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Chapter 5: liability and contract issues.


Most people are aware of the need for liability insurance. If nothing else, they know that liability coverage is required in order for them to legally drive their car. A majority are also aware many legal actions where people or companies are sued for things such as making the coffee too hot or having a barking dog. They may not however, know the legal underpinnings for why there are lawsuits and why they need liability insurance.

If someone breaks the law, it is a criminal act or public wrong. Criminal acts are prosecuted by the government in an effort to protect the general public. On the other hand, someone may commit a civil or private wrong. This is known as a tort. A tort is the result of one individual or organization causing harm to another--either physical, emotional or financial (or any combination thereof). It is also possible for the same activity to be both a public (criminal) and private (civil) wrong.

Torts can either be intentional or unintentional, and the individual who commits either type of tort is called a tortfeasor. Intentional torts seem pretty straightforward. Someone who tries to harm another person on purpose is committing an intentional tort, which is also likely to be a public/criminal wrong. Intentional torts are actions such as assault and battery, libel or slander. (There is no insurance protection available for the person who commits criminal actions, but the standard CGL form does provide coverage for some intentional acts of the insured under coverage B, personal and advertising injury liability.)

Unintentional torts can seem a little less straightforward. In general, an unintentional tort involves some level of negligence. Negligence does not mean the individual had a wrong or harmful intent. Instead, it may be described as not using the care a reasonable adult person would use. If one person brings a civil suit against another, the court will try to determine the degree to which reasonable care was not exercised, and the amount of any directly-related loss or damages.


A court may decide that an individual or organization must compensate another as a result of a tort. However, just because a judgment is rendered, it does not mean that the individual specifically did anything wrong. It may just mean that someone got hurt and someone else was going to have to pay for that hurt. When a judgment is rendered, that individual is said to be liable for the damage. If it sounds like there is the potential for such judgments to be unfair, that's right. The courts do their best job at getting things right, but fair is not always the result.

Another point to remember is, public policy tends to shift over time. One result of this is actions that previously might not have been viewed negatively now create lawsuits. Tort law does not always seem logical either. Consider that most people would applaud a Good Samaritan who tries to help a fellow motorist. However, that fellow motorist may decide to sue for damages --and win in court (although states today do have Good Samaritan laws to protect persons from lawsuits in some circumstances). This illustrates that liability may not be avoidable, no matter what level of care is used. This is one good reason to have liability insurance.


As previously identified, individuals and organizations can have significant amounts of liability without really having done anything wrong. The financial impact resulting from this can truly be devastating. There are certain defenses that may limit an individual's liability exposure.

Assumption of the risk. If an individual recognizes and understands the risk in an activity and still chooses to do it, then someone else cannot be held responsible for the injury. Skiers may recognize this as a clause in the ski ticket agreement.

Contributory negligence. Sometimes the injured person was at least somewhat negligent. When this is true, the defendant is absolved of any liability. This is the strictest approach and has been replaced in many states by comparative negligence.

Comparative negligence. Comparative negligence reduces the defendant's liability by the degree to which the injured party is deemed to have been negligent. So, in a situation where there is a $100,000 award, but where the injured person is deemed to be 40% negligent, the damage award will be reduced to $60,000.

Last clear chance. This is a modification of the contributory negligence rule in which contributory negligence on the part of the injured party will not bar recovery if the other party, immediately prior to the accident, had a last clear chance to prevent the accident but failed to seize the chance. For example, if a driver negligently pulled out onto a highway in front of another auto and an accident resulted, the driver of the second auto might be held liable for the accident if he or she had sufficient time to swerve out of the way but did not do so.


When faced with an adverse judgment, liability insurance can help ease the financial pain. However, the amount of liability insurance carried does not in any way limit potential judgments. Some people might think that carrying $1,000,000 liability coverage means they can never be liable for more than $1,000,000. Not true. The liability insurance will pay up to $1,000,000, but it will not prevent a judgment for more than that amount. What happens if a $3,000,000 judgment is rendered? The insured will be liable for the full $3,000,000--of which the insurance will cover $1,000,000. The rest comes out of the insured's bank account.

