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We formed and operate the first series LLC in Montana (named Aegis) for captive insurers. Several other firms provide key services such as accounting, audit and actuarial work. Please contact us at 832.330.4101 if you'd like to discuss forming a captive for your company.
I. Introductory Concepts
“Life is risk,” or so says King Benny in the movie Sleepers in response to Dustin Hoffman’s character’s attempt to avoid becoming involved in an underworld conspiracy. The point may be a cliché, but it’s true: risk cannot be avoided. Nonetheless, ever since the Renaissance when merchants created insurance to mitigate the damage of lost cargo on voyages to the Far East, business has relied on indemnification from insurance to prevent financial ruin should a risky event occur. Like most common-law concepts, it has taken many individual cases and much time for a settled view to develop of the necessary elements for a valid insurance policy. Put simply, these elements are the following: (i) a definable risk, (ii) a fortuitous event, (iii) an insurable interest, (iv) risk shifting and (v) risk distribution.[1] Each of these elements must be present for a policy to be valid. In addition, there is a very important legal difference between a reserve[2] and an insurance company.[3]
Furthermore, because the law of contracts applies to the formation and interpretation of insurance policies,[4] the basic elements of contract (i.e., offer, acceptance, and consideration)[5] must be present for a court to uphold an insurance agreement. The insured pays a premium to the insurer, who then offers to indemnify the insured in the event a specific risk occurs. Key to the contract is for the risk to be specifically enumerated and clearly defined. As an example, the standard property policy provides coverage in the event of 11 specifically named perils: fire, lightning, explosion, windstorm or hail, smoke, aircraft or vehicles, riot or civil commotion, vandalism, sprinkler leakage, sinkhole collapse, and volcanic action.[6] All other insurance policies contain similar language for their respective underlying coverage. The occurrence of the risk is a condition to the insurer’s performance, and therefore must be clearly evident from a plain reading of the policy or contract.[7]
But the occurrence of a specifically defined risk gives rise to the second required element of valid insurance policies -- fortuity.[8] Indemnification from insurance only occurs if the happening of the loss cannot be predicted. This is because non-fortuitous risks are foreseeable and either planning can mitigate damages or the foreseen risk can be avoided altogether, thereby eliminating the need for insurance. The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses offered by insurers to deny a claim – defenses which have a certain amount of conceptual overlap.[9] The first of these is the “known loss” defense in which an insurer argues either that the loss had already occurred or that the insured should have known the loss would occur at the time he purchased the policy.[10] The assumption in the latter case is that the insured could and should have taken appropriate steps to mitigate the foreseeable damage. The second defense is the “known risk” defense where the insurer will assert that some type of advance preparation was warranted because the possibility of loss was so high as to make the event essentially unavoidable. Finally, the insurer arguing the third fortuity related defense will aver the loss was ongoing when the insured purchased insurance.[11] The one common element to all of these defenses is the assumption that the insured knew or should have known that a loss had either occurred or was so likely to occur as to warrant some type of preventative action. [1] See 1-1 Appleman on Insurance Law & Practice Archive § 1.4 (which explains in detail three different tests to determine if insurance exists: the substantial control test, the ancillary test and the regulatory value test). See also 1 Couch on Ins. § 1:6 (which defines insurance as “a contract by which one party (the insurer), for a consideration that usually is paid in money, either in a lump sum or at different times during the continuance of the risk, promises to make a certain payment, usually of money, upon the destruction or injury of “something” in which the other party (the insured) has an interest” and also provides additional definitions) [2] John Downes et. al, Finance and Investment Handbook, Third Edition © 1990 Barron’s Education Services, pg.446 (a reserve is a “segregation of retained earnings to provide for such payouts as dividends, contingencies, improvements or retirement of preferred stock.) [3] Id at pg. 320 (“In a broad economic sense, insurance transfers risk from individuals to a larger group, which is better able to pay for losses”). See also 1 Couch on Ins. § 1:9 (“It is characteristic of insurance that a number of risks are accepted, some of which will involve losses, and that such losses are spread over all the risks in a way that enables the insurer to accept each risk at a slight fraction of the possible liability upon it.”). While a reserve is only used by one company, an insurance company pools risks from multiple sources. [4] 1 Couch on Ins. § 1:10 [5] See Prof. James E. Byrne, editor, Restatement 2nd of Contracts and UCC Article 2 © 2007, Chapter 3 (Mutual Assent) and Chapter 4 (Consideration) [6] Douglas G. Houser and Thomas W. Rynard, Insuring Real Property, Section 1.06(b) (Mathew Bender 2010). [7] Byrne at Section 224 (“A condition is an event, not certain to occur, which must occur, unless its nonoccurrence is excused, before performance under a contract becomes due”). [8] 1-1 Appleman on Insurance Law & Practice Archive § 1.3 ("Fortuity is another key element in determining what constitutes insurance for purposes of legal classification. It would be foolhardy for insurance companies to sell insurance that would pay for losses strictly within an insured’s control. Obviously, whenever an insured needed money, there would be the temptation to cause the insured event to happen to get the pecuniary insurance benefit. This is the point where the concept of fortuity comes into play. Insurance is designed to cover the unforeseen or at least unintentional damages arising from risks encountered in life and business: injuries and damages caused by negligence and other similar conduct where the insured stands to sustain a real and palpable loss (generally pecuniary) as a result of the event for which the insurance has been purchased."). [9] 7 Couch on Ins. § 102:10 (“The known risk, known loss, and loss in progress defenses are generally considered to be part of the “fortuity” requirement that runs throughout insurance law.”). [10] Id. [11] Id. Comments are closed.
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