insuring Agreement 1.

“Forgery” means signing of the name of another person or organization with intent to deceive; it does not mean a signature that consists in whole or in part of one’s own name signed with or without authority, in any capacity, for any purpose. An example of forgery is a vendor receiving the insured’s $1,000 check in payment for purchased supplies, and then altering the check so it reads $10,000, depositing the check, and receiving $10,000.

3. Inside the Premises—Theft of Money & SecuritiesThe third of the eight coverages provided by the crime coverage forms is Inside the Premises – Theft of Money & Securities. This coverage insures against three specific types of loss that are committed by someone other than an employee:

• Theft, disappearance, or destruction of money and securities• Damage to the insured’s premises• Damage to a locked safe or vault

The first type of covered loss is the theft, disappearance, or destruction of money and securities inside the insured’s premises, or inside a banking premises, when committed by a person present on the insured’s premises:

• This coverage only applies to loss of money and securities—not other property• This coverage only applies if the person committing the dishonest act is on the insured’s

premises—not at the bank, in a parking lot, or using a computer to commit the actThe second type of covered loss is for damage to the insured’s premises or its exterior when caused by an attempted or actual theft. For example, this coverage would apply to a plate glass window a thief smashed to gain entry to the insured’s building or belongings inside the building the thief damaged when gaining access or stealing. The third type of covered loss is for loss or damage to a locked safe, vault, cash register, cash box, or cash drawer that results from actual or attempted entry into such property.

Vandalism, if not related to a theft, is NOT covered by the crime coverage forms. Accounting errors are also excluded, as are resulting fire losses from vandalism, theft, burglary, or robbery. The reason coverage for these perils is excluded is because it is either included under the standard property insurance form or available by endorsement.



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4. Inside the Premises—Robbery or Safe Burglary of Other PropertyThe fourth of the eight coverages provided by the crime coverage forms, Inside the Premises—Robbery or Safe Burglary of Other Property, covers most types of tangible property—including jewelry, firearms, computers, etc.—from loss or damage resulting from an actual or attempted robbery of a custodian—by someone other than an employee. Coverage is also provided for the actual or attempted robbery of a safe inside the insured’s premises, damage to the premises or its exterior, and damage to a locked safe, vault, cash register, etc.

Inside the Premises – Theft of Money & Securities

Inside the Premises – Robbery or Safe Burglary

of Other Property

Property Covered ONLY Money and Securities ONLY Other Property, including the safe or vault

Custodian (someone who is

responsible for property)

Money and security does NOT have to be in the possession of a custodian for safekeeping

Property DOES have to be in the possession of a custodian for safekeeping

A custodian is the insured or any of the insured’s partners or members, or any employee, while having care and custody of property inside the insured premises. Examples of custodians include the insured’s bookkeeper, the insured, or any employee while on the job and inside the insured location. A custodian is NOT a watchperson (a separate definition applies) or a janitor (because janitors do not have “custody” of property, they service or maintain it). A watchperson is any person the insured retains specifically for the purpose of having care and custody of property inside the premises and who has no other duties.

5. Outside the PremisesThe fifth of the eight coverages provided by the crime coverage forms, Outside the Premises, insures money and securities in the hands of a messenger or armored car service for loss resulting directly from theft, disappearance, or destruction. Loss must occur in the U.S., its territories and possessions, Puerto Rico, or Canada. Other types of property are only covered for direct loss or damage from actual or attempted robbery.

The following types of property are excluded under this coverage:

• Motor vehicles

• Vandalism or malicious mischief

• Deception or trickery

• Property transferred without authorization or under threat

6. Computer FraudThe sixth of the eight coverages provided by the crime coverage forms, Computer Fraud, covers losses when a computer is used to fraudulently transfer money, securities, and other property from the insured premises or a banking premises—OR to do so to a person or place outside the insured premises. This is not computer insurance—it is fraud insurance for criminal acts committed when using a computer. Coverage excludes deception or trickery.

7. Funds Transfer FraudThe seventh of the eight coverages provided by the crime coverage forms, Funds Transfer Fraud, covers the loss of funds resulting from a fraudulent instruction that directs a financial institution to transfer, pay, or deliver funds from the insured’s transfer account. Funds are money and securities. A transfer account is an account maintained by the insured at a lending institution from which electronic, cable, or written instructions can be initiated by the insured to transfer, pay, or deliver funds.



8. Money Orders and Counterfeit MoneyThe eighth and final of the coverages provided by the crime coverages forms, Money Orders and Counterfeit Money, covers the insured’s acceptance in good faith of money orders and counterfeit money received in exchange for merchandise or services during the course of conducting regular business activities.

Commercial Crime Endorsements A number of commercial crime endorsements are available; however, our discussion focuses on four that are most commonly used.

Extortion—Commercial Entities (Coverage Form G)Coverage is Extortion, which may be added by endorsement to the crime coverage forms or policy. This endorsement has an equivalent for government entities.) Coverage is provided if a loss of money, securities, or property occurs because a threat was made to the insured to do either of the following:

• Cause bodily harm to any of the following persons who was kidnapped, or allegedly kidnapped: a director, trustee, partner, member, manager, or employee—or a relative or guest of any of these, OR

• To cause damage to the insured premises or property inside the insured premisesAn exclusion applies if the loss occurs after the insured failed to report the extortionist’s demands to an associate, local law endorsement, or the Federal Bureau of Investigation.

Lessees of Safe Deposit Boxes (Coverage Form I)This endorsement provides coverage for loss of securities and property from inside a safe deposit box or a vault inside a financial institution named on the endorsement. It does not provide coverage for money. The insured is able to collect under this coverage without proving negligence on the part of the financial institution; however, the insured’s negligence precludes coverage.

Securities Deposited with Others (Coverage Form J)This endorsement provides coverage for loss by theft, disappearance, or destruction of securities on deposit with others but not located in a safe deposit box or bank vault. The names of the depository and custodian must be shown on the endorsement. Most owners of securities deposit them with others when they are being used as collateral.

Clients’ PropertyThis endorsement provides coverage for loss by theft of money, securities, and other property belonging to clients that is caused by an identified employee.

Crime Policy Terms and Conditions

Limits of InsuranceThe commercial crime policy declarations shows a limit of liability. That limit applies to all loss directly resulting from a single occurrence. If a loss is covered by more than one of the insuring agreements or coverage endorsements, the most the policy will pay for loss will be the largest limit of insurance available under any one of the insuring agreements or coverage endorsements.

DeductibleA deductible will appear on the declarations and applies to all losses.

ExclusionsThe commercial crime policy contains general exclusions that apply to the entire policy. It also contains exclusions applicable to the individual insuring agreements and coverage forms.



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Exclusions Applying to the Entire Policy• Acts committed by the insured, the insured’s partners, or the insured’s members—whether acting

alone or in collusion with others• Acts of employees learned of by the insured before the policy period• Acts of employees, managers, directors, trustees, or representatives, whether acting alone or

in collusion with others—unless insured under the Employee Theft insuring agreement or endorsement

• Loss resulting from the unauthorized disclosure of confidential information• Loss resulting from seizure or destruction of property by order of governmental authority• Indirect loss, including loss of income• Legal fees, costs, and expenses related to any legal action—unless covered under the Forgery or

Alteration insuring agreement or endorsement• Nuclear hazard, war and military action, and pollution

Exclusions Applying by Coverage Part

1. Employee TheftThe exclusions that only apply to Employee Theft include:• Loss that depends solely upon substantiation from inventory shortages or profit and loss

computations• Loss resulting from trading• Loss resulting from the fraudulent or dishonest signing, issuing, cancelling, or failing to

cancel an warehouse receipt or related papers

3. Inside the Premises—Theft of Money and Securities, 4. Inside the Premises—Robbery or Safe Burglary of Other Property, and 5. Outside the Premises

The following exclusions only apply to Coverages 3, 4, and 5 of the commercial crime policy:• Accounting or arithmetical errors or omissions• Exchanges or purchases• Fire• Money operated devices• Motor vehicles or equipment and accessories• Transfer or surrender of property• Vandalism• Voluntary parting of title to, or possession of, property

6. Computer FraudThe only exclusions applying to Computer Fraud include:• Credit card transactions• Funds transfer fraud• Inventory shortages

7. Funds Transfer FraudThe only exclusion applying to Funds Transfer Fraud is Computer Fraud.



Policy ConditionsThe commercial crime policy contains conditions that apply to the entire policy and others that apply specifically to each insuring agreement. Discussion of these conditions is intentionally brief and only includes reference to conditions specific to crime coverage and that are not contained in standard property policies.

Conditions Applying to the Entire Policy• Newly established premises and new employees are automatically insured at no additional

premium.

• Written notice to the insurer is required if the insured consolidates, merges with, purchases, or acquires the assets or liabilities of another entity. Notice must be provided as soon as possible and the extension of coverage only applies if the insurer consents to extend coverage.

• Employee benefit plans shown on the declarations are included as insureds under Employee Theft coverage. Specific requirements apply.

• The insurer has the right to examine the insured’s books and records during the policy period and up to three years afterward.

• An extension of one year from the date of policy cancellation is provided to the insured for the purpose of [the insured] discovering losses.

• The insurer has the right to make inspections and surveys at any time, provide the insured with reports about the findings, and recommend changes to the insured.

• A condition applies to losses sustained during prior insurance issued by the insurance company and describes how the insurer will settle the loss(es).

• A condition applies to losses sustained during prior insurance issued by an insurer other than the insurance company issuing this policy and describes how the insurer will settle the loss(es).

• A condition specifies that coverage only applies to property owned or leased by the insured and property the insured holds for others. However, coverage may only benefit the insured and provides no insurance or rights to any other person or organization. All losses under the policy must be submitted by the named insured.

• A condition called Recoveries stipulates how any settlement will be adjusted after a loss has been submitted and the insured subsequently receives any type of payment from another party or any other type of recovery other than “insurance, suretyship, reinsurance, security, or indemnity” taken for the insurance company’s benefit or of original securities after duplicates have been issued.

• The policy territory is the United States, its territories and possessions, Puerto Rico, and Canada.

• A loss condition titled, Valuation—Settlement, stipulates how losses will be valued and settled.

Conditions Applying to 1. Employee Theft• Coverage terminates for any employee as soon as the insured—or any of the insured’s partners,

members, managers, officers, directors, or trustees who are not in collusion with that employee—learn about a theft or other dishonest act committed by the employee. Such termination occurs whether the act occurred during employment by the insured or before employment by the insured and is effective on the date specified in a written notice mailed to the first named insured.

• Coverage applies outside the policy territory if any employee is temporarily outside the policy territory for no more than 90 consecutive days.



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Conditions Applying to 2. Forgery or Alteration• The deductible does not apply to legal expenses paid

• Electronic and mechanical signatures will be treated the same as handwritten signatures

• When a proof of loss is submitted to the insurer, it must include either any instrument involved in the loss or an affidavit setting the cause and amount of loss

• Coverage applies anywhere in the world and the Policy Territory condition does not apply

Conditions Applying to 4. Inside the Premises—Robbery or Safe Burglary of Other Property and 5. Outside the Premises• A special limit of $5,000 applies for any one occurrence for loss of, or damage to, precious

metals, precious or semi-precious stones, pearls, furs, etc. The limit also applies to manuscripts, drawings, or records of any kind.

• If a loss occurs outside the premises (under Coverage 5), the policy only pays for the amount of loss the insured is unable to recover under a contract with an armored motor vehicle company and/or the armored motor vehicle company’s insurer.

Conditions Applying to 6. Computer Fraud• A special limit of $5,000 applies to any one occurrence of loss of, or damage to, manuscripts,

drawings, or records of any kind• Coverage applies anywhere in the world and the Policy Territory condition does not apply

SuretyshipAlthough surety bonds are not insurance contracts, they provide protection for financial loss and are contracts that stipulate the terms for risk transfer. For these reasons, state insurance departments regulate surety bonds, which are issued by insurance companies. Only licensed producers may sell surety bonds. Some states allow producers to sell surety bonds if they are property and casualty licensed; other states require producers to have surety licenses before selling surety bonds.

The Parties to SuretyshipMost insurance professionals and consumers understand that insurance contracts involve two parties: the policyholder and the insurance company. Surety bonds, however, involve three parties—the principal, the surety, and the obligee—and this difference is often confusing.

The principal is the party owing the duty, performance, obligation, or honesty. In many cases, the principal purchases the bond. Another term used for the principal is obligor.

The surety is the party guaranteeing the contractual duty, performance, obligation, or honesty of the principal. If the principal does not perform as promised in the contract, the surety either performs the principal’s obligations or pays for damages suffered because of the principal’s failure to perform. The surety is usually an insurance company that issues a bond, but can be any type of entity with the financial strength and reputation to guarantee the performances it undertakes when issuing bonds. The surety is also called the guarantor.

The obligee is the party requiring the guarantee that a duty, performance, obligation, or honesty will be carried out. Obligees may be individuals, businesses, or governmental bodies.

For example, a homeowner hires a contractor to build a new home. The homeowner requires the contractor to provide a guarantee that it will complete the construction of the home by a certain date and according to certain specifications. When the contractor purchases a surety bond from an insurance company to fulfill the homeowner’s requirements—per the construction contract, the contractor is the principal, the insurance company is the surety, and the homeowner is the obligee.



If a principal fails to perform as agreed in a contract, the surety must perform in lieu of the principal because of the requirements of suretyship. Suretyship is the assumption of liability for the obligations of another—in other words, a guarantee. The surety has a legal right of action against the principal in the event of default until the principal recovers the amount of the loss. Per the language contained in the bond, the defaulting principal must repay the surety. (In reality, however, this seldom happens.)

Suretyship is similar to the extension of credit. In the same fashion that only fiscally responsible individuals and businesses are able to secure loans and lines of credit, surety bonds are only issued to individuals and businesses with good reputations, the expertise to support the contractual promises they make, and a proven history of financial responsibility.

Not every applicant for a surety bond is able to purchase one. When a surety issues a bond, it underwrites the applicant in a fashion similar to that used by loan underwriters. Because the goal of the surety is to guarantee the performance of the principal, it is only willing to guarantee the performance of individuals and businesses that are willing and able to carry out their contractual obligations.

For example, if a contractor applied for workers’ compensation or general liability insurance, and had submitted several losses to its previous insurer, it is highly likely it will be able to secure insurance with a new insurance company—if it is willing to pay the premium the new insurer wishes to charge. On the other hand, if the same contractor was sued by one or more former clients for failing to complete construction projects as agreed, it is unlikely a surety would issue a bond to the contractor.

If the surety discovered the contractor’s character and reputation were exemplary, it might still refuse to issue a bond if the contractor had recently declared bankruptcy or was involved in litigation alleging unprincipled acts. Because poor money management and unscrupulous acts are often considered irresponsible behavior, the surety would likely doubt the contractor’s ability to complete the project within the legal, ethical, and financial parameters stipulated in the construction contract with the homeowner.

Types of Surety BondsSeveral types of surety bonds exist and each serves a specific purpose. Within each type of bond category, innumerable variations are available.

Public Official Bonds protect the public from the lack of faithful performance on the part of public officials—either elected or appointed. The principal is the public official and the obligee is the city or town, county, state, or other entity requesting the bond.

Public official bonds guarantee the honesty and faithful performance of an official’s duties as prescribed by law. Some of those duties include the recovery of fines, fees, and/or expenses, along with handling money and bank accounts entrusted to the official in the pursuit of his or her duties. These bonds protect taxpayers in the event a public official fails to exercise the standard of care required of the position and financial damage results.

For example, a city’s treasurer may be responsible for the loss of city funds because she did not practice adequate security measures and, as a result, someone stole the funds. Although the treasurer did not act dishonestly, she may be deemed to have failed in her faithful performance of duties as a public official.

Court Bonds are required in connection with court proceedings and are of two types: judicial bonds and fiduciary bonds. Courts and state statues require court bonds to protect parties to lawsuits. Individuals who entrust their welfare to the care of fiduciaries are also protected by court bonds.

Judicial Bonds are sometimes difficult to obtain because of their very nature. Judicial bonds guarantee that individuals and other entities fulfill their statutory obligations in connection with lawsuits and court proceedings and are either plaintiff bonds or defendant bonds.

• Appeal Bonds are issued when one party loses in court and is required to pay damages he or she may post an appeal bond and postpone payment of damages until after the appeal. If losing the appeal, the principal (or the surety) must pay the damages ordered in the original court proceeding.



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• Bail Bonds guarantee a person’s appearance in court at a future date. Bail bonds are issued when the court establishes the dollar amount of bail and the surety provides a bond equal to that amount. Individuals and entities other than insurance companies may act as the surety for a bail bond—depending upon the jurisdiction. Payment for the bond is made in cash or with a combination of cash and the pledging of collateral, usually real estate. If a defendant (who is the principal) fails to appear in court, the surety pays the amount of the bond to the court and then secures reimbursement from either the defendant or the party that pledged money or property as collateral for the bond.

• License and Permit Bonds are required by local, county, and state governmental bodies for the protection of the public. Certain businesses are required to comply with regulations and ordinances; the purchase of a bond guarantees that such businesses will comply with all applicable laws. License and permit bonds are issued in five different categories: ◦ For the protection of the public’s health and safety ◦ For the protection of the public as a result of a public privilege granted to the principal, for

example, hanging a sign on a building adjacent to a sidewalk ◦ For the protection of the public against loss of money or property entrusted to a licensee, such

as an insurance agent ◦ For the protection of the public from businesses that pose high risks of financial loss, such as

car dealers and certain loan companies ◦ To guarantee the payment of taxes collected, such as gasoline and sales taxes

Fiduciary Bonds are required of individuals who act in a fiduciary capacity for others and guarantee the honest and faithful performance of fiduciaries appointed by the court. Examples of court-appointed fiduciaries include the guardian of minor children, the administrator of a deceased person’s estate, and the personal representative of a deceased person’s will (formerly called an executor). This type of bond is required by statute in order to protect the interests of those for whom the fiduciary acts. If a bonded fiduciary fails to conform to state law when carrying out its duties and financial loss occurs, the surety makes payment to inheritors, wards, beneficiaries, and creditors.

Contract Bonds guarantee that a contractor will perform according to a construction contract. If the contractor fails to perform according to the contract, the surety is responsible for the bond limit, which usually equals the value of the completed contract. Examples of contract bonds include:

Bid Bonds guarantee that contractors making bids will, upon acceptance of a bid by the obligor, proceed with the contract and replace the bid bond with a performance bond. Failure of a contractor to proceed with the contract results in default and the surety is required to pay the obligor the difference between the contractor’s bid and the next highest bid. If the contractor enters into the contract as agreed, the bid bond is released.

Performance Bonds promise that the party entering into a contract after making a bid performs the work as agreed in the bid. Contracts that often require the purchase of performance bonds are those for the construction of a home, commercial building, or road.

Completion Bonds promise a lender that the party using the borrowed money will only use the money for the work or project that is the subject of the loan and that the completed work will not be attached by liens.

Supply Bonds promise that materials and supplies will be provided in accordance with a contract, i.e., at the same price, in the same amount, and of the same type.

Payment Bonds promise that invoices for materials and labor will be paid in a timely fashion by the contractor.

Financial Institution Bonds are written to protect commercial banks, savings banks, and savings and loan institutions from numerous forms of dishonesty on the part of employees and others. Financial institution bonds contain six insuring agreements, which are similar to those offered on crime forms; however, they apply specifically to financial institutions and their activities:



• Fidelity – loss that is the direct result of the dishonest or fraudulent acts of employees

• On Premises – loss of property that is the direct result of burglary, robbery, mysterious disappearance, damage, destruction, theft, or larceny committed by a person on the premises

• In Transit – loss of property in transit while in the custody of a messenger or entity transporting the property for loss by robbery, larceny, theft, mysterious disappearance, damage, or destruction

• Counterfeit Currency – loss that is the direct result of acceptance in good faith by the insured of counterfeit money

• Forgery or Alteration – loss that is the direct result of forgery or alteration of any covered instrument

• Securities – loss that is the direct result of dealing in covered securities that it is later discovered were forged, altered, lost, or stolen

Miscellaneous Bonds are those that fall outside the categories previously discussed. A bond may be written to guarantee almost any type of performance required by a legal contract. Examples of miscellaneous types of bonds include Adoption Bonds, Bill of Lading Bonds, Lost Securities Bonds, U.S. Excise Bonds (i.e., Wine Maker’s Bonds and Tobacco Manufacturer’s Bonds), Travel Agency Bonds, and Warehouse Bonds.

Fidelity Bonds protect businesses against fraudulent acts by specified individuals; they are referred to as “dishonesty bonds.” Examples of fidelity bonds are Janitorial Service Bonds, Employee Dishonesty bonds, and Pension Trust (ERISA) bonds. Fidelity bonds usually insure businesses for losses caused by the dishonest acts of their employees.

• An Individual Bond protects an employer against the dishonest acts of a specific employee, such as the treasurer or a bookkeeper.

• A Schedule Bond protects an employer against the dishonest acts of the employees listed in the schedule, either by name (Name Schedule Bond) or by the position held (Position Schedule Bond). A company may wish to list all officers and directors on a name schedule bond or it may wish to list all its salespersons on a position schedule bond.

• A Blanket Bond protects an employer against the dishonest acts of any employees, regardless of their individual names or positions. Additional employees are automatically covered and premiums are adjusted upon audit at the end of the annual bond term. Types of Blanket Bonds include commercial blanket bonds, bankers blanket bonds, and D & O blanket bonds.

Crime and Bond Claim Examples

Crime ClaimsEmployee theft comes in all shapes and sizes:

• An employee initiated electronic funds transfers to bank accounts established in the name of fabricated entities.

• An employee stole more than 100 laptop computers over a long period of time while on site at a customer’s office for the purpose of maintaining its computer system.

• A payroll clerk who was unsupervised increased the amounts of her paychecks without the authorization or knowledge of her employer and embezzled over $65,000.

Other crime claims covered by commercial crime policies include:• An unknown party broke into the insured’s office and stole a safe containing over $70,000 after

unbolting the safe from the office floor.• The insured’s employee and an accomplice not employed by the insurer stole $73,000 from

inventory. The stolen property was discovered elsewhere and, after being investigated by police, the employee admitted to the theft and subsequent attempt to resell the property.



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• A vice president of finance embezzled more than $1 million over a ten-year period by creating false invoices and substituting checks payable to the vendor with a check payable to himself in the same amount.

Surety Bond ClaimBecause the surety guarantees the performance of the principal when it issues a bond, it must indemnify the obligee if the principle does not perform as promised in a contract.

For example, Doris hired Callen Contractors to complete a remodeling of her home and required Callen to secure both performance and payment bonds. When Callen breaches the contract, Doris will submit a claim to the surety.The surety will investigate Doris’ allegations and will review the contract between the parties. It is of the utmost importance to the surety that the obligations of the contract be determined and carried out. If the contractor fails to fulfill its obligations, the surety must do so.In the contract between Callen and Doris, it was agreed that the contract would be completed no later than September 1st and that Callen would hire and pay all the subcontractors needed for the project. On August 25th, the electrical subcontractor calls Doris and says he is suspending all work on the project because Callen is behind in making payments and that he’ll be hiring a lawyer to place a lien on the project if Callen doesn’t make payment immediately. If the electrical contractor walks off the job, the project will not be complete by September 1st, which means Callen will be in default.Doris tells the electrician she will file a claim with the surety immediately, which she does. After the surety initiates its investigation of Doris’ claim, and completes it promptly, the surety agrees that Callen is in default. In fact, the surety determined that Callen never paid the electrical contractor for any of its work and, as the only contractor with outstanding work remaining before completion of the project, if the electrician walks off the job, the job will not be completed by September 1st.Because the surety is obligated to fulfill Callen’s obligations if it defaults, the surety immediately pays the electrician all outstanding invoices and assures the electrician it will make payment in full upon his completion of the work. Because the surety takes this action, the project will be completed on time and the surety will pursue reimbursement from Callen.If the surety’s investigation revealed that Callen had not breached the contract, however, it would respond differently. For example, if the surety’s investigation revealed that Callen had made payment to the electrician for all contracted work to-date, and that the electrician’s request for payment was for additional work Callen had not agreed to or contracted for, it would likely tell Doris that Callen had not breached its contract with her.


1. What type of crime or fidelity products guarantee the fulfillment of contractual obligations, usually with respect to the performance of one of the parties to requirements stipulated in the contract?a. Employee theft coverageb. Surety bondsc. Commercial crime policiesd. Savings bonds

2. What type of insurance protects businesses from the dishonest acts of employees and others?a. Crime insuranceb. Surety bondsc. Savings bondsd. General liability insurance

3. What is the act of stealing or the felonious taking of personal property with intent to deprive the rightful owner of it?a. Burglaryb. Robberyc. Larcenyd. Theft

4. Sid is a contractor who enters into a contract with a homeowner to remodel her home. When the homeowner asks Sid to purchase a bond to guarantee that he will complete the project on time and according to the contract, what type of bond does Sid buy?a. Bid bondb. Appeal bondc. Performance bondd. Savings bond

5. Which of the following is NOT one of the coverages included on a commercial crime policy?a. Employee Theftb. Outside the Premisesc. Computer Fraudd. Counterfeit Fraud and Alteration

6. What crime endorsement may be added to the commercial crime policy to provide coverage if loss of money occurs because an employee was kidnapped and threatened with death?a. Kidnapb. Life insurancec. Extortiond. Robbery

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Chapter 5Business Interruption Insurance

According to the majority of risk managers, business interruption insurance is one of the most misunderstood types of property and casualty insurance. Business interruption insurance—specifically Business Income (BI)—also generates a significant amount of litigation because of misunderstandings both at the time coverage is purchased and during the claims process. The global expert services firm, Navigant, believes many business interruption insurance policies “aren’t thoughtful or well defined enough to address all of the issues that arise out of large scale loss, leading to inconsistent interpretation of policy terms.”1

Business interruption insurance is one form of Time Element Insurance, which is defined by the International Risk Management Institute (IRMI) as coverage for loss resulting from the inability to put damaged property to its normal use. For example, if a fire damages a retail store, in addition to the actual property damage the business suffers, the business will also suffer loss of income because it is no longer able to operate at its location. If the business chooses to resume operations at another location, either permanently or temporarily (while the current location is being repaired or rebuilt), the business will incur additional expenses that would not have become necessary in the absence of the fire loss.

The first issue at hand with respect to misunderstandings about coverage is the use of the terms business interruption and business income because they do not mean the same thing. Although many insurance professionals use these terms interchangeably, they refer to separate and distinct subjects. Business interruption refers to the actual slowdown or termination of business activities due to a loss. Business income is the net income a business would have earned had a business interruption not taken place.

It is essential for agents and clients to keep in mind that the coverage trigger for business interruption insurance contains three elements:

1. A covered peril must cause loss to the insured’s property

2. The property loss must suspend the insured’s business operations, and

3. The suspension of operations must only last as long as it takes to repair or replace the damaged property

Under most business interruption policies, if any of the three elements is absent, coverage is not applicable. It should also be kept in mind that business interruption caused by equipment breakdown is not insured by the Business Income (and Extra Expense) Coverage Form—it is insured under the Equipment Breakdown Coverage Form.

Because the amounts of these consequential losses resulting from an interruption of the insured’s activities depend upon the length of time required to repair or replace damaged property, the term “time element” is used to refer to several types of interruption insurance coverage. In personal lines, time element coverage includes Additional Living Expense (ALE) and Fair Rental Value coverages, which are found on homeowners, dwelling, and mobile home policies. In commercial lines, time element coverages are also referred to as Business Interruption Insurance—a broad term that includes Business Income, Extra Expense, and Contingent Business Income coverages.

In this chapter, our discussion and focus will be on the commercial lines business interruption coverages and forms, specifically ISO’s Business Income (and Extra Expense) Coverage Form, CP 0030 (10/12). Business interruption that results from equipment breakdown is covered later.

1 (Stan Johnson 2010)

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CHAPTER 5: BUSINESS INTERRUPTION INSURANCE 61

OverviewWhen reviewing a business client’s need for business interruption insurance, a number of factors must be considered. The foremost factor is the income at risk should a business suffer a loss covered by the commercial property or businessowners policy. It is important to understand that the limits of coverage for business income insurance must adequately reflect the income the business would have earned in the absence of a loss and NOT the income the business could have earned.

Another major factor is confirming the underlying property coverages adequately insure the business’ risks for loss. If the underlying property policy excludes a peril—for example, earth movement—then the business interruption coverage will also exclude that peril. Equipment breakdown coverage forms have business interruption insurance built into them precisely because that coverage is not included in standard property policies. It is for this reason business interruption caused by equipment breakdown is not covered in the Business Income (and Extra Expense) Coverage Form.

Depending upon the nature of the insured business and its activities and operations, endorsements and additional coverage options may be necessary to provide specialized coverage, such as extended period of interruption coverage, contingent business interruption, service interruption, and claim preparation expense coverage. Deductibles should also be chosen carefully, as different types of deductibles are available and their application to a loss may generate a significantly different outcome than a client might anticipate.

Because business interruption insurance is based on the limit of insurance appearing in the policy’s declarations, and those limits of insurance are calculated by the client, it is essential that the values provided on the original application, and any accompanying Business Income Report/Worksheet, are accurate. The BI Worksheet states (emphasis on the first sentence is that of this author):

The figure in L. represents 100% of your estimated Business Income exposure for 12 months, and additional expenses. Using this figure as information, determine the approximate amount of insurance needed based on your evaluation of the number of months needed (may exceed 12 months) to replace your property, resume operations and restore the business to the condition that would have existed if no property damage had occurred. Refer to the agent or company for information on available coinsurance levels and indemnity options. The Limit of Insurance you select will be shown in the Declarations of the policy.

The insured is expected to report one hundred percent of its business income exposures, along with its expectation of additional expenses should its operations be interrupted. How can a client be expected to see into the future and make allowances for every conceivable type of business interruption loss that might occur?

For example, if a fire damages the insured’s building, how long might it take to repair a fire-damaged building? Three months? Six months? Twelve months? Does the length of time needed for repairs vary based upon the degree of damage to the building? In other words, if a building is totaled by the fire, will it take more time—or less time—to resume operations at another location than to rebuild at the same site? What happens if the building cannot be repaired, but that determination is not made until months after the loss?

How will these questions be answered if the loss causing the business interruption is a windstorm or a truck driving through the side of the building? How will these questions be answered if the business interruption is caused by a hurricane, tornado, earthquake, or flood? How will these questions be answered if the loss causing the business interruption is the explosion at the warehouse of the insured’s only supplier of product? Clearly, each of these scenarios will affect a business in unique ways.

The BI Worksheet requires the insured to provide income and expense values for the following, which must be calculated based on a twelve-month period ending on a date stated in the worksheet. The worksheet also requires the insured’s estimated values for the same income and expenses, assuming a twelve-month period on a beginning date stated in the worksheet.

• Income ◦ Gross sales ◦ Finished stock inventory (at sales value) ◦ Gross sales value of production



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◦ Prepaid freight, returns and allowances, discounts, bad debts, and collection expenses ◦ Other income and earnings, such as commissions, rents, and cash discounts received

• Expenses ◦ Cost of goods sold ◦ Cost of services purchased from outsiders to resell (that won’t continue under contract) ◦ Expenses for power, heat, and refrigeration (that won’t continue under contract) ◦ Payroll expenses (including payroll expenses to be excluded)

Once the expenses have been deducted from the income, the 12-month business income exposure is established. In addition to that figure, the insured must also estimate the value of any extra expenses that might be incurred to avoid or minimize the suspension of the insured business and to continue operations.

