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What Is Insurance Anyway?

03.21.2014

For traditional insurance products, there is little question that the product is “insurance” as defined by state law and therefore subject to state regulation governing the business of insurance.  Outside that well-charted domain, however, lie all manner of contracts providing indemnity or risk transfer that may or may not be regulated as insurance.  How does one know if a particular contract constitutes insurance?  What is insurance anyway?

Insurance, of course, is regulated primarily at the state level.  State statutes establishing the authority of state regulators to regulate the business of insurance typically define the term “insurance” very broadly.  Under California law, for example, insurance is “a contract whereby one undertakes to indemnify another against loss, damage, or liability arising from a contingent or unknown event.”1  On its face, this definition could apply to any contract that includes an indemnification clause.  Clearly, the California legislature did not mean the statute to extend so far.

In general, there are three types of contracts that involve indemnification or other risk transfer but have been recognized as not constituting insurance:  (i) first-party warranties, (ii) extended warranties or service contracts and (iii) contracts where risk shifting or indemnification is not the principal object and purpose of the contract or which otherwise are not insurance under one or more tests employed by courts.  Each of these arrangements is discussed below.

First-Party Warranties

Generally speaking, a first-party warranty is a warranty of the quality of goods or services by the manufacturer or seller with a promise to repair or replace defective goods, repeat services or provide a refund.  Such warranties generally are not regulated as insurance so long as the following conditions are met:  (i) the warranty is incidental to the sale of a product or service, (ii) the warranty is not negotiated separately from that sale, (iii) no separate consideration is charged for the warranty and (iv) the benefit provided is limited to repair or replacement of the product, repetition of services or a refund.2

It also may be permissible for a first-party warranty to cover incidental damage resulting from a defective product or service.3 If, however, a contract covers damage resulting from outside causes unrelated to an inherent defect, it generally is considered insurance.  For example, a warranty from the seller of tires offering to repair or replace the tires if they are damaged due to poor construction or defective materials and expressly excluding damage resulting from road hazards is not insurance.4  In contrast, a contract covering tires for damage resulting from hazards such as punctures, underinflation or poor alignment likely is insurance.5

Extended Warranties and Service Contracts

Like a first-party warranty, an extended warranty involves a promise to repair or replace defective goods, but unlike a first-party warranty, an extended warranty is offered for a separate consideration.  The cost of the extended warranty is not included in the purchase price of the product and is negotiated separately.  In addition, an extended warranty often covers not only inherent defects, but also failure of the product due to normal wear and tear.  An extended warranty may be offered by a seller, but it also may be offered by an unrelated third party. 

Extended warranties have been a growth industry in recent years, and consumers are now very familiar with the extended warranties commonly offered for goods such as electronics, appliances, cars and trucks, watercraft and other vehicles.  Another common form of extended warranty is the home warranty covering major home systems and appliances offered by a party other than the builder.

Most states now regulate these and other types of extended warranties as “service contracts.”  Typically, a separate regulatory scheme is found in state law for vehicle service contracts and service contracts covering electronics, appliances and other consumer goods.  Home service contracts also may be subject to their own regulatory scheme.

Other Contracts

Beyond first-party and extended warranties, there is a third, less defined category of contracts that share characteristics with insurance but are not necessarily subject to regulation as such.  As mentioned above, many state statutory definitions of insurance are broad enough to capture just about any contract that includes an indemnification or other element of risk shifting.  Clearly, not all such contracts constitute insurance. 

Courts employ a variety of practical tests to distinguish non-insurance arrangements involving indemnification or other risk shifting from insurance subject to regulation by state insurance regulators.

