Special Reports

B. Affected Lines of Business

2Punitive damages have to be taken into consideration by insurers for many lines of business. However, the most likely lines of business to be affected are those where courts assume gross negligence on a frequent basis or where someone other than the insured commits the incriminating act, sometimes intentionally. Therefore punitive damages are of special interest to EPLI (Employment Practices Liability Insurance) insurers, since usually employees commit acts of discrimination and moral or sexual harassment intentionally, while it is the employer who is insured. Punitive damages are also of special interest to PI (Professional Indemnity), medical malpractice, D&O (Directors and Officers) and product liability insurers.

3For punitive damages in connection with product liability, the recently much discussed problem of pre-emption is highly relevant: If it is already doubtful that the manufacturer of a product that was approved by a federal authority can be held liable for any damage later caused by the design of that product, it is even more doubtful whether it can be a case of gross negligence justifying the award of punitive damages if such a product that has won the approval of a federal authority is brought to the market.4

II. The Insurability of Punitive Damages

A. Arguments in Favour of the Insurability of Punitive Damages

4There are mainly three arguments in favour of the insurability of punitive damages: The first is that the insured, who trusts that his liability risks are covered, should be protected, even if he is found guilty of gross negligence and punitive damages are awarded. This argument is especially valid in the context of product liability where the line between negligence and gross negligence can be quite unclear and the award of punitive damages, often far exceeding the compensatory damages, can come as a surprise to the insured. The second argument is that the freedom of contract should not be restricted and that if there is a demand for insurance coverage of punitive damages it should be possible to provide such coverage. The third argument in favour of the insurability of punitive damages is that it helps to prevent the defendant from bankruptcy, while making it more likely that the punitive damages are actually paid out. If you take into consideration, however, that the main purpose of punitive damages is not the compensation of damage (for which insurance coverage is certainly often a necessity) but deterrence,5 the risk of the defendant’s bankruptcy should punitive damages be awarded may not seem completely negative or counter-productive.

4One of the pending pre-emption cases dealing with these arguments is the Vioxx-case McDarby v Merck, Superior Court of New Jersey, A-0076-07T1 (29 May 2008).

5For more about the objectives of punitive damages see Sebok (fn. 1) no. 29 ff. A recent summary of the objectives of punitive damages by the U.S. Supreme Court is included in Philip Morris U.S.A. v Williams, 549 U.S. 346 (2007).

About half of all U.S.-states prohibit any insurance coverage of punitive dam- 7 ages, usually on the grounds of a conflict between such coverage and public policy.8 However, in some cases, state laws distinguish between insurance contracts that only provide coverage for the misconduct of the insured himself and insurance policies that also protect the insured from being held liable for the

6For more on these arguments and U.S.-jurisdictions concerned with these matters see the article by E.M. van Meir, Insurability of punitive damages: Who really gets punished, in findlaw: http:// library.findlaw.com/2001/Jun/18/130803.html.

7For an intense discussion on this aspect see: Ch. Lahnstein/I. Ebert (eds.), Tort law and liability insurance: An intricate relationship, Munich Re (2007); based on: G. Wagner (ed.), Tort Law and Liability Insurance (2005).

8An overview of the insurability of punitive damages is given by P.A. Banker in The Risk Management Letter, Vol. 23, Issue 5 (2003) or, more recently, under: www.mcandl.com/puni_frame. html.

consequences of other persons’ gross negligence or even intent. Such states therefore allow the coverage of punitive damages in the context of employer’s liability, liability of parents or guardians for minors and under D&O policies or other forms of vicarious liability.9 Other states prohibit the coverage of punitive damages for intentional acts of the insured but allow it in gross negligence cases.10

2.The Rest of the World

8Few legal systems outside the U.S. provide the option of awarding punitive damages. However, at least for some torts, e.g. defamation, the violation of intellectual property rights, discrimination or bad faith claims, some jurisdictions quite frequently award damages that contain certain punitive elements, without distinguishing them from the compensatory damages awarded. If no such distinction is made, the punitive elements of the damages are for obvious reasons included in the insurance coverage. Some non-U.S. jurisdictions also take a more liberal stand when it comes to insuring U.S. insureds against punitive damages awards. To avoid the restrictions on providing insurance coverage for punitive damages upheld by numerous U.S.-states,11 it is therefore not unusual to seek coverage for such risks elsewhere, especially in London or in Bermuda (“Bermuda-wordings”, “wrap-around policies”).

D. Options for Insurers

9The most comprehensive way for insurers to avoid problems connected with punitive damages would be through an exclusion clause. However, coverage that completely excludes punitive damages is hard to sell, especially in those lines of business where punitive damages are most likely to be awarded. Therefore, there are several options for covering punitive damages, either by separate provisions in a “side letter” or “silent” i.e., by simply not mentioning coverage or exclusion in the contract.12 This coverage is frequently limited – though not necessarily so – to the same amount as the coverage for compensatory damages. A third option, even though rather rare, is to explicitly cover punitive damages. Important examples of this can be seen in the wordings of Bermuda carriers or “wrap-around policies” that avoid the restrictions concerning insurance coverage for punitive damages which some U.S.-states impose.

10If insurers decide to cover punitive damages at least to some degree, they will usually make sure the contract includes limits or caps. The inclusion of punitive damages leads to higher premiums. Further, to avoid moral hazard, the insurer is likely to include deductibles in the contract.

9This distinction is made, e.g., in California, Florida, Illinois, Indiana, Kansas, Maine, New Jersey, Oklahoma and Pennsylvania.

10See arguments for this distinction e.g. in the Texas Supreme Court decision, Fairfield Insurance v Stephens Martin Paving, 04-0728 WL 400397 (Tex. S. Ct. Feb. 15, 2008).

11See supra no. 7 ff.

12See options in Standard ISO Commercial General Liability (CGL)-Policy.

U.S.-market for the coverage of punitive damages makes it, in many cases, unavoidable to grant coverage at least on a silent basis. Either way, since verdicts in civil trials in the U.S. are the exception and verdicts including punitive damages are even rarer, it is more the fear of punitive damages than punitive damages that are actually awarded that drive up the amounts of damages that have to be paid out by insurers. The more punitive damages are restricted by tort reforms and U.S.-Supreme Court decisions, the more foreseeable and therefore insurable they become. However, even then, the political question of whether punitive damages should be insurable remains.