Acts of Fraud and your E&O

by Thomas Barrett, VP of Commercial Sales

Question: Can an E&O policy be of any use when allegations of fraud or dishonest acts are made against an Insured?

Answer: It depends on the fraud, who committed it and the type of E&O policy issued.

Most E&O policies have an outright exclusion relating to any fraudulent activities including simple allegations of fraud.  We believe this is unfair to parties that did not participate or were not aware of such an act.  A standard exclusion in an E&O policy would read as follows:

“This policy does not apply to any claim arising out of or relating to any actual or alleged dishonest, fraudulent or criminal activity by or on behalf of any Insured”

The wording that comes next is the most important.  Many carriers have an absolute fraud exclusion in their policies and will not modify their coverage.  However, we have found that many carriers will modify this exclusion to add back coverage for those innocent parties who did not participate, acquiesce or remain passive relating to the fraudulent act.  For carriers that will not do this, many will at least add back defense until final adjudication proves that there was a fraudulent act.

Why is this important?

Similar to defending the Insured against any covered claim, even if the claim is groundless or false, fraudulent claims can be very expensive and time consuming.  Defending allegations of fraud can be as expensive as any other claim and  could erode assets of the company that we feel should be protected.  Since the investors and shareholders of the insured are usually unaware of a fraudulent act by their employees until after the fact, we believe the other insureds under the policy should be protected and not be put at risk by the unscrupulous actions of one or more individuals.  This is a similar concept to Directors and Officers being protected when others commit a fraudulent action in a D&O policy.

What if the insured is not guilty of fraud?

In many claims that we see, an allegation of Fraud accompanies a negligence allegation. It may be that the negligence cannot be proven and the plaintiff continues with the allegation of fraud in the suit.  We have seen many carriers continue to defend such a suit until a final adjudication in the matter.  In the event a verdict is favorable to the insured, they have been protected from a groundless allegation.  In the event a ruling is favorable to Plaintiff, then coverage typically ceases.

What happens if the Plaintiff wins the allegation of Fraud?

Policy forms differ when there is a final adjudication of fraud. The typical options are as follows:

1. Some policy forms require the named insured or the guilty insured to pay back the defense costs incurred.

2. Some policy forms will just cease coverage at that point.

3. Some policy forms will continue to defend or indemnify innocent parties that are also insureds including the named insured.

Unfortunately, carriers are often locked in by their forms and reinsurance carriers as to which one of the above options are available.  Certainly, option 3 is preferred, but again, not all carriers offer that option.

We recommend that you review the fraud exclusions carefully in your policy and weigh the benefits of what is available in the various options presented.

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