A products liability theory for the judicial regulation of insurance policies.

• Author: Schwarcz, Daniel

ABSTRACT

Many insurance law commentators believe that judges should regulate the substance of insurance policies by refusing to enforce insurance policy terms that are exploitive or otherwise unfair. The most common guide for the judicial regulation of insurance policies is the "reasonable expectations doctrine," which requires courts to disregard coverage restrictions that are beyond insureds' reasonable expectations unless the insurer specifically informed the insured about the restriction at the time of purchase. This Article argues that although the judiciary has a potential role to play in policing insurance policy terms, that role should not be defined by reference to consumers' reasonable expectations. Instead, by drawing on the parallels between insurance policies and ordinary consumer products, this Article advances a products liability framework for understanding how and why courts should regulate insurance policies. It proposes that, just as firms that make defective products must pay for the resulting injuries, insurers that issue "defective" insurance policies should have to provide coverage to insureds. The Article argues that the usefulness of the analogy to products liability law goes well beyond understanding the normative basis for the judicial regulation of insurance policies. Products liability law offers important insights into how courts can efficiently correct failures in insurance markets by encouraging effective disclosure to consumers and appropriately setting penalties so that insurers take an optimal amount of care in drafting policy terms.

TABLE OF CONTENTS

INTRODUCTION I. THE NEED FOR JUDICIAL REGULATION OF PROPERTY/CASUALTY INSURANCE A. Insurance Policies and the Efficiency of Standard-form Contracts B. Consumer Information and Rationality in Property / Casualty Insurance Markets 1. The Assumption of Consumer Knowledge a. Reputation b. Insurance Information Intermediaries c. Secondary Literature 2. The Assumption of Consumer Rationality C. A Role for Judicial Intervention 1. The Social Welfare Consequences of Inefficient Coverage 2. The Limitations of State Administrative Regulation II. REASONABLE EXPECTATIONS AS A FLAWED DOCTRINE FOR THE JUDICIAL REGULATION OF INSURANCE A. The Stunted Evolution of the Reasonable Expectations Doctrine B. Reasonable Expectations as a Corrective for Market Failure? 1. Reasonable Expectations and Inefficient Coverage Exclusions 2. Reasonable Expectations and Informing Consumers III. PRODUCTS LIABILITY LAW AND THE JUDICIAL REGULATION OF INSURANCE POLICIES A. Justifying a Products Liability Model B. Constructing a Products Liability Model 1. Defective Warnings 2. Insurance Harms and Design Defects a. Deviations for a Clause's Purpose as an Insurance Harm b. Defective Insurance Designs c. Damages 3. The Interaction of Design Defects and Defective Warnings C. The Costs of a Products Liability Model CONCLUSION INTRODUCTION

In the wake of Hurricanes Katrina, Rita, and Wilma, insurers feared no one more than Trent Lott. Not only did the Mississippi senator have an obvious political incentive to insist that insurers pay for as much of the unprecedented hurricane damage as possible, he had a strong personal incentive as well: his house lay in ruins, and his insurer insisted that it was not liable for the damage as Lott's policy excluded coverage for all losses caused by flooding. (1) Lott--like thousands of other hurricane victims along the Gulf Coast facing similar resistance from their insurers (2)--quickly filed suit, claiming that his insurer's reliance on the flood exclusion violated his "reasonable expectation" of coverage. (3) Lott had purchased a "Hurricane Deductible Endorsement" precisely so that he would be covered for hurricane damage. (4) He argued that the insurer, by offering this endorsement, had fostered an expectation that he "would have full and comprehensive coverage for any and all hurricane damage." (5) It was that expectation that mattered, Lott claimed, and not the technical wording of the insurance policy. (6)