For example, if the insured’s premises were not fit for occupancy, how much would it cost to rent another location? Would additional employees need to be hired? What other additional expenses might be incurred? Assuming the insured business would be able to resume operations, how much time after it resumes operations might it take before the business is able to resume its original earnings capacity and/or production?

Agents should keep in mind that if business income values are not calculated correctly, or if the client does not understand precisely what the terms in the worksheet mean, the final numbers provided to the insurance company will not be accurate. Most of the E & O claims arising from business interruption insurance are the direct result of BI Worksheets—either they were not completed by the insured, they were not completed accurately by the insured, or the agent did not handle them properly.

If a business does not have a Business Continuity Plan (BCP), it will find the task of establishing values for ensuing business income loss, and foreseeing potential business interruption events, daunting. The Financial Industry Regulatory Authority (FINRA) publishes a Business Continuity Plan Template on its website for insurance professionals to use to comply with FINRA regulations concerning business continuity.2 FEMA3 and Inc.com4 are among many other entities that offer templates for creating a business continuity plan. Of course, hiring a risk manager or risk management firm is probably the best way to assure the most comprehensive of BCPs; however, any type of planning will prove more beneficial than not planning at all.

Statistics show that businesses with BCPs in place resume operations more quickly after suspended operations than businesses without contingency plans do. In addition, they are better able and equipped to mitigate the consequences of suspended operations to their businesses and personnel.

Because most business interruption policies contain language that requires them to make all efforts to mitigate loss, the existence of a BCP in advance of a loss will serve to facilitate the claim settlement and enhance the relationship with both the adjuster and the insurer. In effect, the BCP is proof the insured conducted due diligence in determining its risks for loss and properly insuring those risks.

Because business interruption claims seldom settle quickly or without contention, clients should be advised to conduct advance planning with respect to identifying the members of their team who will be involved in handling any future business interruption claim. Three essential team members will be called upon after a BI loss occurs:

• A single person will need to be appointed as risk manager (if none already exists) to act as the contact person for coordination of all claim efforts and processes.

• A finance person will need to be available to provide and receive financial information to document and support the insured’s claim to the insurer.

• A sales and/or operations person will need to be available to provide information that documents and supports the insured’s claim for loss of production and sales.

2 (FINRA 2010)3 (Federal Emergency Management Agency n.d.)4 (Inc.com n.d.)



Business Interruption Insurance TerminologyThe following definitions include generic terms used to discuss business interruption insurance, along with the definitions contained in ISO’s Business Income (and Extra Expense) Coverage Form, CP0030 (10/12).

Business IncomeBusiness income is the net income (net profit or loss before income taxes) that would have been earned or incurred had a business interruption not occurred. Business income is continuing normal operating expenses, including payroll. If the insured is a manufacturer, net income also includes the net sales value of production.

Business InterruptionBusiness interruption is the cessation or slowdown of a business’ operations due to a loss.

Extra ExpenseExtra expense is the necessary expenses incurred by the insured during the “period of restoration” AND that would not have been incurred by the insured if direct physical loss to covered property had not been caused by a covered peril. Extra expense represents additional costs the insured would not have experienced in the absence of the loss.

Finished StockFinished stock is stock the insured has manufactured, including alcoholic products being aged unless a coinsurance clause applies. Finished stock does not include stock the insured has manufactured if it is held for sale on the premises of any retail outlet insured under the coverage form.

OperationsOperations are the insured’s business activities that take place at the premises described in the declarations. If Rental Value coverage applies, operations also means the tenantability of the described premises.

Period of RestorationThe period of restoration is the time during which coverage is provided:

• After a loss that is caused by • A covered peril, and • That takes place at the described premises

For Business Income Coverage, the period of restoration begins 72 hours after the time of direct physical loss or damage. For Extra Expense Coverage, the period of restoration begins immediately after the time of direct physical loss or damage.

The period of restoration ends on the earlier of two dates:• The date the property at the described premises should be repaired, replaced, or rebuilt with

reasonable speed and similar quality, OR • The date when business is resumed at a new permanent location

The period of restoration does not include any extra time required because of the enforcement of, or compliance with, any ordinance or law regulating the construction, use, repair, or demolition of any property. Neither does the period of restoration include any extra time because of any requirement to test for, monitor, clean up, remove, contain, treat, detoxify, neutralize, respond to, or assess the effects of pollutants.



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Four goals must be accomplished during the period of restoration:1. The building must be repaired or rebuilt or the insured must find a new location2. New or replacement equipment and business personal property must be purchased and installed3. Stock and inventory must be replaced4. The insured business must resume its pre-loss level of operations

Most clients underestimate the length of time needed to accomplish these four goals. Failure to estimate adequately the period of restoration will activate the coinsurance clause, which results in a reduction in loss payments. The policy’s expiration does not affect the period of restoration.

PollutantsPollutants are any solid, liquid, gaseous, or thermal irritants or contaminants, such as smoke, vapor, soot, fumes, acids, chemicals, and waste.

Rental ValueRental value is business income that has two specific components. The first component is net income, or the net profit or loss before income taxes, that would have been earned as rental income from tenant occupancy of the premises described on the declarations—as furnished and equipped by the insured—of a loss had not occurred. Rental value also includes the fair rental value of any portion of the described premises occupied by the insured.

The second component of rental value includes normal operating expenses that continue after the loss and are incurred in connection with the rented premises. Continuing normal operating expenses include payroll and the legal obligations of the tenant that, if not charged to the tenant, would be the insured’s legal obligation.

SuspensionSuspension is the cessation or slowdown of the insured’s business activities. If Rental Value coverage applies, suspension is also the rendering of the described premises, or part of the described premises, as untenantable.

Business Income (and Extra Expense) Coverage FormNot all insurers use the ISO Business Income (and Extra Expense) Coverage Form (BIEE Coverage Form). Even when insurers do use the CP0030, they may allow the addition of manuscripted endorsements to the policy in addition to ISO endorsements. Agents are cautioned to read all policies, forms, and endorsements and to become familiar with not only the terminology used in the policy but also with the underwriting, valuation, and claims processes used by their insurers. As mentioned previously, business interruption insurance is responsible for an increasing number of agent’s E&O claims; agents must be vigilant when explaining coverage to clients, verifying that clients complete their BI worksheets properly, and submitting required BI worksheets to insurers in a timely fashion.

A. Coverage1. Business Income

Business income is the net income (net profit or loss before income taxes) the insured would have earned or incurred if a covered loss not occurred. Business income also includes the continuing normal operating expenses of the business that are incurred as a result of the covered loss, including payroll. If the insured is a manufacturing risk, net income also includes the net sales value of production.



If a limit of insurance is shown on the declarations, coverage for one or more of the following options is provided under the BIEE coverage form:

• Business Income including “Rental Value”• Business Income other than “Rental Value”• “Rental Value”

If separate limits of insurance are shown for more than one of the preceding options, coverage applies separately to each option.

The policy pays for the actual loss of business income the insured sustains due to the necessary suspension of the insured’s business operations. Payments are made during the period of restoration, which is the period of time between the onset of the suspension of operations and the insured’s resumption of operations.

The suspension of operations must be caused directly by physical loss of, or damage to, covered property at the described location listed in the declarations. Coverage applies only if a premium for that location is also shown in the declarations. The direct cause of loss must be included in the applicable causes of loss form attached to the policy.

For example, the insured business is a restaurant that suffers damage to its building when a taxi crashes through the wall in one of its two dining rooms. The restaurant completely shuts down its operations for three days while temporary repairs are made. On the fourth day, the restaurant reopens and is able to continue operations using the undamaged dining room. Repairs to the second dining room take six weeks to complete, after which the restaurant reopens.

Subject to any waiting periods shown in the declarations, the policy will pay for the total loss of income during the days the business is completely shut down. In addition, the policy will pay for the partial loss of income the restaurant sustains during the six weeks it is able to operate using one dining room. (Of course, payment is subject to all policy conditions, terms, and limitations.)

2. Extra ExpenseExtra expense is the necessary expenses incurred by the insured during the period of restoration that the insured would not have incurred in the absence of a loss. Other than for expenses related to the repair or replacement of property, coverage is provided for expenses incurred to avoid or minimize the suspension of the insured’s business and to continue operations at the described premises.

If operations cannot be continued at the described premises, expenses incurred to continue operations at replacement or temporary locations are covered. They include relocation expenses and costs to equip and operate the replacement or temporary locations. In addition, coverage is provided if the insured incurs additional expenses to minimize the suspension of business if the insured is unable to continue operations.

Extra expense coverage is only provided at the described premises and only if the premises is shown in the declarations and a premium charge for coverage also appears in the declarations. Using the restaurant example above, if the restaurant incurred extra expenses to rent equipment, furniture, and other items destroyed in the loss for use during the six-week period of restoration, this coverage would apply.

3. Covered Causes of Loss, Exclusions, and LimitationsThe provisions for the covered causes of loss, exclusions, and limitations of coverage are those of the causes of loss form that is attached to the policy and that appears in the declarations.



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4. Additional Limitation – Interruption of Computer OperationsCoverage under the BIEE coverage form does not apply if a suspension of operations is caused by the destruction or corruption of electronic data. Neither does coverage apply to any actual loss or damage to electronic data other than as provided under the Additional Coverage, Interruption of Computer Operations. This type of loss may be insured under the Equipment Breakdown Coverage Form.

For purposes of the BIEE coverage form, electronic data means information, facts, or computer programs stored, created, or used—as or on, or transmitted to or from:

• Computer software, including systems and applications software• Hard or floppy disks• CD-ROMs, tapes, and drives• Cells, data processing devices, and other repositories of computer software

This additional limitation does not apply if loss or damage to electronic data only involves data that is integrated in, and operates or controls, a building’s elevator, lighting, heating, ventilation, air conditioning, or security system.

5. Additional Coverages

a. Civil AuthorityUnder coverage for civil authority, the described premises is listed in the policy’s declarations and is the only premises at which coverage applies. If a covered cause of loss damages property other than property located at the described premises, business income and extra expense coverage is provided if a civil authority prohibits access to the described premises under two conditions—both of which must be met.

1. Access to the area immediately surrounding the damaged property is prohibited by civil authority as a result of the covered property damage. The described premises must be within that area and not more than one mile from the damaged property.

2. The action of the civil authority must be taken in response to dangerous physical conditions that result from either the damage or continuation of the covered cause of loss that damaged the property OR to enable a civil authority to have unimpeded access to the damaged property.

The preceding conditions are very explicit and should be explained to the insured. If the insured’s location is more than one mile from the damaged property, civil authority coverage does not apply. In addition, if access is prevented or impaired because of any reason, other than civil authority, coverage does not apply.

For example, the insured is a manufacturing plant located two miles from the highway. The only access to the manufacturing plant is a two-mile private road. If the civil authority prevented access to the insured’s private road because of property damage to a building located at the intersection of the highway and the private road, no coverage would apply. Similarly, if the building at the intersection suffered an explosion and debris from the explosion littered the area for two weeks, preventing access to the insured’s private road, coverage would not apply.

Civil authority coverage for business income begins 72 hours after the time of the first action of the authority prohibiting access and lasts no more than four consecutive weeks from the date coverage first began. Civil authority coverage for extra expense has no waiting period and begins immediately after the time of the first action of the authority prohibiting access; it ends at the later of four consecutive weeks after the take of first action or when the civil authority business income coverage ends.



b. Alterations and New BuildingsCoverage for business income and extra expense is extended due to direct physical loss at the described premises if caused by a covered cause of loss to new buildings or structures, alterations, additions to existing buildings and structures. This additional coverage also applies to machinery, equipment, supplies, or building materials located on—or within 100 feet of—the described premises if such property is used in the construction, alterations, or additions and is incidental to the occupancy of the new buildings or structures.

c. Extended Business IncomeIf an insured suffers a business interruption that is not catastrophic in nature, it is usually able to resume operations within a relatively short period of time. However, most businesses do not automatically resume their pre-loss incomes immediately upon reopening. In fact, many businesses take weeks, and sometimes months, before being able to resume the same level of pre-loss earnings. Some businesses are never able to achieve their pre-loss level of income and go out of business.

Even during a four-week suspension of operations, a business’ customers may seek out a new provider of the products, merchandise, and/or services the insured provides. Acquiring “replacement” customers, and replacing the revenue lost by the customers who defected, may take considerable time.

This additional coverage provides coverage for the insured’s actual loss of business income for up to 60 days beyond the last day of the period of restoration. Some insurers permit the insured to extend coverage for a longer period of time (i.e., 90 days) with the payment of an additional premium. The coverage extension is usually available for up to 720 days after the period of restoration ends.

It is also important to realize this additional coverage does not apply to loss of income resulting from unfavorable business conditions caused by the covered cause of loss. For example, if a wildfire were the covered cause of loss, the community’s economic recovery would likely take considerable time. If the insured’s resumption of operations was negatively affected by the community’s inability to make as quick a recovery as the insured’s, the policy does not pay for the loss of income generated by the unfavorable economic conditions in the area.

Coverage applies separately to rental value and business income other than rental value.

d. Interruption of Computer OperationsSubject to the provisions of coverage, the insured may extend business income and extra expense coverage to a suspension of operations caused by an interruption in computer operations due to destruction or corruption of electronic data that occurs due to a covered cause of loss. Separate provisions apply based on the covered causes of loss form attached to the policy (i.e., Special Form, Broad Form, or other causes of loss added by endorsement).

The maximum limit of insurance provided by this additional coverage is $2,500 unless the declarations shows the insured purchased a higher limit. The limit applies to all losses sustained in any one policy year, regardless of the number of interruptions, premises, locations, or computer systems involved in the loss. This additional coverage does not apply to a loss sustained, or expenses incurred, after the period of restoration ends, regardless of the limit of insurance already paid or remaining.

6. Coverage ExtensionIf a coinsurance percentage of 50% or more applies, and is shown in the declarations, coverage under the form may be extended to apply to property at any location the insured acquires, other than property located at fairs or exhibitions. The maximum limit of insurance paid under



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this coverage extension is $10,000 at each location, unless the declarations shows the insured purchased a higher limit.

Coverage provided by this extension ends at the earliest of the policy expiration, 30 days after the insured acquires or begins to construct the property, or the insured reports values to the insurance company. The Additional Condition, Coinsurance does not apply to this coverage extension.

B. Limits of InsuranceThe maximum amount of insurance the policy will pay for loss in any one occurrence is shown in the declarations. Payments made for the following coverages do not increase the limit shown in the declarations:

• Alterations and New Buildings• Civil Authority• Extra Expense• Extended Business Income

If the declarations shows separate limits of insurance for the Interruption of Computer Operations Additional Coverage or the Newly Acquired Locations Coverage Extension, the specified limits apply per the provisions of each separate coverage and apply separately from the limit of insurance shown in the declarations.

C. Loss ConditionsIn addition to the conditions found in the Common Policy Conditions and the Commercial Property Conditions, certain loss conditions apply. Some are similar to standard property conditions; others contain provisions specific to time element coverages. Distinct differences are mentioned below.1. Appraisal2. Duties in the Event of Loss – The insured is required to resume all or part of its operations as

quickly as possible if intending to continue the business.3. Loss Determination – This condition stipulates how the amount of business income and extra

expense losses will be determined.For business income losses, the business’ net income before the loss occurred will be considered. The likely net income of the business if loss had not occurred will also be considered; however, this does not include net income that would have been earned because of an increase in business due to favorable business conditions attributable to the covered cause of loss on customers or other businesses (this means the insured cannot benefit from the loss). The business’ operating expenses, including payroll, that are necessary to resume operations with the same quality of service the insured provided before the loss will be reviewed, along with other pertinent information, such as the insured’s financial records, accounting procedures, bills, invoices, deeds, liens, and contracts.

For extra expense losses, all expenses that exceed the normal operating expenses that would have been incurred by the insured’s business operations during the period of restoration if loss had not occurred will be considered. From that amount, a deduction will be made for the salvage value of any property purchased for temporary use during the period of restoration once operations are resumed. A deduction will also be made for the extra expense for other insurance except insurance written to the same terms as existing extra expense insurance. A final consideration will be made for the necessary expenses that reduce the insured’s business income loss that would otherwise have been incurred.

Specific conditions exist with respect to the insured’s resumption of operations. Specifically, the insurer will reduce the amount of the insured’s business income loss (not to include the extra expense loss) if the insured is able to resume operations, wholly or partially, by using damaged or undamaged property at the described premises or elsewhere. The amount of loss reduction will



be made to the extent the insured did not use such damaged or undamaged property. For extra expense losses, the amount of the loss will be reduced to the extent the insured is able to return operations to normal and discontinue extra expense.If the insured does not resume operations or does not do so as quickly as possible, the insurance company will make payment based on the length of time it would have taken to resume operations as quickly as possible. This condition concerning resumption of operations is often contentious during the claims settlement process because the insured and the insurer do not always agree about what constitutes “as quickly as possible.” Producers should be sure to discuss this condition with clients at the time coverage is purchased, and secure the insured’s acknowledgement of the consequences of failing to resume operations “as quickly as possible.”

4. Loss Payment – The policy begins paying for covered losses within 30 days after receiving the insured’s sworn proof of loss. Payment is contingent upon the insured’s compliance with all terms and provisions of the BIEE coverage form AND the insured and insurer have agreed about the amount of the loss or an appraisal award has been made.This is another provision that is important for producers and policyholders to understand. If the insurer and insured do not agree about the amount of the loss, the insurer does not have to begin making claim payments until an appraisal award has been made. It is essential for the insured to have established values adequately at the time coverage was purchased and for the insured to cooperate fully when providing the insurer with documentation and proof of the loss.

D. Additional ConditionCoinsuranceThe coinsurance provision on the BIEE coverage form differs from the coinsurance clause in traditional property policies. In property policies, the coinsurance percentage is applied to the value of the property being insured. For example, if the replacement value of a building is $100,000 and the coinsurance percentage is 90%, the building must be insured for at least $90,000 at the time of the loss to avoid a coinsurance penalty at the time of loss.

However, because business interruption insurance makes payment for loss based on time and not the value of property, its coinsurance provision is applied differently. The coinsurance percentage under Business Income coverage is applied to a 12-month period of time.

For example, 12 months equals 100% coinsurance. Six months equals 50% coinsurance (12 months x 50% = 6 months) and 9.6 months equals 80% coinsurance (12 months x 80% - 9.6 months).

The coinsurance percentage must equal the insured’s best guess about how long the period of restoration will last. Specifically, the coinsurance percentage is an indication of how long the insured believes it will take to get back to its pre-loss level of operations after a covered suspension of operations. This coinsurance percentage is chosen in conjunction with the insured’s completion of the Business Income Report/Worksheet.

The coinsurance condition on the BIEE coverage form stipulates that the insurer will not pay the full amount of any business income loss if the limit of insurance for business income is less than either:

• The coinsurance percentage shown in the declarations, OR• The sum of the net income and operating expenses that would have been earned or incurred in

the absence of the loss by the insureds operations at the described premises for the 12 months following the policy inception date (or last previous anniversary date), whichever is later

The coverage form describes precisely how the amount of the reduction in loss payment will be calculated and applied and states payment will be made in the amount determined by the calculation or the limit of insurance, whichever is less. The BIEE coverage form also provides two examples; one involves adequate insurance and one involves underinsurance.



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E. Optional CoveragesThe following optional coverages apply if a designation appears in the policy’s declarations. When provided, these optional coverages apply separately to each item insured.

1. Maximum Period of IndemnityThis optional coverage eliminates the coinsurance condition and replaces the limit of insurance for business income and extra expense to the lesser of the amount of loss sustained, and expenses incurred, during the 120 days immediately following the start of the period of restoration OR the limit of insurance appearing on the declarations. (This is four months of payments.)

2. Monthly Limit of IndemnityThis optional coverage eliminates the coinsurance condition and limits payment for business income and extra expense during each 30 consecutive days during the period of restoration to the limit of insurance multiplied by a fraction shown in the declarations.

For example, if the limit of insurance is $120,000 and the fraction is ¼, the most the policy will pay for each consecutive 30 days is $30,000 ($12,000 X ¼ = $30,000)—regardless of the actual loss sustained.

3. Business Income Agreed ValueThis optional coverage is contingent upon the insured’s completion, and submission to the insurer, of a Business Income Report/Worksheet (BI worksheet) during the 12 months prior to the beginning date contained on the worksheet, as well as estimates for the 12 months immediately following the inception date of this optional coverage. The policy’s declarations must indicate the Business Income Agreed Value option applies and an Agreed Value must also be indicated in the declarations.

The Agreed Value must be no less than the coinsurance appearing in the declarations multiplied by the amount of net income and operating expenses for the following 12 months as reported on the worksheet. Under this optional coverage, the coinsurance condition is suspended until 12 months after the effective date of this optional coverage or the expiration date of the policy, whichever occurs first. The coinsurance condition is automatically reinstated if the insured fails to submit a new BI worksheet and Agreed Value within 12 months of the effective date of this optional coverage or when the insured requests a change in the limit of insurance.

It is essential for the insured to submit the worksheet if it wants to continue suspending the coinsurance clause. Failure to submit the worksheet in timely fashion always reinstates the coinsurance provision. It should also be noted that if the limit of insurance were less than the Agreed Value, the policy would not pay more than the amount of a loss multiplied by the limit of insurance divided by the Agreed Value. This is a penalty!

4. Extended Period of IndemnityAfter a covered loss, an insured’s loss of business income often continues beyond the period of restoration. For example, a retail store may resume operations six months after a fire but may not enjoy its pre-loss level of sales until three months after reopening. This optional coverage extends coverage under paragraph A.5.c. Extended Business Income from 60 days to the number of days indicated in the declarations.



Endorsements and Optional CoveragesAs with any type of insurance policy, additional coverages may be added by endorsement to the business interruption coverage forms. Other coverage options may also be triggered by the payment of an additional premium and a designation on the policy’s declarations page. A brief discussion follows about the more commonly available endorsements and coverage options.

Claim Preparation Expense CoverageDuring the settlement of large property insurance claims, the insured inevitably incurs a great deal of lost time and expense in preparing the documents and other materials required by the insurer. In addition, the insured oftentimes is required to hire consultants, experts, and other professionals to assist with its efforts.

It should be noted that while some policies include coverage for claim preparation expenses, others do not. Even when providing claim preparation expense coverage, most policies and endorsements specifically exclude coverage for the fees charged by public adjusters. The ISO Business Income (and Extra Expense) Coverage Form CP 00 30 does not include coverage for claim preparation expense.

Contingent Business Interruption (CBI) CoverageWhen an insured business depends upon one or more suppliers or customers, it may suffer a business interruption if a supplier or customer suffers a covered property loss. Contingent business income (CBI) coverage provides insurance for the insured’s loss of business income, and extra expense, if the supplier or customer upon whom the insured depends suffers a property loss that causes the insured to have a business interruption. For example, if the insured is a lawn care business and the warehouse of its only supplier of fertilizer burns to the ground, the insured may be unable to continue operations until it locates another supplier from which it can purchase product.

In an article about contingent business interruption insurance, Daniel Torpey of Ernst & Young, LLP said, “CBI insurance, on its surface, may appear straightforward; however, the documentation and analysis needed to validate an insurance claim can be quite challenging.”5 Producers should familiarize themselves with the processes involved in accurately determining their clients’ exposures to loss and offering methods to calculate values appropriately.

Contingent business interruption insurance includes coverage for loss of business income and/or extra expense; it is also referred to as dependent properties insurance or contingent time element coverage. The coverage trigger of contingent business interruption insurance, as stated two paragraphs ago, is the covered direct physical loss to property owned by the insured’s supplier or customer—one upon which the insured depends to conduct normal business operations or to acquire and/or service its customers. The “dependent property” may be insured specifically by name in the endorsement or the insured may secure blanket coverage for all suppliers and customers.

The most common situations for which contingent business interruption coverage is needed fall into four major categories:

• The insured relies upon a few suppliers (or sometimes only one) to provide materials

• The insured relies upon a few manufacturers or distributors (or sometimes only one) for the majority of its goods

• The insured relies only upon a few customers to buy the majority of its products and/or goods

• The insured relies on a leader property to provide it with customers (a leader property is a neighboring business)

5 (Torpey 2003)



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If any of the preceding scenarios occur, the insured’s CBI coverage will apply, provided the property loss occurring at the dependent property is the result of a peril covered by the insured’s policy. Four types of dependent properties are addressed by the ISO Business Income (and Extra Expense) Coverage Form and its endorsements: contributing locations, recipient locations, manufacturing locations, and leader locations.

• A contributing location is one that delivers materials or provides services to the insured. The provision of utility services is typically excluded from this definition of dependent property but coverage may be obtained for interruption in service from a utility provider under another endorsement.

• A recipient location is one that receives materials and products from the insured—typically, a customer.

• A manufacturing location is one that delivers products to the insured’s customers per written sales contracts. Typically, the insured takes orders from customers, places the orders with the manufacturer, and the manufacturer ships the product(s) directly to the insured’s customer.

• A leader location is one that draws customers to the insured’s location because of its proximity to the insured business. For example, if the insured is located in a mall, the anchor store (the one drawing in the majority of the mall’s customers) is the leader location.

Contingent business interruption coverage does NOT provide insurance for the following, although coverage is available under other endorsements and coverage parts for these types of loss (except for downstream business interruption):

• Interruption of utility service caused by an off-premises power failure• Interruption of business caused by civil or military authority• Interruption caused by lack of ingress or egress• Downstream business interruption(when damage at a location owned by the insured causes

business interruption of another location owned by the insured)• Interruption caused by damage to heating or cooling equipment that causes a change in

temperatureAn important consideration of the insured and agent when providing CBI coverage is the consequences of the insured’s lack of control over access to the dependent property during the loss settlement process. Because the dependent property is owned by and under the control of another party, the insurance company may be unable to determine the appropriate “period of restoration” accurately.

As a result, the insured’s CBI coverage may be adversely affected by the dependent property’s decisions concerning the time needed to make repairs, move operations to temporary or new locations, etc. Documentation that often helps the insured facilitate prompt CBI claims settlement include monthly profit and loss statements, monthly and daily production reports, monthly inventory, monthly cost accounting reports, and invoices and purchase orders.6

Contingent Extra Expense (CEE) CoverageContingent extra expense (CEE) coverage works in a fashion similar to that of contingent business interruption coverage. It pays for necessary extra expenses that result from a covered property loss that occurs at the location of a dependent property and that renders the dependent property unable to continue operations either temporarily or permanently. Usually, the waiting period that applies to CBI coverage does not apply to CEE coverage.

6 (Insua 2012)



Delayed Completion CoverageAlso known as delay in start-up (DSU), delayed opening, soft costs, or advanced loss of profits (ALOP) coverage, delayed completion coverage provides insurance for lost business income and certain extra expenses caused by the delay in completion of a construction project. Coverage is provided if the delay is caused by damage to covered property by a peril insured against. This coverage is most often added to builder’s risk coverage.

Ingress/Egress CoverageThe subject of ingress/egress coverage is the insured’s access to insured property. Although the ISO BIEE coverage form provides insurance for lack of access to the insured property due to orders of a civil authority, it does not provide coverage for lack of access by other means. If an insurer provides an ingress/egress endorsement, coverage is provided when:

• A covered peril prevented or impaired ingress or egress from the described premises• Business interruption resulted from the prevented or impaired ingress or egress• A loss of business income resulted from the business interruption

Utility ServicesStandard property policies (i.e., the Business and Personal Property Coverage Form and Businessowners Coverage Form) exclude loss caused by the failure of utility services. Specifically, policy language precludes coverage for the failure of power, communication, water, or other utility service supplied to the described premises—however caused—if the failure originates away from the described premises or originates at the described premises and involves equipment used solely for the provision of services to the described premises from a source off-premises.

When a utility services endorsement is added, it essentially adds off-premises power failure as a covered peril for purposes of the time element coverages. The endorsement allows the insured to choose coverage for sources providing water supply, wastewater removal, communication, and power. Coverage may include, or exclude, overhead transmission lines. When the endorsement is added, the coinsurance additional condition does not apply to it.


1. Why does business interruption insurance generate a significant amount of litigation instituted by policyholders?a. Because it’s expensiveb. Because it’s purchased by lawyersc. Because it’s often misunderstoodd. Because it’s simple

2. What type of coverage provides insurance for loss resulting from the inability to put damaged property to its normal use?a. Time elementb. Equipment breakdownc. Inland marined. Flood

3. Which of the following is NOT one of the three elements of the trigger for business interruption insurance?a. A covered peril causes loss to the insured’s propertyb. The insured’s property loss suspends the insured’s business operationsc. The suspension of operations lasts until damaged property has been repaired or replacedd. The suspension of operations lasts for up to 180 days after the damaged property has been repaired or

replaced

4. What is the definition of Business Income?a. Gross salesb. Net salesc. Net incomed. Net sales

5. When does the “period of restoration” end?a. Within 72 hours of the covered lossb. The date the described premises should be repaired, replaced, or rebuiltc. 30 days after extra expenses are incurredd. Within 90 days of the submission of the sworn proof of loss

6. What type of business interruption coverage pays for loss when a dependent property suffers a loss that causes the insured to have a business interruption?a. Extended period of indemnityb. Extra expensec. Contingent business incomed. Ingress/egress coverage

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Chapter 6Equipment Breakdown Coverage

Because standard property insurance policies typically exclude loss caused by the breakdown of equipment, virtually all businesses and homeowners are exposed to significant financial loss if any of their equipment breaks down. The fact that most property insurance policies exclude coverage for equipment breakdown, and that coverage is available by endorsement or on a separate policy, is an indication about the degree of risk posed by this peril and the specialization required to settle equipment breakdown losses.

Although the focus of this chapter is on equipment breakdown coverage for businesses, it is important to recognize that individuals may also benefit significantly from the purchase of equipment breakdown endorsements on their homeowners policies. If an equipment breakdown loss renders a home unfit to live in, the Additional Living Expenses (ALE) coverage provided by the unendorsed homeowners policy will not apply because equipment breakdown is not a covered peril. (ALE coverage is only provided if the loss of use is caused by a covered peril.) If an equipment breakdown endorsement is added to the policy, however, loss of use coverage is provided by the endorsement. The cost of this endorsement to the homeowners policy can be as low as $20 – 25 per year!

