Fraternal but not identical twins
By Donald S. Malecki, CPCU
...There is a certain danger in equating the mechanics of
employee crime forms with liability claims-made forms.
In many circles, "claims-made" might as well be a four-letter word. Policyholders and producers alike learned to dislike the idea of claims-made coverage and its mechanics during the hard market of the mid-1980s when ISO first introduced commercial general liability forms on a claims-made basis.
However distasteful they may find it, policyholders and producers still need to understand claims-made because so many essential coverages commonly are written on a claims-made basis, including products liability, professional and directors and officers liability. In addition, one extremely important coverage for nearly all businesses--employee crime coverage--contains many of the features of a liability claims-made policy.
It should be pointed out, however, that there is a certain danger in equating the mechanics of employee crime forms with liability claims-made forms. For example, in the case of Winthrop and Weinstine, P.A. v. Travelers Casualty and Surety Company, 993 F. Supp. 1248 (U.S. Dist. Ct. D. Minn. 1998), the insurer, relying on a distinction in law between a claims-made and an occurrence liability policy, attempted to equate a claims-made liability policy with a crime policy written on a discovery of loss basis. However, the court concluded that the crime policy was neither a traditional "claims-made" or "occurrence" policy. Thus, relying on court decisions involving liability claims-made forms to interpret crime coverages may lead to erroneous conclusions.
Coverage form triggers
The trigger of most non-employee crime-related coverages is readily discernible, because an actual or attempted robbery or burglary can be pinpointed in time without problem. However, employee-related crimes, such as embezzlement, are referred to as "silent" crimes because they generally take place over a long period of time and are not readily discovered until an employer sustains a loss. With employee crime coverage, there are only two trigger types--loss sustained and discovery.
The loss sustained form covers loss that occurs and is discovered during the policy period or within one year after policy expiration. This form has been in use the longest. The discovery form covers loss that is first discovered during the policy period no matter when the loss occurred, even if the insured had no policy in force at the time of the employee defalcations. The characteristics of both forms are shown in Exhibit I.
A desirable feature of any claims-made policy is prior acts coverage, or the equivalent of an open retroactive date. The reason is that it does not matter when the event giving rise to claim occurs, even before the policy inception, so long as the claim is made during the policy or the extended reporting period.
The discovery form provides this prior acts coverage. It does not matter when the dishonest act or theft actually takes place. What is important is that the loss is discovered during the policy period or during the extended reporting period. (The claims-made liability policy usually requires that a claim be made and reported during the policy period. Employee crime forms written on a discovery basis do not say so specifically, but assume that loss is reported when discovered or within a reasonable period thereafter.)
Whether an underwriter is receptive to issuing the discovery form with its prior acts coverage is open to question. A certain amount of adverse selection may apply here, because an entity can go without insurance for years and still obtain coverage later for an employee-related crime discovered during the policy period that might have commenced years earlier.
Of course, whether an underwriter will issue the discovery form will likely depend on many things, including the length of time the prospect has been without crime coverage, the reason it desires insurance now, and its loss experience. The applicant also will be queried about whether there were any incidents that are likely to result in claims. This is part of the good faith obligation of the insured.
Although the loss sustained form does not have the prior acts coverage feature of the discovery form, the loss sustained form does contain what is referred to as a "loss sustained during prior insurance" provision. When applicable, it may extend coverage to loss discovered during the policy period even though the loss may have occurred during a prior policy period of the same or different insurer.
To qualify for this coverage, the inception of the current policy must correspond to the expiration of the prior policy that was cancelled or non-renewed. Also, the loss must be one that would have been covered by the prior policy, as well as the current policy had it been in effect at the time of the act or event giving rise to the loss in question.
The coverage as may be applicable, however, is subject to a monetary limitation that is stated to be the lesser of (1) the amount recoverable under the current policy, as of the effective date, or (2) the amount that would have been payable under the prior policy.
Were it not for this loss sustained during prior insurance provision, it would be difficult, if not impossible, for an insured to switch insurers. The reason is that there could be a gap in coverage after the expiration of the one-year extended reporting period, since no coverage would be applicable under the new policy for an employee-related act or event that took place before the inception date of the new policy. It is something like the problem with liability insurance when one goes from a claims-made to an occurrence form.
While the loss sustained form provides a so-called one-year tail to discover and report losses, the discovery form provides only a 60-day tail. Like claims-made liability forms, the tail coverage of the discovery form automatically terminates as soon as new coverage is obtained to replace it. It does not matter what form--discovery or loss sustained--replaces the one that was cancelled or non-renewed.
Another desirable feature of claims-made liability policies and crime forms is the awareness provision. The awareness provision is so called because it is similar in purpose to those provisions often found in directors and officers policies. However, there is an important distinction between the D&O and crime policies.
The awareness provision, applicable solely to the discovery crime form because of the short extended reporting period provision, needs to be more definitive. It states that "[d]iscovery of loss occurs when you first become aware of a fact which would cause a reasonable person to assume that a loss covered by this policy has been or will be incurred, even though the exact amount or details of loss may not then be known." In other words, mere suspicion by the insured of an employee theft of money, securities or other property is not sufficient to trigger this provision.
Most employers undoubtedly tread carefully anyway with regard to mere suspicion of employee-related crimes. Failure to do so could lead to false accusations and a lot more costly litigation than the money actually lost through employee thefts had the suspicion turned out to be true. This is one of the reasons crime forms do not require the insured to notify local law enforcement authorities of a loss involving employee thefts.
