THE INSURABILITY OF PUNITIVE DAMAGES– A PRIMERFew things stoke greater fear in risk managers, outrage inC-Suite executives or wrath in Boards of Directors thanrunaway punitive damages jury verdicts. The fear is wellfounded, especially when you consider the difficulty ininsuring such exposures. To be sure, recent headlinesunderscore the very real potential for impairment of acompany’s balance sheet by an uninsured punitive damagesverdict. Below, we present some of the risk transfer productsavailable and touch on the advantages and/or disadvantagesof each in mitigating this exposure.

A. THE BERMUDA “OCCURRENCESREPORTED” FORM

Punitive damages have historically been included in the "Damages"definition of the Bermuda “Occurrences Reported” form and, thus,historically have been considered indemnifiable under the form.

Such “automatic" punitive damages coveragehas long been considered a true advantage ofpurchasing coverage under the BermudaForm. These programs have traditionallyattached at higher levels, but the sustainedsoftmarketplace has driven thoseattachments down. Indeed, severalcompanies across diverse industries havetaken advantage of these lower attachmentpoints to purchase the broad coverageavailable under the Bermuda “OccurrencesReported” form in both traditional andmulti-year programs.

B. THE “PUNI-WRAP” POLICY

Since the early 90s, Bermuda-based carriershave also offered policyholders a separatestand-alone policy to protect against awards

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for punitive damages where the domestic "wrapped" policy isotherwise prohibited from providing punitive damages coverage dueto public policy, statutory, or regulatory considerations. This policy,commonly referred to as the “puni-wrap” policy, is offered on anindemnification basis and is triggered by a judgment in a court oflaw. Paymentsmade under the domestic wrapped policy erode thelimits of the puni-wrap policy; therefore, the puni-wrap policy doesnot provide an insuredwith additional limits or coverage per se.Nevertheless, a puni-wrap policy provides “gap” coverage forpunitive damages verdicts in those 20+ states in which punitivedamages are otherwise deemed uninsurable.

While the insurance industry has long recognized this “gap”protection as the perceived value of the puni-wrap policy, perhaps itsgreater value lies in the alignment of interests puni-wrap coveragecreates between an insured and its insurer in the context oflitigation. Indeed, the determination of whether andwhen a caseshould be settled and the commensurate value of a case often turn onthemerits of the allegations related to the punitive damagesdemand. Alignment of interests between insurer and insuredregarding defense strategy, whether to settle or take a case to trialand case outcome is critical to secure the right result. An insurer,obligated to defend and/or reimburse an insured for defense costsregardless of venue, with exposure for both the compensatory andpunitive elements of a case, provides an insured relative certaintythat its interests and that of the insurer are aligned for purposes ofcase outcome. However, where an insurer has an obligation to aninsured to defend or reimburse the insured for defense costs but hasno obligation to reimburse the insured for the punitive damages partof a verdict (or settlement), differences as to case value inherentlyexist andmay force an insured to contribute the “punitive”component to a settlement or face the potential for a runawayverdict in an undesirable trial.

This puni-wrap alternative is offered by various excess insurancecarriers’ Bermuda facilities, such as ACE (ACEBermuda), Chubb(Chubb Atlantic), Chartis (Chartis Bermuda), XL (XL Bermuda), andothers.

While large numbers of payments have not beenmade to date underthe Bermuda puni-wrap policies, no evidence indicates that aBermuda-based insurer has been unable to indemnify an insured forpunitive damages due to some regulatory or legal prohibition.Nevertheless, given this lack of precedent and the recent heightenedregulatory scrutiny placed upon the insurance industry,policyholders and carriers alike have looked to alternative ways toinsure against the runaway punitive damages verdict.

C. THE MOST FAVORABLEVENUE ENDORSEMENT

TheMost Favorable Venue (MFV)Endorsement, touted by domestic carriers asan alternative to a puni-wrap policy, hasbecome a popular coverage enhancementintended to require the contracting parties toapply the law of the jurisdictionmostfavorable for purposes of determining theinsurability of punitive damages. Domesticcarriers have been largely successful insecuring regulatory approval of suchendorsements and offer them in a boldattempt to compete for business frominsureds otherwise forced to go “off-shore” tosecure affirmative punitive damages coverage.The question often raised about theseendorsements is: can two parties, otherwisesubject to the laws and regulations of the U.S.,contract to apply the law of a specificjurisdiction simply for purposes of avoidingthe prohibition against the insurability ofsuch damages by whichever court they findthemselves in? Only timewill tell. Whateverthe outcome, as with the puni-wrapalternative discussed above, perhaps the truevalue of theMFV endorsement lies in itsability to create an alignment of interestsbetween an insured and an insurer in thedefense of a case where such alignment wouldotherwise not exist absent an insurer’sexposure to punitive damages.

While different insurers take differentapproaches to this endorsement and offerdiffering language, generally speaking theendorsements include language such as “thedefinition of a claim includes punitive andexemplary damages, and the enforceability ofthis provision shall be governed by suchapplicable law thatmost favors coverage forsuch punitive or exemplary damages." Thecost for this endorsement can vary dependingon the risk, operating locations, and theinsurer’s view of the punitive exposurespecific to a particular insured.

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While the endorsement demonstrates a legitimate intent by insurers to provide relativecontract certainty as to coverage for punitive damages, the question remains: what ismeantby "the laws of any jurisdiction that ismost favorable to the insurability of such damages?"While regulators have approved it, the endorsement has yet tomeet heightened scrutiny bythe courts and therefore remains amystery as to whether it will actually work.

CONCLUSION

As brokers and consultants to our riskmanagement clients, we are taskedwith assessing riskand finding viable insurance solutions for them.While the likelihood of being hit with apunitive damages payment, which cannot be appealed away or reduced, is very small, the riskremains. Indeed, absent explicit punitive damages coverage, the policyholder has an inherentand identifiable gap in coverage.Moreover, there is undoubtedly value in securing alignmentof interests between insured and insurer in the defense and outcome of litigation. To thoseriskmanagers who ask: Is there value in purchasing a “puni-wrap” policy? we say simply thatin the unlikely, but possible, event your company gets hit with a punitive damages verdict nototherwise insurable, wewould not want to be in the shoes of the one advising the board that"well…we have a $20M verdict against us for whichwe're not insured." If I'm a boardmember, the first question that comes tomind is, "Could we have been? Is there insurancefor such a thing?" The answer is "yes" and the ramifications of such a situationwould likelybe uncomfortable for themessenger.

CONTACT

Formore information contact:

Rob Lane, J.D.Willis Global Solutions+1 630 362 8290robert.lane@willis.com

The observations, comments and suggestions we have made in this publication are advisory and are notintended nor should they be taken as legal or financial advice. Please contact your own legal or financialadviser for an analysis of your specific facts and circumstances.