Examples of equipment breakdown losses cited by national insurers include:• Businesses1 2 3

◦ Electrical arcing destroyed several major electrical panels in an office building and left it without power – the loss totaled over $1.5 million

◦ A turbine generator that supplied power to a hospital failed – the loss totaled nearly $300,000 ◦ Fresh scallops at a food processing plant were contaminated with ammonia when an ammonia

line ruptured – the loss totaled over $65,000 ◦ A power surge at a service station damaged the electrical system that powered its diagnostic,

telephone, paging, and security systems – the loss totaled over $30,000 ◦ An environmental control computer failed, destroying a crop of vegetables – the loss totaled over

$180,000 ◦ A compressor used in a dairy operation failed, preventing the processing of milk into powdered

milk – the loss totaled over $1 million• Homeowners4 5 6

◦ A device in a deep well pump burned out, requiring excavation to repair – the loss totaled over $5,000

◦ Cracked coils in a heating/air conditioning system required replacement of the system – the loss totaled over $9,000

◦ A central air conditioning system sustained electrical damage – the loss totaled over $10,000 ◦ A circuit board in a subzero freezer arced, requiring replacement of the entire appliance – the loss

totaled over $11,000

1 (CNA 2009)2 (Hartford Steam Boiler n.d.)3 (The Travelers Indemnity Company n.d.)4 (American National n.d.)5 (EMC Insurance 2009)6 (Factory Mutual Insurance Company 2012)

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When agents and consumers equate equipment breakdown coverage with boiler and machinery coverage (which is the title by which equipment breakdown coverage used to be called), they are mentally limiting the scope of coverage. Although equipment breakdown coverage does provide insurance for loss caused by the failure of steam boilers, it also provides four other categories of coverage. Five broad types of equipment are insured under commercial equipment breakdown coverage:

1. Electrical systems, including transformers, panels, and cables

2. Air conditioning and refrigeration systems

3. Boilers and pressure equipment used in heating systems, to provide hot water, and for cooking

4. Computer and communication systems, including telephone, TV satellite, point-of-sale, security, and fire alarm systems

5. Mechanical equipment, including generators, water pumps, ventilation fans, elevator and escalator machinery, motors, engines, etc.

Virtually all equipment contained in a home is insured under homeowners equipment breakdown endorsements, and includes:

• Air conditioning systems

• Electrical generators and panels

• Furnaces and heat pumps

• Washers, dryers, and other household appliances

• Sump pumps and deep well pumps

• Computers, stereos, and televisions

• Swimming pool equipment

• Chair lifts and elevators

• Air and water filtration systems

• Sauna equipment

• Home security systems

Businesses are especially vulnerable after suffering equipment breakdown losses because their operations are often interrupted by the inability to use the damaged equipment. These losses usually translate into an immediate loss of income.

Equipment breakdown coverage provides insurance for certain types of property damage and for business interruption on the same policy. Because insurers are aware of the high potential for significant financial loss as the result of equipment breakdowns, most insurers offer valuable and extensive loss control and risk management services to policyholders that purchase equipment breakdown coverage. These services are offered free of charge and include inspection of steam boilers and steam equipment—some of these inspections are actually required by state law. Since they are included as part of the policy coverage, and paid for by the policy premium, equipment breakdown coverage provides far more valuable a benefit than most businesses realize.

It is important for all businesses to understand their exposures to equipment breakdown loss, including businesses that rent their premises instead of owning them. Although a building owner is responsible for repairing damaged property and equipment it owns, a tenant’s operations can be impaired just as significantly by an equipment breakdown loss as the building owner’s operations can be—sometimes even more. Because a tenant has no control over the loss settlement process and timely repair of damaged equipment, a tenant that has not purchased equipment breakdown coverage is especially vulnerable.


CHAPTER 6: EQUIPMENT BREAKDOWN COVERAGE 77

Another consideration with respect to equipment breakdown coverage is the fact that businesses often depend upon vendors, suppliers, and others off-site. If any of those off-site associates suffer an equipment breakdown loss, it is likely the insured will also suffer a loss.

For example, a manufacturer purchases a component part for its product from an off-site supplier. If the supplier suffers an equipment breakdown loss, will the inability of the vendor to provide the component part affect the insured? Absolutely. If the insured’s Internet sales rely on an off-site IT provider will the provider’s breakdown of computer equipment affect the insured? Again, absolutely.

Because equipment breakdown coverage was specifically designed to address perils that are excluded in other property policies, it provides insurance on a named perils basis. Three major perils excluded by standard policies are specifically insured by equipment breakdown policies and endorsements and are included in the definition of “breakdown” on the equipment breakdown coverage form. The three exclusions are:

• Explosion of steam boilers, pipes, engines, and turbines owned or leased by the insured• Mechanical breakdown, including rupture and bursting caused by centrifugal force (centrifugal force

is associated with circular motion and draws a rotating body away from the center of rotation)• Artificially generated electrical current, including electrical arcing

Equipment breakdown policies exclude many of the same “wear and tear” perils found in other property policies (i.e., rust, corrosion, deterioration, settling, and inherent defect), along with the typically excluded perils of earth movement and water. They also exclude the majority of the named perils found in standard property policies precisely because they are covered perils in those policies; for example, fire, explosion, lightning, windstorm or hail, riot or civil commotion, sprinkler leakage, and volcanic action.

Despite the fact that standard property policies and equipment breakdown coverage appear to provide coverage in a way that fits together seamlessly—especially when agents work with clients to design a comprehensive insurance program—coverage gaps and issues often occur. Even when coverage is eventually provided, initial loss investigation may not provide a clear indication for the cause of a loss. If coverage determination is delayed or a coverage dispute arises, an insured may not be compensated by the insurer in time to stave off the financial consequences resulting from income loss, increased operating expenses, and/or the required repair of property.

An endorsement is available for addition to both the property and equipment breakdown policies to alleviate this issue. ISO calls the endorsement the Joint or Disputed Loss Agreement and other carriers also provide the same endorsement. A few carriers include this coverage automatically in some of their forms, although most do not.

Equipment breakdown policies include many limits and sub-limits of coverage. It is essential for producers to be sure they discuss thoroughly with every insured the potential for loss and provide adequate coverage. Separate limits of coverage are provided for direct damage to property, loss of business income, and increased operating expenses (extra expense). Sub-limits of coverage are provided for perishable items, expediting expense, demolition, ordinance or law, and hazardous substances. It is also important to realize that different deductibles apply to different types of coverage.

Before delving into the policy itself, agents should keep two facts at the forefronts of their minds when discussing equipment breakdown coverage with clients.

1. Equipment breakdown coverage is insurance, therefore, the equipment “breakdown” must be an accident. This means that whatever the cause of loss, it must be unexpected, unintended, and sudden. Equipment breakdown coverage does not provide for loss caused by defects, wear and tear, malfunction, improper maintenance, etc.

2. Different insurers use different forms of coverage, although many insurers (such as Hartford Steam Boiler, which is one of the largest issuers of equipment breakdown coverage) base their policies and endorsement language on the ISO policies and forms.

The remainder of this chapter discusses the Insurance Services Office’s (ISO’s) Equipment Breakdown Protection Coverage Form, (BM 0020 07/01), and a few selected endorsements that may be added to it.



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The PolicyMost insurance professionals understand that equipment breakdown coverage, formerly known as Boiler and Machinery Coverage, provides insurance for the explosion of steam boilers, pipes, engines, etc. Although few businesses still have steam boilers and steam-powered machinery to generate heat or power, the businesses that do are often required by state regulations to be inspected annually. If those businesses purchase equipment breakdown coverage, the insurance coverage form provides an inspection by the insurer in addition to paying for covered losses.

With the advent of technology, however, many businesses and homeowners depend upon far more sophisticated systems to provide heat and other sources of energy than steam boilers and related equipment. Many consumers make the mistake of believing they do not need equipment breakdown coverage because they do not have “boilers” in their homes and buildings. However, steam is still used to power a variety of apparatus, such as air conditioning and heating systems, hot water equipment, steam engines, portable heat and hot water systems—and as components of other equipment.

Even if businesses and homeowners do not have exposure to loss by explosion of steam boilers and steam equipment, they certainly have significant exposure to the perils addressed by two other major coverages provided by equipment breakdown policies: mechanical breakdown and electrical failure. As time goes by, our society depends more and more upon technology. If their computer systems fail, most businesses are unable to continue all of their operations. If electricity is lost, all businesses and homeowners suffer some degree of loss—even if it is just of time and productivity.

Before delving into the equipment breakdown coverage form, a review of the standard property exclusions is in order to establish how and why equipment breakdown coverage fills several key exposures faced by most businesses. Specifically, the three exclusions contained in ISO’s Special Causes of Loss Form are shown below. (Homeowners policies contain their own versions of these exclusions.)

B. Exclusions, 2.a. , Artificially generated electrical current, etc.Artificially generated electrical, magnetic, or electromagnetic energy that damages, disturbs, disrupts or otherwise interferes with any: (1) Electrical or electronic wire, device, appliance, system or network; or (2) Device, appliance, system or network utilizing cellular or satellite technology. For the purpose of this exclusion, electrical, magnetic or electromagnetic energy includes but is not limited to: (a) Electrical current, including arcing; (b) Electrical charge produced or conducted by a magnetic or electromagnetic field; (c) Pulse of electromagnetic energy; or (d) Electromagnetic waves or microwaves. But if fire results, we will pay for the loss or damage caused by that fire.

B. Exclusions, 2.e., Explosion of steam boilers, etc.Explosion of steam boilers, steam pipes, steam engines, or steam turbines owned or leased by you, or operated under your control. But if explosion of steam boilers, steam pipes, steam engines, or steam turbines results in fire or combustion explosion, we will pay for the loss or damage caused by that fire or combustion explosion. We will also pay for loss or damage caused by or resulting from the explosion of gases or fuel within the furnace of any fired vessel or within the flues or passages through which the gases of combustion pass.

B. Exclusions, 2.d.(6), Mechanical breakdownMechanical breakdown, including rupture or bursting caused by centrifugal force. But if mechanical breakdown results in elevator collision, we will pay for the loss or damage caused by that elevator collision.

The value and importance of equipment breakdown coverage will vary based upon the size of the business and its dependence upon various types of equipment. For example, the telephone and computer systems in a small, “main street” business may not be extensive and may be easily—and quickly—replaced in the event of breakdown or failure. On the other hand, a large manufacturing company that utilizes a great deal of complex machinery and technology might be crippled immediately by a breakdown.

Depending upon the nature of a business, the type of equipment needing coverage, and the capacity of the insurer, a great deal of equipment breakdown coverage is underwritten by specialty insurance companies and reinsurers—especially for very large and/or unusual risks. Agents should be aware that they do have access to these markets.



DefinitionsAlthough the definitions section of the equipment breakdown coverage form appears on the last two pages of the form, reference to some of the major definitions is included here to facilitate understanding of the coverage provided.

BreakdownBreakdown is clearly intended to provide coverage for accidental breakdown and not breakdown that is caused by wear and tear, inherent vice (a hidden quality in property that causes or contributes to its deterioration or damage), or issues concerned with maintenance of equipment. In most cases, the breakdown must occur within the covered equipment, and not from external perils such as fire and vandalism.

Three types of direct physical loss are included in the definition of breakdown. Breakdown must occur to “covered equipment” and require its repair or replacement. The three types of direct physical loss (unless otherwise excluded in the coverage form) covered by the form are:

1. Failure of pressure or vacuum equipment2. Mechanical failure, including rupture or bursting caused by centrifugal force3. Electrical failure, including arcing

Breakdown does not include any of the following:• Malfunction • Defects, erasures, errors, viruses, etc. in computer equipment and programs• Leakage of any valve, fitting, shaft seal, joint, connection, etc.• Damage to any vacuum tube, gas tube, or brush• Damage to any structure or foundation supporting covered equipment or any of its parts• The functioning of any safety or protective device• The cracking of any part on an internal combustion gas turbine exposed to the products of

combustion

Business IncomeWhen a covered loss provides insurance for loss of business income, business income is defined as the net profit or loss before income taxes that would have been earned by the insured had the loss not occurred and the insured’s continuing normal operating expenses, including payroll.

Computer EquipmentComputer equipment is the insured’s programmable electronic equipment used to store, retrieve, or process data. It includes related equipment that provides communication, including input and output functions such as printing and data transmissions. Data and media are not computer equipment.

Covered EquipmentFour distinct types of property are considered “covered equipment” on the coverage form:

1. Equipment built to operate under internal pressure or vacuum other than the weight of contents

2. Electrical or mechanical equipment used to generate, transmit, or utilize energy

3. Communication equipment and computer equipment

4. Equipment of the types listed above that is owned by a public or private utility and used solely to supply utility services to the insured’s premises

Other than property cited in number 4. above, all covered equipment must be located at a premises described on the Declarations and owned, leased, or operated under the insured’s control.



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The following types of property are not covered equipment:• Media• Any part of pressure or vacuum equipment not under internal pressure of its contents or

internal vacuum• Insulating or refractory material unless it is a glass lining of covered equipment• Non-metallic pressure or vacuum equipment unless constructed and used per American

Society of Mechanical Engineers (A.S.M.E.) code or comparable code• Any catalyst• Vessels, piping, and other equipment buried below ground that requires the excavation of

materials to inspect, repair, remove, or replace it• Structures, foundations, cabinets, or compartments that support or contain covered equipment

or any part of covered equipment• Vehicles, aircrafts, self-propelled equipment, or floating vessels or any covered equipment

mounted on, or used solely with, such vehicles or equipment• Dragline, excavation, or construction equipment or any covered equipment mounted on, or

used solely with, any such equipment• Any felt, wire, screen, die, extrusion plate, swing hammer, grinding disc, cutting blade, non-

electrical cable, chain, belt, rope, clutch plate, brake pad, no-metal part, or any part or tool subject to periodic replacement

• Any machine or apparatus used solely for research, diagnosis, medication, surgical, therapeutic, dental, or pathological purposes or any covered equipment that is mounted upon, or used solely with, any such machine or apparatus

• Any equipment, or part of any equipment, manufactured for sale by the insured

Covered PropertyCovered property is property owned by the insured. Covered property is also property in the insured’s care, custody, or control and for which the insured is legally liable.

DataData is programmed and recorded material stored on media, along with programming records used for electronic data processing or electronically controlled equipment.

Extra ExpenseExtra expense is the additional cost incurred by the insured to operate the insured business during the “period of restoration” over and above the costs the insured would normally have incurred to operate if the insured breakdown had not occurred.

Hazardous SubstanceA hazardous substance is any substance other than ammonia that has been declared by a government agency to be hazardous to human health.

MediaMedia is any electronic data processing or storage films, tapes, discs, drums, or cells.

One BreakdownIf an initial breakdown causes other breakdowns, they will be considered, collectively, One Breakdown. In addition, all breakdowns that occur at any one premises, manifest themselves at the same time, and are the direct result of the same cause of loss will be One Breakdown.

Period of RestorationThe period of restoration begins and ends at specific times. It begins at the time of the breakdown, or 24 hours before the insurer receives notice of the breakdown, whichever occurs later. It ends 5



consecutive days after the date when the damaged property is repaired or replaced with reasonable speed and similar quality. Keep in mind that the damaged property must be located at the premises show on the Declarations unless it is owned by a utility company and used solely to provide services at the insured’s premises. The period of restoration may be extended by endorsement.

StockStock is merchandise the insured holds in storage for sale, raw materials, property in process, or finished products. Stock includes supplies used in its packing or shipping.

Covered Causes of LossThe equipment breakdown coverage form provides insurance on a named perils basis and the only covered cause of loss is a “breakdown” to “covered equipment.” For this reason, it is essential that agents and policyholders clearly understand the definitions of both terms.

Insuring AgreementsThe equipment breakdown coverage form provides ten different coverages, each of which provides its own insuring agreement. Three of the coverages are business interruption coverages and make payment in the event the insured’s operations are suspended partially or completely: Business Income and Extra Expense, Utility Interruption, and Contingent Business Income.

• Property Damage• Expediting Expenses• Business Income and Extra Expense (or Extra Expense Only)• Spoilage Damage• Utility Interruption• Newly Acquired Premises• Ordinance or Law Coverage• Errors and Omissions• Brands and Labels• Contingent Business Income and Extra Expense (dependent properties)

a. Property DamageThe policy pays for direct damage to “covered property” located at the premises designated on the Declarations. This coverage pays for damage to property owned by the insured if it is caused directly by a covered equipment breakdown, such as damage to the building or business personal property. Coverage is also provided for property of others in the insured’s care, custody, or control if a covered equipment breakdown causes loss and the insured is legally responsible for the damage.

b. Expediting ExpensesThis coverage pays for extra expenses the insured incurs to make temporary repairs after a covered equipment breakdown. It also makes payment for extra costs the insured incurs to hurry up, accelerate, or expedite permanent repairs and/or the replacement of damaged property. Although this coverage is similar to extra expense coverage, it is not as comprehensive.

c. Business Income and Extra Expense (or Extra Expense Only)This first of the three time element coverages provided by the equipment breakdown coverage form makes payment for the insured’s actual loss of business income during the period of restoration after a covered loss. It also pays for the extra expenses the insured incurs to operate the insured business during the period of restoration. (The insured has the option of purchasing coverage for extra expense only.)



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Coverage is provided for total or partial suspensions of business operations and continues for five days after the damaged equipment is repaired or replaced (see definition for “period of restoration”). When settling losses, the insurance company will review the insured’s records to evaluate the income received, and expenses incurred, before the breakdown. It will also review other factors to determine the probable income the insured would have received, and probable expenses the insured would have incurred, had the breakdown not occurred.

The insured may extend coverage beyond the five days contained in the definition of period of restoration if a different number of days appears in the policy Declarations. ISO provides an endorsement for this purpose, Extended Period of Restoration.

If the covered breakdown damages media or corrupts data, business income and/or extra expense coverage will continue for the time the insured needs to research, replace, or restore the damaged property. It will also continue while the insured reprograms covered computer equipment.

The limit of liability for this coverage, unless the insured purchases higher limits, is the lesser of the insured’s business income and/or extra expense up to 30 days after the period of restoration, or $25,000, whichever is less.

d. Spoilage DamageThis coverage pays for spoilage to raw materials, merchandise in the process of manufacture, and finished products if three conditions are met. First, the property must be either in storage or in the process of being manufactured. Second, the insured must own or be legally responsible for the property. And third, the spoilage must be the result of a covered equipment breakdown loss that causes the lack or excess of power, light, heat, steam, or refrigeration. If the insured incurs necessary expenses to reduce the amount of spoilage loss, those expenses will also be covered.

e. Utility InterruptionThis second of the business interruption coverages only applies if Business Income and Extra Expense, Extra Expense only, and/or Spoilage Damage coverage is provided. Utility interruption coverage extends those coverages to breakdowns of covered equipment that result from the interruption of utility services if three conditions are met.

First, the interruption that causes the covered breakdown must damage “covered equipment” owned, operated, or controlled by a local utility or distributor. The utility services must be directly generated, transmitted, distributed, or provided to the insured.

Second, the covered equipment must be used to supply any of the following services to the insured’s premises: electric power, communication services, air conditioning, heating, gas, sewer, water, or steam. Finally, the interruption of utility service to the insured’s premises must last at least the same number of consecutive days (i.e., the waiting period) shown on the Declarations that applies to this coverage. Once the waiting period has been met, coverage begins at the time of the interruption and is subject to all applicable deductibles.

f. Newly Acquired PremisesIf the insured acquires a new premises, either via purchase or lease, coverage provided under the equipment breakdown coverage form is extended automatically to the new premises. The coverage extension begins the day the insured acquires the premises and continues for the number of days shown in the Declarations for Newly Acquired Premises.

The coverage extension is subject to four conditions, all of which must be met:1. The insured must inform the insurer of the acquisition of the premises “as soon as

practicable.”2. The insured must agree to pay an additional premium to be determined by the insurer.3. The coverage extension is subject to the same terms, conditions, exclusions, and limitations

insuring other premises.



4. If coverages and deductibles are different for different premises appearing in the Declarations at the time of the new acquisition, insurance for the newly acquired premises will be provided at the broadest coverage, highest limits, and deductible that apply to the existing premises.

g. Ordinance or Law CoverageThis coverage applies despite the Ordinance or Law Exclusion and is only provided if increased loss costs are incurred due to the enforcement of any ordinances or laws in effect at the time a covered breakdown occurs. The ordinances or laws to which this coverage applies must regulate the demolition, construction, repair, or use of the building or structure that was damaged because of a covered breakdown.

Loss payment is provided for the loss in value of the undamaged portion of the building or structure because it must be demolished due to enforcement of applicable ordinances or laws. Loss payment is also made for the insured’s actual cost to demolish and clear the site of the undamaged parts of the building or structure. Finally, loss payment will be made for the insured’s actual and necessary costs to repair or reconstruct both the damaged and undamaged portions of the building or structure.

If reconstructing or remodeling the undamaged portions of a building or structure, coverage will be provided for materials of like kind and quality and at the same height, floor area, and style of occupancy, regardless of requirements pertaining to demolition. This provision applies whether reconstruction takes place at the same premises or at another premises.

A number of exclusions apply, including:• Demolition or site clearing until the undamaged portions of buildings and structures are

actually demolished• Increase in loss until damaged or destroyed buildings and structures are actually rebuilt or

replaced and approved by any regulatory agency• Loss due to any ordinance or law that required the insured to comply before the loss occurred

and the insured failed to comply• Increase in loss due to the insured’s failure to meet minimum requirements of any ordinance

or law in effect at the time of the breakdown• Increase in loss caused by a substance declared to be hazardous to human health or the

environment by any government agencyIf a covered breakdown results in damage of which only a portion is covered by the equipment breakdown coverage form (meaning other damage occurred that is not insured by this form), the policy will only pay its proportionate share of any ordinance or law loss.

h. Errors and OmissionsThe equipment breakdown coverage form provides coverage that would otherwise be provided, under certain circumstances, if the insured inadvertently fails to notify the insurer about property or premises to be insured. Specifically, if the insured unintentionally makes a mistake or omission in providing a description or location of property to be insured under the coverage form and subsequent amendments, coverage will be provided.

Coverage will also be provided if the insured made an error and unintentionally failed to include an owned or occupied premises at the inception date of the policy or that resulted in cancellation of any premises insured by the policy. However, no coverage is provided if the insured makes an unintentional error with respect to the reporting of values or types of coverage to be provided.

If the insured discovers an error or unintentional omission, the correct information must be reported when discovered. The insurance company will adjust the policy premium to reflect the date the premises should have been added had the error or omission not been made.



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i. Brands and LabelsIf a covered breakdown damages covered property, the insurer has the right to take all or part of the property at an agreed or appraised value. Because the property is considered salvage, the insurer requires the insured to stamp the damaged property (or its container) with the word salvage, if doing so does not physically damage the merchandise.

Because businesses generally do not want to keep their labels on property that will be sold as salvage, this coverage pays the insured’s reasonable costs to remove brands or labels from the damaged property (or its containers) if doing so does not physically damage the merchandise. After removing brands and labels, the insured is required to re-label merchandise and/or its containers to comply with any applicable laws.

The total amount paid for damage to the property and removing brands and labels will not exceed the value of the limit of insurance applying to the property.

j. Contingent Business Income and Extra Expense (or Extra Expense Only)This third, and final, of the business interruption coverages only applies if Business Income and Extra Expense (or Extra Expense only) coverage is provided. This insuring agreement provides business interruption coverage if a supplier, buyer, provider, or driver sustains a covered breakdown that renders the insured’s business unable to operate. Because the insured is highly dependent upon its suppliers, buyers, providers, and drivers, and because the insured’s operations are contingent, or dependent, upon them, they are referred to as “dependent properties.”

For example, an electric company may be the insured’s only source of power to operate its manufacturing plant. If the electric company’s equipment breaks down and renders it incapable of providing electricity to the insured’s premises, the insured may suffer significant, and profound, loss of income, even if it is able to purchase generators to power some of its machinery and equipment. In this circumstance, the insured would also sustain considerable extra expenses.

Another example of a dependent property is a local hotel that purchases the all the baked goods it serves in its restaurant from a local bakery on a daily basis. If the hotel sustains a covered equipment breakdown loss that renders it unable to operate—and therefore, doesn’t need to purchase baked goods until it’s back in operation—it will have a considerable negative effect on the bakery.

The location of the dependent property must be listed in the insured’s Declarations and the covered breakdown must occur at that location. A loss of sales at the insured’s premises (which must also appear in the Declarations) must also take place. The insured is required to “use your influence to induce the contributing or recipient premises to make use of any other machinery, equipment, supplies, or premises available in order to resume operations and delivery of services or materials” to the insured. In addition, the insured must cooperate in every way with the dependent property but may not cooperate in a financial manner unless the insurance company authorizes such financial cooperation.

ExclusionsThe general exclusions contained in the equipment breakdown coverage form apply to direct loss and any losses that are the result of concurrent causation. They are very similar to the general exclusions contained in standard property policies. Those specific to the equipment breakdown coverage form contain details of the exclusions.

• Ordinance or Law• Earth Movement• Water• Nuclear Hazard• War or Military Action



• An explosion, other than explosions of covered equipment (i.e., steam boilers, electric steam generators, steam piping, steam turbines, steam engines, gas turbines, or moving or rotating machinery when explosion is caused by centrifugal force or mechanical breakdown)

• Fire or combustion explosion, including those that result in a breakdown, occur at the same time as a breakdown, or ensue from a breakdown

• Explosion within a furnace• Damage to covered equipment that is undergoing a pressure or electrical test• Water or other means used to extinguish a fire• Depletion, deterioration, corrosion, erosion, or wear and tear• If the insured has a property policy that provides coverage for the following perils, even if

insurance isn’t collectible, breakdowns caused by the following perils: ◦ Aircraft or vehicles ◦ Freezing caused by cold weather ◦ Lightning ◦ Sinkhole collapse ◦ Smoke ◦ Riot, civil commotion, or vandalism ◦ Weight of snow, ice, or sleet

• Breakdowns caused by windstorm or hail• Delay in, or interruption of, any business, manufacturing, or processing activity not specifically

covered by the insuring agreements providing Business Income, Extra Expense, and Utility Interruption

• With respect to Business Income, Extra Expense, and Utility Interruption coverages: ◦ Business that would not, or could not, have been carried on in the absence of the breakdown ◦ The insured’s failure to use due diligence and all reasonable means to operate the insured

business as close to normal as possible at the premises shown in the Declarations ◦ Suspension, lapse, or cancellation of a contract following a breakdown beyond the time

business could have resumed had the contract not lapsed, cancelled, or been suspended• Lack or excess of power, light, heat, steam, or refrigeration except as otherwise provided in the

policy under the business interruption coverages• With respect to Utility Interruption Coverage:

◦ Acts of sabotage ◦ Collapse ◦ Deliberate acts of load shedding by the utility ◦ Freezing caused by cold weather ◦ Impact of aircraft, missile, or vehicle ◦ Impact of objects falling from aircraft or missiles ◦ Lightning ◦ Riot, civil commotion, or vandalism ◦ Sinkhole collapse ◦ Smoke ◦ Weight of ice, snow, or sleet

• Any indirect loss resulting from a covered breakdown except as provided under the business interruption coverages

• The insured’s neglect to use all reasonable means to save and preserve covered property from further damage at, and after, the time of a loss



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Limits of InsuranceLimits of insurance may be chosen per individual insuring agreement or as one limit that applies for all coverages pertaining to a covered breakdown. Risk managers recommend that the minimum limit of insurance should equal the value of the property at the premises. Any applicable limits of insurance will appear in the policy’s Declarations.

Unless a higher limit of insurance appears on the Declarations, a limit of $25,000 is the most the policy will pay for each of the following:

• Ammonia Contamination (including salvage expense)• Consequential Loss• Data and Media, specifically, the insured’s cost to research, replace, or restore damaged data or

media• Hazardous Substance, specifically, the insured’s additional expense incurred for the clean-up,

repair, replacement, or disposal of covered property that is damaged, contaminated, or polluted by any “hazardous substance” (ammonia is not considered a hazardous substance)

• Water Damage, including salvage expense; however, no coverage applies to damage resulting from the leakage of a sprinkler system or domestic water piping

DeductiblesDeductibles for all insuring agreements may be combined or applied separately. If combined, the deductible appears in the Declarations as “Combined.” Otherwise, separate deductibles apply.

Four different types of deductibles are available.• A dollar deductible is stated in the Declarations and losses are paid only after that amount is

subtracted from the amount of the loss.• A time deductible is stated in the Declarations and applies to business interruption losses. When

shown in days, a day equals twenty-four consecutive hours. For example, a 3-day deductible would translate into 72 consecutive hours after the loss.

• A multiple of daily value deductible is stated in the Declarations and is used with business interruption losses. It is an alternative to other types of deductibles and is based on the daily value—or average daily value (ADV)—of lost income. A calculation is involved that divides the total amount of business income that was lost by the number of days the business would have been open during the loss’ period of restoration.

• A percentage of loss deductible is stated in the Declarations and is applied to the total loss. It is often used for spoilage losses.

The equipment breakdown coverage form includes a provision that allows for minimum and/or maximum deductibles to be shown in the Declarations. If such deductibles are shown in the declarations, and any multiple of daily value or percentage of loss deductibles are less than, or more than, these deductibles, the minimum and/or maximum deductibles will apply.

Equipment Breakdown Protection ConditionsIn addition to any common policy conditions that apply, the following conditions apply specifically to equipment breakdown coverage. They are very similar to the common policy conditions form contained in commercial property policies. Those specific to the equipment breakdown coverage form contain details of the conditions.

• Loss Conditions: Abandonment, appraisal, duties in the event of loss, other insurance, legal action against the insurer, loss payable clause, transfer of rights of recovery

• Privilege to Adjust With Owner: The insurer has the right to settle losses with the owner of property owned by others that is in the care, custody, or control of the insured.



• Reducing Your Loss: The insured is required, as soon as possible after a covered breakdown, to: ◦ Resume operations, either partially or completely ◦ Make up for lost business within a reasonable time ◦ Make use of every reasonable means to reduce or avert loss, including:

– Working overtime – Utilizing the property and/or services of other concerns – Using merchandise or other property, such as duplicate parts and surplus machinery the

insured owns, controls, or may be able to obtain – Salvaging damaged property

• Valuation: Covered property will be valued at replacement cost unless it is obsolete and useless to the insured. ◦ If the repair or replacement of damaged property improves the environment, increases

efficiency, or enhances safety while maintaining the existing function (i.e., includes an upgrade), the policy will pay up to 25% of the property’s value—subject to the limit of insurance.

◦ If a breakdown causes an extended warranty to a maintenance contract to become void, the policy reimburses the insured for the unused costs of non-refundable and non-transferrable warranties and contracts.

◦ Unless agreed otherwise in writing, if the insured does not repair or replace damaged property within 24 months of a covered breakdown, the policy pays the lesser of the cost it would have taken to repair or replace the damaged property or the actual cash value of the property at the time of the breakdown.

◦ If the insured holds finished stock, its value will be the selling price less discounts and costs for shipping if three conditions are met: (1) The insured manufactured the property, (2) The selling price is more than the replacement value of the property, and (3) The insured is unable to replace the property before its anticipated sale.

◦ Valuation of spoiled property varies based upon the type of property that spoiled: (1) For raw materials, valuation is replacement value; (2) For property in process, valuation is replacement value of the raw materials, the labor expended, and the appropriate proportion of overhead; and (3) For finished products, valuation is the selling price less discounts and expenses.

• Business Income and Extra Expense Conditions: The insured has three additional obligations with respect to BI and EE coverage. (1) The insured must complete an Annual Report of Values Form once a year within three months of the annual report date. (2) The insured must pay any premium due that is calculated based on the annual report. If the insured is owed a refund, the insurer will issue one; however, no refund will exceed 75% of the original premium. (3) If the annual report of values form is not received when due, a coinsurance provision applies.

General ConditionsMost of the general conditions contained in the equipment breakdown coverage form are typical property conditions; however, four are specific to the form. The typical conditions are:

• Additional Insured• Bankruptcy• Concealment, Misrepresentation, or Fraud• Liberalization• Mortgageholder• No Benefit to Bailee• Policy Period and Coverage Territory• Arbitration



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The four conditions specific to the equipment breakdown coverage form are Premium and Adjustments, Suspension, Joint or Disputed Loss Agreement, and Final Settlement between Insurers.

