The Crimes They Are a Changin’

Am I the only one providing expert witness assistance for fidelity claimants? Fidelity coverage (also known as “employee theft” or “employee dishonesty” coverage) is just a small part of the insurance universe, generating many fewer claims than property and liability coverage and of those, even fewer end up as lawsuits. Nevertheless, my expert witness activity of late has been skewed towards fidelity. In the last few years I’ve worked with three insureds and their attorneys to resolve fidelity claims1. In all three cases, the claimants have prevailed. It’s apparently brought me my fifteen minutes of fame (or notoriety).

The most recent case is particularly interesting to us as it involved changes in employee theft coverage that we should be aware of. In addition, it once again showed how dismally poor insureds and their advisers are in selecting fidelity insurance limits and it demonstrated the advantage of using the Discovery Form version of coverage. The firm that was a victim of the embezzlement, which I’ll call Service Company, serviced self-directed IRA accounts for numerous individuals who wanted to purchase portions of real estate and other complex investments. Service Company deposited the funds from the investors, transmitted the funds to the investment trusts, and maintained records of the individual accounts. When a participant wanted to withdraw funds, Service Company, instructed the trust to sell the necessary shares. When the proceeds were deposited, Service Company’s employee instructed the bank to transmit the funds to the IRA participant. But there was the fatal flaw in the process.

Although the instructions to sell shares and issue drafts required the signature of at least one of Service Company’s executives, in practice the executives just signed whatever papers the employee who handled the transactions prepared. It was simple for her to prepare orders for the bank to issue checks to her boyfriend as if he were an IRA participant. The pair split the proceeds. In the more than six years of embezzling, they netted $1.3 million dollars!2. Did Service Company have employee theft coverage? Yes they did. But the amount of coverage was just $50,000 a year until the very last year of the scheme. In that year the limit had been increased to $1,000,0003. It’s astonishing that the insured and its broker felt that $50,000 was in any way an appropriate amount of coverage.

Furthermore, the increase to $1,000,000 was the result of a demand from the investment trust they serviced, not something that the insured or the broker came up with. The policy in question contained two separate provisions that govern loss during previous policy periods: Loss Sustained During Prior Insurance Issued By Us Or Any Affiliate and Loss Sustained During Prior Insurance Not Issued By Us Or Any Affiliate (provisions identical to those used in the ISO loss sustained crime forms). Neither provision is triggered unless coverage has been continuous. If there is any lapse in coverage, no loss prior to that time of the lapse is covered. Furthermore, the loss is covered only if it would have been covered by the current policy had it been in force at the time of the loss. When coverage in the prior period was written by a company not affiliated with the current insurer, coverage is also limited to the amount of insurance in force when the loss occurred. In the case of Service Company, because the loss took place primarily during the policy periods when the limit of insurance was $50,000 per year, the amount Service Company could collect for the $1.3 million loss would have been less than $300,000. However, Service Company’s coverage was written by the same insurance company from April 1, 2004 until the loss was discovered in December of 2008. The provision applying to loss covered by the current policy and by prior insurance issued by the current insurer or any affiliate in Service Company’s policy read: If any loss is covered:

(1) Partly by this insurance; and

(2) Partly by any prior cancelled or terminated insurance that we or any affiliate had issued to you or any predecessor in interest; the most we will pay is the larger of the amount recoverable under this insurance or the prior insurance. 4 Service Company argued that this meant the highest limit carried ($1,000,000) was available to cover the entire loss; it did not matter in which policy period the funds had been stolen. The insurance company contended that the amount collectible is limited to the amounts embezzled in each policy period up to the coverage applicable to each of those policy periods, but not more, in total, than the highest limit carried in any one year. In short, the insured felt it was entitled to $1,000,000; the insurance company offered less than $300,000.

My interpretation of the meaning of the prior insurance provision has always agreed with Service Company’s. That’s what I wrote in CPCU texts long before I was involved in this case.

