The Changing Role of Liability Insurance:

Contract of Indemnity or Source of Compensation?

John Dwight Ingram

I.

Liability Insurance as a Contract of Indemnity

Business firms purchased the first liability insurance in the late 1800s to provide a source of indemnity for tort claims asserted by their injured employees.[1] Theretofore, liability insurance would have been deemed contrary to the public policy favoring deterrence of improper conduct, a basic tenet of tort law.[2] With the rapid growth of automobile use in the early 1900s, liability insurance for motorists also became widely available.[3] These and other forms of liability insurance have developed and expanded to meet the needs of an increasingly urbanized society and its accompanying commercial activities.[4]

The original purpose of liability insurance was clearly to protect a person or business from the economic peril of a liability judgment. By purchasing insurance, an insured could pay a specified premium in return for the assurance of indemnification in the event of an adverse judgment in favor of an injured third party.[5] With indemnification of the insured being the sole purpose of the insurance, an injured third party could not bring an action against the insurer even after obtaining a judgment against the insured. Nor could the insured bring an action against its liability insurer prior to sustaining an actual loss by paying the amount of the judgment.[6] Thus, if the insured was insolvent and judgment proof, there could be no claim under the policy.[7]

As highway traffic rapidly increased during the Twentieth Century, with the resultant increase of tort claims, legislatures in many states enacted financial responsibility laws to increase the likelihood that insurance funds would be available to victims of vehicular accidents. While these statutes were almost entirely limited to automobile insurance, the public policy rationale supporting them undoubtedly had a strong influence on the courts as they developed rules applicable to both vehicle and other forms of liability insurance.[8]

Many states also enacted statutes providing that the obligation of an insurer under a liability insurance policy “shall become absolute whenever the loss or damage for which the insured is responsible occurs, and the satisfaction by the insured of a final judgment for such loss or damage shall not be a condition precedent to the right or duty of the [insurer] to make payment on account of said loss or damage.”[9] In Saunders v. Austin W. Fishing Corp., the court held that this statute nullified a policy provision providing for indemnification of the insured for liabilities “he shall have become liable to pay and shall have in fact paid. . . .”[10]

Even in the absence of such a statute, many courts hold that the insurer’s duty is created by the insured’s legal liability. The rationale for this view was well stated in Wolfberg v. Prudence Mutual Casualty Co.,[11] where the insured was dead and the estate was apparently insolvent. The court said:

Were payment or showing of ability to pay the rule, encouragement would be given to an insurer with an insolvent insured to unreasonably refuse to settle. Such a course would impair the use of insurance for the poor man. Further, the fullness or the emptiness of an insured’s purse would be an irrelevant and poor measure of liability and performance of duty by the insurer under his contract.[12]

As statutes and cases have made clear that the insurer’s duty to indemnify is now created by the insured’s liability, the language of most liability insurance policies has been changed to reflect that situation. A typical provision states: “we [the insurer] will pay those sums that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damage’ to which this insurance applies.”[13]

II.

The Injured Victim Becomes a Third Party Beneficiary

Barrera v. State Farm Mutual Automobile Insurance Co.[14] is probably most often cited for the proposition that an insurer may not assert policy defenses[15] against an injured third party after an accident occurs. In Barrera, the insurer claimed there was no coverage because, a year-and-a-half before this accident, the insured had made a material misrepresentation in his application for automobile insurance. The injured third party contended that laches should apply and that State Farm was estopped to rescind because the insurer failed to discover the misrepresentation prior to the accident. However, the trial court granted rescission, based on its finding that the insurer had acted promptly upon discovering the misrepresentation after the accident.[16]

The California Supreme Court disagreed, holding “that an automobile liability insurer must undertake a reasonable investigation of the insured’s insurability within a reasonable period of time from the acceptance of the application and the issuance of a policy.”[17] The court expressly decided that this duty is for the benefit of injured third persons. Furthermore, such a person, after obtaining a judgment against the insured, may proceed against the insurer, which may not then defend successfully on grounds “of its own failure reasonably to investigate the application.”[18]

As to State Farm’s failure to investigate, the court reasoned that the insurer “pursued a policy of saving minor costs[19] on its part at the expense and sacrifice of the interests of its insured and those of the general public who were the potential victims of the insured’s negligence.”[20] To allow the insurer to rescind in such a situation would be to fail to recognize “the ‘quasi-public’ nature of the insurance business and the public policy underlying the financial responsibility law . . . .”[21]

Many other courts have adopted the same reasoning and imposed the same duty as the California court did in Barrera.[22] And in other states, the legislatures have achieved the same result by enacting appropriate statutes.[23] The practical effect of these decisions and statutes is to make the injured victim a third party beneficiary of the liability insurance policy.[24]