Choosing the best form
The discussion of these forms, thus far, begs the question of which form is better.
The answer depends on the situation at hand. The loss sustained form is the older of the two coverages. In fact, it was not until 1997 that the discovery form was first introduced for most businesses other than financial institutions.
The discovery form, as noted earlier, provides coverage on an open retroactive date basis and might be suitable for an entity that has been in operation longer than it has maintained some form of employee crime coverage. This form might protect the entity against loss from an earlier dishonest act that would otherwise fall between the cracks. While the discovery form has a 60-day reporting period, it can be extended with the "Change Extended Period to Discover Loss" endorsement, CR 20 04 03 00.
However, if a business has been in operation for many years and has been covered by the loss sustained form, there appears to be no reason to change to the discovery form even if it is possible through the use of a bridge endorsement entitled "Policy Bridge - Discovery Replacing Loss Sustained," CR 20 03 03 00.
Biggest problem area
While the mechanics of the crime forms can lead to argument, the biggest problem area involving employee-related dishonesty or thefts is with losses that take place over a period of years, and the amount of loss falls short of the limit for one policy period. The biggest problem, therefore, is having insufficient limits to recover full losses.
Over the years, many articles have been written pointing out the warning that crime policy limits are not cumulative from year to year. Insureds need to purchase a limit for a one-year period that represents what might be the maximum amount of long-term loss that could occur.
Insurers of these crime forms insert several provisions to bolster the intent that the limits of only one policy period apply to the same or series of related acts of employee theft. The provisions in question applicable to the discovery form are: Limit of Insurance; Loss Covered Under More Than One Coverage of This Policy; Non-Cumulation of Limit of Insurance; Other Insurance; and definition of "occurrence."
The provisions of the loss sustained form are the same as the preceding one, except that it also includes provisions titled Loss Covered Under This Policy And Prior Insurance Issued By Us Or Any Affiliate; and Loss Sustained During Prior Insurance.
What seems to be a fertile area for litigation is the question of how many occurrences have taken place, because these forms are dependent in part on the form's definition of occurrence. Insurers commonly take the position that only one occurrence has taken place, while insureds, in attempting to recover the policy limit multiple times, take the position that more than one occurrence has taken place.
A case in point is Valley Furniture & Interiors, Inc. v. Transportation Insurance Company, 26 Pac. 3d 952 (Ct. App. Washington 2001) where the employee dishonesty occurrence limit was $50,000 and where the amount of loss was more than $193,000.
Over a period of six years, the payroll manager issued advances to herself and to two other employees but failed to forward notices of these draws to the outside payroll company. Her embezzlement totaled $102,800. She also assisted two other employees in embezzling $91,000.
Since the policy defined "occurrence" as meaning all loss or damage ... involving a single act or series of related acts, the insurer maintained that only one occurrence took place. The insured, on the other hand, argued that a separate "series of related acts" occurred as to each employee's receipt of unreimbursed wage advances.
The court sided with the insurer, holding that one series of related acts occurred. Although three employees profited from the embezzlement, the court said, the loss would not have occurred but for the acts of the payroll manager. The other two employees had no independent access to the funds. The embezzlement as to all three employees began at the same time and continued for a period of years, ending at the same time.
This was the same conclusion in the case of American Commerce Insurance Brokers, Inc. v. Minnesota Mutual Fire & Casualty Co., 535 N.W. 2d 365 (Minn. App. 1995). The policy limit was $10,000 per occurrence and the loss, through a series of related acts, in a 13-month period was $192,000.
However, if the policyholder can show that losses were totally independent thefts, they may recover multiples of their occurrence limits. An example is the case of Ran-Nan, Inc. v. General Accident Insurance Company of America, 252 F.2d 738 (U.S. Ct. App. 2001), where the owner of a convenience store maintained employee dishonesty coverage for a limit of $25,000 per occurrence. The employee thefts of money took place during the fourth and fifth renewal years and involved two employees in two entirely independent thefts amounting in loss in excess of $63,000.
The policy definition of occurrence was "all loss caused by, or involving, one or more 'employees,' whether the result of a single act or series of acts." The insurer argued that there had been only one loss and that the "involving one or more employees" clause of the occurrence definition meant that regardless of how many employees steal from the insured, there was only one loss and occurrence.
The problem with the insurer's interpretation was that there could never be more than one occurrence. According to the court, which ruled against the insurer, the "involving" clause signified a group of employees conspiring together to steal. This would be one occurrence, said the court, but not when there are independent thefts by employees not working together.
Unfortunately, employers usually feel that they will not encounter a situation where thefts by employees will take place over years and amount to substantial sums. The foregoing cases show otherwise. No one says it is easy, but producers need to educate employers on the need for higher limits. *
Donald S. Malecki, CPCU, is chairman and CEO of Donald S. Malecki & Associates, Inc. He is a committee member of the International Insurance Section of the Society of CPCU, on the Examination Committee of the American Institute for CPCU, and an active member of the Society of Risk Management Consultants.
Comparison of Coverage Form Triggers
Type of Form Prior Acts Discovery of Loss Extended Awareness Covered During Policy Period Reporting Period Provision
Discovery Yes 1 Yes 3 60 days Yes
Loss Sustained No 2 Yes 3 One Year No
1 Some underwriters may apply a retroactive date endorsement.
2 Except to the extent the Loss Sustained During Prior Insurance provision
3 Except when the Extended Reporting Period provision applies.