The most widely used test considers whether risk shifting is the “principal object and purpose” of the relationship between the parties to the arrangement.  Where it is not, courts conclude that the relationship does not constitute insurance.  The leading case applying the “principal object and purpose test” is Jordan v. Group Health Association.6  In that case, the Court of Appeals for the District of Columbia Circuit concluded that the following analysis should be employed in evaluating whether an agreement constitutes a contract of insurance:

[O]bviously it was not the purpose of the insurance statutes to regulate all arrangements for assumption or distribution of risk.  That view would cause them to engulf practically all contracts….  The question turns not on whether risk is involved or assumed, but on whether that or something else to which it is related in the particular plan is its principal object and purpose.7

Under the principal object and purpose test announced in Jordan, the fact that an agreement contains an element of risk shifting will not cause the agreement to be deemed a contract of insurance so long as the principal object and purpose of the agreement is something other than shifting risk.

Courts in many states have employed the principal object and purpose test in evaluating whether an agreement that includes an indemnification or other risk shifting constitutes insurance.8  State attorneys general also have employed the principal object and purpose test when asked to opine on this issue.9

The principal object and purpose test is a fairly subjective analysis.  There is no bright line for determining whether risk shifting is sufficiently incidental to a larger relationship or transaction so as not to be characterized as insurance.  Of course, the more limited in scope the indemnification or other risk shifting is in relation to a larger relationship between the parties, the greater the likelihood that it will be deemed not to be insurance.

In applying the principal object and purpose test, some courts have added a second criterion for evaluating whether an arrangement constitutes insurance—namely, “to what extent the specific transactions or the general line of business at issue involve one or more of the evils at which the regulatory insurance statutes were aimed.”10

For example, in Truta v. Avis Rent A Car System, Inc.,11 the California Court of Appeals held that a collision damage waiver offered by a rental car agency was not insurance.  The court based its holding on two grounds.  First, the waiver was incidental to the main purpose of the transaction, which was the rental of a car.  Second, the waiver was not the sort of arrangement the insurance regulatory statutes were designed to address.  In this regard, the court noted there was no risk the rental agency could default on the waiver because the waiver did no more than release the customer from liability for damage to the rental agency’s property.  Thus, a central concern of the insurance regulatory statutes—to regulate the maintenance of reserves and the investments of insurers to protect insureds in the event of loss—was absent from the transaction.12

Not all courts have adopted the principal object and purpose test.  Some courts have combined the test with various other considerations.  Other courts have focused on whether certain standard indicia of insurance are present in a relationship, such as the transfer and spreading of risk and payment of fees as consideration for the assumption of risk.13  Still other courts have looked to the same elements in determining whether a relationship constitutes insurance but have considered an additional factor—namely, whether the relationship involves the transfer and distribution of risk among a large group of persons bearing similar risks.14

The Minnesota Supreme Court’s decision in Allen v. Burnet Realty, LLC,15 provides an excellent example of the variety of factors a court may consider in evaluating whether an arrangement constitutes insurance.  In Allen, the court considered an indemnification and legal defense program offered by a realty agency to its brokers.  The court concluded that the arrangement was not insurance because the agency was not assuming any risk for the conduct of its sales associates that it did not already have under principles of respondeat superior.16  In addition, the court noted that the agency exercised a certain amount of control over the actions of the sales associates from whom liability might arise, which was inconsistent with the concept of insurance.17  Finally, the court found that although the agency charged sales representatives an annual fee to participate in the program, it charged all representatives the same fee and therefore did not engage in any underwriting of risk unique to individual representatives.18 From these facts, the court seemed to conclude that the agency was not acting in the manner one would expect for the creation of an insurance contract

In the end, whether a contract involving indemnification or other risk shifting constitutes insurance often is a difficult question to answer given the variety of tests the courts have relied upon to answer this question and the frankly impressionistic analysis that often is used.  Nevertheless, several common themes emerge from a reading of the cases in this area.  Factors that may cause a court to conclude that a contract does not constitute insurance include the following:  the element of risk shifting is incidental to a larger relationship or transaction; the covered risk is wholly or at least partially within the control of the party offering indemnification, causing the arrangement to look more like a first-party warranty; the arrangement is no more than a waiver of liability so that the consumer is not at risk of default by the other party; and the arrangement does not bear the common indicia of insurance, such as the payment of premiums, case-by-case underwriting of risk or adjustment of claims.


