Insurance Coverage in Outsourcing:
When May Enterprise Customer Collect from Service Provider's Insurer?

© 2004 William B. Bierce.  All rights reserved.

    Outsourcing contracts require the service provider to maintain insurance.  When the enterprise customer suffers a loss to its property that is situated on the service provider's premises, can the enterprise customer collect under the service provider's insurance policy?  A New York court decision, focused on real estate law but applicable to outsourcing, sheds some light on novel issues arising out of property losses incurred by a World Trade Center tenant in the 9/11 terrorist attacks that demolished the building.

    The Insurance Policy.  The landlord of 7 World Trade Center, New York was a limited partnership.   It had insurance on the real property in which it had an insurable interest and personal property that it owned or used in such real property.  Only Landlord's Property was insured under the policy, the landlord claimed, since the policy's coverage of "the insured's interest in and the Insured's Liability for personal property of others, while it is in the custody of the insured."  The court held that the landlord had no insurable interest in the tenant's property, so that the landlord's insurer was not liable to cover the lost Tenant's Property. 

    Adjustor.  The policy states that the losses would be adjusted, and losses paid by the insurer as directed, by the limited partnership's general partner.  

    No Privity.  Citigroup, as tenant, was not a party to the policy.   Nor was Citigroup named as an insured, additional insured or loss payee.  

    The Contract.  The lease classified all property in the building as either Landlord's Property or Tenant's Property.   Improvements by the tenant were classified as Landlord's Property unless they could be removed without structural damage. As required under the lease, Citigroup paid a portion of the insurance premiums applicable to policy covering the Landlord's Property.   The lease also required Citigroup to obtain its own insurance on  Tenant's Property.   Citigroup claimed, and the landlord disputed, that under separate lease provisions the Landlord was required to insure Tenant's Property.   In fact, the lease expressly stated that the landlord was no going to insure Tenant's Property.

    The Losses.    Citigroup claims to have invested $280 million in improvements to the building, but its claim for insurance only covered Tenant's Property.

    Insurable Interest.  A basic principle of insurance law is that the insurance policy does not cover any property in which the insured has no insurable interest.  The insurance must cover property (or other loss) in which the insurance beneficiary has some legal right.  Otherwise "insured" parties could gamble in the risks of loss by others and thereby turn insurance underwriting into a casino for gamblers.  Without an insurable interest, the underwriter has no assurance that the insured will use any efforts to protect and preserve the insured property (or other potential liability) from loss.  

    An insurable interest may exist even though the insured might have bought the property from a thief, Scarola v. Ins. Co. of N. Am., 292 N.E. 2d 776 (N.Y. 1972) or the insured's contract to purchase the property might be voidable, Deck v. Chautauqua Co. Patrons' Fire Relief Assoc., 343 N.Y.S. 2d 855 (N.Y. Sup. Ct. 1973).   In this case, the tenant had not made any plans to transfer its Tenant's Property to the landlord, and it had not abandoned the property to the landlord.  As tenant, Citigroup did insure its Tenant's Property.  

    The court ruled that the lease did not give it any insurable interest in the Landlord's rights in the Landlord's Property including the tenant's improvements that became the Landlord's Property by becoming affixed to the structure.  

    Loss Payee.   A "loss payee" is not an insured party, but is a party to whom the loss is made payable upon agreement by the underwriter to pay in accordance with instructions from the insured party.  Usually, evidence of such a designation is done by the insurance broker in a separate certificate addressed to the insured party and the named loss payee.  

    Value of Broker's Certificate.  If the loss payee is not actually covered under the insurance policy, the broker's erroneous certificate does not create any insurance claim.  American Ref-fuel Co. of Hempstead v. Res. Recycling Inc., 671  N.Y.S.2d 93 (N.Y. App.. Div. 1998) [summary judgment in favor of insurance carrier].  If the certificate proves to be false, such as when the insurance underwriter never authorized such a certificate and limited the authority of the broker, then the loss payee who had received a broker's certificate may seek to invoke the broker's liability for negligence but has no claim against the carrier.  Thus, a broker's certificate of insurance is merely evidence of the insurance policy but does not constitute the insurance policy.  

