A very recent (April 10, 2007) decision of the Seventh Circuit Court of Appeals in Farmers Automobile Insurance Association, v. St. Paul Mercury Insurance Company (Case No. 06-2810) reflects a thoughtful analysis of the insured/insurer relationship in the context of employment practices liability insurance and uses a common sense application of the concept of “moral hazard,” which is a core concept in insurance. The case is also noteworthy for its discussion of contra preferentem (construction of ambiguous terms against the drafter, usually the insurer) in non-traditional circumstances; because both the insured and the insurer were sophisticated commercial entities-indeed both parties were insurance companies.
With the recent explosion of claims by employees against their employers, many employers have purchased specific coverage known as employment practices liability insurance or “EPLI.” Such coverage generally provides defense costs and/or a duty to defend when the insured employer is sued by its employees for certain types of claims, including discrimination or wrongful termination. The policies take many different forms and like many newer coverages there is substantial variation among the policy forms used by different insurers. Sometimes this coverage is provided within a subsection (Enterprise Coverage) of a liability policy which also provides Directors and Officers liability insurance. In other instances the EPLI coverage is a stand alone insurance policy.
Insurers sometimes insist on substantial deductibles or self insured retentions, because the insured employer at least in theory has substantial control over the risk (the employment relationship) and should bear a substantial portion of the liability. Another method of controlling the risk is the use of a specific coverage limitation such as an exclusion from the grant of coverage.
One such exclusion, precluding coverage for violations of the Fair Labor Standards Act, other named statutes and “other similar provisions of any federal state or local statutory or common law” was addressed by the court in the Farmers v. St. Paul case. The dispute arose when the insured, Farmers (itself an insurance company) was sued by its own claims adjusters for failure to pay overtime under the Illinois Wage Law. The question for the court was whether the Illinois Wage Law was an “other similar provision” of any state law when compared with the named statute, the federal Fair Labor Standards Act. Farmers argued that the word “similar” in this context was ambiguous and should be construed against the insurer. The court rejected this approach and found the words of the exclusion to unambiguously exclude coverage for Illinois Wage Law claims.
The Court found that the exclusion of Illinois Wage Law Claims, like the exclusion of claims under the virtually identical federal Fair Labor Standards Act which was referenced by name in the exclusion was necessary to avoid a “moral hazard,” which the court defined as:
the temptation of an insured to precipitate the event insured against if the insurance goes beyond merely replacing a loss. It’s why an insurer will not insure your house against fire for more than it’s worth,” and why liability-insurance policies are presumed not to insure against breaches of contract. (citations omitted) Insurance against a violation of an overtime law, whether federal or state, would enable the employer to refuse to pay overtime and then invoke coverage so that the cost of the overtime would come to rest on to the insurance company. The employer would have violated the overtime law with impunity, unjustly enriching itself by the difference between the overtime wage for the hours in question and the straight wage. No insurance company any would knowingly write a policy that would enable the insured to trigger coverage any time it wanted a windfall.
The Court rejected Farmers assertion that the undefined word “similar” should be interpreted based on the understanding of an average consumer because the insurance at issue was not directed at consumers, but at employers who would be expected to know the federal and state laws applicable to payment of overtime. While constrained by its use of Illinois law to accept that contra preferentem should apply regardless of the size or sophistication level of the insured, the court rejected its application where the meaning of “similar” was clear in the context in which it was used, because the purpose served by the exclusion-excluding claims based on failure to pay overtime applied to both the Fair Labor Standards Act and the identical state statute (other than the interstate commerce requirement).
Simply put, the court recognized that EPLI insurance was never meant protect insureds from the business risk of failing to pay wages. My guess is that most insureds would not consider this risk as one which would be assumed by insurers.