I can see the insurance company’s position as a possible interpretation. But that would make the policy wording ambiguous and the accepted rule for resolving ambiguities in insurance policy wording is that ambiguities are resolved in favor of the insured.5

The clinching factor for me, and the reason for writing about it here, is a change in the ISO crime form introduced in 2006. Until then, the ISO wording regarding coverage for losses sustained during prior insurance issued by the current insurer or an affiliate was the same as the wording quoted above. ISO form CR 00 21 05 06, introduced in 2006, replaced the five lines shown above with a provision that runs just shy of two pages.

The key wording is as follows:

(1) Loss Sustained Partly During This Insurance And Partly During Prior Insurance

If you “discover” loss during the Policy Period shown in the Declarations, resulting directly from an “occurrence” taking place:

(a) Partly during the Policy Period shown in the Declarations; and

(b) Partly during the Policy Period(s) of any prior cancelled insurance that we or any affiliate issued to you or any predecessor in interest; and this insurance became effective at the time of cancellation of the prior insurance, we will first settle the amount of loss that you sustained during this Policy Period. We will then settle the remaining amount of loss that you sustained during the Policy Period(s) of the prior insurance.

(2) Loss Sustained Entirely During Prior Insurance

If you “discover” loss during the Policy Period shown in the Declarations, resulting directly from an “occurrence” taking place entirely during the Policy Period(s) of any prior cancelled insurance that we or any affiliate issued to you or any predecessor in interest, we will pay for the loss, provided:(a) This insurance became effective at the time of cancellation of the prior insurance; and (b) The loss would have been covered under this insurance had it been in effect at the time of the “occurrence”. We will first settle the amount of loss that you sustained during the most recent prior insurance. We will then settle any remaining amount of loss that you sustained during the Policy Period(s) of any other prior insurance.

(3) In settling loss subject to this Condition:

(a) The most we will pay for the entire loss is the highest single Limit of Insurance applicable during the period of loss, whether such limit was written under this insurance or was written under the prior insurance issued by us.

The provision ends with more than one page of examples showing how this provision would work in various situations. One of the examples should suffice to demonstrate the ISO approach. It is as follows: An employee embezzled $250,000 during the current policy period and the prior period, One insurance company covered the insured during both periods. The current limit in policy A is $125,000. The coverage in prior policy B was $150,000. $175,000 of the loss was sustained in the current policy period and $75,000 was sustained in the prior policy period.

The insured can collect $!25,000 for the loss under policy A (it’s limit) but only $25,000 of the loss during policy B’s term for a total of $150,000, which is the highest amount of insurance provided by either of the policies during the period of the loss and is therefore the maximum collectible for the entire loss. 6 In essence, the new ISO form calls for the loss to be settled in the manner proposed by the insurance company in the Service Company matter. However, the new wording makes that clear; the previous wording did not.

The expansion of the provision wording (more than ten-fold plus the addition of more than a page of examples) demonstrates that the previous version was unclear. The insurance company’s lawyer in the Service Company case apparently agreed. This issue was not raised at trial although it was part of the insurance company’s letter of declination.

Discovery Form—A Better Alternative

The crime policies discussed so far were all “Loss Sustained forms.” That is, the policy covers loss sustained during the policy period. The only exceptions are losses that meet the requirements of the loss under prior coverage provisions. The Discovery Form is a better alternative. In previous articles, I’ve written that I like the discovery form because the policy in effect when the loss is discovered covers the entire loss. It’s irrelevant what the previous limits were or whether there was any prior insurance at all.7 The two loss-under-prior- insurance provisions found in the loss sustained version do not appear in the discovery form; there’s no need for them. Had Service Company’s most recent policy been a discovery form, the $1,000,000 current limit would have been clearly available to cover the entire loss.

The discovery form does not help the insured when the current policy has a lower limit of insurance than prior coverage. In the example from the new ISO form cited above, had the most recent form been a discovery form instead of a loss sustained form, the insured would have been able to collect only $125,000, not $150,000 since the current limit was $125,000. That makes for an interesting illustration, but in the real world, why would an insured reduce its coverage from $150,000 to $125,000? The longer an insured is in business, the greater the chance there has been an undiscovered loss extending over many periods. Employee theft insurance should be increased, not decreased. Discovery form is the way to go.