1 Cal. Ins. Code § 22. Other states have similarly broad definitions of insurance. See, e.g., Fla. Stat. § 624:02; N.Y. Ins. Law § 1101.
2 See, e.g., Ark. Code Ann. § 4-114-102(c)(1) and 4-114-103(14); N.C. Gen. Stat. § 58-1-20(a)(1); W.Va. Code § 33-4-2(a)(4) and (b)(5).
3 See, e.g., Cal. Ins. Code § 12805(a)(4) (warranty of vehicle or watercraft part that includes indemnification for consequential and incidental damage resulting from failure of the part does not constitute insurance).
4 State ex rel. Herbert v. Standard Oil Co., 35 N.E.2d 437 (Ohio 1941).
5 State ex rel. Duffy v. Western Auto Supply Co., 16 N.E.2d 256 (Ohio 1938). But see Petro, Inc. v. Serio, 804 N.Y.S.2d 598 (Sup. Ct. NY 2006) (service contract from home heating oil contractor that included clean-up service for oil spills was not insurance because although risk of spill was not entirely a matter of whether contractor's services were satisfactory, risk was sufficiently within contractor's control for clean-up service to qualify as a first-party warranty of services).
6 107 F.2d 239 (D.C. Cir. 1939).
7 Id. at 247 - 248.
8 See, e.g., Sasiadek's, Inc. v. Tucson, 765 P.2d 566 (Ariz. App. 1988); Title Ins. Co. of Minnesota v. State Bd. of Equalization, 842 P.2d 121(Cal. 1992); Transp. Guarantee Co. v. Jellins, 174 P.2d 625 (Cal. 1946); Automotive Funding Group v. Garamendi, 114 Cal. App. 4th 846 (2003); Lemy v. Direct Gen. Fin. Co., 885 F.Supp. 2d 1265 (M.D. Fla. 2012);Boyle v. Orkin Exterminating Co., 578 So.2d 786 (Fla. App. 1991); Barberton Rescue Mission, Inc. v. Dep't of Commerce, 586 N.W.2d 352 (Iowa 1998); State ex rel. Londerholm v. Anderson, 408 P.2d 864 (Kan. 1965); Allen v. Burnet Realty LLC, 801 N.W.2d 153 (Minn. 2011); New Mexico Life Ins. Guar. Association v. Moore, 596 P.2d 260 (N.M. 1979); Hertz Corp. v. Corcoran, 520 N.Y.S.2d 700 (Sup. Ct. NY 1987); H&R Block Eastern Tax Services v. Dep't of Commerce, 267 S.W.3d 848 (Tenn. App. 2008); Rayos v. Chrysler Credit Corp., 683 S.W.2d 546 (Tex. App. 1985).
9 See, e.g., 1973 Ariz. AG Lexis 57; 61 Ops. Cal. Atty. Gen 214 (1978); 55 Op. Atty. Gen. Md. 196 (1970); 1960 Tex. AG Lexis 90.
10 Truta v. Avis Rent A Car System, Inc., 193 Cal. App. 3d 802, 812 (1987).
11 Id.
12 Truta at 813. See also Automotive Funding Group, Inc. v. Garamendi, 114 Cal. App. 4th 846 (2003) (debt cancellation program offered by an auto lender did not constitute insurance because it was incidental to the loan contract between the lender and borrower and was not the sort of transaction the California insurance regulatory statutes were designed to regulate).
13 See, e.g., Griffin Systems, Inc. v. Washburn, 505 N.E.2d 1121, 1123-24 (Ill. App. 1987).
14 See, e.g., Jim Click Ford, Inc. v. Tucson, 739 P.2d 1365, 1367 (Ariz. App. 1987).
15 801 N.W.2d 153 (Minn. 2011).
16 Id. at 158.
17 Id. at 159.
18 Id.