Lott's basic argument, which is echoed in the lawsuits of thousands of other hurricane victims, (7) is founded in a controversial rule of insurance law known as the "reasonable expectations doctrine." Under the doctrine, insureds are entitled to the insurance coverage they reasonably expect even though the applicable policy terms unambiguously exclude such coverage. (8) Insureds, therefore, can overcome unambiguously applicable exclusions in their policies if an objectively reasonable insured would expect coverage on the basis of factors such as policy language and structure, the insurer's marketing practices, underwriting theory, and generalized beliefs among consumers about the scope of different types of insurance. (9) Lott's complaint advanced each of these arguments: It claimed that the policy's language--in particular, its "Hurricane Deductible Endorsement"--created an expectation of complete hurricane coverage, and that Lott's insurance agent implicitly fostered this expectation. (10) It also suggested that the insurer's advertising campaign, which held the insurer out as a "[g]ood [n]eighbor," reinforced this expectation. (11) Finally, it argued that most ordinary consumers would reasonably expect that hurricane insurance coverage would cover losses due to flooding associated with a hurricane. (12)

Seizing on the breadth of the arguments available to those invoking the reasonable expectations doctrine, some have suggested that it inappropriately legitimizes "judge-made insurance." (13) But most insurance law commentators view the doctrine as a sensible response to the argument that insurance policies are contracts of adhesion, which sophisticated insurers unilaterally draft and offer to uninformed consumers on a take-it-or-leave-it basis. (14) Commentators have argued that, without the threat of the "judicial regulation of insurance"--the ex post alteration of an insurance policy's provisions by courts (15)--insurers would exploit unwary consumers by inserting unfair coverage exclusions into insurance policies. (16) Not only does a reasonable expectations rule protect consumers from such exploitation, according to this view, but it also encourages insurers to inform consumers about potentially surprising terms because insurers can avoid liability under the doctrine by adjusting inaccurate consumer expectations before the policy is purchased. (17)

Despite this relatively widespread support from insurance law commentators, the reasonable expectations doctrine suffers from serious practical and theoretical failures. (18) Only a handful of state courts follow the rule, and the case law endorsing it is confused and inconsistent. (19) Moreover, contract law scholars have largely debunked the contracts-of-adhesion argument on which the reasonable expectations doctrine was originally justified. They have established that neither consumer assent nor government regulation is necessary to lead firms to design efficient standard forms when market forces work sufficiently well. (20) Given the doctrine's stunted evolution in the courts and the academic undermining of its core rationale, it is hardly surprising that some view it to be both antiquated and largely irrelevant. (21) Because the reasonable expectations doctrine has served as the primary theoretical and doctrinal construct for the judicial regulation of insurance over the past forty years, the demise of the reasonable expectations doctrine has corresponded with the demise of judicial intervention in the content of insurance policies.

This Article seeks to reinvigorate the idea that limited judicial regulation of insurance may be in the best interests of insurance consumers. (22) Focusing on consumer-oriented markets for property/casualty insurance, (23) it claims that the market mechanisms that ordinarily lead firms to draft efficient standard-form contracts may fail to produce socially optimal results in many insurance markets. In part this is because various unique features of the property/casualty insurance industry, such as policy standardization, the use of endorsements, and price regulation, limit the effectiveness of market mechanisms. (24) But it is also because consumer behavior in many of these insurance markets departs from the assumptions of the standard economic model: consumers in property/casualty insurance markets tend to be ill-informed about policy details and to ignore nonsalient policy terms. (25) In the absence of government intervention, insurers may have an incentive to exploit these consumer limitations by drafting inefficient terms. (26) Because state administrative regulation of substantive policy terms is both inherently and practically limited, targeted judicial intervention to prevent such insurer overreaching is potentially appropriate. (27)

Given the failures of the reasonable expectations doctrine in defining the appropriate contours of such judicial intervention, this Article advances a products liability model for the judicial regulation of insurance. Although several commentators have previously explored the implications of products liability law for contract law, none have done so in the context of insurance policies. (28) The model provides analytical clarity as to why courts should potentially regulate the content of insurance policies: these policies are consumer products, (29) and, in certain cases, they may be "defectively" designed. By requiring that firms pay damages to consumers who are "injured" by these defective insurance products, the judicial regulation of insurance can induce insurers to design their products optimally despite consumer ignorance and bounded rationality. Just as products liability law attempts to promote social efficiency by placing obligations on firms beyond what they "agreed" to give to the consumer, (30) appropriately tailored "judge-made insurance" has the potential to help promote the...