OWNERSHIP OF PROPERTY; INTERESTS COVERED

The issue that was raised when the Service Company case went to trial was whether Service Company’s interest in the money its employee stole met the standards set out in the “Ownership of Property; Interest Covered” policy provision. Under that provision, only property owned or held by the insured or for which the insured was legally liable was covered property. Service Company did not own the IRA funds, but the jury decided, after deliberating for about 20 minutes, that Service Company did “hold” the funds, presumably because the insured, through its employee, could direct disbursement of the funds. The jury awarded Service Company the full policy limit of $1,000,000. (Because this case occurred in California, there was a separate action against the insurance company for bad faith claims handling. The insurance company paid Service Company $250,000 to settle that matter.)

Clients’ Property Endorsement

One of the arguments the insurance company made in the Service Company case was that the insured had not elected the Clients’ Property endorsement offered in the quote for the policy. The clients’ property endorsement provides coverage for theft of clients’ property by the insured’s employees.

While the jury didn’t find this point persuasive, it’s of importance to us because it highlights another change to the ISO employee theft program in 2006. Prior to the 2006 changes, the Clients’ Property endorsement provided coverage for theft of a client’s property by the insured’s employees, provided the theft took place on the client’s premises. The requirement that the theft take place on the client’s premises was eliminated in the 2006 version. Both versions are entitled “Clients’ Property,” but the form number of the new form is CR 04 01 05 06. The earlier version was CR 04 01 03 00.8 One example of the difference in coverage is a theft from an accounting firm’s client by the firm’s employees. Let’s assume the employees empty the client’s bank account by wiring fraudulent instructions to the client’s bank from their home computers. This would not be covered under the old form, but would be covered under the new one.

LEARNING POINTS:

1 Employee theft/employee dishonesty coverage should be written on a discovery basis form, but the amount should not be less (and should probably be more) than prior insurance.

2 If the insured’s employees can steal clients’ property, the new clients’ property endorsement should be added to the policy.

3 Embezzlement losses are seemingly everywhere. In case you missed it, the New York Times reported on January 30, 2012, that a trusted employee of the New York Archdiocese was charged with stealing more than $1,000,000 of the Archdiocese’s funds in a seven-year long embezzlement. Had a criminal background check been done before she was hired, it would have revealed that she had been convicted of grand larceny in one case and pleaded guilty to a misdemeanor in another.9

4 Expert witness services are just a small part of my work as an insurance consultant for businesses. I turn down far more cases than I accept, often because I don’t agree with the claimant’s theory.

5 See US Justice Department Press Release “Palo Alto Pair Plead Guilty In $1.3 Million Financial Institution Fraud Scheme” http://www.justice.gov/usao/can/press/2010/2010_08_04_kerr.perrone.guiltyplea. press.html

6 At first the insurance company felt that the amount of insurance had been increased because the insured had discovered the embezzlement. However, the insurer did not raise this issue in court. 4 The form is identified as ISO copyrighted form CR 10 00 10 90. That form provided employee dishonesty coverage rather than the employee theft coverage of current ISO form, but that was not an issue in this loss.

7 This is derived from the standard rule for interpreting contracts: ambiguities in a contract are construed against the one who imposed the wording. The legalese for the rule is “contra proferentem.” See: http://en.wikipedia.org/wiki/Contra_proferentem

8 The form also specifies that the current deductible applies to the loss if the loss occurred during the current policy period. If not, the deductible in the most recent policy applies. However, the deductible is applied to the loss, not to the limit of insurance when the loss exceeds the limit. In this hypothetical the deductible was $10,000 in the most recent policy, which would not reduce the amount collectible. 7 The insurer can eliminate claims prior to a certain date by attaching endorsement CR 20 05 10 10 (Include Retroactive Date) or provide only limited coverage prior to a certain date with endorsement CR 20 24 10 10 (Provide Limited Coverage For Loss Occurring Before Retroactive Date).

9 The last four digits in ISO forms are the month and year that the form was promulgated in MM YY format.

10 Sharon Otterman and Ross Buetner “In Million-Dollar Theft Case, Church Worker With a Secret Past” NY Times, January 31, 2012. http://www.nytimes.com/2012/01/31/nyregion/new-york-archdiocese-bookkeeper-charged-with-stealing-1-million.html?nl=nyregion&emc=ura2