If that's the case, how much coverage should the average individual carry? First, average is not especially relevant. Each person should evaluate his or her financial status and go from there. It seems prudent for $300,000 coverage to be a minimum starting point (contrast this with required state auto liability minimums to see the potential for huge out-of-pocket liability amounts). For personal, as opposed to professional liability insurance, premiums tend to be fairly reasonable. This means that, even the average person might consider coverage of at least $1,000,000--perhaps more, depending on asset and income levels. In general, higher assets and/or income indicate a need for higher levels of coverage.


An attractive nuisance is something that attracts children, and where they might get injured. Swimming pools and tree houses come to mind. The owner of these things is expected to exercise very high levels of care in order to protect children.

Negligence is where the expected level of care is not exercised. Negligence per se is where the level of care owed is identified by law or statute. Negligence per se can come to bear when a law is enacted to protect a specific group of people, and one of those people gets harmed by someone.

Speeding through a school zone provides an example where negligence per se might come into play. If a driver speeds through a school zone and hits a school child, he or she would be guilty of negligence per se. If that same driver hit a non-school child (e.g., a regular pedestrian), he or she would not be guilty negligence per se (just negligence). Why? The school zone statute was written to protect schoolchildren, not regular pedestrians.

A person or organization may be held responsible even when there has not been any demonstrated negligence. This is known as absolute liability. An employer may be held liable under this concept for actions of its' employees.

Strict liability is also known as liability without regard to fault. It is a form of absolute liability in which there is no possible defense. Product liability lawsuits often rely on the concept of strict liability.

When someone is held liable for the acts of someone else, it is known as vicarious liability. A parent may be held vicariously liable for the acts of her child, or an employer may be vicariously liable for acts of employees. Note that sometimes more than one type of liability may be applicable. So in an employer/employee situation, both strict and vicarious liability may be factors.

The collateral source rule states that if a judgment is rendered against person 1 who committed a tort (the tortfeasor) against person 2, person 1 is responsible to pay the entire damage award--regardless of things such as any insurance person 2 might have that also pays.


There are significant differences between personal and professional liability. In general, the standard of care requirement is far greater for professionals. When a professional (say, a financial planner) starts working with a client, a contract is created--whether written or oral. That contract is a legal document that carries with it certain expectations. One of those expectations is the assumption that the professional will operate with all due care. In some cases, the due care requirement extends to being considered a fiduciary, which includes an even greater expectation of care.

A professional who fails to conduct himself or herself in a professional manner and causes harm to another may be considered negligent. Negligence is applicable when the professional has a duty to conform to a certain standard of conduct and fails to conform to that standard. There must be an actual loss or harm, and there must be a direct connection between the loss and the professional's actions.

Agency Relationships

Depending on the exact nature of the engagement, an agency relationship may be created. When one is considered to be an agent for another (the principal), the agent has both increased authority and increased responsibility. Agency relationships carry three general types of authority:

* Express

* Implied

* Apparent (ostensible)

Express authority is that which is specifically given. As an example, a life insurance company that gives an agent the authority to write whole life and universal life insurance coverage has given that agent the express authority to write those coverages. Notice that no express authority has been given to write variable life insurance (more on this shortly).

Even though the insurer may not have specifically said that the agent can do things such as complete applications, order physicals, or issue conditional receipts, that authority is implied. Implied authority is essentially that which is required in order for the agent to do his or her job. An agent will almost always have the implied authority to carry out the functions conferred in the giving of express authority.

There is, however, another type of authority that has not truly been given, but can have significant implications, including substantial liability. Consider a situation where the agent above (not having express authority to write variable life insurance) meets with a potential client who wants to purchase a variable life policy. The client has no easy way of knowing, nor any reason to assume, that the agent does not have express authority to write the coverage. If the agent writes the application, is the client covered? Technically, yes. The concept of apparent (also know as ostensible) authority may be applies. Apparent authority exists when a third party believes that an agent truly has the authority to act, and it can create legal liability for the principal (as well as the agent).

When a professional has an agency relationship--either with a client or a parent organization (e.g., insurance company)--there is increased potential for liability. Judgments rendered will also likely carry higher dollar amounts.