In states where the third party beneficiary issue has been raised, the courts have held that the injured person is a real party at interest, and can intervene in an action between insurer and insured, and appeal an adverse judgment. For example, in Allstate Insurance Co. v. Hayes,[25] the insurer filed a declaratory judgment action against the insured and the third party, alleging no coverage on several grounds. The insured defaulted and did not contest. There was a judgment of no coverage that the third party tried to contest. Both trial and appellate courts held that because the third party was not a third party beneficiary of the insurance contract, he could not continue to pursue an action after the insured’s default. However, the Michigan Supreme Court held that since the insurer made the third party a defendant in the declaratory action in order to obtain a binding decision as to coverage, the court had the power to declare the rights of any interested party before it. The court did not rule on the question of whether the injured person was a third party beneficiary, saying that was not determinative. The court also did not reach the issue of whether the injured party had a “vested” right from the time of the injury that would permit him to institute a declaratory action.

A Kentucky appellate court addressed the third party beneficiary issue, and held that the injured person is indeed a third party beneficiary of the liability insurance policy, and has standing to sue the insurer on the policy.[26] Similarly, an Illinois appellate court determined that injured persons “are beneficiaries of liability insurance policies . . . [and therefore have] rights under the policy which vest at the time of the occurrence giving rise to [the] injuries.”[27] “[T]he injured person must be given the opportunity to litigate the question of coverage . . .[,] is a necessary party [in the declaratory action,] . . . and . . . may appeal from a judgment that there is no coverage.”[28]

III.

Third Party as Affected by Defenses against the Insured

Under traditional insurance law principles, an insurer may rescind or deny liability on a liability insurance policy if the insured misrepresents facts in the insurance application,[29] fails to cooperate in the defense of a suit against the insured,[30] or fails to give the insurer timely notice of the occurrence. However, the effect of the statutes and case law discussed in the foregoing section of this article is that these defenses are no longer available as to the claim of the injured third party against the insurer.

A typical example of this is found in Ambassador Insurance Co. v. Montes.[31] The insured was convicted of arson that resulted in the death of a tenant. There was no applicable exclusion clause in the comprehensive general liability policy issued to the insured, but the insurer argued that public policy prohibits insurance indemnification for the civil consequences of the insured’s intentional wrongdoing.[32] But the court observed that in this case the wrongdoer would not be benefited. It would be an innocent third party who would receive “the protection afforded by the insurance.”[33] Thereafter, the insurer would have a right of indemnification against the insured. Thus, the insured would not be relieved of financial responsibility, and requiring the insurer to pay the third party furthers the public interest in compensating victims.[34]

While most courts now hold that public policy favors increasing the likelihood of compensation for innocent injured persons, at least one case has recognized and given effect to a competing public interest.[35] The insured made a material misrepresentation in his application for automobile insurance. The court applied South Carolina law that permits ab initio rescission of automobile insurance contracts when the applicant fraudulently induced the coverage.[36] The court noted that the purpose of this rule was to protect South Carolina residents from higher insurance rates, which would result if the insurer had to investigate all applications for misrepresentation at the time that the policy was issued.[37] However, as I have indicated previously in this article, most courts take the position that this small burden is outweighed by the strong public interest in protecting innocent victims.[38]

IV.

Statutory Limit or Full Limit of the Insured’s Policy

There is considerable disagreement among the courts as to whether the injured third party may recover up to the full limits of liability in the insured’s policy, or whether the third party is entitled to recover only up to the mandatory statutory limits of liability. In states that limit the third party’s recovery to the statutory minimum required by the state’s financial responsibility law, the courts conclude that a third party has a right to recover only because of the presence of the financial responsibility law. Since that right results from the statute, the amount of any recovery should be based on the statutory mandate and not on the insurance policy limits. Therefore, the maximum recovery will be the statutory minimum, even though the insured’s policy may provide higher coverage.[39]

There are some states, however, that have decided that since the insurance coverage becomes irrevocable as to the third party at the time of the occurrence, this must apply to the full amount of the insurance coverage, not just the mandatory minimum amount.[40]

V.

The Insurer's Right of Indemnification from the Insured

Rescission of an insurance policy is effective ab initio to the original date of issue; the effect is the same as if the policy had never taken effect. When only the insured and the insurer are involved, such as with a claim by the insured for his[41] own property damage or medical payments, there is no public policy reason to abrogate the insurer’s right to rescind -- “[t]o hold otherwise would permit an insured to benefit from his or her fraudulent misrepresentations and leave the insurer without a remedy.”[42]

The courts have found this rationale persuasive as to the insurer’s rights of indemnification from the insured after the insurer has paid the third party.[43] There is every reason to impose the ultimate burden on the insured if that is possible.[44]

VI.

