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Monday, August 30, 2010

Guest Blogger Tom Baker: "Liability and Insurance: New Developments"

I’d like to use the opportunity to alert torts profs to the new American Law Institute Principles of Liability Insurance project and my forthcoming book with Sean Griffith, Ensuring Corporate Misconduct: How Liability Insurance Undermines Shareholder Litigation (U. Chicago Press 2010).  Both projects grow out of my long term participation in insurance as governance research.

 

    The ALI project is predicated on a jurisprudential and sociological claim.  In jurisprudential terms, liability insurance is an important meeting place between tort and contract, legal fields in which the ALI has a long tradition of involvement.  Within the area of insurance,  liability insurance is uniquely intertwined with the law: the law (mostly, though not only, tort law) defines the underlying liabilities that the insurance is designed to cover, and the existence and nature of liability insurance coverage has had and will continue to have a major impact on the development of those liabilities. 

 

As a sociological reality, the presence or absence of liability insurance can affect whether a particular liability action is brought in the first place, and against whom.  Judges and legislatures develop liability rules with an understanding, whether implicit or explicit, that insurance may be available to cover the resulting liabilities. In light of this close relationship between liability insurance and the real world of liability, particularly tort liability, the law of liability insurance was a natural choice for an ALI law-improvement project.

 

While the ALI project will surely evolve, our current plan is to have three chapters.  The first will address a variety of contract doctrines in the liability insurance context.  The second will address the definition of the range of liabilities covered by various forms of liability insurance.  The third will address the management of the liabilities, including such topics as the duty to defend, the duty to settle, and the duty to cooperate.

 

Ensuring Corporate Misconduct contributes to our understanding of the sociological claim underlying the ALI project.  Beginning with Ross’s magnificent Settled Out of Court, sociolegal researchers have explored the practical connection between liability and insurance almost exclusively in relation to personal injury and almost exclusively in relation to claims brought against individual defendants.  In this project, Sean and I went into the field to explore the relationship between liability and insurance in a very different context: shareholders’ claims against large corporations. 

 

Despite the name, D&O insurance is largely corporate asset protection insurance, not directors’ and officers’ protection insurance.  Corporate indemnification agreements provide the main protection for directors and officers.  D&O insurance indemnifies the corporation for its indemnification obligations to directors and officers and, in the case of securities claims, for the corporation’s own liabilities as well.  D&O insurance protects directors and officers only when the corporation cannot, most significantly in the case of insolvency or derivative actions for which corporate indemnification is prohibited by state corporate law.

 

The narrative of the book follows our efforts to evaluate the impact of Directors and Officers Insurance on the deterrence effect of shareholder litigation.  We explore D&O insurance pricing and underwriting process as part of the deterrence process.  We evaluate D&O insurers’ efforts to control the moral hazard of their insurance products.  We describe the insurers’ role in the litigation and settlement context.  And we explore whether D&O insurance coverage defenses and related coverage litigation preserves the deterrence function of shareholder litigation. 

 

The title gives away our bottom line.  We conclude that D&O insurance undermines the deterrence role of shareholder litigation.  D&O insurers manage the moral hazard of their insurance products by pricing to reflect the moral hazard, with the result that D&O insurance likely facilitates corporate misconduct.  All is not lost, however. Mandatory disclosure of the terms of D&O insurance contracts and of the amount of D&O insurance payments for the defense of settlement of each shareholder claim would allow D&O insurance to further, rather than undermine, the deterrence impact of shareholder litigation, magnifying the deterrence signals of D&O insurance underwriting and coverage decisions by transmitting those signals through the securities markets.

 

--Tom Baker

Deputy Dean and William Maul Measey Professor of Law and Health Sciences

University of Pennsylvania Law School

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