Insurers need to know about third party liability coverage

Third party coverage is not new, but it does still command a strong demand from the insurance-buying market. This is especially true as pressure mounts on companies to minimize their costs of doing business and therefore attempt to have such costs – insurance costs, for example – borne by other parties to the business contracts.

The insurance underwriter must be able to distinguish the risks involved between the various third party coverage requests. Only then will the underwriter be able to appropriately assess and price these coverages.

From the broker’s perspective, it is vital to have an understanding of these coverages and their client’s exposures to the risks in order to meet client expectations and to minimize potential broker errors and omission liability.

BACKGROUND

Courts currently hold that commercial crime bonds do not cover an insured’s vicarious liability to third parties, even if liability is based on the insured’s employees’ dishonesty. There are three main reasons for this:

* First, crime bonds cover losses of property owned or held by the insured resulting directly from the dishonest or fraudulent acts of an employee. Liability insurance covers the legal liability of an insured to a third party.

* Second, an insured’s liability to others is an indirect loss outside the scope of coverage afforded under the fidelity bond. The fidelity bond insures against immediate harm from employee dishonesty and not for any obligations the insured might have to others as a result of that dishonesty.

* Third, an employee does not act with the manifest intent to cause the insured (his employer) a loss when he defrauds a third party. In short, the manifest intent requirement is not satisfied in a third party scenario. The only exception here would be a situation in which the employee committed the dishonest act with the intention of getting caught and therefore imposing liability on his employer.

Third party liability coverage also presents difficulty in adjusting claims. Under both first party and third party liability policies, the insured is obligated to meet the policy terms and conditions. Although third party liability coverage picks up the third party exposure, responsibility to meet the policy terms and conditions remains with the primary insured.

The typical commercial crime bond provides only first party coverage – the insured organization is covered for losses caused by its own employees’ dishonesty. Third party coverage extends this to include loss of a third party’s property due to dishonesty of the insured’s employee(s). While the demand for third party liability coverage is not new, it does remain strong with a limited number of carriers providing the coverage.

Third party liability coverage requests often arise out of the insured’s contractual obligations. Clients of service providers naturally want to protect themselves from all possible loss exposures and, in so doing, seek to have the service provider show evidence that it carries a fidelity bond. In their bid to transfer risk to another party, risk managers employed by service-providing companies frequently request this kind of coverage. Nevertheless, a contingent exposure remains with the client of the service provider.

THIRD PARTY LIABILITY AND ERISA

As a result of US regulation that governs pension and benefit plans, fund managers providing services to these plans may request third party liability coverage to satisfy the demand of their plan sponsor and plan administrator clients. This regulation is called ERISA (Employee Retirement Income Security Act of 1974). The full extent of ERISA is beyond the scope of this article, but a brief overview of ERISA’s breadth of coverage is warranted.

The Act (Federal Law) is intended to protect the assets of Americans, so that when they place funds in retirement plans during their working lives, the funds will be still be there when they retire. ERISA does not require any employer to establish a pension plan. It only requires that private employers who establish plans meet certain minimum standards.

ERISA’s requirements are vast and technical; one of the many specific requirements is the ERISA bond. This bond protects the Plan against acts of fraud or dishonesty by any officer, trustee, employee, administrator or manager of the insured benefit plan. ERISA mandates a limit of liability of at least 10% of the plan assets, with the upper limit being $500,000 unless required otherwise. The Department of Labor has the authority to prescribe a bond in excess of $500,000 – up to 10% of the value of all plan assets as of the beginning of the plan year. Complementing these federal requirements are state-specific insurance bonding requirements, which can mandate even higher limits.

The situation starts to get complicated when the federal plan covers employees in multiple states, and therefore the federal plan might be subject to multiple-state regulatory provisions. Each plan must have its own insurance and therefore this scenario present to the insurance underwriter a situation of limitless liability. Failure to comply with ERISA Bond requirements can result in severe consequences for the Plan Sponsors and Plan Administrators.

With pressure mounting on plan trustees to exercise due diligence, financial institutions managing US pension fund assets may request that their insurance include an ERISA Bond for their pension fund clients. The ERISA Bond itself is a first party coverage, but it becomes a third party coverage request when the trustees of plans request that the managing financial institution pick up the exposure. ERISA’s intent to mandate first-party coverage is reflected in how the Canadian market currently handles ERISA implications. Plan sponsors expect the financial institutions that administer the plans to provide proof of insurance.

CANADA’S MARKET SITUATION

The Canadian market for providing third party liability coverage extensions on fidelity bonds is limited and premiums can be relatively high. The reasons, notwithstanding those outlined earlier – from intent of coverage standpoint – are also risk-driven. Specifically, carriers are unable to adequately assess and price unknown risk associated with potential third party property at risk for dishonesty losses.

In Canada, carriers tend to address the ERISA issue through the provision of an ERISA Rider. Essentially, the rider includes any person – director or trustee – of the insured financial institution as an employee under the bond while that person is handling funds or other property of any Employee Welfare or Pension Benefit Plan that is owned, controlled or operated by the insured or any natural person who is a trustee, manager, officer or employee of the plan. The key here is that coverage applies only to the insured financial institution’s plan(s) and not the plans of any clients of the insured financial institution. In short, third party coverage is not provided.

There are exposures that may be more appropriately covered under errors and omissions and fiduciary liability policies. Some of these have been discussed in previous articles in this magazine. It is important for both the insurance underwriter and broker to distinguish between the various insurance products available to pension plans and to ascertain which situations call for which products.