The Premium and Adjustments condition requires the insured to report 100% of the total insurable values at each premises on an annual basis at the policy’s anniversary date. Values must be provided separately for each coverage provided by the policy. The insured must keep records pertaining to the values for inspection during business hours for the duration of the policy period and for twelve months after the end of the policy period.

The Suspension condition allows the insurer to suspend coverage for any piece of covered equipment if it is found to be in, or exposed to, a dangerous condition. Once suspended, coverage may only be reinstated by issuance of an endorsement.

The Joint or Disputed Loss Agreement condition is designed to facilitate claims payment under certain circumstances. The insured must have both equipment breakdown and commercial property policies in effect at the time of a loss. Covered property must be insured by both the equipment breakdown and commercial property policies. The insurers must disagree about whether coverage exists or about the amount of a loss that should be paid by each insurer under its own policy. Basically, each insurer pays the amount it agrees it owes. In addition, it pays immediately one-half the disputed amount and the insurers then proceed to arbitration to settle their dispute.

The Final Settlement Between Insurers condition stipulates how insurers will refund each other for any excess payments made under the Joint or Disputed Loss Agreement condition.


1. Which of the following is NOT a type of “covered equipment” under equipment breakdown coverage?a. Electrical systemsb. Air conditioning systemsc. Computer systemsd. Buildings

2. All of the following are coverages provided by the equipment breakdown coverage form that are specifically excluded in standard property policies, EXCEPT:a. Explosion of steam boilersb. Sprinkler leakagec. Artificially generated electrical currentd. Mechanical breakdown

3. Which of the following IS a “breakdown” under an equipment breakdown policy?a. A building fire damages an air conditioning systemb. A security system malfunctionsc. A power surge destroys a telephone systemd. A computer virus destroys a business’ entire communications system

4. If an insured speeds up the process of repairing damaged property after a covered equipment breakdown, which insuring agreement under the equipment breakdown coverage form will pay the additional costs incurred by the insured?a. Property Damageb. Business Income or Extra Expensec. Utility Interruptiond. Expediting Expenses

5. Which of the following is NOT one of the three business interruption insuring agreements on the equipment breakdown coverage form?a. Spoilage Coverageb. Contingent Business Incomec. Business Income and Extra Expensed. Utility Interruption

6. On what valuation basis are losses to covered property insured under the equipment breakdown coverage form settled?a. Actual Cash Valueb. Replacement Valuec. Agreed Valued. Functional Replacement Value

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Part ThreeProfessional Liability

In this final section of the course, we address several types of liability insurance that are not standard and, in fact, are typically excluded under the commercial general liability policy. General liability insurance, as the name denotes, is insurance protection for liability exposures of a basic and wide-ranging nature, such as those described in the previous paragraph. It provides insurance for the insured’s legal liability that arises from the typical exposures faced by businesspersons and commercial enterprises: their premises, operations, products, completed operations, and independent contractors.

Because certain businesspersons and commercial enterprises have exposures in addition to those that are general in nature—meaning certain exposures are particular to the work being provided and not held in common with the majority of other businesspersons—those exposures require protection by unique and specific insurance products. Those particular exposures are not covered under general liability insurance coverage forms.

The types of professional liability insurance discussed in this section of the course include:• Errors and Omissions (E&O) Liability• Directors and Officers (D&O) Liability• Employment Practices Liability (EPL)• Cyber Liability• Identity Fraud

It should be noted that although professional liability coverage issued by different insurers for the same types of professionals contain similar components and policy language, no standard forms of coverage exist. Each professional liability policy is unique to both the insurer and the type of professional it insures. Insurance producers and agents should be sure to read all pertinent policy forms, endorsements, limitations, and exclusions of all carriers issuing quotes or proposals before recommending the purchase of a specific professional liability policy. Claims under professional liability coverage are on the rise—and never more so than for insurance agents!

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Chapter 7Professional Liability Fundamentals

IntroductionIt is tacitly understood that the people who own and are employed by businesses enterprises work hard, provide value in exchange for the money they charge, and undertake their duties with responsibility and consideration. They place the best interests and welfare of their clients, customers, employees, and co-workers before their own. They are professional.

Sometimes, however, businesspersons and commercial entities become legally liable for injury or damage sustained by third parties because they make mistakes. An employee misjudges the distance between the back bumper of the delivery truck he is driving and a customer’s building and crashes into a loading dock. A restaurant unknowingly serves tainted food and a patron contracts food poisoning. An insurance agent inadvertently fails to renew a client’s policy and, when the client’s house is destroyed in a fire, no insurance is in place to provide coverage for the loss. Similar scenarios occur on a daily basis across the United States.

If the restaurant mentioned in the previous paragraph is sued by the customer who contracted food poisoning, it will probably find insurance protection for its “mistake” under its general liability policy. However, the insurance agent’s general liability policy specifically excludes coverage for harm caused by the agent’s mistakes. Why? Because giving advice and performing service transactions are not duties and responsibilities the “average” businessperson or commercial enterprise undertakes; therefore, they are specifically excluded by general liability policies—policies that insure exposures of a basic and broad-spectrum nature.

When a businessperson or business entity provides services instead of products, such as the offering of advice, the creation of designs and plans, and the performance of other tasks and duties that require specialized knowledge and training—all in exchange for a fee for services, they are referred to as professional services. The International Risk Management Institute (IRMI) defines professional liability as:

Coverage designed to protect traditional professionals (e.g., physicians) and quasi professionals (e.g., real estate brokers) against liability incurred as a result of errors and omissions in performing professional services. Although there are a few exceptions, most professional liability policies cover economic losses suffered by third parties, as opposed to bodily injury (BI) and property damage (PD), which is typically covered under commercial general liability (CGL) policies. The vast majority of professional liability policies are written with claims-made coverage triggers.

Professionals, in the context of those who are eligible for professional liability insurance coverage, hold themselves out to the public as having greater knowledge or expertise in particular fields of endeavor. They perform services the average or ordinary individual us unable to provide due to a lack of education, training, or experience. Surgeons, architects, and hairdressers are examples of such professionals.

In order to provide surgical services, an individual must be licensed to do so and is required to complete many, many years of learning and training. A schoolteacher cannot perform an appendectomy—and probably would not want to do so. Architects and hairdressers must also be licensed to practice in the U.S. and, although the length of time necessary to obtain licenses is vastly different in the two professions, a consumer probably does not want an architect waxing her eyebrows or a hairdresser designing a commercial building.

If these professionals fail to provide their specific services as others in their field would do under similar circumstances, their clients are at risk of suffering grave financial loss. In some circumstances, as with medical professionals (and hairdressers!), their clients may suffer bodily injury in addition to economic loss. Examples of individuals with exposures requiring the protection of professional liability insurance include, but are not limited to:

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• Physicians, surgeons, psychologists, psychiatrists, optometrists, dentists, chiropractors, nurses, social workers, and other medical and healthcare providers

• Veterinarians and dog groomers• Architects and engineers• Accountants and tax preparers• Insurance agents, brokers, and adjusters• Risk management consultants• Stockbrokers, securities brokers, registered representatives, and financial planners• Viatical settlement brokers• Lawyers and attorneys• Real estate brokers and agents• Internet service providers, computer consultants, IT providers, and software designers• Human resources consultants and employment agencies• Management, media, and marketing consultants• Advertising agencies and public relations consultants• Title agents and notaries public• Funeral directors• Hair dressers and barbers• Printers• Third party administrators and employee benefit plan consultants• Translators and court reporters• Environmental consultants• Directors and officers of corporations (both for-profit and non-profit)• Employers and managers

In addition to the unique exposures professionals face with respect to the services they provide, certain individuals also have exposures pertaining to their positions as directors and officers of corporations (both non-profit and for-profit), as employers and managers of employees, and with respect to their activities on the Internet and using computers and other forms of electronic communication.

Most professional liability policies differ from other types of liability insurance in several respects. Primarily, professional liability insurance does not provide coverage for bodily injury or property damage; it provides coverage for financial or economic loss. Medical malpractice coverage is one notable exception. In addition, many professional liability policies do not allow the insurance company to settle losses without either the insured’s input during the settlement process or the insured’s specific consent to settle. Lawyer’s professional liability policies are a typical example.

Professional RelationshipWhen an individual engages in a professional relationship with a client (or anyone who later becomes a claimant), that individual is expected to provide a degree of care required of such professionals. For example, hairdressers are expected to color their clients’ hair without causing injury. Employers are expected to treat their employees fairly, with respect, and according to law. If a hairdresser burns a client’s skin, or if a store manager discriminates against an employee, these professionals are likely to be viewed as having breached the standard of care they owed the respective injured parties.

When an individual is deemed to have breached the expected standard of professional care, he or she is considered negligent. To be deemed legally responsible for professional negligence, the following components must be present in the rendering of, or failure to render, professional services:


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• A professional relationship was established and existed between the professional and the client (meaning a duty was owed to the client)

• An expected standard of care existed and the professional breached that standard of care (meaning the professional provided services to the client were provided at a level of care below what was owed and expected)

• The client suffered harm that can be proven• The professional’s breach of duty to provide a standard of care was the proximate cause of the client’s

harm AND the harm was a foreseeable consequence of such a breachOf course, whenever a professional liability claim is brought, the party bringing the claim or lawsuit must prove its allegation(s) for the insured to be deemed legally responsible and/or for the professional liability policy to make payment. If the claim or lawsuit goes to trial, all the legal requirements of legal liability must be met in the jurisdiction.

In law, the standard of care professionals are expected to exhibit is generally derived from the customs of the industry in which the professional practices or works. For example, in the healthcare industry, medical providers perform professional services according to accepted medical practices. If a nurse provided care that deviated from accepted medical practices—and a patient died as a result—he or she would have failed to exhibit the required standard of care. If an attorney failed to use the expertise, care, and conscientiousness other attorneys would have used under similar circumstances—and the client’s legal battle were lost due to the attorney’s failure to exhibit the required degree of care—it is likely the attorney would be considered professionally liable.

If a person trips, falls, and breaks a leg, it is obvious the broken leg is a direct result of the fall. However, if a professional makes a mistake, or fails to act, the connection between the act and the harm may not be as clear. Oftentimes, the simple allegation that a professional caused harm may prove as disastrous to the professional as actually causing harm does. Unfortunately, the filing of false and groundless claims and lawsuits is one of the by-products of doing business in our litigious society.

Precisely because parties are permitted to file claims and lawsuits at will, the greatest value of professional liability insurance rests with its defense provision. This element of all types of professional liability insurance cannot be overstated. Professionals who practice without professional liability insurance leave themselves exposed to potentially unlimited expense in the event they are viewed as being professionally negligent.

Liability Coverage FormsBefore we delve into the specifics of the three types of professional liability coverage addressed in this section of the course, a discussion of the claims-made liability form of coverage is in order because professional liability coverage is written on claims-made forms. No two policies are exactly alike—and this sentiment has been, and will be, repeated numerous times because it is a crucial element of understanding professional liability coverage.

Although many types of liability insurance are available, they are all written on one of two basic forms of coverage: occurrence or claims-made. The majority of standard liability insurance is written on the occurrence form, however, professional liability coverage is typically written on a claims-made form.

Depending upon the nature of the risk being insured, commercial general liability (CGL) and crime insurance may also be written on a claims-made form. For example, Carl just established himself as a self-employed Certified Nursing Assistant (CNA). When he applies for new CGL and professional liability insurance, it is quite possible his agent will secure coverage for both policies from the same carrier—and both on claims-made forms—because of two factors: a) he is working in the healthcare industry, and b) as a business, he has no prior loss experience. Because any claims submitted under Carl’s policies are far more likely to be submitted after a long delay than those of, for example, a retail store, an insurer may very well choose to protect itself by using the claims-made form to price Carl’s policies more accurately based on the actual risk he (and his new business) poses.



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The claims-made form was first introduced in the 1940s and, by the 1970s, was often used to insure professionals such as attorneys, architects, engineers, and medical practitioners. It was not until the legal liability crisis in the 1970s that the claims-made form was redesigned in response to the special coverage needs of professionals, the needs of insurers to be able to price certain liability insurance products adequately, and the abundance of asbestos and pollution liability claims that were submitted.

Under normal circumstances, when a loss occurs, it is reported immediately—especially when the loss results in damage to property. Unfortunately, the individuals who submitted claims for asbestosis and other types of pollution in the 1980s did not realize they were injured until many years later, sometimes even decades after their first exposure to asbestos or pollution.

All insurance policy premiums are calculated based on a variety of factors, including the number, type, and severity of anticipated losses. Because the insurance industry had no way to predict the asbestos and pollution losses would occur, they were unable to calculate premiums to adequately cover losses resulting from asbestosis and other pollutants. In addition to the actual dollar values of the unanticipated losses, insurers were forced to pay amounts for the accumulated costs related to the many years of inflation, pain and suffering, and consequential loss.

The claims-made form was created to address these additional costs that arise long after the original injury occurs. In most cases, policies that primarily insure economic loss, such as professional liability policies, require use of the claims-made form precisely because injuries and damage often do not manifest themselves immediately. The claims-made form allows an insurer to price a liability insurance policy based on the specific exposure to potential future claims posed by the insured and its operations.

The difference between the occurrence and claims-made forms revolves around when coverage is activated, or triggered. Insurers choose the specific form of coverage based on whether they expect claims to be submitted relatively soon after a loss occurs, or some time afterward.

Occurrence FormUnder an occurrence form of liability coverage, insurance is triggered when an occurrence takes place in the coverage territory and during the policy period. The actual definition of occurrence varies by policy; however, the general definition accepted by the insurance industry is an “accident, including continuous or repeated exposure to substantially the same harmful conditions.” The insuring agreement of each specific liability insurance policy will indicate what types of damages are insured when caused by a covered occurrence (i.e., bodily injury, property damage, personal injury, etc.).

The premises and operations liability coverage provided by a commercial general liability policy is written on an occurrence basis. If Dawn trips and falls in the driveway of Edie’s Bakery, liability coverage will be triggered if the event that causes injury a) occurs in the policy territory, b) occurs during the policy period, c) is deemed an occurrence, and d) is not otherwise excluded. Even if Dawn submits her claim 10 years after the event that caused injury, the policy will respond—up to its limits of liability. Other liability policies that are written on an occurrence form include auto, homeowners, and most excess and umbrella liability insurance.

Claims-Made FormsUnder a claims-made form of liability coverage, insurance is triggered only if several conditions are met simultaneously. To complicate matters, different types of claims-made forms are available (i.e., pure claims made and claims made and reported) and each policy includes its own specific language depending upon the nature of the risk insured (i.e., an insurance agent or a surgeon).

Depending upon the type of policy being written on a claims-made form, the word occurrence may not appear in the definitions section of the policy. If a commercial general liability policy is written on claims-made form, it will be included. However, most claims-made policies upon which professional liability policies are written, such as E&O and D&O coverage, typically refer to wrongful acts, claims, or offenses rather than occurrences.



When liability insurance is written on a claims-made form, two coverage triggers must be met for coverage to apply:

1. The claim must be reported during the policy period, AND2. The loss must occur after the policy’s retroactive date

Retroactive DateThe retroactive date on a claims-made form is an underwriting tool used by insurance companies to limit or expand the time frame for which they will insure losses.

For example, if Fred graduates from college in May of 2014 and promptly opens his own architectural firm, he will apply for professional liability insurance. When the policy is issued on 7/1/2014, its retroactive date will also be 7/1/2014—because Fred neither worked as an architect before that date nor had professional liability insurance before that date. When his policy renews on 7/1/2015, the retroactive date of that policy should be 7/1/2014—meaning the policy would honor claims reported during the policy period that occurred after 7/1/2014—or during the previous policy term.For illustrative purposes, assume Fred did not secure professional liability insurance immediately upon graduating from college and establishing his business. Instead, he waited three years before applying for insurance, anticipating he would be in a better financial position to pay premiums. When the professional liability policy is issued on 7/1/2017, it is very likely the insurer will issue the policy with a retroactive date of 7/1/2017—the policy’s inception date—because it does not want to provide coverage for the three years during which Fred was uninsured. However, the insurer may decide to provide Fred with a retroactive date of 7/1/2014 if it believes the exposure for loss during that time was minimal. If the insurer does issue a retroactive date of 7/1/2014, it is providing him with prior acts coverage—meaning, it will insure wrongful acts that took place after the retroactive date of 7/1/2014 and before the policy’s effective date of 7/1/2017.

Illustration of Difference between Occurrence and Claims-made Coverage FormsThe following illustration demonstrates the basic differences between the occurrence and claims-made coverage. Assume the policy period and the date of loss is the same under both coverage forms.

1/1/2014 7/1/2014 1/1/2015

Z

Policy Effective DateRetroactive Date

(claims-made form)

Z

Date of Loss

Z

Policy Expiration Date

Occurrence Form Claims-Made FormLoss is covered because it takes place during the policy period

Loss if covered IF it’s reported during the period because it occurred after the retroactive date

Using the preceding illustration, if the policy were written using an occurrence form, coverage would be provided even if the 7/1/2014 loss were reported twelve years later—in the year 2025. The important thing to remember about the use of an occurrence form is that losses MUST OCCUR during the policy period.The only concern about when the loss occurs when using a claims-made form is that it MUST occur AFTER THE RETROACTIVE DATE. The second important aspect of the claims-made form is that losses MUST BE REPORTED during the policy period. For example, if the policy shown in the illustration were a claims-made form that renewed every year for the next twelve years, and the 7/1/2014 loss is reported in April 2025, it would be covered during the 2025 policy term because it meets the two requirements: 1) It’s reported during the policy period (1/1/2025-2026), AND 2) it occurred after the retroactive date of 1/1/2014.



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Types of Claims-made FormsTwo basic types of claims-made forms exist, and each has different variations based on the policy contract and type of professional being insured. In addition, each professional liability policy contains its own precise definitions and reporting requirements, of which the following are essential to understand and communicate clearly to the insured:

• Claim• Wrongful act• Incident reporting• Claim reporting

The two distinct types of claims-made forms are based on the different types of professional exposures they are intended to insure. One type is E&O coverage, which addresses the commission of negligent acts or oversights in the carrying out of one’s professional duties. The second type is Executive or Management coverage, which addresses the commission of negligent acts or omissions with respect to an individual’s executive or managerial duties, such as with respect to financial or fiduciary responsibilities or those pertaining to employment practices.

Because the activation of coverage is triggered differently for these two types of professional exposures, the language of the respective claims-made forms is somewhat different. In all cases, the “claim” or “wrongful act” must take place after the retroactive date in a claims-made liability policy. However, depending upon the type of claims-made form, different requirements exist with respect to when the claim must be made and when it must be reported.

The two types of claims-made forms are:1. Pure claims-made, and2. Claims-made and reported

The pure claims-made form is the original version of the claims-made form of liability coverage. As opposed to the occurrence form of liability insurance—under which coverage is activated when a loss occurs during the policy period, the pure claims-made form activates coverage when a claim is first made against the insured during the policy period.

Over time, however, disputes about the precise definitions of “claim” and “first made” arose under this form of coverage. Was a “claim” a phone call reporting an occurrence that took place? Or was a “claim” the filing of a lawsuit? Was a claim “first made” during the phone call to the insured ... or upon the insured’s receipt of the legal papers?

Because of the conflicting perceptions of claimants and insurers, it was often left to the courts to answer coverage questions. Sometimes, the courts’ decisions made things clear and at other times, they only muddied the waters of the insurance companies’ intentions to provide coverage. As is the case when insurance companies become unhappy with the courts’ interpretations of insurance policy language, insurance carriers re-drafted policy language to communicate more explicitly their intentions with respect to liability insurance written on the claims-made form.

The claims-made and reported form of coverage was introduced and is currently the most popular form of claims-made liability coverage. Such a form contains two requirements for coverage to be activated:

• The “claim” must be made during the policy period, AND IT MUST ALSO• Be reported during the policy period

IMPORTANT NOTE: Some policies declaring they are “claims-made” policies are really “claims-made and reported” policies. Agents MUST read the policy language to determine what type of claims-made form is being used.



The following is the insuring agreement from a claims-made and reported E&O policy:

We will pay on behalf of the Insured all Damages and Claim Expenses in excess of the Deductible and subject to the applicable Limit of Liability that the Insured becomes legally obligated to pay as a result of any covered Claim that is first made against the Insured and reported in writing to Underwriters during the Policy Period or during any properly exercised and applicable Extended Reporting Period, for any Wrongful Act by the Insured or by anyone for whom the Insured is legally responsible, provided, however, that such Wrongful Act was committed or allegedly committed on or after the Retroactive Date set forth in Item 8. of the Declarations and further provided that the Insured had no knowledge of the actual or alleged Wrongful Act prior to the inception date of this Policy.

Issues with Definitions in Claims-made FormsE&O policies and executive liability policies contain different definitions based on the professionals they insure and the types of wrongful acts committed by those insureds. Until the definitions and provisions of professional liability policies are studied in detail, producers should not assume an understanding of coverage or how coverage will be triggered.

Wrongful ActIn liability policies other than professional liability, an occurrence is what triggers coverage. The accepted industry definition of occurrence is, an accident, including continuous or repeated exposure to substantially the same general harmful conditions. For example, if a carpenter builds a staircase and the banister breaks off after installation, the act of the banister breaking off is an occurrence. Likewise, if a contractor was repeatedly exposed to asbestos while working on a job site, that exposure to asbestos is an occurrence.

Professional liability policies, however, do not provide insurance for occurrences—they provide coverage for wrongful acts. In general, a wrongful act is an actual or alleged negligent error or omission committed by an insured. Of course, each policy defines wrongful act differently; for example:

• “Any actual or alleged breach of duty, negligent act, error, omission, or personal injury committed solely in the performance of the professional services of the insured”

• “Any negligent act, error, or omission of the insured in rendering or failing to render professional services as stated in Item 6 of the declarations for others on behalf of the insured organization and caused by the insured except as excluded or limited by the terms, conditions, and exclusions of this policy”

• “Any actual or alleged act, error, omission, misstatement, misleading statement, breach of duty, neglect by, or any matter asserted against: ◦ An insured person in his or capacity as such; ◦ An insured person in his or her outside position; ◦ The insured organization; or ◦ Any matter asserted against an insured person solely by reason of his or her status

as such”If an accountant prepared a tax return improperly because he was not familiar with specific IRS rulings that pertained to his client’s business industry, and the client suffered financial harm, the accountant probably committed a wrongful act. If a doctor failed to diagnose a patient’s illness accurately because he did not run diagnostic tests according to accepted medical practices, and the patient later suffered serious illness, the doctor probably committed a wrongful act.

In certain professional liability policies, such as Employment Practices Liability (EPL), additional offenses may be included in the definition of wrongful act, such as “wrongful employment practices.”



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ClaimOnce the definition of “wrongful act” is understood, the next definition of concern in any professional liability policy is claim. The following are different insurance companies’ definitions of “claim:”

• “Any notice received by the insured of a demand for damages or non-monetary relief based on any actual or alleged wrongful act”

• “A demand received by any insured for money or services, including the service of suit or institution of arbitration proceedings”

• “A written demand for monetary damages or non-monetary relief; a civil proceeding commenced by service of a complaint or similar pleading; a criminal proceeding commenced by filing of charges; a formal administrative or regulatory proceeding, commenced by a filing of charges, formal investigative order, service of summons, or similar document; an arbitration, mediation, or similar alternative dispute proceeding if the insured is obligated to participate in such proceeding or if the insured agrees to participate in such proceeding, with the Company’s written consent; the service of a subpoena on an insured person identified by name if served upon such person pursuant to formal administrative or regulatory proceeding; or a written request to toll or waive a statute of limitations relating to a potential civil or administrative proceeding—against an insured for a wrongful act, provided that claim does not include any labor or grievance arbitration or other proceeding pursuant to a collective bargaining agreement”

Not only MUST a producer understand the definition of “claim” contained in a professional liability policy, he or she MUST also explain that definition to the insured to be sure the insured understands precisely what types of wrongful acts and events are considered a “claim” in order to report them! In one policy, an allegation of a wrongful act may be considered a “claim”; in another policy, only a written demand for damages as the result of a wrongful act will be considered a “claim.” Later in the course, we will discuss that some policies not only require all claims to be reported but also that all incidents that might give rise to a claim be reported, as well.

Professional ServicesProfessional liability policies generally provide insurance for one specific profession. For example, if Mary is a licensed insurance producer AND a licensed attorney, she will need to purchase two separate professional liability policies because each policy will exclude coverage for professional services rendered as a professional other than the single profession designated on the policy’s declarations page.

On the other hand, certain professionals such as accountants and attorneys may find that their E&O policies provide coverage for a broader than average range of services. One accountant’s E&O policy offers coverage for accountants, accounting consultants, bookkeepers, tax preparers, investment advisers, enrolled agents, personal fiduciaries, arbitrators, and mediators. One lawyer’s professional liability policy provides coverage to the insured attorneys as well as to retiring members of the firm and attorneys acting as title agents.

To illustrate the manner in which insurers consider professional services, the following language was excerpted from an insurance agent’s E&O policy’s definition of professional services:



• Services rendered as a managing general insurance agent, general insurance agent, insurance agent, insurance broker, or insurance consultant

• Premium financing services provided by the named insured to the named insured’s clients for insurance products placed through the named insured’s agency

• Loss control, risk management, or anti-fraud services rendered in connect to insurance placed through the named insured

• Services as a registered representative rendered in connection with the sale and servicing of variable life and variable annuity products

• Acting as a countersigning agent for out-of-state insurance agencies on policies issued with the state of domicile of the insured

Another policy defines professional services as the following—but only “when rendered in connection with a covered product by the insured to a client in the conduct of the named insured’s profession as an insurance agent, broker, solicitor, general agent, managing general agent, surplus lines broker, or notary public:”

• Soliciting, negotiating, recommending, selling, or servicing a covered product but not including the sale, surrender, conversion, or any alteration of a covered product in order to acquire or invest in anything other than a covered product

• Providing advice or consultation solely related to a covered product, including financial planning or consulting

• Incidental claims adjusting in connection with first party property claims draft authority

• Appraising real or personal property in connection with soliciting, placing, selling, or servicing a covered product

• Providing loss control or risk management services in connection with soliciting, placing, selling, or servicing a covered product

• Assisting a client to secure premium financing from a licensed premium finance company for a covered product placed by or on behalf of the insured

• Training, managing and supervising others, but only in connection with covered products• Employee benefit plan administration• Expert witness testimony related to professional services or a covered product• Insurance class instruction

The definitions contained in the two policies are not the same. The second definition contains language that is much more restrictive. A policy’s definition of professional services may also list specific activities that are NOT professional services, such as the:

“ownership, creation, formation, operation, administration, adjustment, or adjustment of claims of or for any Multiple Employer Welfare Arrangement (MEWA), any health maintenance organization (HMO) or preferred provider organization (PPO), risk retention group, Professional Employer Organization (PEO), or captive insurance program.”

The exclusions section of each professional liability policy also contains specific professional services, such as COBRA administration and acting as a named fiduciary under ERISA. These facts underscore the importance of reading and understanding the entire professional liability insurance contract before recommending it for purchase to a client.

Coverage TriggersA coverage trigger is an incident that activates the insurance coverages provided by an insurance contract. For example, if a car crashes into a tree, an auto policy will be triggered by the car accident. If a home is destroyed in an explosion, the explosion will trigger the homeowners coverage.

Assume an insurance agent receives a client’s premium payment and then fails to submit the payment to the insurance company after giving the client a receipt. If the insurer later denies the client’s claim because the insurance policy was cancelled for non-payment of premium prior to the date of loss, it



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is clear the insurance agent’s failure to submit the insurance premium is what “triggered” the client’s economic loss. This wrongful act triggers coverage in the professional liability policy.

Sometimes, however, the triggering event is not clear—at least not to all parties. In these circumstances, the dispute between the insured (or claimant) and the insurance company is settled by the courts. Over time, the courts have used four theories with respect to the triggering of insurance coverage:

• Injury-in-Fact: Coverage is triggered if a policy is in place at the time the loss actually took place, even if the loss advances or continues over time. If an auto liability policy is in force at the time of a car accident, this is the theory that will be used.

• Exposure: Coverage is triggered when the injured party was first exposed to the condition that caused loss. This trigger theory is most commonly used in cases that involve asbestos, pollution, and other injuries that are often reported long after they occur.

• Manifestation: Coverage is triggered when the loss first manifests itself, becomes known, or is first discovered. A woman develops a rash on her face and it is not determined until six months later, after numerous diagnostic testing, that her makeup is causing an allergic reaction. This theory will be used because although the woman may have purchased the makeup six months before she developed the rash, the rash is the manifestation of the injury. Depending upon the circumstances, the courts may deem coverage triggered even if the loss had not been discovered but could have been discovered—or if loss had been occurring before actual discovery.

• Continuous: Coverage is triggered if multiple events occur, such as exposure to the conditions that caused loss, actual injury or damage, or manifestation of injury or damage. This theory is also called the multiple trigger theory or the triple trigger theory. Like the exposure theory, it originated from asbestos liability cases because injury develops and then advances over time, consequently becoming more severe.

Although the primary determinant of the triggering of insurance coverage is the actual jurisdiction of the court resolving a dispute, the type of insurance policy or injury may also be a significant determining factor. While the manifestation theory is the one used by most jurisdictions in the United States, and is also the theory used in liability policies issued on occurrence forms, professional liability policies and their claims often require utilization of the exposure or continuous trigger theories.

Because harm caused by professionals often does not manifest itself until a long time after the wrongful act took place, if the triggering of coverage only took place when the injury became known (manifestation theory), it is possible insurance coverage might not be in effect and no coverage would be available to cover the loss.

Extended Reporting Periods (ERPs)Extended reporting periods (ERPs) are provisions contained in claims-made liability policies that lengthen the time frame during which claims may be made and reported. ERPs are also known as tails or tail coverage.

Unlike occurrence forms, which provide coverage for losses that occur during the policy period—regardless of when they’re submitted (even 10 years later), claims-made forms leave the insured parties vulnerable to claims that are made and reported after their policies expire or cancel. Examples of situations that leave professionals vulnerable result in the cancellation or non-renewal of a claims-made liability policy for the following reasons:

1. The insured terminates the policy (either voluntarily or because the business closed or was sold)2. The insurance company cancels or non-renews the policy3. The claims-made policy is replaced with a liability policy issued on an occurrence form



In each of the preceding situations, the insured will not have liability coverage for any claim that occurs after the policy’s retroactive date if it is reported after the policy’s expiration date (or after the end of any extended reporting period contained in the basic policy).

For example, Cathy is a CPA who decides to retire on December 31st. If she cancels her E&O policy on January 1st and a client makes a claim on June 30th for a wrongful act that took place on December 1st, the policy will not respond unless Cathy purchased an extended reporting period. Extended reporting periods do not change any of the policy’s terms or conditions, nor do they extend the policy period. They simply apply to the submission and reporting of claims that meet three criteria:1. The wrongful act occurred after the retroactive date2. The wrongful act occurred before the end of the policy period, AND3. The claim is first made and reported during the extended reporting period

Some ERP provisions are contained in policies themselves, such as the basic extended reporting period (BERP). Others ERPs may be purchased as separate endorsements, with additional premiums charged, and are known as a supplemental extended reporting periods (SERP).

