Way Out ‘West’

When a company is scammed, who pays the insurance?

Insurance coverage case law sometimes reads like a supermarket tabloid, and no case has more tabloid-like facts than the October 2005, decision in Federal Insurance Co. vs. Ace Property and Casualty Co., a case from the United States Court of Appeals for the Fifth Circuit.

In this case, a technology services company was approached by a man who called himself “Colonel West,” who said he was running a secret NATO purchasing project that would involve buying electronic equipment worth some $80 billion to $100 billion. The bidding process for the secret project supposedly required that samples be shipped to NATO representatives, and the representatives would have the right to test and destroy the samples. The technology services company signed off on “Test to Destruction Authorization Agreements” and shipped millions of dollars of equipment.

You, the loyal readers of this column, have no doubt figured out the first part of this case: Colonel West was not a real colonel; this was not a secret NATO project; and the equipment was stolen. While the circumstances beg the question “How do these insane things happen?” (a question later addressed), the central question was insurance coverage.

The insurance question arose because the technology services company that met with the “colonel” brought in subcontractors to provide equipment. The subcontractors sued the technology services company, alleging among other things, negligent misrepresentation. The primary insurer denied coverage on the grounds that the negligent misrepresentation was not an “occurrence.” The excess carrier paid the defense and indemnity. The excess carrier then sued the primary insurer.

The occurrence issue distilled down to a central question: Did the negligent misrepresentation constitute an occurrence within the meaning of the insurance policy? The policy defined occurrence as “an accident, including continuous or repeated exposure to substantially the same general conditions.” Was this an accident?
Surely the company did not intend to ship equipment to a fake colonel and suffer the loss of the equipment. The company completely misunderstood the true circumstances, and the company did not intend to give the equipment to a conman.

But, this property was expected to be destroyed; it was expected that it would not be returned. An agreement consenting to the damage was signed. Therefore, while the company did not intend to benefit the conman, it did intend to lose the equipment. Since the insured intended that the property be destroyed, the destruction cannot be called an accident. Consequently and appropriately, the court concluded that the loss of the property was not covered.

These circumstances also can be viewed as a commercial or economic loss rather than property damage, accidental or otherwise. The company’s problem was not the loss of the equipment; the problem was that the equipment loss was intended to generate an economic benefit-a huge economic benefit-and that benefit did not materialize. The failure to achieve the economic benefit may be disconcerting to the insured, but it was not an insured risk. The insurance did not cover the failure to achieve economic results.

Ultimately, this decision demonstrates three things:

? First, the occurrence issue requires careful review. Coverage is limited to “property damage” caused by an occurrence. Under this decision, if the property damage is intended, even if it is intended because of a mistake, it is not covered.

? Second, courts are wary of attempts to push economic losses into liability insurance coverage. Indeed, courts should be wary of such efforts. Liability policies do not cover pure economic losses.

? Third, intra-insurer suits often produce odd results. Here, the excess insurer was suing the primary insurer. Had a policyholder been present, it surely would have argued that the term occurrence does not restrict coverage to this degree. The policyholder’s occurrence arguments might well have been more aggressive and expansive.
Finally and most importantly, I want to address the question noted at the start: “How do these insane things happen?” The answer, of course, is: As the promise goes up, common sense goes down.

If the scam artist here-“Colonel West”-had promised to spend $1,000 or even $100,000, the computer company would surely have rejected the proposal as preposterous. But the suggestion of somehow spending $80 billion to $100 billion can lead companies to do silly things.

Reprinted with permission from A.M. Best Company, Inc. January 2006 issue of Best’s Review.  All rights reserved.