    Disclaimers in Broker's Certificate.  In the Citigroup situation, the Landlord's insurance broker had issued such a certificate to Citigroup.   But it was couched in terms that effectively excluded the broker's liability.   The tenant was only a "loss payee" to the extent that "its interests" "appeared"  and that the certificate did not change the terms of the insurance policy.  Further, the certificate stated:

THIS CERTIFICATE IS ISSUED AS A MATTER OF INFORMATION ONLY AND CONFERS NO RIGHTS UPON THE CERTIFICATE HOLDER.  THIS CERTIFICATE DOES NOT AMEND, EXTEND OR ALTER THE COVERAGE AFFORDED BY THE POLICIES BELOW.  [Emphasis in the original.]

    No Change in Insurance Coverage by Erroneous Certificate by Broker.  Under insurance law, a certificate of insurance issued to someone other than the insured party does not change the insurance policy.  "When a certificate of insurance issued to a third party expressly states that it does not change the policy listed on the certificate, the language of the policy controls."  See Taylor v. Kinsella, 742 F.2d. 702 (2d Cir. 1984).  This rule is based on the basic principle (applicable particularly to insurance law) that the parties' intent to incorporate additional papers into an insurance policy (which is a contract) must be plainly manifest.  

    Did the Insurer Authorize a Change in Coverage?   How does the insurer become legally liable to honor the addition of a third party as a loss payee, when the insurance policy does not add the third party?   The Citigroup court explored five possibilities, none of which was found to have applied.

• Broker as Agent of Insurer.   The broker might have some authorization from the carrier.  Where the insured service provider's broker issues a certificate of insurance to the enterprise customer, the broker is normally working for the insured policy holder.  As such, the broker normally lacks authority from the insurance carrier to modify the terms of the insurance policy.   In the Citigroup case, there was no evidence that the insurance carrier had ever authorized the broker to modify the policy.  

• Endorsement to Amend the Policy.  Policy amendments are normally done by an endorsement issued by the carrier or an authorized agent.  The Citigroup court noted that the insurer never amended the policy.   

• Insurer's Issuance of Certificate of Coverage of Third Party (Enterprise Customer).  Nor did the insurer re-issue the broker's certificate on its own form.

• Insurer's Assurances to the Third Party Enterprise Customer (Doctrine of Estoppel).   In the Citigroup case, the broker had submitted to the insurer a copy of the broker's erroneous certificate showing Citigroup as a loss payee.  That submission occurred in the renewal process.  The broker asked the insurer to "get the ball started" so that Citigroup would be a loss payee.  The insurer was aware of the broker's erroneous certificate and the broker's request for action.   Was the insurer legally bound by this notice?   The court held, "The doctrine of estoppel cannot be used to create coverage in the absence of any evidence that [the insurance carrier had] assured [the third party claiming to be an intended loss payee] that it would be a loss payee."    Citigroup, Inc. v. Industrial Risk Insurers and Westport Ins. Corp., __ F.3d ___, NYLJ, at p. 24, col. 2 (Sept. 3, 2004) (S.D.N.Y. 2004), per Judge Cedarbaum.  Mere notice to the insurer is not sufficient because it does not obtain the insurer's binding agreement.    

• Judicial Correction of a Scrivener's Error (Doctrine of Mistake).  In some cases, the insurance carrier may be held liable for coverage where it can be shown that the insurance carrier intended to cover the loss payee but that the policy contained a "scrivener's error" that inadvertently omitted naming the loss payee on the policy document.   In such a case, the court may determine that the error must be rectified as a matter of law to give effect to the intent of the parties.  In the Citigroup case, there was no sufficient evidence to indicate that the insurer had intended to add Citigroup as a loss payee.  Citigroup argued unsuccessfully that the insurer should be held liable for various circumstantial reasons, including (1) the insurer had the "capacity" to insure the loss, (2) coverage of Citigroup's risk would not have changed the character of the risk insured or the premium paid, and (3) the insurer never rejected the broker's request to add Citigroup to the policy.  None of these arguments supported the theory that the insurer had somehow agreed to cover Citigroup as a loss payee.  So the insurer's motion for summary judgment for dismisal was granted.