When a policy offers a basic extended reporting period, the BERP usually extends the claim-reporting period for a short time—such as 30 or 60 days. (60 days is most common.) This ERP does not require the payment of an additional premium.

When a policy offers a supplemental extended reporting period, the SERP extends the claim reporting period for durations of one, three, and/or five years. A SERP is offered subject to certain conditions:

• The SERP is available if the policy is cancelled or non-renewed—except if the policy is cancelled for non-payment of the policy premium.

• The insured must request the purchase of a SERP, in writing, within the number of days specified in the ERP provision contained in the policy (usually 30 or 60 days). If the insured does not make such written request within the specified time frame, the insurance company is not obligated to offer or sell a SERP at a later date.

• The insured must pay the additional premium in full before the SERP goes into effect. The premium is fully earned and usually falls between 100% and 200% of the policy’s annual premium—depending upon the length of the ERP. (One policy may charge 100% of the policy’s annual premium for a 12-month ERP, 150% of the policy’s annual premium for a 36-month ERP, and 200% of the policy’s annual premium for a 60-month ERP.)

• The SERP does not increase or change any of the policy’s limits of liability—whatever limits are available on the day the policy expires will be the limits available under the SERP. For example, if the $500,000 aggregate limit of liability were impaired by payment of a $50,000 loss, only $450,000 of insurance would be available for claims submitted under the SERP.

Reporting Incidents and ClaimsEvery claims-made coverage form, whether it is used to provide general or professional liability insurance, conditions coverage on compliance with its requirements for reporting incidents and/or claims. Insureds who fail to report incidents and claims as required will find themselves uninsured in the event of a loss. Likewise, if insurance producers fail to inform their clients about the specifics of the incident and claim reporting provisions in the professional liability policies they buy, the producers themselves may have an issue when it comes to reporting their own E&O incidents and claims!

Incident ReportingIncidents are not claims—they are events that generate circumstances from which claims may arise. Basically, an incident is something that might become a claim. For example, a patient tells a doctor he secured a second opinion that reveals the doctor botched a previous surgery. Although it has not been determined the patient will be submitting a claim—or, in fact, that the patient even



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suffered harm—the mere circumstance of the conversation communicating the possibility of a claim will be viewed as an incident.

Incidents must be reported before the policy term expires and most contracts require the insured to provide specific details about the error or omission that gave rise to a circumstance from which injury or damage might arise. The insured is also required to report how the insured first became aware of the incident and the circumstances surrounding it. For example, one lawyer’s professional liability policy requires the reporting of incidents as follows:

If you become aware of conduct that gives rise to a "claim" or that could reasonably give rise to a "claim," you must notify us, in writing, as soon as practicable. Such notice must provide: a. A description of the "wrongful act," including all relevant dates; b. The names of the persons involved in the "wrongful act," including names of the potential claimants; c. Particulars as to the reasons for anticipating a "claim" which may result from such "wrongful act”; d. The nature of the alleged or potential damages arising from such "wrongful act;" and e. The circumstances by which the insured" first became aware of the "wrongful act."

The preceding language clearly requires incidents to be reported in writing, along with specific information. If the insured fails to report incidents according to the above language, he or she risks coverage.

A different policy, a miscellaneous professional liability contract, requires incidents to be reported in the following manner:

If during the Period of Insurance, the Insured first becomes aware of any circumstance that could reasonably be the basis for a Claim it must give written notice to Underwriters through persons named in Item 7. of the Declarations as soon as practicable during the Period of Insurance of:

1. the specific details of the negligent act, error, or omission that could reasonably be the basis for a Claim;

2. the injury or damage which may result or has resulted from the circumstance; and3. the facts by which the Insured first became aware of the negligent act, error, or omission.

Any subsequent Claim arising out of such circumstance made against the Insured who is the subject of the written notice will be deemed to have been made at the time written notice complying with the above requirements was first given to Underwriters.

An EPL policy clearly lists in its exclusions section that NO coverage is provided for incidents that are not reported as required:

The Company will not be liable for Loss for any Claim for any fact, circumstance, situation, or event that is or reasonably would be regarded as the basis for a claim about which any Executive Officer had knowledge prior to the applicable Continuity Date set forth in ITEM 5 of the Declarations for this Liability Coverage.

Because incidents are not claims, the policy’s extended reporting period does not apply to incident reporting. Extended reporting periods only apply to the reporting of claims to which the insurance applies.

Claim ReportingAs previously discussed, each professional liability policy defines the term claim. Each professional liability policy will also contain its own instructions for reporting claims. The following are examples of common claim reporting requirements:

• Claims must be reported in writing. Depending upon the contract, they must be reported as soon as practicable or in some other fashion, such as no later than 60 days after the end of the policy period or, if applicable, during the extended reporting period.

• The insured must immediately forward to the insurer every demand, notice, summons, or other process received.



• The insured must provide details of the claim, including: ◦ The alleged wrongful act ◦ The name of the insured(s) who committed the alleged wrongful act ◦ The date the wrongful act was committed ◦ A summary of facts upon which the claim is based ◦ The potential or alleged damages that might result from the claim ◦ The names of all claimants or potential claimants ◦ How the insured came to learn of the claim

Despite the fact that professional liability policies contain explicit language with respect to the reporting of claims, these requirements are not always understood clearly by agents and insureds—especially by those who do not read their policies. Failing to read and understand the claim reporting requirements of any professional liability policy will prove calamitous in the event of a loss because failing to report claims as required results in the denial of coverage.

Although policyholders are obligated to report claims and comply with the contractual requirements of their professional liability insurance policies, insurance producers risk claims being submitted against their E&O policies if they do not document their explanations of the claims reporting provisions to their clients. It is also important for producers to explain to clients the consequences of not filing claims as required—or first attempting to handle claims internally before reporting them to their carriers.

Many professional liability policies contain language that specifically prohibits coverage in the event the insured chooses to voluntarily settle or make payment for a loss. The following language was excerpted from an insurance agent’s E&O policy:

The INSURED shall not without our written consent, do any of the following:

1. admit liability; 2. participate in any settlement discussions nor enter into any settlement; 3. incur any cost or expenses; or 4. produce documents, provide a recorded statement, or give any deposition regarding

any actual or alleged WRONGFUL ACT.

It should be clearly understood by all parties that the claims-made and reported form of coverage contains two requirements for coverage to be activated:

• The “claim” must be made during the policy period, AND IT MUST ALSO• Be “reported” during the policy period

The following exclusion was excerpted from a miscellaneous professional liability policy:

Any Claim alleging a Wrongful Act:1. committed or allegedly committed prior to the Retroactive Date; or2. which has been the subject of any notice given under any other policy prior to the beginning

of the Policy Period and of which this Policy is a renewal or replacement; or3. as to which the Insured had knowledge prior to the Policy Period and the Insured had a

reasonable basis to believe that such Wrongful Act could give rise to a Claim; provided, however, that, if this Policy is a renewal or replacement of a previous policy issued by Underwriters providing materially identical coverage, the Policy Period referred to in this Section V.D.3 will be deemed to refer to the inception date of the first such policy issued by Underwriters;

Renewals and Retroactive DatesIt cannot be stated emphatically enough that the policy period of a professional liability policy is the term stated on the declarations page and it is not extended by any of the policy’s terms, provisions, or endorsements. The renewal of a professional liability policy constitutes a new policy term and does NOT allow the reporting of a claim to be made during the term of the subsequent renewal policy.



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Even if a claims-made liability form contains a retroactive date that falls before the policy’s inception date and/or an extended reporting period (ERP) that extends after a policy’s expiration date, the policy term is NOT changed by either the retroactive date or the ERP. The retroactive date simply indicates the date after which wrongful acts will be covered unless otherwise excluded. The retroactive date does NOT affect the claims reporting requirements. The ERP allows claims to be made and reported during its term, but does not extend the policy period.

Remember, a retroactive date is a liability policy provision that stipulates coverage only applies to events that occur on or after the retroactive date. Sometimes this date is the same as the inception date of the policy; sometimes it is a date before the policy’s inception date. To complicate matters further, a retroactive date may be advanced—meaning it is changed to a point in time after the policy’s original retroactive date.

For example, assume Patty Producer opened her insurance agency on January 1, 2014 after working for an insurance company for five years. Her “claims-made and reported” E&O policy was issued with January 1, 2014 as the effective AND retroactive dates. For losses to be covered by her policy, claims must have been made between 1/1/2014 and 1/1/2015 and must also be reported between 1/1/2014 and 1/1/2015.Further, assume Patty Producer’s E&O policy renews on January 1, 2015 for another one-year term; its retroactive date is still January 1, 2014. For losses to be covered under the renewal policy:1. Wrongful acts must occur after 1/1/14, AND2. Claims must be made between 1/1/2015 and 1/1/2016, AND3. Claims must be reported between 1/1/2015 and 1/1/2016The retroactive date of 1/1/2014 has nothing to do with the claims reporting requirements of either policy. If the 2014-2015 policy is to respond to covered wrongful acts, claims have to made and reported during that policy period. For the 2015-2016 policy to respond, claims have to be made and reported during that policy period.

The only purpose of the retroactive date is to signal the date on or after which covered wrongful acts must take place.

Replacing Liability Coverage FormsSometimes, an insured will replace a professional liability policy issued on one form of coverage with a policy issued on another form of coverage. If a policy issued on an occurrence form is replaced by a policy issued on a claims-made form, a coverage gap will exist if a future claim is made and it is determined the loss occurred after the occurrence policy’s expiration date.

This eventuality occurs far more often with general liability policies than with professional liability policies. However, if it does materialize, the coverage gap can be filled by the insured’s purchase of a discontinued operations endorsement on the original occurrence policy or full prior acts coverage on the replacement claims-made policy. (Discontinued operations coverage is similar to an extended reporting period.) Prior acts coverage provides insurance for wrongful acts that took place at any time before the policy’s inception date; in essence, the policy does NOT have a retroactive date.

A much larger coverage gap arises, however, when a claims-made policy is replaced with an occurrence policy. Because the claims-made form requires claims to be made and reported during the policy period, and an occurrence form requires claims to occur during the policy period, neither requirement is met if a loss occurs and is reported after the claims-made form’s expiration date.



Note the following illustration:

Date of Loss May 31,2014

Jan 1, 2014 Jan 1, 2015 Jan 1, 2016

Claims-made form Occurrence form

The claims-made policy only provides coverage for claims that are made and reported before the policy expires on January 1, 2015. If the May 31st loss is reported before January 1, 2015, the claims-made policy will respond. However, if the May 31st loss is reported during the term of the occurrence policy (1/1/2015-2016), neither policy will provide coverage because:

• The claims-made form does not provide coverage for claims reported after the policy period, and

• The occurrence form does not provide coverage for claims that take place outside the policy period

The only solution to this coverage gap is a SERP endorsement added to the original claims-made policy.


1. What type of businesspersons hold themselves out to the public as having greater knowledge or expertise in particular fields of endeavor?a. Retailersb. Wholesalersc. Salespersonsd. Professionals

2. What type of harm do most professional liability policies provide coverage for?a. Bodily injuryb. Property damagec. Economic lossd. Personal injury

3. When a professional is deemed negligent, what did he or she do?a. Breached the expected standard of professional careb. Breached a contractc. Liedd. Erred

4. What type of liability coverage form activates coverage when a claim is both made and reported during the policy period?a. Pure claims-madeb. Claims-made and reportedc. Reportedd. Occurrence

5. Which of the following is NOT one of the four theories that determine the triggering of insurance coverage?a. Injury-in-factb. Exposurec. Riskd. Manifestation

6. What provision must a claims-made policy have in order for claims reported after the policy’s expiration date to be covered?a. Hat coverageb. Coat coveragec. Extended reporting periodd. Retroactive date

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Chapter 8Professional Liability Coverages

Errors & Omissions (E&O) Liability InsuranceConsumers and businesses engage professionals to perform a variety of services they, themselves, are not qualified to handle. Although many people are able to file their own tax returns each year, most are confounded by tax law and the myriad forms that need to be filed with the Internal Revenue Service; therefore, they hire accountants to prepare their tax returns. Other services, such as practicing law and selling insurance, cannot be performed by most consumers and business owners because they require a practitioner to be licensed.

Because professionals require specific training to carry out their duties and responsibilities, even if they are not required to be licensed, the consequences of their failure to perform services using the standard of care expected of them creates a significant liability exposure. For example, consider the potential for loss in the following scenarios—which are all genuine:

• A business owner purchased a building based on a real estate agent’s advice that the building was zoned commercial. After the purchase, the building owner learned the real estate agent made a mistake and the building was really zoned residential—resulting in his inability to operate his business from the building. This claim resulted in a several million-dollar award against the real estate agent.

• An attorney filed an Equal Employment Opportunity Commission (EEOC) right-to sue-letter pertaining to a client’s federal employment discrimination lawsuit. Unfortunately, the wrong letter was filed and the client’s lawsuit was later dismissed because related claims were not filed within the proper time frame. This claim resulted in an award of nearly $400,000 against the attorney.

• An architect provided design and construction oversight services for the construction of a new commercial building. The project ran over budget because the architect made a design error. This claim resulted in an award for the over-budget amount: $24 million.

As the previous examples illustrate, each type of professional is faced with unique opportunities for loss; therefore, their professional liability policies require equally unique provisions to meet their needs in the event they become legally liable for causing harm. In this chapter, our discussion does not go into detail about the myriad unique provisions that apply to different types of miscellaneous professional liability policies. Instead, the information provided is of a general nature and producers should contact their carriers directly for the highlights of coverage for specific professionals, along with sample policy forms and endorsements.

The Errors & Omissions PolicyAn E&O policy contains sections—just like any other type of liability policy. Although the contents of each professional liability policy vary from carrier to carrier, certain policy provisions are common, despite the fact they may not appear in the same location in all policies of which they are a part. The following chart contains provisions that are common to many E&O policies:

Insuring Agreement Definitions ExclusionsConditions Defense and Settlement Who is an InsuredPolicy Territory Limit of Liability DeductibleInnocent Insured Extended Reporting Period Notice of ClaimOther Insurance Action against the Insurer Notice of CircumstanceService of Suit Coverage Extensions Subrogation

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In certain policies, some of the preceding provisions were, in and of themselves, separate sections of the policy. In other policies, however, they were provisions of major policy sections. For example, in one policy the Conditions section contained the following provisions: Notice of Claims, Notice of Circumstance, Assistance and Cooperation of the Insured, Subrogation, Acquisitions, Mergers, and Material Changes, Application, Other Insurance, Changes, Assignment, Cancellation/Non-renewal, Audit, Action Against the Company, Bankruptcy or Insolvency, Authorization, Conformity of Statutes, Governing Law, and Arbitration.

E&O Declarations PageThe declarations pages of professional liability policies are arranged differently than those of other property and casualty insurance policies. Because of the uniqueness of the coverage provided, and the variations between contracts and insurers, no two declarations pages look exactly alike. However, certain characteristics are common to E&O policy declarations pages.

Named Insured, Address, and ProfessionAs with any insurance policy, it is essential for the named insured listed on the declarations page to be represented accurately. If the insured is an individual practicing under a trade name or business name, both names should appear on the declarations to be sure all legal entities are covered. E&O policies contain language that stipulates coverage is expressly excluded for individuals and entities not listed on the declarations or in an attached endorsement.

Some policies contain provisions that include spouses and domestic partners of the named insured as an insured under certain circumstances. Typically, the spouse or domestic partner must have a financial interest in the named insured’s business, either while the named insured is alive or after death.

Most declarations pages require the “principal” address to be listed; the principal address is the address at which the named insured primarily performs professional services. If the professional conducts services at additional locations, they should also be cited in the policy. Other declarations pages merely include the insured’s mailing address.

The nature of the professional services rendered and covered by the policy appears on the declarations page and the term “professional services” is defined in the contract. Although the description on the Dec page is brief, it should reflect the named insured’s activities as accurately as possible. Producers should always remember that most professional endeavors that are not specifically described on the policy declarations would be excluded from coverage.

A classic example of an exception to this rule is notary public services. Most E&O policies issued to attorneys, insurance agents, and real estate agents either include coverage for notary publics or permit coverage for them by endorsement. Other exceptions will apply to various other E&O policies based on the particular professionals insured.

Policy PeriodThe policy period is shown on the declarations and indicates the term during which coverage is provided. Coverage begins at 12:01 a.m. standard time at the address shown on the declarations. Depending upon the Dec page, that address will be either the principal address or the mailing address.

Limit of LiabilityMost E&O declarations pages show the limits of coverage provided for each claim and also for the annual, or policy, aggregate. Some declarations pages specifically state the limits of liability include damages, claim expenses, and supplementary payments. Others do not; however, the absence of this statement does NOT automatically mean defense is included within the limit. The contract itself must be read to determine whether defense is paid for within, or in addition to, the policy limits.


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Policy Premium and DeductibleThe policy premium appears on the declarations page, along with any applicable deductible(s). Typically, the policy deductible applies per claim and the declaration page indicates this fact. Sometimes, the declarations page indicates the deductible also applies to damages, claim expenses, and supplementary payments. As is the case with the limit of liability, the absence of this statement does not automatically mean the deductible does not apply to defense.

Retroactive DateIf the professional liability policy is written on a claims-made form, which it probably will be, the declarations page will include a retroactive date. For a new policy, this date is often the same as the policy’s effective date. Sometimes, however, the retroactive date is a date prior to the policy’s effective date.

If a policy provides coverage for all incidents that occurred prior to the policy effective date, the term full prior acts will appear as the retroactive date. If a policy provides coverage for incidents that occurred after the effective date of a prior term of the current policy, that particular date will appear. For example, if the current policy term is 1/1/2014 to 1/1/2015, and it is the third renewal of the same policy, the retroactive date will be 1/1/2011—the policy’s original inception date.

EndorsementsA list of all policy endorsements and forms attached to the policy usually appears on the declarations page of a professional liability policy. It is critical for producers and clients to review all endorsements and attachments to a professional liability policy to be sure they understand all the terms and conditions of coverage.

Policy Notice/DisclosureMost professional liability policies contain a notice or disclaimer that explains the particular nature of the claims-made form upon which it is written. For example, a claims-made and reported policy will include a notice stipulating that claims must be made and reported during the policy period for the policy to respond. The following are samples of policy notices from three different E&O contracts:

Contract #1This is a Claims made and Reported Policy in which Claim Expenses are included within the Limit of Liability unless otherwise noted. Please read the entire policy carefully and consult with your insurance broker or advisor. Those words (other than the words in the captions) which are printed in Boldface are defined in the Policy.

In consideration for the payment of premium and in reliance on the statements made and information provided to Underwriters, including but not limited to the statements made and information provided in and with the Application which is made a part of this Policy, as well as subject to the Limits of Liability, the Deductible and all of the terms, conditions, limitations and exclusions of this Policy, Underwriters and the Insured agree as follows:

Contract #2THE LIABILITY COVERAGES ARE WRITTEN ON A CLAIMS-MADE BASIS. THE LIABILITY COVERAGES COVER ONLY CLAIMS FIRST MADE AGAINST INSUREDS DURING THE POLICY PERIOD. THE LIMIT OF LIABILITY AVAILABLE TO PAY SETTLEMENTS OR JUDGEMENTS WILL BE REDUCED BY DEFENSE EXPENSES, AND DEFENSE EXPENSES WILL BE APPLIED AGAINST THE RETENTION. THE COMPANY HAS NO DUTY TO DEFEND ANY CLAIM UNLESS DUTY-TO-DEFEND COVERAGE HAS BEEN SPECIFICALLY PROVIDED HEREIN.



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Contract #3THIS POLICY PROVIDES CLAIMS MADE AND REPORTED COVERAGE. CLAIMS MUST FIRST BE MADE AGAINST THE INSURED AND REPORTED TO THE COMPANY DURING THE POLICY PERIOD UNLESS AN EXTENDED REPORTING PERIOD APPLIES. THE PAYMENT OF CLAIM EXPENSES REDUCES THE LIMIT OF INSURANCE. PLEASE READ THE ENTIRE POLICY CAREFULLY.

Various provisions in this policy restrict coverage. Read the entire policy carefully to determine rights, duties, and what is and is not covered. Words and phrases that appear in capital letters, other than the captioned titles, have special meaning set forth in SECTION II – DEFINITIONS.

In consideration of the payment of premium by the INSURED and in reliance upon the statements in the INSURED’S Application attached hereto and made a part hereof, the Company agrees with the INSURED, subject to all terms, exclusions, Limits of Liability and conditions of this Policy, as follows:

According to its disclosure, Contract #2 is a pure claims-made policy. Contracts #1 and #3 are claims-made and reported policies. Further review of the language contained in Contract #2 is required to confirm that claims do not need to be reported during the policy period.

Insuring Agreement or CoverageThe insuring agreement in E&O policies is the portion of the policy that discusses precisely how coverage is provided. It is in this section of the professional liability policy that language will indicate whether a policy is a pure claims-made or claims-made and reported policy.

For example, one policy’s insuring agreement states:• It will pay on behalf of the insured,• Both damages and claims expenses,• In excess of the deductible and up to the limit of liability,• For covered wrongful acts,• That take place on or after the retroactive date, BUT ONLY• IF:

◦ The insured becomes legally obligated to pay, AND ◦ The claim is made during the policy period or any ERP, AND ◦ The claim is reported during the policy period or any ERP, AND ◦ The insured did not know about the wrongful act before the policy’s effective date.

That language contains a lot of ifs ... which is precisely why it is imperative that producers not only understand the policy language contained in professional liability policies but also explain it so their clients also understand it.

Defense and SettlementMost professional liability policies obligate the insurer to provide a defense. However, the manner in which defense is provided varies from contract to contract, especially with respect to the type of professional insured.

For example, some contracts do not allow the insurer to settle losses without the consent of the named insured. Other contracts allow the insured to request, in writing, the appointment of specific defense counsel. Of course, if the insured refuses to consent to settlement, the contract contains language that limits the insurance company’s payment for the claim. The limitation applies any time a loss is either settled or a judgment is rendered against the insured and the amount required to be paid is more than the amount for which the insurer would have settled had the insured granted consent.



As is the case with most liability policies, the insurance company has the duty to defend claims that might be groundless, false, or fraudulent and only pays up to the limit of liability stated on the declarations page. The insurer has the right to investigate all claims and it may only cease defending a claim after it is paid out the policy limits.

One provision most E&O policies contain is to prohibit the insured from admitting liability or attempting to settle a claim without the prior written consent of the insurer. If the insured admits liability or attempts settlement, the policy does not have to make payment. Note: This is especially true of insurance agent E&O policies. In addition, if the insured makes any payments or incurs any expenses, he or she does so at personal expense and does not obligate the insurer to make reimbursement.

Policy TerritoryMost professional liability policies provide coverage worldwide; however, they will only respond to lawsuits, arbitration, and any type of proceeding or action that is made in the United States, its territories and possessions, Puerto Rico, or Canada.

General ExclusionsThe following are typical exclusions found in E&O policies classified as “miscellaneous professional liability” contracts. Contracts designed to insure specific professionals (i.e., attorneys, insurance agents, accountants, etc.) will contain additional exclusions.

• Any act that’s dishonest, criminal, fraudulent, malicious, or deliberate—whether it’s committed by or at the direction of an insured

• Bodily injury and property damage• Claims made by one insured against another insured• Personal injury (i.e., libel, slander, invasion of privacy, wrongful eviction, etc.)• Any type of discrimination• Professional services rendered outside the profession indicated on the declarations• Contractual liability—unless the insured would have been liable in the absence of the contract• Services provided in the capacity of director, officer, partner, trustee, or fiduciary• Any act that violates federal, state, or local statutes or any insurance law, securities laws,

ERISA, RICO, telecommunications, or other similar law• Any gain or profit to which the insured is not entitled• Actual or alleged infringement of copyright, patent, trademark, service mark, trade dress,

trade name, or trade secret• Actual or alleged breach of contract—unless the insured would have been legally liable in the

absence of the contract• Any wrongful act committed, or allegedly committed, before the policy period or retroactive

date, if applicable—including acts the insured knew about but didn’t report to the insurance company until after the policy effective date or retroactive date

• Pollution• Services provided as any of the following (unless, of course, the insured’s E&O policy is

issued to one of the following professionals): third party claims administrator, accountant or tax preparer, attorney, architect, actuary, engineer, real estate agent or broker, title insurance agent

• Employment-related practices



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General ConditionsIn addition to the policy provisions pertaining to the reporting of claims and incidents, and the extended reporting period, the following conditions are contained in many E&O policies:• The insured must assist and cooperate with the insurer in the investigation and settlement of any

claim or lawsuit. This condition is usually a requirement of coverage and policy language usually contains the phrase, “as a condition precedent to any coverage under this policy.”

• The insurer is subrogated to all the insured’s rights of recovery.• In the event of any mergers, acquisitions, or material changes that occur after the policy inception

date, the insured must comply with requirements outlined in this condition.• The application contains material representations and is part of the policy; if any of the

representations are later found to be false, coverage will not apply. Some conditions state the representations are actually warranties.

• The other insurance condition states the E&O policy is excess over all other types of available insurance—regardless of the type or whether it’s primary, contributory, excess, or contingent.

• The policy is subject to audit.• No action may be taken against the insurer unless all terms of the policy have been complied

with.• The insured’s bankruptcy does not invalidate the policy or relieve the insurer of its obligations.• Appraisal, arbitration, and/or mediation provisions apply as outlined.• Cancellation and non-renewal is permitted according to the terms outlined in the provision. Of

course, state law will supersede those terms.• The insured may not assign the policy without the insurer’s written consent.

Directors & Officers (D&O) Liability InsuranceThose who serve as directors and officers of corporations are exposed to claims alleging they were responsible for the mismanagement of the corporation. Although the D&O risks and exposures of public companies are often quite different from those of private companies, our discussion does not delve into those differences.

Like other professional liability coverage, D&O coverage is non-standard and policy language, terms, conditions, definitions, and exclusions vary by insurance carrier. Producers and their clients should take special care to review all policy language and terminology to be sure they obtain a complete and thorough understanding of the subject.

One of the most important pieces of legislation affecting organizations and their directors and officers with respect to the regulation of financial practice and corporate governance is the Sarbanes-Oxly Act of 2002 (SOX). Sarbanes-Oxly was enacted by Congress in response to a number of corporate and securities scandals, most notably those involving Enron and Arthur Anderson, WorldCom, and Adelphia. The purpose of SOX is to protect investors from corporate accounting errors and fraud.

The Securities and Exchange Commission (SEC) administers Sarbanes-Oxly, which defines what accounting records are to be stored and for what periods of time they are to be stored. Sarbanes-Oxly does not prescribe how an organization must do business or how it must store records; however, it does contain requirements that pertain to the financial and IT departments of an organization.

Although Sarbanes-Oxly contains eleven titles, five are considered the most important:1. Section 302 pertains to corporate responsibility for financial reports. Signing officers (i.e., members

of senior management) are responsible for internal controls and must certify that they are taking place and being reported accurately. This means the signing officers are responsible for the accuracy of the reports. Organizations may not reincorporate or transfer their activities outside the United States to avoid requirements of this section.



2. Section 401 pertains to enhanced financial disclosures and disclosures in periodic reports. Any published financial statements must contain accurate information and must admit that all material information is published accurately.

3. Section 404 pertains to management assessment of internal controls. Annual reports must contain information concerning the scope and adequacy of internal controls and procedures for financial reporting.

4. Section 409 pertains to real time issuer disclosures. Issuers are required to disclose to the public, on an urgent basis, any information about material changes to their financial condition or operations.

5. Section 802 pertains to criminal penalties for altering documents. If anyone alters, destroys mutilates, conceals, or falsifies records, documents, or tangible objects with the intent to obstruct, impede, or influence a legal investigation, the imposition of penalties, fines, and up to 20 years imprisonment will result. The imposition of penalties, fines, and up to 10 years imprisonment applies to any accountants who knowingly and willfully violate certain provisions concerning maintenance of audits and review of papers.

The majority of the mandates in SOX only apply to public companies that have certain filings with the SEC; however, private and non-profit organizations are often pressured to meet its requirements. According to many sources, despite a number of recent financial institution failures, the SEC has not filed many actions for allegations of accounting fraud although it has filed some actions for disclosures fraud.

Because of the increase in corporate financial oversight, D&O insurance has become more sophisticated and complex in response to the increasing exposure of corporate directors and officers and the resulting litigation. One national insurer that specializes in issuing executive and management liability policies revealed the results of a recent survey of private companies:

• Approximately 12% of surveyed companies experienced a D&O lawsuit in the previous 5 years and the average cost of the suits, including damages and all legal costs, was just over $225,000.

• Nearly one-third of all D&O lawsuits reported in the survey were filed by customers and clients; the remainder were filed by: ◦ Regulatory or government agencies (28%) ◦ Vendors (20%) ◦ Competitors (17%) ◦ Shareholders or partners (6%)

• Although the frequency of D&O liability claims is relatively low compared to other types of liability claims, severity is high; losses as high as $1 million and $5 million are not uncommon.

• Only about half of large companies surveyed (250+ employees) and twenty percent of small companies surveyed (25 - 49 employees) purchase D&O liability insurance.

The same insurer reports the following statistics with respect to public companies:• Approximately 36% of surveyed companies experienced at least one D&O lawsuit in the previous 10

years; one-third of those occurred within the previous two years.• Of all lawsuits brought against the directors and officers of all public companies in the U.S. in one

recent year: ◦ 69% were brought by shareholders ◦ 18% were brought by a regulatory or government agency ◦ 15% were brought by employees

• Of the 65 court-approved securities class-action settlements in the United States in that same year, the median settlement was $5.8 million



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Typically, defense costs and penalties imposed against directors and officers are much higher than those in other types of litigation are. As the number of D&O claims has risen, along with the size of the average claim settlement, the cost and complexity of coverage has also increased. Most D&O claims are filed by employees and stockholders but, depending upon the type of corporation and actions of the directors and officers, they may be filed by other parties—including regulatory and governmental bodies.

D&O Liability Insurance TerminologyA-Side CoverageA-side coverage is insurance for the costs of defense, settlements, and judgments against directors and officers when the organization does not indemnify the executives for these costs. In most cases, organizations indemnify their executives except where prohibited by law.

B-Side CoverageB-side coverage is insurance for the insured organization’s costs to reimburse directors and officers for the costs of defense, settlements, and judgments against them. This coverage generally requires a deductible or retention.

ContinuityContinuity is insurance coverage that renews after issue, uninterrupted and without coverage gaps.

Defense ExpensesDefense expenses are the reasonable costs, charges, fees, and expenses incurred to defend any claim, including attorneys and expert witness fees and the premiums for appeal, attachment, and similar bonds. Defense expenses do not include remuneration, wages, salaries, fees, overhead, benefits, etc.

EmployeeAn employee includes a full-time, part-time, seasonal, or temporary worker. An employee also includes a volunteer, leased worker, and independent contractor for which the insured provides indemnification in a written contract.

ExecutiveAn executive is any natural person who—in the past, present, or future—becomes a duly elected or appointed director, officer, trustee, executive director, or member of the board of directors of the insured organization.