Conclusion

Over the years, liability insurance has evolved from a pure contract of indemnity for the insured to a contract that public policy deems to be a source of compensation for injured victims. Indeed, the latter may well be the primary purpose of liability insurance in today’s world. Insurers are usually unable to use a traditional or contractual policy defense to defeat the claim of an innocent third party. However, when the goal of assuring compensation for an innocent victim has been realized, the goal of putting the ultimate burden on a wrongdoer-insured is generally given effect.

ENDNOTES

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* The valuable contributions of my very capable research assistants, Chris Sulkson, Sara Busche, and Erin Van Arkel, are gratefully acknowledged.

[1] Alan I. Widiss, Abrogating the Right and Duty of Liability Insurers to Defend their Insureds: The Case for Separating the Obligation to Indemnify from the Defense of Insureds, 51 Ohio St. L.J. 917, 917 n. 1 (1990).

[2] Gary T. Schwartz, The Ethics and the Economics of Tort Liability Insurance, 75 Cornell L. Rev. 313, 314 (1990).

[3] Widiss, supra note 1, at 917 n.1.

[4] Id.

[5] Theodore J. Tucci, Primary and Excess Insurers and Their Common Insured: The Triangular Relationship With No Love Lost, 32 Case W. Res. L. Rev. 265, 265 (1981).

[6] A distinction was made between indemnification for “liability for damages” and for “loss from liability for damages.” As to the latter phrase, there would be no duty of indemnification for the insurer until the tort claim had resulted in a judgment, which had been paid by the insured. James M. Fischer, Broadening the Insurer’s Duty to Defend: How Gray v. Zurich Insurance Co. Transformed Liability Insurance Into Litigation Insurance, 25 U.C. Davis L. Rev. 141, 146 and n. 12 (1991). See also, Finley v. United States Cas. Co., 83 S.W. 2, 3 (Tenn. 1904).

[7] See, e.g., Cushman v. Carbondale Fuel Co., 98 N.W. 509 (Iowa 1904)(Contract provided that insurer would reimburse insured for "loss actually sustained and paid in satisfaction of a judgment after trial of the issue.” Since the judgment against the insured had not been paid because the insured was insolvent, the action by the injured third party against the insurer failed. See also, Connolly v. Bolster, 72 N.E. 981 (Mass. 1905).

[8] Fischer, supra note 6, at 148.

[9] Saunders v. Austin W. Fishing Corp., 224 N.E.2d 215, 217 (Mass. 1967).

[10] Id.

[11] 240 N.E. 2d 176 (Ill. App. Ct. 1968).

[12] Id. at 180.

[13] Insurance Services Office, Commercial General Liability Policy (cited in Widiss, supra note 1, at 917 n. 3.

[14] 456 P.2d 674 (Cal. 1969).

[15] E.g., misrepresentation in the application; failure to give timely notice of the occurrence; lack of cooperation in the defense against the claim.

[16] Barrera 456 P.2d at 677.

[17] Id.

[18] Id.

[19] E.g., obtaining a report on the applicant from the state Department of Motor Vehicles. In determining whether the insurer was reasonable in its investigation or the lack thereof, the cost and administrative burden of an investigation should “be weighed against the importance of the protection of innocent members of the public . . .” Barrera, 456 P.2d at 690.

[20] Id. at 680.

[21] Id. at 680-81. The goal of Financial Responsibility Laws is “to make owners of motor vehicles responsible to those injured by them in the operation of such vehicles.” Id. at 682-83 (citation omitted).

[22] See, e.g., Reagor v. Travelers Ins. Co., 415 N.E.2d 512 (Ill. App. Ct. 1980); American Underwriters Group, Inc. v. Williamson, 496 N.E.2d 807 (Ind. Ct. App. 1986); National Ins. Ass'n v. Peach, 926 S.W.2d 859 (Ky. Ct. App. 1996); Bossert v. Douglas, 557 P.2d 1164 (Okla. Crim. 1976); Ferguson v. Employers Mut. Cas. Co., 174 S.E.2d 768 (S.C. 1970).

[23] Arizona was one of the early states: Ariz. Rev. Stat. § 28-1170(F) (1969) made the insurer’s liability to the third party absolute at the time of the accident. In Allstate Ins. Co. v. Dorr, 411 F.2d 198 (9th Cir. 1969), the insurer contended that the statute was unconstitutional, because it was “arbitrary and unreasonable” for one to be bound to a contract even though “induced by fraud to enter into [the] contract, which he would not have entered into if not fraudulently misled …” Id. at 199. The court rejected this argument, applying the same rationale as that of the California court in Barrera. The court pointed out that insurers “can alleviate their situation by exercising more care in selling their policies, by exerting more diligence in earlier discovery of their mistakes, and, of course, by increasing their insurance rates to spread the cost over the larger numbers of the motoring public.” Id. at 201.

