Sunday, February 26, 2012

Captive Case Law Conclusion: The Harper Test, Part I: What Is Insurance?

If you're interested in forming a captive, or simply learning more, please see this link.

Today, I want to turn to the Harper Test, which states that a captive must comply with the following three factors:

(1) whether the arrangement involves the existence of an “insurance risk”;

(2) whether there was both risk shifting and risk  distribution; and

(3) whether the arrangement was for “insurance” in its commonly accepted sense.

I've already discussed the idea of risk shifting and risk distribution.  For the next few posts, I want to focus on factors 1 and 3, starting with one, that the arrangement involves the existence of an "insurance risk."  

Legally, insurance risk has three factors: an insurable interest, risk shifting and risk distribution and risk of loss.  The following excerpts are from my doctoral dissertation and discuss insurable interest and risk of loss:

The historical roots of this policy [insurable interest] date back to England when maritime insurance was sold to an insured whether or not he had a personal or financial interest in the ship or cargo. This sales practice “caused many pernicious practices, whereby great numbers of ships with their cargoes, [were] either … fraudulently lost or destroyed.”[1]  The second root of the insurable interest doctrine is judicial policy to prevent using insurance for gambling or wagering.[2]  During the 1800s, people purchased life insurance on famous elderly persons as a way to speculate on the time of their death.[3]  This practice displaces the primary purpose of insurance -- to protect the purchaser against unforeseen losses that directly impact his personal or financial interests.[4]  The third root of the insurable interest doctrine is the prevention of waste[5] by preventing non-essential insurance policies (such as those previously mentioned) from being written.

A person has an insurable interest in property “when he or she will derive a pecuniary benefit or advantage from its preservation or will suffer a pecuniary loss or damage from its destruction, termination or injury by the happening of the event insured against.”[6]  The interest can exist in law or equity[7] and can be found in a legal interest that is slight,[8] contingent or beneficial.[9]  In fact, outright ownership or title of ownership is not relevant to the inquiry.[10]  Obviously, courts construe the interest very liberally.[11]  The amount of insurance purchased cannot be disproportionate to the insurable interest or the court will rule the insurance policy is a wagering contract and therefore void against public policy.[12]


The primary purpose of an insurance contract is to transfer risk, which is an unforeseen and uncertain event that is a “disadvantage to the party insured.”[1]  The insured can’t prevent the risk from occurring;[2] it must be accidental[3]  or “fortuitous,” also defined as

‘…an event which so far as the parties to the contract are aware, is dependent on chance.  It must be beyond the power of any human being to bring the event to pass; it may be within the control of third persons; it may even be a past event, such as the loss of a vessel, provided that the fact is unknown to the parties.’[4]

Fortuitous should not be confused with natural degradation or depreciation – which is foreseeable but whose timing may be unpredictable.  In contrast, a fortuitous event is unforeseen and its timing is unknown, thereby impacting the insured when he is less prepared to mitigate the damages.[5]  The unknown or unforeseen element of the fortuity definition is best explained by the three primary fortuity-related defenses insurers offer to challenge an insured’s claim, the first of which is the “known loss” defense, where an insurer will argue the loss had “already occurred or [the insured should have known] the loss already occurred at the time the policy was written.”[6]  The second fortuity related loss defense is the “known risk” defense, where the insured knew the probability of loss was so high as to warrant some type of advance preparation or attempt to avoid the event on the part of the insured.[7]  “Loss in progress” is the third defense, which the insurer will argue when the loss was preceding at the time the insured purchased the insurance contract.[8]  The one common element to all of these defenses is actual or legally impugned knowledge on the part of the insured of the risk actually occurring or having a statistically significant possibility of occurring when he purchases the policy.

[1] 1A Couch on Insurance Section 17.7
[2] Id
[3] Appleman, Section 1.05[2][a]
[4] Appleman, section 1.05[2][b]
[5] Id
[6] Id
[7] Id
[8] Id

[1] Robert H. Jerry II, New Appleman on Insurance Law Library Edition, © 2009 Matthew Bender and Co. Section 1.05
[2] 44 Am. Jur. 2d Insurance Section 934
[3] Appleman, Section 1.05
[4] Id
[5] Id
[6] 44 C.J.S. Insurance Section 318
[7] Id
[8] Id
[9] 44 Am. Jur. 2d Insurance Section 932
[10] Id
[11] 44 C.J.S. Insurance Section 319
[12] 3 Couch on Ins. Section 41:2

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