    Additional Named Insured.  Naming the enterprise customer to the policy gives the customer legal rights against the insurer.  As an additional named insured, the enterprise customer could refuse to allow the policy to be amended at the service provider's request.   If the policy is intended to cover multiple risks of loss, that might arise out of any one or more service agreements with different customers, the service provider could lose important maneuverability if it were to agree to have the enterprise customer named as an additional named insured.   By adding the enterprise customer as a loss payee, the enterprise customer is still entitled to payment of its claim, subject to the conditions applicable for such payment.  Consequently, naming the enterprise customer is not required and could lead to unnecessary problems for the service provider.

    No Man's Land: Customer who Is Neither Loss Payee Nor Additional Insured.   The lack of being named as a loss payee or as an additional named insured should not deprive the enterprise customer of the right to be paid upon a loss.  However, if a loss occurs and the insurance proceeds are paid directly to the service provider, the service provider's other creditors may have a superior claim to the proceeds.  

    Implications for Outsourcing.   

• When Does the Enterprise Customer Have an Insurable Interest in the Service Provider's Property (or other Protected Right) under the Service Provider's Insurance Policy?   When the insurance broker issues a certificate that the enterprise customer is a "loss payee," it usually includes the caveat that the coverage will be paid to the loss payee "as its interest may appear."   In accepting such a certificate, the enterprise customer should understand that, without an insurable interest in the covered assets or rights, the enterprise customer has no "interest" that may "appear," and it loses any claim under the policy.   In analyzing whether to accept being named as a loss payee, the enterprise customer must make its own decision, and use appropriate measures to ensure, that it does indeed have an insurable interest.  This will require case-by-case analysis.

• Should the Enterprise Customer Become an Additional Insured Party?   Insured parties have certain rights directly against the insurer that a loss payee does not.   The insurance carrier owes to the each insured the same obligations that it owes to the other insureds, including notices of default and intention to terminate for non-payment.   Where there are multiple insureds on the same policy, any of the insureds may be in a position to veto any change in the policy terms or coverage by refusing to allow any changes.  Thus, designation of an enterprise customer as a co-insured can potentially deprive the service provider of essential flexibility in managing its insurance portfolio.

• Unbundling of Insurance Premiums in Service Pricing.   Real estate leasing customarily involves a "net" lease where the customer pays the rent plus a portion of taxes, maintenance costs and insurance.  Such other costs are unbundled.   By contrast, in outsourcing, the service provider typically offers a price that is fixed and bundled.  Historically, bundled pricing served the service provider's interests by cloaking the operating cost components, which is competitive information.   Bundled pricing serves the enterprise customer by establishing a ceiling on costs, subject to those charges that cover variable units of service delivered.  To the extent that insurance premiums covering the service provider's relationship with a particular customer could fluctuate severely, the service provider might wish to offer an unbundled pricing.   This approach might be particularly appropriate if the services are "commodity" services for "routine" transaction processing for which market pricing is highly competitive and profit margins are "razor thin."  Such conditions might exist in the case of a contract renewal where the service provider offers a lower price for the same services. 
  

• Get the Right Certificate of Insurance.   To avoid the risk of not being covered by the service provider's insurance policy, the enterprise customer should request and obtain a proper certificate of coverage.  Where property of the service provider will be located on customer premises, similar insurance coverage might be requested for the service provider's benefit.  
  

• Get the Right Coverage.   This case study focused on property insurance.  Other types of insurance should be considered in consultation with your insurance broker, risk manager and legal counsel. 

Posted: September 2004