In the Financial Responsibility Acts in many states, there is a provision that an insurer’s liability will become absolute as to injured third parties whenever loss or damage covered by the policy occurs. See, e.g., Del. Code Ann., Title 21, § 2902 (2000); Haw. Rev. Stat. § 287-29 (West 2000); 625 Ill. Comp. Stat. 5/7-301 (West 2000); Iowa Code Ann. § 321A.21 (West 2000); Kan. Stat. Ann. § 40-3118 (2000); Neb. Rev. Stat. § 60-538 (2000); N.J. Stat. Ann. § 39:6-48 (West 2000); N.C. Gen. Stat. § 20-279.21(f) (2000); S. D. Codified Laws § 32-35-74 (West 2000).

[24] One of the clearest examples of the intent to protect innocent victims, rather than the insured, can be found in Florida Int'l. Indem. Co. v. Metter, 952 F.2d 1297 (11th Cir. 1992). “A provision of the Georgia constitution … waived the sovereign immunity of the state and its departments and agencies … to the extent of the coverage of any liability insurance.” Id. at 1302. Clearly this provision was only for the benefit of injured parties. The governmental body needed no protection, since it could maintain its full sovereign immunity by not providing any liability insurance.

[25] 499 N.W.2d 743 (Mich. 1993).

[26] Willis v. Hamilton Mut. Ins. Co., 614 S.W.2d 251 (Ky. Ct. App. 1981). However, the court held that the third party had no greater right than the insured and, since the policy excluded intentionally caused injury, there was no coverage, and thus there could be no recovery by the third party. Id. at 252.

[27] Reagor v. Travelers Ins. Co., 415 N.E.2d 512, 514 (Ill. App. Ct. 1980).

[28] Id.

[29] E.g., previous accidents or traffic violations, age and number of additional drivers of the vehicle, medical history of drivers, where and under what conditions the vehicle will be primarily used.

[30] An exception will usually be made to bar the third party’s recovery where the insured’s non-cooperation is combined with collusion between the third party and the insured. See, e.g., Utah Code § 31A-22-303(6)(a) (2000).

[31] 388 A.2d 603 (N.J. 1978).

[32] Id. at 606.

[33] Id.

[34] Id.

[35] American Centennial Ins. Co. v. Sinkler, 903 F. Supp. 408 (E.D.N.Y. 1995).

[36] Id. at 411.

[37] Id. at 414.

[38] See Part II supra.

[39] See, e.g., Progressive N. Ins. Co. v. Corder, 15 S.W.3d 381 (Ky. 2000); Odum v. Nationwide Mut. Ins. Co., 401 S.E.2d 87 (N.C. App. 1991); Tibbs v. Johnson, 632 P.2d 904 (Wash. 1981).

[40] Sandoval v. Chenoweth, 428 P.2d 98 (Ariz. 1967); Van Horn v. Atlantic Mut. Ins. Co., 641 A.2d 195 (Md. 1994); Allstate Ins. Co. v. Sullam, 349 N.Y.S.2d 550 (Sup. Ct. 1973).

[41] When the gender for a personal pronoun could be either male or female, I use the masculine pronoun generically, due to habit and my masculine personal orientation. By doing so I avoid the rather awkward “he or she” and the grammatically incorrect “they”. I trust that female authors will balance the scales on the other side.

[42] Ferrell v. Columbia Mut. Cas. Ins. Co., 816 S.W.2d 593, 596 (Ark. 1991).

[43] Continental W. Ins. Co. v. Clay, 811 P.2d 1202 (Kan. 1991); Progressive N. Ins. Co. v. Corder, 15 S.W.3d 381 (Ky. 2000); Ambassador Ins. Co. v. Montes, 388 A.2d 603 (N.J. 1978); Erie Ins. Exch. v. Lake, 671 A.2d 681 (Pa. 1996).

[44] It is quite common today for automobile insurance polices to expressly provide for this indemnification.

(Author's bio)

John Dwight Ingram is a Professor of Law at John Marshall Law School in Chicago. He holds an A.B. from Harvard University (1950) a C.L.U. from American College of Life Underwriters (1957) and received his J.D. from John Marshall in 1966. Professor Ingram has sometimes served as a consultant, expert witness, and arbitrator in cases involving questions of insurance law.