Hammer ClauseThis provision in a D&O policy pertains to the insured’s right to withhold consent for the insurance company to settle a claim. The hammer clause is generally found in the contract’s defense provision and limits the insurer’s liability for claims, under certain circumstances, when the insured opts NOT to settle a claim or lawsuit.

If the insured refuses to consent to a settlement when the insurer and claimant wish to settle a loss, the insurance company’s payment for the loss—including defense—will be no more than the amount for which the insurer and claimant would have settled had the insured not withheld consent. The maximum amount the insurer will pay does not include any additional defense costs incurred by the insurer because of the insured’s withholding of consent to settle.

Insured PersonAn insured person is any natural person who was, is, or becomes an “executive” or an “employee.”



LossA loss is any monetary amount an insured is legally obligated to pay as a result of a covered “claim”; a loss includes monetary damages, judgments, settlements, investigative costs, pre-judgment interest, and post-judgment interest. Depending upon the contract and state law, punitive or exemplary damages may also be included. Loss does NOT include civil or criminal fines or penalties, taxes or tax penalties, or costs to comply with an injunction.

Prior or Pending LitigationPrior or pending litigation is lawsuits or legal proceedings filed against an insured that were pending prior to the effective date of an insurance policy

Severability

Severability involves the distinction between separate insured persons with respect to their commission of wrongful acts and statements made on D&O insurance applications. If one insured party commits a wrongful act or misstatement, this provision stipulates the wrongful act or misstatement will not invalidate the policy or preclude coverage for other innocent insureds. Severability may apply either to coverage exclusions or the warranties made on the original application and its renewals.

D&O CoveragesD&O liability insurance is written on a claims-made form and typically provides three types of coverage, although other coverages may be added by endorsement. The three basic types of D&O coverage are:

A. Non-indemnified lossesB. Indemnified liabilityC. Organization liability

Insuring Agreement A A-Side Coverage protects directors and officers when the organization does not indemnify them for loss. This is direct coverage to the directors and officers for the commission of “wrongful acts” and includes defense costs. Reasons for the organization not to indemnify its directors and officers include being prevented from doing so by law, being financially unable to do so, and choosing not to do so. Typically, only large public companies purchase A-Side Coverage.

Insuring Agreement BB-Side Coverage reimburses the organization after it has indemnified directors and/or officers for claims made against them for company-related actions and failures to act. B-Side Coverage does not provide insurance for the organization’s liability for such acts and omissions.

Insuring Agreement CC-Side Coverage protects the organization against securities claims for its own liability. Some policies offer this coverage as an endorsement rather than as part of the basic policy.

Employment-practices liability may be included on many D&O policies by endorsement or as an available coverage option and will be discussed in the next section of this chapter. Coverage for privacy breaches may also be added by endorsement to some insurers’ D&O contracts as Identity Fraud Expense Coverage—which will also be discussed later in this chapter

D&O Liability Insurance Provisions and ConcernsBecause of the complexity of D&O coverage and the various contracts, our discussion of the most common D&O policy provisions and conditions is brief and stated in general terms. Producers should be sure to conduct exhaustive research of any D&O carriers and products before recommending them to clients.



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DefenseMost D&O policies are written on an indemnity basis and do not require the insurance company to defend the insured; however, they do pay for defense expenses, which are defined in the policy. Most contracts allow the insured to choose its own legal counsel (with the insurer’s consent) and to decide when, and whether, to settle a loss.

It should be noted that although an indemnity contract requires the insured to pay for defense and settlements and then seek reimbursement from the insurer, most carriers advance D&O defense costs as they are incurred. It should also be noted that if an insurer advances costs and it is later determined coverage does not apply, the insured must reimburse the insurer for monies paid.

Although many insurance professionals view indemnity contracts with disfavor, one of the advantages to indemnity coverage on a D&O policy is the insured’s ability to control all issues pertaining to defense. So long as the policyholder requests indemnification for reasonable costs, charges, fees, and expenses, it does not have to worry about the hiring of counsel or withholding consent to settle (i.e., a hammer clause).

Reporting of Claims and Potential ClaimsMost D&O policies contain language similar to that in E&O policies with respect to the reporting of claims and potential claims. It should be noted that most D&O policies require claims and circumstances to be reported “as soon as practicable” within the policy period as a condition precedent to coverage.

Producers should keep in mind that D&O policies are written on claims-made forms and the precise language of the policy will determine if claims and potential claims must be made during the policy period (pure claims-made policy) or if claims must be made and reported during the policy period (claims-made and reported policy).

Extended Reporting Periods Extended reporting periods in D&O policies are similar to those in other professional liability policies; however, some contracts may only offer an ERP if the carrier cancels or non-renews the policy—not if the insured requests cancellation. A bilateral, or two-way, ERP is offered whether the carrier or the insured cancels the policy.

Continuity and SeverabilityD&O contracts are slightly different from other types of professional liability insurance policies issued on claims-made forms; EPL contracts are, as well. The issues of continuity and severability as they pertain to EPL policies will be discussed later.

The purpose of D&O liability insurance is to obtain continuous and uninterrupted insurance without any coverage gaps. The ideal situation is for the insured organization to have the original D&O policy continuously renew, under the same terms of coverage and with the same insurer. Because D&O policies require certain warranties on the initial application for coverage—which most other insurance policies do not—canceling and/or replacing D&O coverage can be a dicey undertaking

WarranteesThe standard property and casualty insurance policy application requires the applicant to make representations, which are statements made to the best knowledge and belief of the applicant. In most cases, the only time a representation would either void coverage or result in denial of a claim would be if it were a material misrepresentation. A misrepresentation is a statement made with knowledge of its falsity. An applicant’s misrepresentation is considered material to the issuance of coverage if the insurer would not have issued coverage if it had known the truth—meaning the applicant had not lied or misrepresented the information provided.



D&O policies, however, require warranties on their initial applications—meaning the applicant guarantees the accuracy of the information provided in the warranty; coverage provided by the policy is conditioned on its accuracy. If it is later discovered that information provided on the original application was not accurate, either the policy or coverage pertaining to a loss is voided. Most D&O insurers use renewal applications that do not require warranties; however, some renewal applications do contain warranties.

A typical warranty on a D&O policy is for the applicant to assert that no person or organization to be insured by the policy is aware of any fact or circumstance that might result in claim being made against the organization or its executive and employees. Once the original application—with the warrantees—is signed by the applicant (usually the organization’s president or chief executive officer), it becomes part of the policy.

Each insurance company handles the issues, and verbiage, of warranties differently, so it is essential for producers to investigate thoroughly both policy language and insurer perspectives with regard to this issue. It is also crucial for producers to confirm, and document, their clients’ understanding about how warrantees work.

Prior and Pending Litigation ExclusionMost D&O policies do not contain retroactive dates or prior acts exclusions, although some do. Instead, those that provide coverage for full prior acts contain a prior or pending litigation date, which appears on the declarations page, and is part of a provision that excludes coverage for litigation and legal proceedings that were pending prior to the effective date of the policy. Litigation and legal proceedings include administrative or regulatory proceedings that were known by any insured before the stated date.

One insurer’s exclusion reads that no coverage is provided:

...based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any prior and/or pending litigation or administrative, regulatory or arbitration proceeding against any Insured as of the applicable Pending or Prior Date stated in ITEM 3 of the Declarations, or the same or substantially the same fact, circumstance, situation, transaction, event or Wrongful Act underlying or alleged therein.

Another insurer’s prior and pending litigation exclusion reads:

The Company will not be liable for Loss for any Claim based upon or arising out of any fact, circumstance, situation, event, or Wrongful Act underlying or alleged in any prior or pending civil, criminal, administrative or regulatory proceeding, including audits initiated by the Office of Federal Contract Compliance Programs, against any Insured as of or prior to the applicable Prior and Pending Proceeding Date set forth in ITEM 5 of the Declarations for this Liability Coverage.

Continuity DateA continuity date is similar to the prior or pending litigation date because it does not exclude coverage for wrongful acts that occurred prior to the specified date. It excludes coverage for any facts, incidents, circumstances, wrongful acts, or claims that were known before the specified date.

The continuity date is usually the date contained in the last warranty statement an insured signed AND the date that establishes the prior and pending litigation exclusion. It is also usually the inception date of the first D&O policy. If an insured changes carriers, it is extremely important for the replacement D&O policy to include the same continuity date as the policy it replaces—although it is not always possible to obtain when replacing coverage, especially if the insured does know of a prior incident or litigation.

Producers and policyholders should understand that both the prior and pending litigation date/exclusion and the continuity date pertain to reporting and NOT to wrongful acts. For example, if an applicant sought to replace existing D&O coverage with a new carrier, and was aware of a situation that might give rise to a claim, it is unlikely the insurer would agree to provide continuity.



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D&O Liability Insurance ExclusionsThe exclusions contained in most D&O policies mirror those found in E&O policies. In addition, the following exclusions are also commonly found:

• Any wrongful act of a director or officer committed in an “outside capacity”• Actual or alleged violations of the Occupational Safety and Health Act (OSHA), Consolidated

Omnibus Budget Reconciliation Act (COBRA), Employee Retirement Income Security Act (ERISA), Worker Adjustment and Retraining Notification Act (WARN), or the National Labor Relations Act (NLRA), Fair Labor Standards Act (FLSA), including their amendments

• Violations of responsibilities, duties, and obligations that pertain to Social Security, unemployment insurance, workers’ compensation statute, or disability insurance

• Wrongful acts related to employment• The actual or proposed payment by the insured in connection with the insured’s purchase of

securities or its public offer, sale, or solicitation of securities it issues• Infringement of copyright, patent, trademark, intellectual property, etc.• Violation of any laws pertaining to interstate commerce, including but not limited to the Sherman

Antitrust Act of 1890, Clayton Act of 1914, Federal Trade Commission Act of 1914

Employment Practices Liability (EPL) InsuranceOnce upon a time, employers were in charge in all aspects of the workplace and the employer-employee relationship. This absolute power was first challenged in the United States at the turn of the twentieth century in the form of employer’s liability laws. Later, the establishment of unions and workers’ compensation statutes resulted in numerous transformations in the workplace. Subsequent federal laws have continued to modify landscape of the employer-employee relationship.

Employment practices liability insurance has evolved in direct response to federal and state regulations that affect employment. The United States Equal Employment Opportunity Commission (EEOC) is the federal agency responsible for enforcing federal laws that make it illegal to discriminate against job applicants and employees because of age, race, color, religion, gender (including pregnancy), national origin, age (40 or older), disability, or genetic information. The EEOC also enforces laws that prohibit discrimination against persons who complain about discrimination, file a charge of discrimination, or participate in an employment discrimination investigation or lawsuit.

Federal laws overseen by the EEOC apply to all types of work situations, including:• Hiring• Firing• Promotions• Performance evaluations• Harassment• Training• Wages• Benefits

The EEOC is administered by the Office for Civil Rights (OCR), which is a division of the U.S. Department of Health and Human Services (HHS). Another federal agency, the National Labor Relations Board, protects the rights of most employees who work in the private sector by investigating charges, facilitating settlements, deciding cases, and enforcing orders.



Some of the major laws (in no particular order) that also affect workplaces and workers are listed below:• Title VII of the Civil Rights Act of 1964 prohibits employment discrimination based on race, color,

religion, sex, or national origin. (Subsequent amendments have added protected classes.) The EEOC administers Title VII.

• The Pregnancy Discrimination Act is an amendment to Title VII that made it illegal to discriminate against any woman because of pregnancy, childbirth, or a medical condition related to pregnancy or childbirth. The Act also makes it illegal to retaliate against any person because such person complained about discrimination, filed a charge of discrimination, or participated in an employment discrimination investigation or lawsuit.

• The Fair Labor Standards Act (FLSA) prescribes standards for wages and overtime pay; it is administered by the Wage and Hour Division of the U.S. Department of Labor.

• The Equal Pay Act requires men and women in the same workplace to be given equal pay for equal work. Job content determines whether jobs are substantially equal; job titles do not. The Equal Pay Act is administered by the Equal Employment Opportunity Commission.

• The Americans with Disabilities Act (ADA) prohibits discrimination in employment against people with disabilities, as well as in transportation, public accommodation, communications, and government activities. The ADA is enforced by four federal agencies: 1. The Equal Employment Opportunity Commission (EEOC)2. The Department of Transportation (DOT)3. The Federal Trade Commission (FTC)4. The Department of Justice (DOJ).

• The Age Discrimination in Employment Act of 1967 (ADEA) protects employees and job applicants who are 40 years old or older from employment discrimination based on age. The ADEA is administered and enforced by the Civil Rights Center (CRC) of the U.S. Department of Labor, as well as by the EEOC.

• The Family and Medical Leave Act (FMLA) requires employers with 50 or more employees to provide up to 12 weeks of unpaid, job-protected leave to eligible employees for the birth or adoption of a child or for the serious illness of the employee or the employee’s spouse, child, or parent. The FMLA is administered by the Wage and Hour Division.

• The Occupational Safety and Health (OSH) Act is administered by the Occupational Safety and Health Administration (OSHA), which requires employers to provide their employees with work, and a workplace, free from recognized and serious hazards—as promulgated by OSHA.

• The Employee Retirement Income Security Act (ERISA) regulates employers who offer pension and/or welfare benefit plans for their employees. ERISA is administered by the Employee Benefits Security Administration (EBSA), which also administers:

◦ The Comprehensive Omnibus Budget Reconciliation Act of 1985 (COBRA) ◦ The Health Insurance Portability and Accountability Act (HIPAA)

• The Labor-Management Reporting and Disclosure Act (LMRDA) of 1959 addresses the relationship between a union and its members; it is also known as the Landrum-Griffin Act. The U.S. Department of Labor’s Office of Labor-Management Standards (OLMS) administers and enforces most provisions of LMDRA.

• The Worker Adjustment and Retraining Notification Act (WARN) protects workers, their families, and communities by requiring most employers with 100 or more employees to provide notification 60 calendar days in advance of plant closings and mass layoffs. WARN is administered by the Employment and Training Administration of the U.S. Department of Labor.

• The Genetic Information Nondiscrimination Act of 2008 (GINA) prohibits any type of employment discrimination based on genetic information, which is information about an individual’s genetic tests and those of the individual’s family members. Genetic information also includes information about the manifestation of diseases or disorders in an individual’s family members. The majority of GINA



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is administered by the EEOC, however, Title I is administered by the Employee Benefits Security Administration (DOL) and the Office for Civil Rights (HHS) because this portion of the Act addresses the use of genetic information in health insurance.

• The Social Security Act became law in 1935 and many amendments have been enacted since that time. Retirement benefits first became available for retired workers age 65 or older beginning in January 1937. Benefits for spouses, minor children, and survivors became available with the 1939 Amendments. Medicare benefits were signed into law in 1965 and in 1972; Supplemental Security Income (SSI) [disability] benefits became available. The programs available under the Social Security Act are funded by payroll taxes as promulgated by the Federal Insurance Contributions Act (FICA) tax and are deposited into the Federal Old-Age and Survivors Insurance Trust Fund (Social Security), the Federal Disability Insurance Trust Fund (SSI), and the Social Security Trust Fund. The Social Security Administration (SSA) administers the social insurance programs of the United States.

• Other federal legislation has been enacted to address the following employment concerns: ◦ Workers’ compensation ◦ Re-employment of certain members of the military ◦ The use of polygraphs (lie detectors) by employers ◦ Garnishment of wages, which is regulated by the Consumer Credit Protection Act ◦ Employment and training of veterans and certain federal employees ◦ Migrant and seasonal agricultural workers ◦ All persons who work on mine property ◦ The construction and transportation industries ◦ Drug testing that ONLY pertains to some federal contractors and all federal contract grantees; no

comprehensive federal law pertains to drug testing in the private sector

EPLI Claims ExamplesEmployment practices liability insurance protects employers against claims made by hopeful, present, or past employees alleging their legal rights were violated by the employer. Examples of common employment practices violations include, but are not limited to:

• Discrimination of a protected class (age, race, color, religion, gender, national origin, age, disability, or genetic information)

• Wrongful termination• Retaliation• Negligent evaluation• Failure to employ or promote• Deprivation of career opportunity• Sexual harassment• Breach of employment contract (written or oral)• Wrongful discipline• Wrongful infliction of emotional distress• Mismanagement of employee benefit plans• Hostile work environment

As classes of individuals protected by state and federal laws increase, and those protections are expanded, the number of EPL claims grows and the claims become more complex. It is estimated that 30% of all civil litigation in the United States involves employment issues and the EEOC reports that discrimination claims by employees have increased significantly in recent years.



One major EPL insurer reports that employers are more likely to suffer an EPL loss than either a general liability or property loss. That same insurer also reports that of all litigation against corporations, 75% is employment related.

Industry experts report that nearly half of all EPL claims are filed by employers with up to 100 employees and the three most common claims are discrimination based on race, sexual harassment, and retaliation. The following examples of actual employment practices claims illustrate typical losses.

Example #1: Discrimination Based on DisabilityAn employee sustained a workplace injury, was unable to work, and took medical leave from work due to the injury. While out on medical leave after filing a workers' compensation claim, the employee was terminated. The employee alleged that, after sustaining the injury, his employer threatened to fire him if he filed a workers' compensation claim, made many discriminatory and harassing comments, and exhibited discriminatory and harassing behavior.

After he was terminated, the employee filed suit against the employer for discrimination based on disability, wrongful termination, and violation of state law. The employer’s EPL policy paid more than $75,000 for defense and settlement of the lawsuit.

Example #2: Wrongful TerminationAn employee was terminated for shaving her head not long after receiving a salary increase during a performance evaluation. All of her previous performance evaluations were positive. The employee’s lawsuit sought general damages, punitive damages, attorney’s fees, and costs. The employer’s EPL policy paid more than $250,000 for defense and settlement of the claims.

Example #3: Sexual HarassmentA woman sued the car dealership she worked for, alleging repeated sexual harassment over a two and a half year-period. She presented evidence of seventeen separate incidents of harassment and after a jury verdict of over $6 million; the trial judge reduced the verdict to just under $4 million, which included punitive damages.

Example #4: Discrimination and Violation of ADAThe EEOC filed suit on behalf of a paraplegic job applicant who was denied employment at a national retail department store despite being qualified for several open positions. The job applicant alleged that he was told by the hiring manager that the store had no positions for a person confined to a wheelchair. The jury award included over $8,000 in back pay, $75,000 in compensatory damages, and $3.5 million in punitive damages.

Example #5: Religious DiscriminationAn employee of a temporary employment agency filed a lawsuit against a former employer that denied her promotion to manager’s position. Although the woman who received the promotion had six years less experience than the plaintiff did--and did not have an MBA, as the plaintiff did--she was a member of a religious group that predominated at the company, which the plaintiff was not. The plaintiff received a jury award of over $600,000 in addition to nearly $6 million in punitive damages.

Example #6: RetaliationIn a landmark Supreme Court case, an employee was fired from his job three weeks after his fiancée, who also worked for the same company, filed a sexual discrimination action. His original lawsuit, alleging retaliation, was unsuccessful in a U.S. Circuit Court of Appeals. However, in its unanimous decision, the Supreme Court overturned the original ruling, stating that although the plaintiff had not been a party to his fiancée’s sexual discrimination case, nor had he been discriminated against before his termination, he was clearly a victim of retaliation by his former employer. According to the Supreme Court’s ruling, retaliating against family members and other close associates of employees filing suit falls within the scope of Title VII’s retaliation provision. The former employee was permitted to proceed with his suit against his former employer.



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Example #7: Retaliation and Age DiscriminationAn employee with more than 20 years tenure as the head of a human resources department was terminated because an outside consultant’s survey alleged the employee created a threatening, demoralizing, and dysfunctional work environment—which was not acceptable of a person in that position. The employee, who stated the termination was retaliation for complaining about the employer’s business practices, filed a lawsuit against the employer. The lawsuit also stated the boss who terminated the employee was twenty years younger and the termination was the result of age discrimination in addition to retaliation. The EPL lawsuit was settled for $1.15 million plus more than $200,000 of defense costs.

Example #8: Discrimination Based on RaceAn international corporation was sued based on allegations it refused promotions and wage increases to more than 1,000 previous and current employees of African-American descent. After transcripts of secretly taped conversations were released (they demonstrated Caucasian members of management belittling African-American employees), and after allegedly destroying documents required by the defendants’ attorneys, the corporation agreed to settle the lawsuit for more than $170,000,000.

Example #9: Discrimination Based on Race and GenderThe EEOC sued an employment agency that supplied temporary workers because it illegally classified applicants by both race and gender to fulfill the requests of certain clients to provide employees of specific races and genders. The lawsuit was settled with the employment agency agreeing to pay $285,000 and three of its clients agreeing to pay $50,000 in administrative costs.

Example #10: Discrimination Based on Age, Disability, National Origin, Race, and GenderThe EEOC sued a temporary employment agency for practicing a multitude of discriminatory practices at the requests of some of its clients. Specifically, the temporary agency:

• Refused to refer certain applicants to clients based on their races and genders• Refused to refer certain applicants with disabilities to clients after requiring all applicants to complete

medical questionnaires that required disclosure of disabilities• Terminated an employee when it learned she was pregnant• Retaliated against an employee who questioned its discriminatory practices against those with

disabilities• Refused to refer certain applicants to clients if they were over a certain age

The temporary agency settled the lawsuit for $500,000 and two of its clients each agreed to pay $80,000.

Employment Practices Liability FAQsEmployment practices liability insurance exists because no other insurance coverage protects employers for most perils pertaining to injury caused by its employment practices. In fact, the insurance policies most employers have in place (i.e., CGL, D&O, E&O, WC) specifically exclude EPL perils.

Workers’ compensation policies—which are designed to provide coverage for injured employees—only provide coverage for bodily injury to employees “caused or aggravated by conditions of employment.” Perils such as discrimination and wrongful termination do not result in bodily injury; therefore, the workers’ compensation policy does not provide coverage.

If another type of liability policy did extended coverage for the typical EPL perils, the insured would still have a difficult time finding coverage for EPL losses because of the intentional injury exclusion. The majority of EPL claims occur precisely because the employer knowingly violated the employees’ rights or inadvertently broke the law!

When the EPL product was first introduced to the marketplace in the 1980s, large corporations were the primary clients. The need for coverage expanded in the early 1990s with enactment of the Americans with Disabilities Act of 1990 and the Civil Rights Act of 1991. The resulting surge in litigation against employers created an enormous need for insurance protection as well as coverage for defenses costs. In the current marketplace, small and mid-sized employers are finding the need for coverage almost as urgent as large employers are.



As the number of classes protected by the federal government against discrimination and other harm grows, more and more lawsuits are being filed. Because of access to the Internet and other methods of disseminating information, agencies such as the EEOC are better able to inform consumers and they, in turn, are becoming more sophisticated and knowledgeable when it comes to their rights. In addition, the trend toward the filing of class-action lawsuits against brand name employers further compounds the issue of EPL litigation. These factors have combined to create a tremendous upsurge in EPL claims against organizations of all sizes.

One of the problems faced by smaller employers is the cost of EPL coverage. Many small employers have a difficult time justifying the expense. Of course, most small businesses do not have the resources to self-insure even a small EPL claim and, in the long run, not purchasing EPL coverage is oftentimes often much more costly than purchasing coverage would have been.

Statistics vary based on the jurisdiction of the employer and the type of EPL claim, but the following numbers represent a conservative consensus with respect to the “average” EPL claim for small to mid-sized organizations:

• Settlement before trial - $40,000• Jury or court award/judgment after trial - $200,000• Defense costs - $50,000• Two-thirds of EPL defendants lose if the case goes to trial

• More than one-third of EPL claims are filed against employers with 15 to 100 employeesOf course, the settlements, awards, and defense costs for EPL claims filed against larger, and public, companies are much higher.

Most insurers of EPL insurance will negotiate the terms of the contract with an applicant—or insured who is renewing a current policy. For example, although most EPL contracts exclude coverage for punitive damages, an applicant may be able to negotiate removal of the exclusion or a limited amount of coverage in states that have not outlawed punitive damages.

As is the case with D&O coverage, EPL contracts may or may not permit the insured the right to choose counsel and consent to settlement. In a similar fashion, policy definitions of “claim” and other terms should be evaluated because they vary widely between carriers and contracts.

Unfortunately, EPL claims increase as the economy worsens. What is equally unfortunate is that many employers are not familiar with all the state and federal laws that affect how they interact with their employees—and they pay the price for that ignorance in the form of lawsuits. Some small employers believe they are immune from employment-related lawsuits because they employ fewer than a certain number of employees (i.e., Title VII applies to employers with 15 or more employees and the FMLA applies to employers with 50 or more employees). However, an employer with five employees who discriminates or otherwise violates the law, even if it is not Title VII or the FMLA that is violated, may find itself on the losing end of an EPL lawsuit.

It is also ironic that larger companies, who have the finances to establish human resources departments and hire professionals who are qualified to create policies and procedures to assure the fair treatment of employees, often disregard the very procedures created for their protection—and that of their employees. On the other hand, smaller companies that cannot afford to establish HR departments tend to violate the law through ignorance rather than intentionally.

Regardless of the reasons that cause an employer to violate an employee’s rights, the Courts have very little sympathy for employers that do just that and, as previously mentioned, two-thirds of employers lose lawsuits filed by employees if they go to trial. In addition to complying with federal laws that regulate employment, employers must also comply with state and local employment laws, as well. Some states and cities have actually enacted employment laws that are more stringent than federal laws. California and New York City are examples of such jurisdictions.



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EPL Risk Management and Loss PreventionBecause EPL loss experience is linked directly with an organization’s business and human resources philosophies, EPL claims are often a direct result of these philosophies. Because EPLI is not a “standard” insurance coverage, carriers underwrite according to their own appetites and may be very particular about the types of risks they want to insure. Most EPL carriers offer risk management and loss prevention services free of charge to help their insureds avoid the submission of EPL claims and reduce any potential settlements, awards, or judgments.

Employers should be sure their human resources staff members are trained, qualified, and conversant with all applicable laws in their jurisdictions. Employers that do not have human resources departments are advised to out-source certain employment duties to be sure to avoid inadvertent violation of pertinent employment laws. The recruitment, interviewing, and hiring of employees is strictly regulated and many small employers without human resources professionals violate a number of employment laws unintentionally during the process of hiring employees. The same holds true of employee discipline, layoff, and termination.

For example, many small employers are unaware they have been required to obtain and retain a Form I-9 (Employment Eligibility Verification) from all employees hired after November 1986 for the purpose of documenting that employees are authorized to work in the United States. In fact, the form states:

"...an individual may not begin employment unless this form is completed, since employers are subject to civil or criminal penalties if they do not comply with the Immigration Reform and Control Act of 1986."

Interviewing potential employees for open positions is fraught with the potential for all employers to violate discrimination laws based on the types of questions they may and may not ask. For example, it is illegal to ask job applicants if they were born in the United States but it is legal to ask them if they are able to submit verification of their right to work in the United States. Similarly, it is illegal to ask job applicants what religions they belong to but it is legal to ask if they will be available to work all required days, including holidays.

The following list contains some of the regulated employment areas that require complete understanding by employers to be sure they avoid committing offenses that might prompt an EPL claim. Of course, familiarity with all applicable local, state, and federal laws—and compliance with them—is the best method of avoiding allegations of committing wrongful employment acts.

• Employment applications• Job interviews• Employment background checks and references• Immigration considerations• Medical testing and ADA limitations• Drug and alcohol testing• Psychological and personality testing• Polygraph (lie detector) testing• HIV testing• Performance and aptitude testing• Fingerprinting• Genetic testing• Workplace harassment and prohibited conduct• Protected groups• Reporting of harassment and employer response• Personnel policies and employee handbook



• Employee performance evaluations• Discipline and corrective actions• Employment terminations• Layoff and downsizing

The EPL PolicyIn this section, we will discuss policy provisions that are specific to EPL coverage. As is the case with all types of professional liability insurance, no standard form of EPL coverage exists. EPL contracts are even more distinctive than other types of professional liability policies and their provisions are often negotiable. Producers should exercise extreme caution when reviewing, recommending, and writing EPLI coverage.

As the E&O and D&O policies are, the EPLI policy is a claims-made professional liability policy. Employment practices insurance may be written on a standalone basis, as an endorsement added to a businessowners or package policy, or on a management liability policy (i.e., with D&O coverage and/or Fiduciary Liability coverage).

NoticeEPL policies contain an introductory notice that describes the type of claims-made policy (pure claims made vs. claims-made and reported) under which coverage is provided. Most EPL policies are written on a pure claims-made basis, meaning coverage is provided for covered wrongful acts if the claim is made during the policy period or any applicable extended reporting period. Coverage for defense costs may reduce the limit of liability or may allow defense costs to be paid in addition to the limit of liability, depending upon the contract—which is contingent largely on the business operations of the insured and the carrier’s appetite for specific classes of business.

DeclarationsEach management liability or EPL policy will contain designations for the limits of liability and retentions (deductibles) for the types of coverage provided. Some EPL coverage is issued on the same policy as D&O, Entity Liability, Fiduciary Liability, and E&O or Miscellaneous Professional Liability coverages. If more than one type of coverage is purchased, the declarations page generally contains a schedule of the limits of liability and retentions that apply.

Applicable endorsements are also designated on the declarations, along with the named insured (employer or business), the named insured’s address, the policy number and dates, the policy premium, and the address to which all notices must be provided (mail, fax, e-mail, etc.). Some carriers’ declarations pages include details of any available extended reporting period, such as its length and premium represented as a percentage of the policy’s premium. The type of coverage may also be designated on the declarations, such as “indemnity” or “duty-to-defend.”

DefinitionsIn addition to the definitions previously discussed in this chapter, the following definitions appear in EPL contracts. Again, producers are cautioned to review all the definitions in any EPL policies they sell because verbiage may vary significantly by contract and insurer.

ClaimThe definition of claim may include one or more of the following:

• Any written notice received by an insured stating that any person or entity intends to hold the insured responsible for a wrongful employment act

• Any judicial or administrative proceeding initiated against any insured seeking to hold the insured responsible for a wrongful employment act, including any proceeding conducted by the EEOC or a similar agency

• A written demand for monetary damages or non-monetary relief



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• A civil proceeding commenced by service of a complaint or similar pleading• A criminal proceeding commenced by filing of charges• A formal administrative or regulatory proceeding commenced by the filing of a notice of

charges, formal investigative order, service of summons or similar document—including a proceeding before the EEOC or any similar agency

• An arbitration, mediation, or similar alternative dispute resolution proceeding• A written request to toll or waive a statute of limitations relating to a potential civil or

administrative proceedingNote: Many employers, when receiving notice from the EEOC (or a similar agency) that a charge has been filed, fail to realize that such a charge is often considered a “claim” by the insurer. Any time the insured is charged with committing a violation of employment law, the charge should be reported to the EPL carrier.

ClaimantA claimant is a past, present, or future employee of the insured or any individual who applied for employment with the insured. A claimant is also a government entity or agency, including the EEOC or a similar agency when acting on behalf of or for the benefit of a past, present, or future employee or any individual who applied for employment with the insured.

Coverage PartBecause EPL coverage can be written as one of several coverages provided by the same management or executive liability policy, coverage part only means the coverages designated on the declarations as being included in the policy.

Defense CostsDefense costs are reasonable and necessary legal fees and expenses incurred to defend the insured or conduct any investigation, adjustment, or appeal in connection with a claim. Defense costs include other costs, fees, and bonds but do not include wages, salaries, overhead expenses, and benefits of the insured.