If a contract is created along with each professional relationship, it is important to understand the basic nature of contracts and what happens when disputes arise. Not all contracts work as originally intended, and in any related legal action, the courts have to decide what went wrong, why it went wrong, and who may be at fault.

The parol evidence rule is one guideline used by the courts. This rule states that, when the parties put their agreement into a final, complete, written form, all previous understandings will be considered invalid.

The doctrine of waiver means that an individual or organization has voluntarily given up a contractual right. As an example, if a claims adjuster agrees to pay a small claim even though the insurance contract conditions have not been met, the adjuster has just waived the insurer's contractual rights (the adjuster is acting as an agent of the insurer). The insurer will not be able to reassert that right later on.

The doctrine of estoppel keeps an individual or organization from re-asserting a contractual right which previously has been waived. Continuing the example above, assume the insured had a later claim under the same circumstances of the first, but with larger dollar amounts. Additionally, assume that the adjuster now tries to deny claim payment. If the claim is taken to court, the insurer will technically have to pay. In other words, they will be stopped (or estopped) from asserting the contractual right the adjuster previously waived.

Estoppel also may be brought to bear when an agent provides misinformation on which the insured relies and, as a result, suffers a loss. As an example, assume that an insured call her agent to see whether a new diamond bracelet was covered under her homeowners policy. If the bracelet has a relatively high dollar value--say, $10,000--the correct answer is no, it is not fully covered. However, assume that the agent incorrectly stated that there was full coverage. If as a result, the insured did not increase her coverage and the bracelet was later stolen, the insurance company would technically be required to pay. Why? In misleading the insured, the agent was, in a sense, waiving the insurer's contractual rights, and the company would be (e)stopped from asserting that right.

Rescission is an equitable remedy by which the original contract is terminated from its beginning. For rescission to take place, there must be evidence of material fraud or misrepresentation. A contract so terminated is said to be rescinded, making it as if it were never enacted.

Reformation is an equitable remedy in which a contract is changed to more accurately express the original intentions of the parties. The purpose of reformation is to make the contract language conform to what was originally intended.

A contract of adhesion is one in which one entity writes the contract and the other party only has a choice either to accept it or reject it. In this case, any misunderstandings likely will be ruled in favor of the second party. Any unclear language will be interpreted by the courts in favor of the party that did not write the contract. Insurance contracts are contracts of adhesion. One way to describe this is, if you wrote it, you're stuck with it.


1. Mittra, Sid, Tom Potts, and Leon Labrecque, Practicing Financial Planning for Professionals, 9th Edition (Rochester, MI: RH Publishing).

2. Snowdon, Michael, Financial Planning Process and Insurance: Introduction to Risk Management and Related Legal Issues (Greenwood Village, CO: College for Financial Planning, 2007).

3. Trieschmann, James S., Robert Hoyt, and David Sommer, Risk Management and Insurance, 12th edition (Mason, OH: South-Western College Publishing, 2005).

4. Vaughan, Emmett J. and Therese M. Vaughan, Fundamentals of Risk and Insurance, 9th edition (New York: Wiley & Sons, 2003).


1. Insurance protection is usually available for the person who commits an intentional tort.



2. Being liable always means you have done something wrong.



3. Under the doctrine of comparative negligence, an injured party may have his damage award reduced by the percentage he is determined to be negligent.



4. Liability judgments are limited to the amount of insurance the defendant owns.



5. A swimming pool is a good example of an attractive nuisance.



6. An employer may be held liable for the acts of an employee under the concept of absolute liability.



7. An example of express authority is an insurance company licensing an agent to sell universal life insurance.



8. A principal cannot be held liable for the acts of an agent under the doctrine of apparent authority.



9. The parol evidence rule says that, even after a contract is written in final form, previous verbal agreements are considered valid.



10. The doctrine of estoppel keeps an organization from re-asserting a contractual right that had previously been waived.


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Publication:Tools & Techniques of Risk Management for Financial Planners, 2nd ed.
Date:Jan 1, 2007
Previous Article:Chapter 4: insurance company selection.
Next Article:Chapter 6: automobile and recreational vehicle insurance.

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