An hoary case in this area concerned a bicycle store that guaranteed to replace bike tires for a period, no questions asked (i.e., regardless of the cause of loss). The bicycle-tire guarantee provided a remedy broader than a simple warranty against defect; innumerable events exogenous to product failure could trigger the bike shop’s obligation to perform (to replace the tire). The Ohio Supreme Court found the transaction to constitute “insurance”, such that it had to be provided by a licensed insurance company or not at all. As the Court explained:

If the contracts of indemnity involved here are not violative of the insurance laws, then every company may, in consideration of the purchase price paid therefor, furnish its product and also undertake to insure it against all hazards for a specified period. Even if such a contract is an incident in the sale of merchandise and its use therein does not constitute the business of insurance, it is in effect a contract ‘substantially amounting to insurance’ within [the statute].

Ohio ex rel Duffy v. Western Auto Supply Co., 16 N.E.2d 256, 259, 119 A.L.R. 1236, 1240 (Ohio 1938). See also Ollendorff Watch Co. v. Pink, 17 N.E.2d 676, 677 (N.Y. 1938) (a watch replacement policy included with the sale of a watch was insurance).

We see similar transactions where, for example, for a fixed annual fee a company will provide maintenance to a fleet of trucks. See Transportation Guarantee Co. v. Jellins, 174 P.2d 625 (Cal. 1946). Or take the example of a supplier of medicines to a dispensary, where the supplier agrees to provide all pharmaceuticals required annually in exchange for a capitated price (i.e., a fixed dollar fee per participant). Compare Group Life & Health Ins. Co. v. Royal Drug Co., Inc., 440 U.S. 205 (1979). These transactions transfer the risk of greater demand by third parties, price spikes, and other risks outside the parties’ controls, but also involve incentives to provide the service or to produce the medications at lower costs to actualize the profit in the known revenue stream. Usually, to mitigate their exposure, the sellers concurrently maintain several programs, so as to decrease the likelihood that one site would prove to be particularly prone to loss or claims. (Sometimes, sellers will purchase an insurance product -- or what may be characterized as a reinsurance product depending on how the antecedent transaction is characterized -- to fund their obligations. E.g., Ollendorff Watch, 17 N.E. 2d 676.) For a price these transactions both transfer and distribute risk, key badges of insurance transactions. Are these types of transactions “insurance”? Should they be considered to be insurance and unlawful unless approved by the insurance commissioner?

A recent New York trial court decision confronted these issues in connection with a heating fuel oil company’s provision, for a fee, to its fuel-oil customers of clean-up services for spills up to $100,000, an amount well in excess of the value of the fuel oil provided or any service performed. In Petro, Inc. v. Serio, 2005 WL 1792866 (N.Y. Sup. July 29, 2005), the insurance commissioner sued for an injunction barring continuation of the program.

The Petro case is different from the bicycle-tire or watch-replacement cases above in that the New York legislature had passed a statute expressly exempting at least some such fuel-oil clean-up programs from insurance regulation. (The rationale includes that this is an important consumer benefit that protects the environment and thus should be encouraged.) New York law defines an insurance contract (which may be offered only by regulated insurance entities (with some exceptions not pertinent here)) as a contract that confers pecuniary benefit “dependent upon the happening of a fortuitous event.” N.Y. Ins. Law 1101.

The New York insurance department focused on the fact that the clean-up agreement would respond to losses on a much broader basis than merely those consequent to a defect in the fuel-oil system or some poor service that was performed. Particularly to the extent that the clean-up program would respond to losses having no relationship to the product or service that the fuel-oil company provided, the New York insurance department argued, the transaction constituted “insurance.” Compare Anstine v. Lake Darling Ranch, 233 N.W. 2d 723, 728 (Minn. 1975) (“[A] contract which requires the indemnitor to indemnify an indemnittee for losses with which the indemnitor had no connection and over which it had no control would be a contract of insurance.”), overruled on other grounds, 281 N.W.2d 838, 842 n.4 (Minn. 1979).

The court recognized that where a seller provided for the maintenance or repair of products made by others such an arrangement was more akin to insurance than it was to a warranty. 2005 WL 1792866 at *8. Yet, the court recognized that sometimes, where the other product was so closely tied to the seller’s product that its failure impugns the quality of the seller’s product, the relationship is sufficiently close as to fall outside the insurance box. Id. at *9. This is particularly true where the seller exercises some degree of substantial control over the circumstances that might give rise to covered loss.

While conceding in effect that the spill clean-up arrangement at issue does provide “insurance” where unrelated or exogenous events occur – such as third-party negligence, vandalism, or an animal’s intervention – the Petro court found these to be incidental to the arrangement rather than characteristic of it, especially because the fuel oil company made the showing that of the 1750 claims it had handled to date not a single one resulted from some catastrophic event or act of God. See id.

The court further recognized the limitations in the program for losses from the customer’s negligence or recklessness and from war and revolutions, all of which were reasonable efforts to limit the indemnification provided to those circumstances where the fuel-oil company’s product or service were substantially related. As a result, the court found the transaction to be more like a warranty, and thus outside the scope of regulated insurance contracts.

While the Petro case involved several parts of the New York Code that specifically exempted certain programs offered by fuel-oil companies from the reach of insurance regulation (and given this the NY Department's decision to prosecute is somewhat surprising), the reasoning of the court applies more broadly to companies that wish to offer some form of protection to their customers along with the sale of product or services. Petro is helpful in that it allows considerable fuzziness at the edges of transferring risks that are not associated with the product or service. In other words, the New York department was undoubtedly correct that many aspects of the risk transferred were exogenous to the relationship and thus insurance-like; the Petro court, however, resisted the invitation to focus on theory and the abstract, particularly where the company made a factual showing (having sold these instruments for a while) that the insurance aspects were incidental.

For companies interested in providing similar benefits, Petro suggests that this type of program can be offered where some reasonable effort is made to tie the obligation to indemnify to those risks of loss over which the seller has some substantial control – particularly, the quality of its product or its services. To the extent these programs pick up liabilities outside of these, the more insurance-like the transaction becomes.

Another way to approach this issue from a company’s perspective is to focus on the fact that in all cases that I’m aware of the transaction found to be insurance constituted an extra benefit conferred on the customer. In other words, the customer still possessed whatever remedies it had under the law for product defects or the like, but in addition possessed a contractual right to some pecuniary benefit, replacing the bike tire or watch, for example. (Tangentially, an extension of a manufacturer's warranty has withstood challenge as not being insurance, GAF Corp. v. County School Board of Washington County, 629 F.2d 981 (4th Cir. 1980), and under the view I'm suggesting can be conceived of as a waiver of the statute of limitations for claims that would otherwise be subject to tort or contract remedies.)

In structuring a non-"insurance" program, a different approach would be to limit the customer’s legal remedies and channel all claims to the benefit sought to be conferred. If in Petro for example a customer could not sue the fuel oil company for negligence resulting in an oil spill but instead was limited to its $100,000 clean-up right, that type of election of remedies provision should not be found to constitute insurance. Instead, it represents a reasonable, ex ante compromise of potential legal uncertainty that if its terms are disclosed clearly and is substantively fair is likely to withstand challenge. At a minimum, such arrangements should withstand challenge from insurance regulators; the question becomes then whether they withstand challenge from the customer who has a claim for greater than the contract-limited amount.