DiscriminationDiscrimination is an act or alleged act that violates any employment discrimination law. Discrimination is also disparate treatment of an individual, or the refusal to hire the individual, because he or she is, or claims to be, a member of a legally protected class.

EmployeeAn employee is a natural person whose labor and/or services are engaged and directed by the insured while performing duties related to the conduct of the insured’s business. Some EPL policies require an employee to be on the insured’s payroll; others include independent contractors in the definition. Many contracts also include in the definition of employee the following persons: part-time workers, volunteers, leased workers, temporary workers, and interns.

Employment AgreementAn employment agreement is an express or implied employment agreement, in writing or made orally. Collective bargaining agreements are NOT employment agreements.

HarassmentDifferent definitions for harassment exist and may make distinctions between generic and sexual harassment. For example:

• Sexual harassment is any actual or alleged unwelcome sexual advance, request for sexual favors, or verbal or physical conduct of a sexual nature that is made a condition of



employment, is used as a basis for employment decisions, or that creates a work environment that is hostile, intimidating, offensive, or interferes with performance.

• Workplace harassment is any actual or alleged work environment that is hostile, intimidating, offensive, or that otherwise interferes with performance.

Independent ContractorAn independent contractor is a natural person who is not an employee but who performs labor or services for the insured under a written contract or agreement.

Interrelated Wrongful ActsInterrelated wrongful acts are any wrongful acts that are logically connected by any common fact, circumstance, situation, transaction, or event.

LossLoss is money the insured is legally obligated to pay as damages, settlements, front and back pay, and pre-judgment and post-judgment interest awarded by a court. Loss may also include punitive or exemplary damages, if permitted by law. Loss does NOT include civil or criminal fines, penalties, taxes, multiplied portions of any multiplied damage award, and other monetary sanctions. Depending upon the contract, loss may also include defense costs.

RetaliationRetaliation is any actual or alleged retaliatory treatment against an employee because:

• An employee exercised a right under law or attempted to exercise such a right• An employee disclosed, or threatened to disclose, to a government agency or a superior actual

or alleged wrongdoing by any insured• An employee filed a claim under any local, state, or federal whistleblower law or the Federal

False Claims Act • An employee refused to violate the law• An employee cooperated or assisted with a proceeding or investigation regarding the

employer’s alleged violation(s) of lawNote: The Supreme Court ruled in January 2011 that retaliation might also be any of the above actions taken against an employee’s family member or someone close to the employee.

SubsidiaryA subsidiary is any entity in which the insured owns more than 50% of the voting stock on or before the effective date of the EPL policy OR after the effective date of the EPL policy if the insured requests coverage for the entity. A subsidiary may be a corporation, partnership, limited liability company, or other legal entity. Depending upon the EPL contract, a subsidiary may be a non-profit or for-profit organization and the percentage of voting stock owned may vary.

Third PartyA third party is any person or entity with whom an insured interacts on behalf of the insured’s business operations while performing duties related to the conduct of the insured’s business.

Wrongful Act or Wrongful Employment Act (or Practice)A number of actual or alleged acts may be included in this definition—each of which may also be included in the policy’s definitions section, including:

• Discrimination• Harassment• Retaliation• Wrongful Termination



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• Wrongful Tort• Negligent violation of specified employment laws (i.e. FMLA)• Third party discrimination• Third party harassment• Breach of employment agreement• Employment-related misrepresentation• Employment-related defamation (including libel, slander, and invasion of privacy)• Failure to create or enforce adequate workplace policies and procedures• Wrongful discipline, wrongful demotion, deprivation of career opportunity, or deprivation of

seniority• Wrongful infliction of emotional distress• Negligent hiring, supervision, training, evaluation, etc.

Wrongful acts and practices must be committed (or allegedly committed) by an insured person acting within his or her capacity as such on behalf of, or for, the insured.

Wrongful TerminationWrongful termination is the actual or constructive termination of an employee, including demotion or failure to promote, that is illegal, a wrongful act, or in breach of an employment agreement. Constructive termination occurs when an employee is forced to terminate employment because the employer created intolerable working conditions.

EPLI ExclusionsThe following exclusions were found in contracts issued by three major carriers that write EPL coverage. (No contract contained all of the exclusions.)

• Any wrongful act or event that took place before the inception date of the policy• Prior or pending litigation• Any wrongful act, event, or circumstance that might give rise to a claim that was known

before the policy inception date and wasn’t reported to the carrier• Violations of ERISA, COBRA, WARN, OSHA, FLSA, the National Labor Relations Act

(NLRA)—including their amendments—and any other federal, state, or local statutes, ordinances, regulations, or common law

• Bodily injury or property damage• Any workers’ compensation, unemployment insurance, Social Security, or disability benefits

law• Contractual liability unless the insured would have been legally liable in the absence of the

contract• Wrongful acts of a subsidiary committed or allegedly committed before that entity became a

subsidiary• Breaches of any independent contractor services agreement or third party services agreement• Pollution• Employee benefits or stock benefits due• Breach of an employment contract unless the insured would have been legally liable in the

absence of the contract• Violates of any antitrust or unfair trade practices law• Violations of any Wage and Hour law (unless the claim is for retaliation or violation of the

Equal Pay Act)



• Severance pay, damages or penalties under an express written employment agreement, or sums sought solely on the basis of a claim for unpaid services

• Conduct of an insured that was proven to be fraudulent, dishonest, or criminal—once it’s proven

• Modification of real or personal property to make it more accessible to, or to accommodate, any disabled person

• Any lockout, strike, picket line, replacement of workers, etc. that results from a labor dispute or labor negotiations—except for retaliation

RetentionsThe retention on an EPL policy, or its deductible, is designated on the declarations page. If the policy provides more than one type of management liability insurance, the retention for EPL insurance will be specifically stated.

In all cases, the insurance company will only begin making payment after the retention has been exhausted or eroded in payment by the insured. The insurance company has no obligation to pay any portion of the retention and, if it chooses to do so, the insured agrees to reimburse the insurer.

Spousal and Domestic Partner ExtensionSome EPL policies extend coverage to spouses and domestic partners of any individual insured. Coverage is extended when the lawful spouse or domestic partner of the individual insured becomes legally responsible to make payment for a claim because of his or her status as spouse or domestic partner OR because the spouse or domestic partner has ownership interest in property or assets sought as recovery for such covered claim. The extension does NOT apply to wrongful acts committed by the spouse or domestic partner unless, of course, he or she is also an insured person by definition.

Full Prior ActsAlthough EPL policies are written on claims-made forms, most do not contain a retroactive date and do provide coverage for all prior acts. Some policies will include the term “full prior acts” on the declarations in the place where the retroactive date usually appears. Other policies contain a provision, such as the following:

Coverage shall apply to any Claim made against an Insured for Wrongful Employment Acts arising solely out of the Insured’s duties on behalf of the Organization committed prior to the expiration date of the Policy or the effective date of cancellation or nonrenewal of this Policy, provided that the Claim is first made during the Policy Period, or the Extended Reporting Period, if applicable, and written notice of said Claim is reported to the Company as soon as practicable. However, coverage shall not apply to any Claim based upon or arising out of any Wrongful Employment Act or circumstance likely to give rise to a Claim of which the person or persons signing the Application had knowledge or otherwise had a reasonable basis to anticipate might result in a Claim, prior to the earlier of: A. The inception date of this policy; or B. The inception date of the first policy of this type issue by the Company to the insured, provided that the Company has written continuous coverage from such date to the inception date of this Policy.

Cyber Liability InsuranceFew people will argue that a businessperson is unable to conduct operations today without the assistance of a computer and access to the Internet. In fact, most Americans also use devices such as smartphones and tablets to transact business. Because it is unlikely that working at a computer or hopping online with a handheld device will cause physical harm to a third party, most insurance agents, consumers, and businesses are entirely unaware of the myriad cyber liability risks to which they are exposed.

Part of the reason for this lack of awareness is the fact that our relationship with electronic technology is relatively young. In fewer than 30 years, we have transitioned from recording and maintaining business information entirely on paper to becoming dependent upon little machines to do our thinking, processing, and recordkeeping. Today, a tremendous percentage of our business communications and transactions take place electronically instead of face-to-face.



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Here are a few facts about how the cyber world has advanced since AT&T introduced the first modem in 1960:

• The Internet was introduced to the public in 1969 by UCLA, at which time it became the first node on the Internet

• CompuServe became the first commercial online service in 1969 and, after being overtaken by giants such as AOL, shut down in 2009

• The first portable computer was released in 1975 by IBM; it weighed 55 pounds and its monitor was a five-inch CRT display

• The first laptop computer, the Osborne I, was released in 1981 and weighed 24.5 pounds. It included a five-inch display and 64KB of memory

• In 1987, the number of network hosts surpassed 10,000• The World Wide Web server was released to the public in 1991• In 1992, the number of network hosts surpassed 1,000,000• Microsoft Internet Explorer was released in 1995• In 1996, the number of e-mail transmissions surpassed the pieces of mail sent via the U.S. Postal

service• Yahoo introduced Yahoo Mail in 1997• Google became incorporated in 1998 and, two years later, announced it had indexed over one billion

pages on the Internet• In 2001, McAfee released the first virus protection software• Apple released the first iPhone in 2007 and the first iPad in 2010• In 2010, Amazon sold more Kindle books than hardcover books

Admittedly, some people do not own computers, share the details of their lives on Facebook, or communicate routinely via e-mail. However, a recent survey conducted by FleishmanHillard reveals that an overwhelming majority of consumers uses the Internet before making purchases—even if those purchases are not made online. The survey, which was conducted in the U.S., Canada, China, France, Germany, Japan, and the United Kingdom, reports the following statistics based on the responses of those surveyed:

• Nearly 90% use Internet search engines to make purchasing decisions• Seventy-five percent relied on information obtained online before obtaining healthcare products and

services• Nearly two-thirds used a mobile phone or smartphone to obtain information about a brand, product, or

service several times a week• Nearly half follow specific brands or vendors on a social networking site

Because the Internet is a complex system of technological networks, trust is the glue that holds it together. That trust is the Internet’s greatest strength ... and its most vulnerable weakness. Hackers, intruders, and cyber criminals are able to misdirect Internet traffic because the protocol that connects all the networks does not have internal methods to prevent such abuse. Other security issues exist with respect to the Domain Name System (DNS) and malicious code. The Federal Communications Commission (FCC) estimates that the international cost of cyber crime exceeds $1 trillion a year.

According to the FCC:

There are criminals in nearly 200 countries lurking online – plotting large-scale attacks like the cone that crashed a CIA website in early February 2012, as well as smaller attacks aimed at stealing personal information from unsuspecting citizens’ home computers. This is a growing threat. In January 2012, the FBI’s Director Mueller warned, “Down the road, the cyber threat will be the number one threat to the country,” surpassing the dangers of terrorism. If we fail to tackle these challenges and secure the Internet, we will pay the price in the form of lost jobs, lost opportunities, and hundreds of billions of dollars lost to digital criminals.



The FCC cites the following as the 10 most important tips for small businesses with respect to cyber security:1. Train employees about the principles of security2. Protect information, computers, and networks from attack3. Use a firewall on all computers4. Monitor the use of mobile devices and include them in security plans5. Backup all data on a regular basis and keep the backups in secure location6. Limit physical access to computers, allow access only by individuals with user accounts and

passwords, and limit the number of individuals with administrative privileges7. Be sure wireless and Wi-Fi networks are not broadcast (they should remain hidden), are secure, and

are encrypted8. Only use banks and payment processing systems that utilize the most up-to-date and trusted tools and

anti-fraud services9. Employees should only be able to access to data and information they need to perform their jobs and

shouldn’t be allowed to install software10. User passwords should be unique, require multi-factor authentication, and be changed on a regular

basis—at least every three monthsThe FCC also recommends a number of sources to assist small businesses learn about, and protect themselves from, cyber security risks. Its website contains information and resources on the following page: Cybersecurity for Small Business.

What is Cyber Liability and Why is Coverage Needed?Before discussing the basic elements of cyber liability risks and insurance coverage, reviewing recent cyber liability claims is probably the best way to understand how individuals and businesses are exposed to liability for their acts, and those of employees, when using the Internet:

• In 2009, the U.S. Department of the Treasury and the Secret Service Department websites were hacked during the Independence Day holiday.

• In 2010, one of the NASDAQ’s web-based applications was hacked.

• A restaurant chain and 5,000 of its customers were the victims of international hackers when credit card information was stolen from the restaurant’s computerized cash registers.

• A rehabilitation center was sued after an employee violated its privacy policy and improperly disposed of 4,000 client records that contained Social Security numbers, credit and debit card account numbers, and private health information.

• One year, a non-profit corporation inadvertently sent 50 percent of its 1099 forms (which contain Social Security Numbers) to the wrong recipients.

• In 2011, data breaches occurred at Sony, Citigroup, Stratfor, and Lockheed Martin—all of whom believed they had top-notch security systems in place.

• A county employee opened an e-mail attachment that contained a virus that infected the county’s computer system. The virus was inadvertently transmitted to a number of parties via e-mail transmissions, some of whom were forced to shut down operations.

• An employee discovered attractive graphics and photos on another company’s website and used them when designing marketing material for his employer.

• An employee’s laptop was stolen while traveling and the thief gained access to personal information about the employer’s customers.



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Cyber liability and privacy insurance is a form of professional liability insurance. Because the harm generated by the use of electronic activities is financial rather than tangible, as bodily injury and property damage are, standard liability policies provide limited, if any, coverage for negligent acts arising out of the use of computers and the Internet.

Because the subject of cyber liability is complex, and the policies providing coverage are not standard, this section of the chapter discusses subjects in general terms. Agents are cautioned to conduct their own research when working with carriers to offer and issue cyber and privacy insurance to their clients.

Glossary of Cyber TermsCyberThe term cyber refers to the use of computers, computer networks, or the Internet.

Cyber and Privacy InsuranceCyber and privacy insurance protects individuals and businesses that use technology. Specifically, cyber and privacy insurance provides property and liability insurance to cover losses that result when electronic transactions generate harm or loss. Examples of such transactions include online sales or the collection of personal information via the Internet.

Cyber liability coverage most often provides insurance for the legal liability arising from data breaches, website content, computer fraud, funds transfer loss, cyber extortion, etc. Cyber liability is NOT technology errors and omissions coverage because it is not designed to protect individuals and entities that manufacture or distribute computer hardware and software, design websites, or provide network security—it protects anyone who uses electronic means to transact activities or business. Cyber liability and privacy insurance also provides coverage for the legal liability associated with intellectual property and intangible assets.

Intangible AssetAn intangible asset is property that is not physical but that has value, such as the goodwill of a business or intellectual property (i.e., copyrights, patents, and trademarks). The value of most intangible assets is difficult to determine because it is tied to subjective criteria. For example, if one author pirated another author’s book and sold it under her own name, determining the income the original author lost would be problematical. In accounting, an intangible asset is anything that cannot be seen or touched but that has the potential to generate future income.

Intellectual PropertyIntellectual property is the by-product of a person’s idea or thoughts, such as an invention or song lyrics. In the United States, the Patent and Trademark Office (USPTO) protects the following types of intellectual property:

• Patents• Trademarks• Geographical Indications (for goods, such as Florida for oranges and Vidalia for onions)• Copyrights• Trade

Intellectual property is protected by federal legislation that regulates patents, trademarks, copyright, and trade secrets. According to the American Intellectual Property Law Association:

In general:

• patents protect inventions of tangible things;

• copyrights protect various forms of written and artistic expression; and

• trademarks protect a name or symbol that identifies the source of goods or services.



PatentA patent is a legal document issued by the U.S. government that endows the party to which it is issued the exclusive right to practice the invention described in the document. That right is legally enforceable, which means the patent owner may sue to enforce its rights with respect to the patent. Patents are issued for twenty years from the date of filing and may be inherited, sold, rented, mortgaged, and taxed. For example, Elisha Graves Otis was granted a patent for the elevator. After the patent expired, others were able to design, build, and sell elevators.

TrademarkA trademark is a word, phrase, design, sound, or symbol upon which the public relies to recognize a particular product or service, along with its source or degree of excellence. The term trademark is used synonymously with service mark and brand name. Google owns the world’s most valuable trademarks, which are valued in excess of $44 billion and include Gmail™, Blogger™, and YouTube™. Other famous trademarks include the hundreds owned by Apple, including Apple®, iPod®, and iPad® and those owned by Microsoft, including Bing®, Excel®, and numerous logos, such as the “W” used to depict Microsoft Word software.

Trademark rights are generated by filing an application for a genuine intention to use a mark or product in connection with a service or by using the mark in connection with a product or service. The filing of a trademark application endows more rights than simple use of a mark does. Trademark registrations are issued for ten years and may be renewed for subsequent ten-year periods if the mark is used consistently. So long as registration renewal documents are filed when and as required, a trademark does not expire. Once a trademark’s registration is cancelled or expires, it cannot be revived or reinstated.

The symbol ® indicates a trademark has been registered and the symbol ™ usually indicates a mark is not yet registered but the user wants exclusivity. Trademarks and service marks may be licensed, which is the foundation of the franchising industry. Legally, the only parties that may use a trademark are its owner and anyone to whom use has been granted via a license or permission by the owner.

CopyrightA copyright is a legal property right granting authors exclusive rights to certain creations for a stated length of time. Specifically, the expression of those creations is protected by copyright while the actual ideas that spurred them are not protected. Examples of creations protected by copyright are books, graphics, paintings, sculptures, music, photos, movies, and computer programs. The title of a book or painting, however, cannot be copyrighted.

A copyright actually entails a collection of specific rights:1. Reproduction of the work2. The making of derivative works (i.e., making a movie based on a book)3. Distributing copyrighted works to the public4. Performing works publicly (i.e., singing songs)5. Publicly displaying works (i.e., exhibiting paintings)

One of the most misunderstood facts about copyright is when the rights actually begin. Copyright is granted immediately upon creation and lasts the entire lifetime of the author, plus an additional fifty years. For example, if a photographer snaps a photo, the copyright for the photo is automatically generated. (For works created before 1975, the length of copyright is 75 years.) Although registration of copyright is not required for copyright to exist, it is required to sue for enforcement of copyright infringement.



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Domain NameA domain name is a distinctive label of characters that refers to a person, organization, or other entity on the Internet. Domain names are created and maintained by the Domain Name System (DNS) and represent Internet Protocols (IPs) such as a computer or a laptop, a server that hosts websites, or websites themselves.

Domain names are used to identify specific users of the Internet, such as computers, networks, and services and are not case sensitive (meaning AD Banker is the same as ad banker). Domain names are subject to the Truth in Domain Names Act, the PROTECT Act of 2003 (pertaining to the prevention of child abuse), and the Anticybersquatting Consumer Protection Action.

Hacker or IntruderTwo definitions of hacker exist. The first is someone who is an expert at computer programming and troubleshooting. The second is someone who gains access to computers without authorization or when overstepping permission.

CybersquattingCybersquatting is the practice of registering a domain that is the same as, or similar to, another’s trademark for the specific purpose of profiting from that trademark. It includes registering, using, or trafficking in another’s trademark and is also known as domain squatting. For example, if United Parcel Service (UPS) had not yet registered a domain name, Fred would be Cybersquatting if he registered the domain name UPS.com for the sole purpose of blackmailing UPS into buying the domain name. Fred would also be Cybersquatting if he intended to use the brand UPS to increase traffic to the site he created for his business, UPSO Manufacturing. Bad faith must be a component of the plaintiff’s actions for an action to be considered Cybersquatting.

TyposquattingTyposquatting is the practice of registering domain names that are nearly identical to the trademark(s) of another for the specific purpose of profiting from the trademark(s). An example of Typosquatting is registering the domain name UPS.net or UPS.org with the intent of seeking compensation from the owner of UPS.com or directing traffic from UPS.com to one’s own website.

PhishingPhishing is a form of identity theft. It is carried out by a party attempting to fraudulently collect personal information under the guise of making a legitimate request for that information. Typically, phishing is conducted via e-mail or an instant message sent by an apparently legitimate source, such as a known person or legitimate organization. The phishing message either asks for personal information (i.e., Social Security numbers, user IDs, passwords, etc.) or asks the recipient to click on a link to a website. That website is typically NOT legitimate and usually contains malicious code.

Malware (Malicious Code)The terms malware and malicious code are used to describe computer code and programs designed to self-install on computers without their owners’ consent. Malware includes viruses, worms, and Trojans.

• A virus is a software program designed for the specific purpose of impeding the processing of a computer. Viruses may remove data or alter, damage, collect, or transmit data from one computer to another. According to Microsoft, most computer viruses are transmitted via instant messaging, attachments to e-mails, and Internet downloads.

• A worm is a computer program that copies itself from one machine to another, generally through a security flaw in a computer’s operating system.

• A trojan is a computer program or software that seems genuine; however, when it runs, it does something the user did not expect it to do—like steal personal information. Trojans differ from computer viruses and worms because they do not reproduce; they remain in the computer and continue their dishonest activities until detected.



Anti-Virus SoftwareAnti-virus software is computer software designed to detect and remove computer viruses and other types of malware so they do not damage a computer, interfere with its operation, or steal personal information. Anti-virus software is a form of computer security and helps prevent data breaches.

Cyber SecurityAccording to the United States Computer Emergency Readiness Team (US-CERT), cyber security is protecting the following types of information by preventing, detecting, and responding to attacks:

• Communications transmitted via e-mail and cell phones• Digital cable and MP3 transmissions• Information and signals emitted by transportation systems, such as car engine computers and

aircraft navigation systems• Purchases made online and with credit or debit cards• Stored data pertaining to medical records and equipment

FirewallA firewall is software or hardware contained in a computer that helps prevent hackers, intruders, and malware from gaining access. Firewalls inspect information on the Internet or a computer network and determine whether that information is a potential threat. If the firewall suspects the information has the potential to be damaging, it blocks entry; otherwise, it allows access. Although firewalls are important components of computer security, they are not one-hundred percent effective.

Cyber Liability CoveragesThe reason cyber and privacy insurance exists is to provide insurance protection that is not included in other types of insurance policies. Clearly, if other policies provided adequate coverage, this type of insurance would not be necessary. Comprehensive general liability (CGL) coverage and other standard liability insurance provide limited, if any, coverage for exposures that can be insured on a cyber liability policy.

CGL and other liability insurance provide coverage for the insured’s legal liability that arises out of bodily injury, property damage, and personal and/or advertising injury. Specifically, the definition of “property damage” in standard liability policies only includes tangible property. The ISO CGL form defines property damage as:

a. Physical injury to tangible property, including all loss of use of that property. All such loss of use shall be deemed to occur at the time of the physical injury that caused it; b. Loss of use of tangible property that is not physically injured. All such loss of use shall be deemed to occur at the time of the “occurrence” that caused it.

Cyber liability coverage specifically provides insurance for intangible property and assets, including loss of use.

In the CGL and other liability policies, an exclusion exists under advertising liability coverage for an insured that is in the business of advertising, broadcasting, publishing, or telecasting—which may actually involve cyber exposures. Most cyber liability policies do not contain a similar exclusion. In addition, the CGL policy contains exclusions for the following—for which coverage is included or available in cyber liability policies:

• Breach of security• Inadvertent transmission of personal and/or confidential information• Infringement of copyright, trademark, or patent• Financial or economic loss of third parties resulting from the above



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Although a CGL policy provides advertising injury liability, it does not provide coverage for the infringement of intellectual property rights that are not connected to the insured’s advertisements. For example, it is possible a website or electronic activity may not be viewed by an insurer, court, or jury as being related to advertising or an advertisement. In such a case, the electronic activity would be excluded if it generated a loss.

Another potential coverage gap is that infringement of intellectual property rights must meet the specific definitions of personal and advertising injury contained in the policy. For example, many existing policies do not address the terms piracy or unfair competition—which are common allegations under cyber liability policies.

Unintentionally, an insured may infect another party’s computer or network with a virus, causing damage and suspension of operations to a third party that generates significant economic loss. If the resulting damage does not meet the definition of property damage in the CGL policy—i.e., damage to tangible property—no coverage will apply. Because loss of use coverage in the CGL only applies to loss of use of tangible property, no coverage for loss of use would be provided, either. It is also important to note that economic damage is NOT bodily injury or property damage.

Available Types of CoverageBecause cyber liability insurance is a specialty coverage, it is estimated that fewer than 100 insurers write standalone policies. These insurers have developed products based on how they evaluate cyber risk and whether they choose to write property coverage, liability coverage, theft coverage or all three. In addition, some insurance companies offer cyber and privacy endorsements to management liability and businessowners policies.

Because cyber and privacy insurance is a relatively new form of insurance, rates are not excessive in the current marketplace. Of course, that might change as a carrier’s market share alters and as future losses develop. It should also be noted that policy language for cyber and privacy coverage is non-standard and varies greatly by carrier.

The basic types of cyber liability coverage include security breach, virus, unauthorized access, personal injury, advertising injury, loss of use, business interruption, infringement of copyright, infringement of trademark or service mark, and infringement of patent—which is usually only available by endorsement. Specifically, policies may include coverage for:

• Third-party damage caused by a breach of network security• Mistakes made by administrative or operational activities• Violations or alleged violations of HIPAA and other federal and state privacy regulations• Violations or alleged violations of consumer protection laws, such as the Fair Credit

Reporting Act (FCRA)• Expenses incurred to comply with customer notification of security and privacy breaches,

including credit monitoring, legal expenses, postage costs, and advertising costs• Expenses incurred to repair the insured’s reputation that was damaged as the result of a data

breach• Expenses incurred for regulatory fines, penalties, investigation, and defense

Cyber and privacy insurance usually provides three types of coverage:

1. Liability

2. Remediation

3. Fines and penalties



Liability coverage applies to the insured’s legal liability for security and/or data breach as stated in the insuring agreement and includes the costs of defense. Remediation coverage pays for the insured’s expenses incurred to respond to a security or data breach. This includes investigation, public relations, notifying customers, credit monitoring, and similar expenses. If fines and/or penalties are charged by regulators for violating laws, some carriers provide coverage—others do not.

Depending upon the carrier and the type of coverage purchased, different events may activate coverage. The failure to secure data may be a triggering event, as may the theft or disappearance of private property containing data that must be secured (i.e., a computer or paper files). Coverage may be triggered by the acts of the insured, the insured’s employee, or certain other persons. Policies may also specify the types of data that are covered, for example, Personally Identifiable Information (PII), Protected Health Information (PHI), nonpublic data—such as corporate information, and non-electronic data such as that contained on paper records and reports.

Of those businesses purchasing cyber liability insurance, remediation coverage is often the most valuable component of the policy. Because of the numerous federal and state regulations that exist concerning the securing and safeguarding of private and confidential information, a business can be required to spend a great deal of money to respond to a security or data breach. In addition, a great deal of money is often spent to mend the reputational damage and loss of trust that follow a publicized breach.

According to a recent research report by the Ponemon Institute, the average cost of a data breach in the United States is $194. If 10,000 records were involved in a breach, the cost to the organization responsible for the breach would be nearly $2 million. Even small companies are at tremendous financial risk; a data breach involving 100 customers would generate an average cost of just under $20,000. The costs to notify victims of security and data breaches continue to rise as federal and state laws that govern data breach notification become stricter.

Another report, a marketing survey on cyber and privacy insurance, indicates that in one recent year only 435 data breaches affected 500 or more victims. In that same year, however, more than 42,000 data breaches affected fewer than 500 victims. The interpretation of this phenomenon seems to be that most data breaches affect a small number of people and, therefore, often go undetected, are not reported, and the underlying issues are not addressed.

Cyber Policy Forms and ProvisionsCyber liability coverage is written on a claims-made form, so it is important for clients to understand all the issues inherent to that form of coverage, including the retroactive date, the coverage trigger, the definition of claim, reporting provisions, extended reporting periods, etc. Most insurers want to choose or approve counsel in the event of a claim or lawsuit and many include a hammer clause as found in D&O and EPL coverages.

Cyber liability policies contain different insuring agreements and the policy exclusions often apply separately. Sample insuring agreements (coverages) include:

• Network Security and Privacy Liability – For breaches of security, privacy, and data• Security Event Costs and Special Expenses – That result from the above breaches• Employee Privacy Liability – For breaches caused by employees, contractors, and others for

whom the insured is legally responsible• Electronic Media Liability – Display of data on floppy disks, CDs, hard drives, magnetic

tapes, or other media that results in: ◦ Defamation ◦ Libel or slander ◦ Product disparagement ◦ Trade libel



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◦ Invasion of privacy ◦ Plagiarism or misappropriation of ideas ◦ Infringement of copyright, trademark, trade name, trade dress, title, slogan, service mark,

or service name ◦ Domain name infringement

• Privacy Notification Expenses – For costs associated with covered breaches and reputational injury

• Crisis Management and Reward Expenses – Reasonable and necessary expenses of an independent attorney, information security forensic investigator, or public relations consultant

Exclusions vary by insuring agreement, insurer, and type of entity being afforded coverage. Producers should be sure to familiarize themselves with policy language and coverage before making any recommendations.

Legislation Regulating Cyber Security and PrivacyHundreds of federal and state laws have been enacted to protect the privacy and confidentiality of consumer information and to prevent various cyber crimes, including fraud, theft, and pretexting. The following list contains some of the major federal laws that regulate privacy, computers, computer networks, and the Internet.

• The Counterfeit Access Device and Computer Fraud and Abuse Act of 1984 prohibits attacks on computer systems owned by the federal government, banks, and involved in interstate foreign commerce.

• The Electronic Communications Privacy Act of 1986 prohibits unauthorized electronic eavesdropping.

• The Computer Security Act of 1987 gave responsibility for developing security standards for most federal computer systems to the National Institute of Standards and Technology (NIST).

• The Paperwork Reduction Act of 1995 gave responsibility for developing cybersecurity policies to the Office of Management and Budget (OMB).

• The Clinger-Cohen Act of 1996 (also known as the Information Technology Management Reform Act) was designed to improve the way the federal government obtain, utilizes, and disseminates information technology and included the definition of information technology used in other federal laws.

• The Health Insurance Portability and Accountability Act of 1996 (HIPAA) established a national standard for the protection and privacy of health information, including how and when it can be used or disclosed.

• The Digital Millennium Copyright Act (1998) implemented two treaties of the World Intellectual Property Organization (WIPO) and made it a crime to thwart digital rights management that controls access to copyrighted works or to manufacture, sell, or distribute devices that allow the illegal copying of software

• The Identity Theft and Assumption Deterrence Act (1998) made identity theft a federal crime.• The Gramm-Leach-Bliley Act (also known as the Financial Modernization Act of 1999)

contains three major provisions: ◦ The Financial Privacy Rule regulates how businesses may collect and disclose the personal

financial information of its customers. It defines companies that are subject to the Rule, which are called “financial institutions” although they need not be banks.

◦ The Safeguards Rule requires businesses meeting the definition of “financial institution” to develop, put into practice, and maintain safeguards to protect customer information. The Rule applies to “financial institutions” and other organizations, such as credit reporting agencies, which receive customer information from other financial institutions.

◦ Pretexting was outlawed in the GLBA and is the practice of obtaining personal financial information under false pretenses. The Act protects consumers from pretexting.



• The Anticybersquatting Consumer Protection Act (1999) was designed to outlaw and prevent cybersquatting.

