The practical art: on the archaeology and architecture of liability insurance contracts.

• Author: Johnson, Gary L.

The exclusion of office and related expenses from the exclusion of legal expenses is pure surplusage in a contract that excepts, rather than covers, legal expenses. It is true that to see this, one must know something about how insurance contracts are made. But this is just to say that interpretation, like other legal methodologies, is at bottom a practical art. (1)

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ONE OF THE MOST ubiquitous contract forms in use in modern commercial life is the insurance policy. In a world perceived to be filled with risk, we are obsessed with its management through insurance. (2) In the twentieth century, the insurance industry experienced unprecedented growth. In 1900, the property/casualty sector of the insurance market received an estimated $210,000,000 in premium. (3) By 1998 (excluding state-operated funds) the premium dollar had grown to $281,600,000,000. (4) In the same time period, the life insurance market saw its premium grow over a thousand-fold, from $338,000,000 to $460,000,000,000. (5)

Because of the explosive growth in the use of insurance contracts, it should come as no surprise that there has been a concomitant increase in the number of cases involving the disputed interpretation of insurance contracts. (6) The ability of litigants and courts to efficiently and consistently resolve these insurance contract disputes turns, in part, on how well we have mastered the "practical art of interpretation." This article proposes to aid in that process by taking to heart the admonition from Judge Posner quoted above that in order to interpret insurance contracts, initially we must know a little something about their origin and structure.

This article will focus primarily on the archeology and architecture of the public liability insurance policy. First, this article will briefly review the historical development of insurance, focusing on the development of the Commercial General Liability coverage form. Next, this article will discuss different ways to categorize insurance contracts. This article will then identify the basic components of the modern liability insurance contract. This article concludes by reviewing the topography of the insurance marketplace.

1. Something About How Insurance Contracts are Made

   One definition of contemporary insurance is a contractual arrangement "under which one party agrees to indemnify another against loss or damage arising from an unknown event. Under this arrangement, insurance is purchased in order to transfer the risk to a professional risk bearer by means of the underwriting process." (7) According to the United States Supreme Court, both "historically and commonly," insurance involves risk shifting and risk distributing. (8) Risk shifting in the insurance context involves the transfer from the insured to the insurer of one or more uncertain risks, and risk distributing means that the party assuming the risk distributes it among others. (9)

   An additional defining characteristic for insurance is the requirement that an insured have an "insurable interest" in the contingency insured against in order to uphold the insurance contract. (10) For one to have an insurable interest, one must have a lawful and substantial economic interest in the non-occurrence of the event insured against. (11) One can have an insurable interest in property or in a person. (12)

   1. A Brief History of Insurance

      Since the beginning of recorded commercial life, providers of goods and services have attempted to manage the risks inherent in their businesses. At least four thousand years ago in the Code of Hammurabi, one can find evidence of the practice of "bottomry." The bottomry arrangement consisted of the trading ship owner pledging the ship as security for the repayment of money advanced or lent for the journey. (13) If the ship was lost in transit, the lender lost the money. If the ship arrived safely, the lender received the money advanced plus a premium specified previously. Bottomry became widespread in trading societies throughout the ancient world, in particular in Greece, (14) and continued in Roman times.

      Enforcing any agreement--whether financial services, the sale of goods or a promise to insure--requires a certain minimal judicial framework and continuity of government. With the fall of Rome and disruption of trade, the willingness to serve as a professional risk bearer, understandably, declined. In the late middle ages, as some sort of semblance of order crept over Europe, insurance again became available to commercial enterprises through the bankers and merchants of northern Italy. (15) Although bottomry agreements were in common use in the trading centers of Italy before the year 1000, the Lombard merchants of northern Italy developed marine insurance coverages in the city of London by the end of the twelfth century. (16)

      Insurance developed as a tool to cushion the uncertainties of life. Although its origins are probably rooted in the development of commercial trading ventures, by the Middle Ages insurance--both risk-shifting and risk-distributing--had expanded beyond the mere shipment of goods. For example, farmers in Italy who were annually subject to the uncertainty of the forces of nature set up agricultural cooperatives to insure members in the event of bad weather. (17) Spreading the risk to provide peace of mind to those insured appears to have been part of the insurance process from its earliest development.

      By the seventeenth century, international commerce spurred growth in marine insurance. The story of the establishment of Edward Lloyd's coffee house as a center of maritime insurance has been recounted often. (18) At his coffee house, Lloyd served both a mean cup of joe and published a "list" that contained information on the arrival and departure of ships, information on conditions elsewhere, and shipping hazards. (19) Those seeking insurance for their commercial ventures would contact brokers, who would then place the risk with individuals willing to accept the perspective loss or gain. The agreement would be complete when the proposed indemnifier would place a signature under the terms of the agreement. This practice is the origin of the term "underwriter." (20)

      Over the past several centuries, individuals and cooperatives willing to underwrite risks have been replaced, by and large, by corporations. (21) Developments in probability theory, in particular, Bernoulli's theorem for calculating probabilities--known as the "Law of Large Numbers"--have enabled the insurance industry to create sophisticated actuarial models that allows them to classify and rate various types of hazards. (22)

      The mathematical premise of the Law of Large Numbers states that the degree of uncertainty of insuring a risk is reduced as the number of events increases. Insurance is built upon this premise, permitting forecasts of loss in a large group of similar risks. (23) With the possible exception of certain products sold in the "excess and surplus lines" market, (24) insurance markets today rely upon the application of the Law of Large Numbers. The application of this theorem requires both that the number of risks to be insured is sufficiently large and that the risks are independent of each other. The importance of this latter requirement cannot be overemphasized.

      Modern insurance, "in its substance, in its nudity," addresses itself to the uncertainty of a specified event occurring. (25) Whether it be the loss of jewelry, a house fire or an automobile accident, the hazard insured against must be fortuitous. (26) When an insured's conduct contributes to either the probability or severity of the loss, the chance of loss is increased. "Moral hazard" is the increase of underwriting uncertainty that is caused by such action. (27) Moral hazard undermines the actuarial bases for assessing risk by destroying the independence of events upon which the Law of Large Numbers is based. In other words, moral hazard can undermine the necessary risk-shifting component of insurance. (28)

      In the following discussion of the development of the CGL coverage form, we will use the terms "coverage" or "liability" frequently. "The word coverage is, indeed, a term of art in the insurance industry, meaning the sum of all the risks assumed under the policy." (29) Coverage is also referred to as "protection" and "is the specific protection which is provided by the policy against the results of the perils insured against up to the limits of liability." (30) Coverage refers to the contractual obligation of an insurer to indemnify an insured (or in most liability policies, to defend and indemnify an insured) for those risks agreed upon and to the limits set forth in the policy. "Liability" on the other hand, references the legal responsibility of the insured to other persons or parties arising out of an event or circumstance. (31) The two concepts (to borrow a mathematical metaphor) are different sets for which there may or may not be an intersection or union under an insurance policy.

   2. Development of Commercial Liability Insurance

      Modern insurance "in its complete entirety" has become as myriad and complex as modern commercial life itself. In order to obtain a sense of how we arrived at the liability insurance contracts we have today, we will start by examining what is meant by a "line of insurance." Historically, insurance policies sold in the United States--until roughly the middle of the twentieth century--could not contain more than one line of insurance, e.g., workers compensation or fire loss. (32) The major groups of insurance were "property" (protection against loss or damage to real and personal property) and "casualty" (protection against liability claims), (33) with companies writing only one sub-risk within the property or casualty line.

      As state legislatures allowed insurance companies to sell multi-line policies, insurance carriers tended to categorize their lines of business into two major...