• The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act of 2001 was designed to deter and punish terrorist acts and to strengthen law enforcement and investigation measures. It also allows investigators to investigate organized crime and drug trafficking by facilitating the exchange of information among government agencies.

• The Homeland Security Act of 2002 gave responsibility for some cybersecurity responsibilities to the Department of Homeland Security under the Cyber Security Enhancement Act of 2002, which authorizes the Department to access, receive, and analyze law enforcement information, intelligence information, and other information provided by federal, state, and local government agencies for use toward preventing terrorist acts.

• The Sarbanes-Oxley Act of 2002 (also known as SOX or the Public Company Accounting Reform and Investment Protection Act of 2002) established national standards for the boards of directors, management, and accounting firms of all U.S. public entities to regulate corporate financial responsibility.

• The Cyber Security Research and Development Act (2002) authorized funding for research and development pertaining to computer and network security.

• The E-Government Act of 2002, which also contains the Federal Information Security Management Act of 2002 (FISMA) and the Confidential Information Protection and Statistical Efficiency Act (CIPSEA), was designed to promote the use of the Internet and other information technologies to provide more online information and services to consumers.

Cyber SummarySecurity and data breaches can happen anywhere ... to anyone. Few people intend to disclose confidential information, use another party’s copyrighted works, or make a mistake that harms another person. However, there are people who do deliberately intend to steal, deceive, and defraud. Criminals who want to buy private and confidential information will pay $1 for a Social Security number and $50 for an individual’s protected health information—which is very scary.

Businesses that do not purchase cyber liability insurance can expect to pay, out-of-pocket, all costs associated with a data breach, which are estimated to be $194 per record, and an average of $504,000 in defense costs. Additional costs per record include roughly $50 for discovery and notification, $30 for credit monitoring, up to $100 for fines and penalties imposed by regulators, and as much as $150 for the loss of customers, meeting legal requirements, loss in productivity.

Despite its youth in the insurance marketplace, cyber liability coverage addresses a very real exposure that most businesses do not even realize they possess.

Identity Fraud InsuranceAccording to the Federal Trade Commission (FTC), identity theft is a serious crime that disrupts the finances, credit history, and reputation of an individual or business. Because an identity is intangible, in reality, it cannot be stolen. However, when the personal information of an individual or business is stolen and used by another without authorization, and with fraudulent intent, the crime is called identity theft. Resolving all the issues related to the theft and fraudulent use of one’s personal information, and reversing the harm it causes, takes time, money, and a great deal of patience.

In short, identity theft is fraud. It involves theft and deliberate deception for the sole purpose of achieving personal gain—typically financial gain. For example, a stranger steals someone’s wallet and then uses the stolen driver’s license and credit cards to establish bank accounts, secure loans, and make purchases. Sometimes, instead of using the personal information they steal, thieves sell it. The Department of Justice cites one of the many cases that prompted Congress to create the crime of identity theft:



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A convicted felon not only incurred more than $100,000 of credit card debt, he obtained a federal home loan and bought homes, motorcycles, and handguns in the victim’s name, and called his victim to taunt him, saying he could continue to pose as the victim for as long as he wanted because identity theft was not a federal crime. He later filed for bankruptcy in the victim’s name. While the victim and his wife spent more than four years and more than $15,000 of their own money to restore their credit and reputation, the criminal served a brief sentence for making a false statement to procure a firearm and made no restitution to his victim for any of the harm he had caused.

The FTC reports that approximately 9 million Americans have their personal information stolen every year. Some fraudsters rent apartments in the names of their victims; others open bank accounts in the names of their victims and use them to fraudulently obtain property and services. Quite often, such crimes are not discovered until long after they occur, usually when a person reviews his or her credit report or is contacted by a bill collector.

Congress enacted the Identity Theft and Assumption Deterrence Act in 1998, thereby making the theft and unauthorized use of personal information a federal crime. According to federal law, a person commits identity theft when he or she:

“(7) knowingly transfers or uses, without lawful authority, a means of identification of another person with the intent to commit, or to aid or abet, any unlawful activity that constitutes a violation of Federal law, or that constitutes a felony under any applicable State or local law;”

The definition, as interpreted by the federal government, includes theft and unauthorized use of a name or Social Security number as “a means of identification.” According to the Fair Credit Reporting Act (FCRA), both individuals and businesses may be victims of identity theft.

Because identity theft is a federal crime, it is investigated by federal law enforcement agencies, including the Secret Service, Federal Bureau of Investigation (FBI), Postal Inspection Service, and the Social Security Administration (SSI). Federal identity theft crimes are prosecuted by the Department of Justice (DOJ). The Identity Theft Penalty Enhancement Act provides for a mandatory two-year prison term—in addition to any other penalty provided by law—for anyone who is convicted of aggravated identity theft. The Act considers the following acts to be aggravated identity theft—and felonies:

• Certain crimes pertaining to theft of public money, property, or rewards• Certain crimes pertaining to theft, embezzlement, or misapplication by bank officers and employees• Certain false statements in connection with the acquisition of firearms• Certain crimes pertaining to mail, bank, and wire fraud• Certain crimes pertaining to nationality and citizenship• Certain crimes pertaining to passports and visas• Certain crimes that pertain to obtaining customer information under false pretenses in violation of the

Gramm-Leach-Bliley Act• Certain other crimes under the Immigration and Nationality Act and the Social Security Act

Types of Identity TheftBefore discussing the actual process of stealing personal information, and the consequences, it is important to understand the enormous scope of the crime of identity fraud.

Types of Identity Theft

Financial Exploits the financial relationships and credit of the victim, such as fraudulent use of bank accounts, credit card accounts, retirement accounts, etc.

CriminalOccurs when someone commits a crime when using the identity or personal information of another person. Some criminals actually serve time in jail or prison under the names of their victims, thus endowing an innocent person with a criminal record!

Employment Takes place when a fraudster obtains a job when using the personal information of another person.



Types of Identity Theft

Driver’s license Occurs when an imposter obtains a driver’s license through the use of stolen personal information.

Social Security Results from identity theft when an imposter fraudulently obtains Social Security benefits, files tax returns, receives student loans and food stamps, etc.

Medical

Occurs when a fraudster obtains treatment and services for health issues under the name of another person—and those medical treatments and services are documented in the victim’s medical records. This is one of the most dangerous types of identity theft because the victim may never know it occurred and it may actually jeopardize the victim’s life if it remains undetected and medical diagnoses and decisions are made on fraudulently altered medical records.

ChildTakes place when a fraudster uses the Social Security number and identity of a child. This crime usually goes undetected for many years, usually until the child is old enough to apply for a driver’s license, bank account, or credit card in his or her own name and it is learned that those documents and accounts have already been issued.

How Personal Information is StolenA thief can steal a wallet and, if it contains a driver’s license, Social Security card, and a couple of credit cards, that haul will more valuable than several hundred dollars in cash. Why? Because the thief not only uses the personal information to obtain products and services, he or she can also sell the personal information to make even more money.

However, not everyone’s wallet is vulnerable to theft. If a person’s pocket or handbag is inaccessible, a thief is unable to steal the personal information they contain. If a person’s house is protected by a security system (of either the canine or the technological variety), it is unlikely a thief will be able to steal its contents—including any personal information that might be accessible.

Because consumers have become more security conscious with their physical possessions, criminals have become more creative when devising methods to steal personal information. The following are schemes fraudsters use, regularly, to steal personal information:

• Poking around in trash cans and dumpsters to obtain personal information contained on bills, statements, and other documents

• Stealing wallets, purses, backpacks, or mail for the purpose of obtaining credit cards, driver’s licenses, passports, health insurance cards, and other items that contain personal information

• Finding a job with a business, financial institution, insurance agency or company, medical office, or government agency for the sole purpose of stealing personal information while on the job

• Fraudulently assuming the identity of a legitimate business or organization for the sole purpose of tricking victims into providing personal information (this is known as pre-texting)

• Pretending to offer a loan, job, housing, or something else for the sole purpose of securing personal information

• Phishing, which is the collection of personal information via e-mail, instant messages, and other electronic transmissions when pretending to be a legitimate business or known individual who has a right to such information

• Changing someone’s address with a vendor, employer, or the Post Office for the purpose of diverting mail and then stealing personal information

• Shoulder surfing, which is the act of watching and/or listening from a nearby location for the purpose or recognizing and stealing a person’s PIN, telephone calling card number, or credit or debit card number

• Stealing wireless devices such as smartphones, notebooks, and laptops to access personal information both on the devices and through apps on the devices; smartphones are increasingly vulnerable to identity theft



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What a Thief Can Do with Stolen Personal InformationIn addition to simply selling the information they steal, thieves can use the personal information and identity of others in myriad ways. A common use of fraudulently obtained personal information is to secure one or more new credit cards in the victim’s name. Victims of this typed of scheme do not realize their information has been stolen for quite some time because, in most instances, the thieves use a phony mail address for the new cards. The victims discover the crime when delinquent accounts appear on their credit reports or after the credit card companies manage to contact them at their legitimate addresses because of the delinquencies.

Many thieves purchase wireless telephone accounts in the names of their victims, as well as cable television. Others use their victims’ personal information to open bank accounts and then write counterfeit checks. They will also use the stolen information to access legitimate bank accounts in the victim’s name and then secure additional ATM or debit cards and use those devices to make withdrawals from the victim’s accounts.

Some thieves go so far as to secure phony loans in their victims’ names, as well as driver’s licenses, health insurance and other benefits, including Social Security benefits. Others have been known to use stolen personal information to secure jobs, rent apartments, and obtain utility services such as electricity and heat.

Example: In California, a man established a bank account into which he deposited $764,000 of counterfeit checks after stealing private bank account information about the policyholders of an insurance company.Example: In Florida, a person was indicted on bank fraud charges for stealing names, addresses, and Social Security numbers from a website and then using the stolen information to secure a number of phony car loans over the Internet.Example: A defendant pleaded guilty to fraudulently obtaining a driver’s license in another woman’s name and then withdrew more than $13,000 from the woman’s bank account. She also fraudulently obtained five credit cards in the woman’s name and charged roughly $4,000 on the cards.Example: The FBI reports that a common scheme involves fraudsters locating a vacant home or rental property that is unoccupied and stealing the personal information of the owner. Then, after preparing fraudulent documents that transfer the deed and filing the property transfer, the fraudsters “sell” the property.Example: In Ohio, several thieves stole the personal information of people who had recently died and then filed false and fraudulent tax returns in the names of the deceased persons; the total haul from the scam was nearly $2 million!

How Identity Fraud Can Be PreventedMost thieves who steal personal information do so because it is easy for them to take advantage of an opportunity. Consumers should not have to be on guard constantly and act like the “bad guys” are out to get them but the simple fact is that not being cautious might very well be all it takes to make a consumer victim.

The following list includes prevention tips suggested by the FBI, the Federal Trade Commission, the Department of Justice, banks and lending institutions, and a number of other entities that are invested in preventing identity theft:

• Never carry a Social Security card in a wallet or purse; keep it in a safe, secure place.• If a state uses Social Security numbers as the default driver’s license number, ask for an alternate

number.• Never write a PIN on a debit or credit card or other access device. Do not jot down a PIN leave it

in a wallet, either!



• Do not carry all credit and debit cards in a wallet or purse when going out. If the wallet or purse is lost or stolen, anyone who takes possession of it will have immediate access to all a person’s accounts.

• When receiving bank and credit card statements, be sure to review all the charges to verify they are legitimate. When disposing of these statements, be sure to shred them first.

• When receiving pre-approved credit card offers that are unwanted or that will not be taken advantage of, cut up any cards and shred the documents that accompany them.

• Individuals and businesses should review their credit reports at least once a year. Better yet, they should review a copy of the report from each of the three credit reporting bureaus at least once a year.

• If anyone seems to be receiving less mail than usual, or if a vendor or credit card company insists it has been mailing statements that were never received, verification with the Post Office (and the vendor) will reveal if someone has fraudulently changed a mail address.

Data BreachesA data breach is generally defined as in incident during which it is possible protected information was viewed, stolen, or used by an unauthorized person. The key to a data breach is potential access, not actual access.

For example, if an insurance agent has a client’s completed life insurance application spread across his desk, a data breach occurs if anyone other than the life insurance applicant walks into the agent’s office and has the potential to view information contained on the application. The life insurance application contains protected information: protected health information (PHI) and personally identifiable information (PII).

Many people mistakenly assume that if information is available to the public it is not protected. The Department of Homeland Security explains that although information contained on a business card or in a public listing of employees is personally identifiable information, it is not sensitive personally identifiable information and, therefore, is not protected. However, certain pieces of information (which are discussed in a few paragraphs) are always sensitive, and always protected, regardless of whether they appear in a public environment.

According to HIPAA, health information means:

Any information, including genetic information, whether oral or recorded in any form or medium, that: (1) Is created or received by a health care provider, health plan, public health authority, employer, life insurer, school or university, or health care clearinghouse; and (2) Relates to the past, present, or future physical or mental health or condition of an individual; the provision of health care to an individual; or the past, present, or future payment for the provision of health care to an individual.

HIPAA further defines protected health information (PHI) as:

Individually identifiable health information: (1) Except as provided in paragraph (2) of this definition, that is (i) Transmitted by electronic media; (ii) Maintained in electronic media; or (iii) Transmitted or maintained in any other form or medium. (2) Protected health information excludes individually identifiable health information: (i) In education records covered by the Family Educational Rights and Privacy Act, as amended, 20 U.S.C. 1232g; (ii) In records described at 20 U.S.C. 1232g(a)(4)(B)(iv); (iii) In employment records held by a covered entity in its role as employer; and (iv) Regarding a person who has been deceased for more than 50 years.

The Department of Homeland Security defines personally identifiable information (PII) as:

Any information that permits the identity of an individual to be directly or indirectly inferred, including any information which is linked or linkable to that individual regardless of whether the individual is a U.S. citizen, lawful permanent resident, visitor to the U.S., or employee or contractor to the Department.

DHS further defines sensitive personally identifiable information (sensitive PII) as:

Personally identifiable information, which if lost, compromised, or disclosed without authorization, could result in substantial harm, embarrassment, inconvenience, or unfairness to an individual.



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Sensitive PII is not always as easy to identify as protected health information is. According to DHS, the following information is always considered sensitive PII, regardless of where or how it is maintained:

• Complete Social Security numbers (all 9 digits)• Biometric identifiers such as fingerprints, iris scans, and voice prints)• When grouped with a person’s name, address, or phone number:

◦ Citizenship or immigration status ◦ Medical information ◦ Driver’s license number ◦ Passport number ◦ Full date of birth ◦ Authentication information (i.e., mother’s maiden name or passwords) ◦ A portion of a Social Security number (i.e., last four digits) ◦ Financial information (i.e., account numbers)

Although several federal laws exist to regulate various types of private and sensitive information, none of those laws is standard nor do any of them apply to all types of information or the privacy of all Americans. In fact, some federal laws only apply to specific business industries.

Because of the lack of an all-encompassing federal law, 46 states, the District of Columbia, Guam, Puerto Rico, and the Virgin Islands have enacted legislation that requires businesses and government agencies to notify the victims of data breaches. The 4 states that did not have security breach laws as of January 2014 were Alabama, Kentucky, New Mexico, and South Dakota. In some cases, state law requires those possessing PII or PHI to maintain specific types of security programs for the safeguarding of the information they possess. (For links to each state’s security breach notification laws, visit the NCSL’s website.)

A number of federal laws govern the security and protection of certain types of information, including notification requirements for data breaches, including:

• The Privacy Act regulates the collection, use, and distribution of information contained in the “record” of an “individual” maintained in a federal agency’s “system of records” and doesn’t apply to information collected and maintained by private enterprises

• The Federal Information Security Management Act (FISMA) regulates the protection of information and information systems operated and maintained by the federal government

• The Veterans Affairs Information Security Act regulates the Veterans Affairs’ “sensitive personal information” (SPI), information systems, and security procedures

• The Health Insurance Portability and Accountability Act (HIPAA) regulates protected health information and its collection, possession, security, and transmission

• The Health Information Technology for Economic and Clinical Health Act (HITECH) is an amendment to HIPAA and regulates protected health information and protected health records (PHR)

• The Gramm-Leach-Bliley Act (GLBA) regulates how financial institutions must notify customers of their privacy policies and how they must protect and safeguard their customers’ “nonpublic personal information” and contains the Financial Privacy Rule and Safeguards Rule and outlaws pretexting (also called social engineering)

• The Federal Trade Commission Act is an independent agency of the federal government that enforces the GLBA’s Safeguards Rule and numerous other consumer protections, including anticompetitive, deceptive, and unfair business practices

• The Fair Credit Reporting Act (FCRA) regulates credit bureaus and businesses and individuals that use or supply information to credit bureaus



It should be noted that the four major credit card companies also developed an industry regulation, the Payment Card Industry Data Security Standard (PCI DSS), for those who use credit card and bank account information.

The federal government considers a data breach to occur when personally identifiable information (PII) is:• Lost• Stolen• Accessed by unauthorized individuals

According to the U.S. Department of Homeland Security, many crimes are now being committed online, or being facilitated through use of the Internet. It cites identity theft and credit card fraud among those crimes, along with human trafficking, embezzlement, and others. DHS reports, “Cyber crime has surpassed illegal drug trafficking as a criminal moneymaker.” Most victims of cyber criminals are not targeted for any specific reason ... other than the vulnerability of their computer security systems. Smaller businesses are increasingly vulnerable to hackers and cyber crime because they either cannot afford security systems or do not believe they need them. The two business industries in which most opportunistic data breaches occur are hospitality and retail.

On the other hand, intruders routinely hack into systems that were previously considered to be inviolate, such as those of Google, AT&T, and Sony. Types of businesses that are most often targeted include those within the financial services industry.

According to a study conducted by the U.S. Secret Service in cooperation with Verizon and the Dutch High Tech Crime Unit, half of all data breaches are the result of some form of hacking. Nearly half of all data breaches also utilized some type of malware. Other facts about data breaches that were revealed by the study include:

• More than 80% of victims weren’t targeted; they were the victims of opportunistic fraud• More than 90% of data breaches were committed deliberately and maliciously• More than 90% were committed without difficulty• Nearly 90% were discovered by third parties; of those, approximately half were members of law

enforcement• 96% could have been avoided if simple or intermediate controls had been used• 89% of victims weren’t in compliance with security requirements• In one recent year, the Secret Service arrested more than 1,200 individuals for committing

cybercrime; those investigations involved more than $500 million of actual loss by fraud and prevented $7 billion in fraud loss

• More than 2/3 of data breaches caused by hackers were committed by individuals who used remote access and desktop services to gain entry to a computer system

• The use of face-to-face contact and pretexting has been an increasing method of obtaining information necessary to commit data breaches

• ATM and gas pump skimming are on the rise and are generally committed by organized criminal groups that target specific businesses and locations

• In approximately one-third of data breaches, the crime was committed within a few minutes• In more than one-half of data breaches, the crime was committed during a period that required at

least several daysAlthough each state’s laws govern requirements about data breach notification, certain common sense responses are called for. If the potential exists for individuals or businesses to be harmed, law enforcement should be notified. If the local authorities are not equipped to respond, or are unfamiliar with responding, to data breaches, the FBI and the U.S. Secret Service should be informed. If a data breach involves the U.S. Mail, the Postal Service should be informed. Credit bureaus, credit card companies, and



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banks should also be notified if a data breach affects Social Security numbers or account numbers. It is understood that the individuals or businesses whose information was compromised should also be notified so they can take measures to protect themselves.

Although many businesses fear the consequences of admitting to a data breach, the reputational and financial harm of not pursuing notification is often far more destructive that prompt notification would have been.

Identity Fraud InsuranceAccording to the Insurance Information Institute, many homeowners insurance carriers offer coverage for identity theft within their policies, via an endorsement that can be attached to a policy, or as a standalone policy. Business policies may also allow the addition of coverage for identity fraud or identity theft via endorsement. ISO offers both personal and commercial lines endorsements:

• Homeowners endorsement HO 04 55 (0511), Identity Fraud Expenses Coverage• Crime endorsement CR 04 15 (0803) and (1010), Identity Fraud Expense

Of course, not all insurers offer these endorsements, just as not all commercial lines insurers will offer standalone identity fraud coverage. When offering coverage, many insurers choose to design their own forms of coverage rather than using ISO forms. The Insurance Information Institute reports on its website that the following carriers provide identity theft coverage in some form: Allstate, Chartis, Chubb, Encompass, Erie, Farmers Group, Fireman’s Fund, Liberty Mutual, Nationwide, State Farm, Travelers, and West Bend Mutual. Most businesses are able to obtain coverage for identity fraud on either crime or cyber and privacy policies.

ISO Identity Fraud EndorsementsBecause identity theft coverage is non-standard, this portion of the chapter refers to the language contained in the ISO forms; verbiage appearing inside text boxes has been excerpted from those forms.

The definition of identity theft is identical in the ISO homeowners and crime endorsements with the exception of its reference to the named insured (i.e., the crime endorsement refers to the insured business and the personal policy refers to individual insureds):

“Identity fraud” means the act of knowingly transferring or using, without lawful authority, a means of identification of __________________________ with the intent to commit, or to aid or abet another to commit, any unlawful activity that constitutes a violation of federal law or a felony under any applicable state or local law.

The definition of expenses is slightly different in the forms—again because of the type insured receiving coverage. The following expenses appear in both forms:

• Costs for notarizing affidavits and similar documents that attest to fraud that are required by financial institutions, credit agencies, and creditors

• Costs of certified mail to law enforcement agencies, credit agencies, financial institutions, etc.• Lost income incurred by the insured that results from having to take time off from work to

complete fraud affidavits or meet with law enforcement officials, credit agencies, and legal counsel; the personal lines endorsement limits this coverage to $200 per day for a total of $5,000 and the crime endorsement limits coverage to $250 per day for a total of $10,000

• Loan application fees for reapplying for one or more loans if they are rejected solely because the lender received incorrect credit information

• Reasonable attorneys fees incurred because of identity fraud: ◦ To defend lawsuits brought against an insured by merchants, financial institutions, and

collection agencies ◦ To remove any criminal or civil judgments wrongly entered ◦ To challenge the accuracy or completeness of any information contained in a credit report



• Charges incurred for long distance telephone calls to merchants, law enforcement officials, financial institutions, credit agencies and grantors to report or discuss actual identity fraud

The crime form includes expenses for advertising and public relations costs incurred by the named insured to restore the business reputation damaged as a result of an identity fraud. It does not list a specified limit of insurance as the homeowners form does because the Declarations will contain the limit of coverage that applies.

The crime endorsement also contains a schedule that allows the names of individuals to be excluded from coverage and also excludes expenses due to any theft or dishonest acts committed by the named insured, any insured person, or any person named in the schedule.

Duties after a loss are those contained in the policy, plus the insured’s duty to send the insurer, within 60 days after its request, any receipts, bills, or other records that support the insured’s claim for expenses under the endorsement. If a deductible applies to coverage under the crime endorsement, it will appear on the declarations.


1. What provision in an E&O policy describes the form of claims-made coverage that applies?a. Policy Notice/Disclosureb. Retroactive Datec. Policy Periodd. Limit of Liability

2. Under an E&O policy, when may the insured admit liability or attempt to settle a claim?a. Neverb. With the prior written consent of the insurerc. With the prior verbal consent of the insurerd. Any time

3. All of the following are typical exclusions in an E&O policy, EXCEPT:a. Bodily injury or property damageb. Personal injuryc. Employment-related practicesd. Wrongful acts

4. What type of professional liability insurance provides coverage for corporations and their executives against allegations the corporation’s business affairs were mismanaged?a. Errors and Omissions Liability b. Directors and Officers Liabilityc. Employment Practices Liabilityd. Cyber Liability

5. What subject does a D&O policy’s Hammer Clause address?a. Tools and equipmentb. Exclusionsc. Consent for claim settlementd. Continuity

6. Which of the following coverages is NOT found on a D&O policy?a. Direct coverage for wrongful acts, including defenseb. Reimbursement coverage for the indemnification of directors and officersc. Coverage for securities claims against the organizationd. Indirect coverage for consequential bodily injury

7. What type of professional liability policy does not require the insurer to defend the insured but, instead, pays for defense expenses?a. Errors and Omissions Liability b. Directors and Officers Liabilityc. Employment Practices Liabilityd. Cyber Liability

8. What type of professional liability coverage pays for claims submitted because an employer violated an employee’s rights?a. Errors and Omissions Liability b. Directors and Officers Liabilityc. Employment Practices Liabilityd. Cyber Liability

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9. What is disparate treatment of an individual, or the refusal to hire the individual, because he or she is or claims to be a member of a legally protected class?a. Discriminationb. Harassmentc. Interrelated wrongful actd. Retaliation

10. All of the following are examples of intellectual property, EXCEPT:a. Patentsb. Trademarksc. Copyrightsd. Buildings

Chapter Review Answer Key

Chapter 11. C. The three types of risks that are generally ineligible for coverage in the standard marketplace are

distressed risks, high-capacity risks, and unique risks.2. B. A nonadmitted insurer has not submitted its applications, policy forms, endorsements, and pricing to

the jurisdiction for approval by the department of insurance3. D. Managing general agents may bind surplus lines insurance on behalf of the insurers they represent.4. B. Specialty lines of insurance are those providing insurance coverage on risks that are unusual and

difficult to insure because of their uniqueness and/or because they pose extraordinary risk to the insurer.

5. D. A surplus lines broker is only required to be licensed in the home state of the insured.6. A. The insured’s home state is the only state that may require the payment of surplus lines insurance

premium tax.

Chapter 21. D. The two parties to a reinsurance contract are the reinsurer and the ceding company.2. C. Reinsurance transfers the risk of loss between two insurance companies.3. A. Excess of loss reinsurance is a form of reinsurance that only indemnifies the ceding company for

losses in excess of a specific retention.4. B. A retrocessionaire is a reinsurer that accepts the transference of some, or all, of a reinsurer’s risk via a

reinsurance agreement or agreements.5. C. A ceding company’s underwriting capacity is increased by purchasing reinsurance.6. A. Reinsurance has no effect on the nature of risks insured by the ceding company.

Chapter 31. A. Insurers have difficulty insuring terrorism risks because they do not have enough data and statistics to

accurately calculate loss costs based on frequency and severity.2. C. The September 11, 2011 terrorist attacks on the U.S. created much disturbance in the U.S. economy

and within the insurance marketplace, and caused Congress to enact federal regulations to ease the disturbance.

3. D. TRIA was extended for a second time under the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) and is scheduled to expire on December 31, 2014.

4. D. An act of terrorism must be certified as terrorism by the Secretary of the Treasury, the Secretary of State, and the Attorney General of the United States,

5. B Terrorism insurance does not cover acts of terrorism that do not take place in the U.S., on certain U.S. vessels, or on the premises of a U.S. mission.

6. D Only commercial property and casualty insurance is covered under TRIA regulations.

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CHAPTER REVIEW ANSWER KEY

Chapter 41. B. Surety bonds guarantee the fulfillment of one party’s contractual obligations and/or its contractual

obligation to perform.2. A. Crime insurance, also called fidelity insurance, protects organizations from the loss of assets and

property due to business-related dishonesty and crime.3. D. Theft is the act of stealing—or the felonious taking of personal property with the intent to deprive the

rightful owner of it.4. C. Performance bonds guarantee that contractors will perform as agreed in the contracts they enter into. 5. D. Commercial crime policies include coverage for employee theft, outside the premises, computer

fraud, and counterfeit money—among other coverages.6. C. Extortion coverage may be added to the commercial crime policy by endorsement to cover bodily

harm to certain persons who were kidnapped or allegedly kidnapped.

Chapter 51. C. Business interruption insurance—specifically Business Income—also generates a significant amount

of litigation because of misunderstandings both at the time coverage is purchased and during the claims process.

2. A. Time element coverage provides insurance for loss resulting from the inability to put damaged property to its normal use.

3. D. The coverage trigger for business interruption insurance contains three elements: (1) A covered peril must cause loss to the insured’s property; (2) The property loss must suspend the insured’s business operations; and (3) the suspension of operations must only last as long as it takes to repair or replace the damaged property.

4. C. Business income is the net income (net profit or loss before income taxes) the insured would have earned or incurred if a covered loss not occurred.

5. B. The period of restoration ends on the earlier of two dates: the date the property at the described premises should be repaired, replaced, or rebuilt with reasonable speed and similar quality OR the date when business is resumed at a new permanent location.

6. C. Contingent business income provides insurance for the insured’s loss of business income, and extra expense, if the supplier or customer upon whom the insured depends suffers a property loss that causes the insured to have a business interruption.

Chapter 61. D. The five types of “covered equipment” are electrical systems, air conditioning and refrigeration

systems, boilers and pressure equipment, computer and communication systems, and mechanical equipment.

2. B. Three major perils excluded by standard policies are specifically insured by equipment breakdown policies and include explosion of steam boilers, mechanical breakdown, and artificially generated electrical current, including electrical arcing.

3. C. Artificially generated electrical current is a covered “breakdown.”4. D. Expediting Expenses pays for extra expenses the insured incurs to hurry up, accelerate, or expedite

permanent repairs and/or the replacement of damaged property.5. A The three business interruption coverages on the equipment breakdown coverage form are Business

Income and Extra Expense, Utility Interruption, and Contingent Business Income. 6. B Under the equipment breakdown coverage form, property will be valued at replacement cost unless it

is obsolete and useless to the insured.



Chapter 71. D. Professionals hold themselves out to the public as having greater knowledge or expertise in particular

fields of endeavor.2. C. Primarily, professional liability insurance does not provide coverage for bodily injury or property

damage; it provides coverage for financial or economic loss. 3. A. When an individual is deemed to have breached the expected standard of professional care, he or she

is considered negligent.4. B. The claims-made and reported form of coverage triggers coverage when a claim is made during the

policy period and it is also reported during the policy period.5. C The four trigger theories are injury-in-fact, exposure, manifestation, and continuous. 6. C Extended reporting periods (ERPs) are provisions contained in claims-made liability policies that

lengthen the time frame during which claims may be made and reported.

Chapter 81. A. Most professional liability policies contain a notice, or disclosure, explaining the particular nature of

the claims-made form upon which it is written.2. B. One provision most E&O policies contain is to prohibit the insured from admitting liability or

attempting to settle a claim without the prior written consent of the insurer. 3. D. Wrongful acts, as defined in the contract, are covered by an E&O policy.4. B. D&O liability insurance provides coverage for corporations and their executives against allegations

the corporation’s business affairs were mismanaged.5. C A D&O policy’s hammer clause pertains to the insured’s right to withhold consent for the insurer to

settle a claim. 6. D The three basic types of coverage on a D&O policy are Non-indemnified Losses, Indemnified

Liability, and Organizational Liability.7. B Most D&O policies are written on an indemnity basis and do not require the insurance company to

defend the insured; however, they do pay for “defense expenses,” which are defined in the policy.8. C The majority of covered EPL claims occur precisely because the employer knowingly violated the

employees’ rights or inadvertently broke the law.9. A Discrimination is an act or alleged act that violates any employment discrimination law.

Discrimination is also disparate treatment of an individual, or the refusal to hire the individual, because he or she is, or claims to be, a member of a legally protected class.

10. D Intellectual property is the by-product of a person’s idea or thoughts, such as an invention or song lyrics.

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