April 4, 1989 Number 4

April 4, 1989 Number 4 Paula Gold, Secretary Executive Office of Consumer Affairs and Business Regulation One Ashburton Place Boston, Massachusetts 02108 Roger M. Singer Commissioner of Insurance Commonwealth of Massachusetts 280 Friend Street Boston, Massachusetts 021 14 Dear Secretary Gold and Commissioner Singer: You have requested my opinion pursuant to G.L. c. 12, § 9 whether a used- home warranty product offered by Home Security of America, Inc. ("HSA") constitutes a contract for insurance which may be regulated by the Commissioner of Insurance.* Your question is: Does the contract between Home Security of America, Inc. (HSA) and either the seller or the buyer of a home, under which HSA warrants specified items in the house against "operational failure," constitute a contract of insurance within the meaning of G.L. c.175, § 2? HSA takes the position that the Plan is nothing more than a warranty and 1 The Home Security Plan ("the Plan") offered by HSA is a contract which provides coverage on residential real estate for repair or replacement of a list of enumerated items when such items suffer an "operational failure" due to "mechanical breakdown." The Plan is purchased by the seller of the residential real estate, protecting the seller in renewable six month increments until the home is sold, and then covering the purchaser for thirteen months after the sale. When "operational failure" of a covered item occurs, HSA provides indemnification for the cost of repair or replacement, within the specific per item dollar limits and the overall $10,000 limit of the Plan. Covered items range from the roof to internal wiring, and from appliances such as dishwasher, disposal and furnace, to plumbing. However, if specific builders', sellers' or manufacturers' warranties on covered items still apply, or if the items are covered by insurance policies, then the Plan only provides coverage after these warranties or insurance policies have been exhausted. "Operational failures" caused by lack of maintenance, inspections, cleaning, adjustment or lubrication services are excluded from coverage. Some items over a certain age are excluded from coverage as well. 126 P.D. 12 should not be regulated as insurance.^ You have advised me that the Insurance division in the past has characterized similar plans as insurance. For the reasons stated below, it is my opinion that the used-home warranty contract offered by HSA falls within the statutory definition of insurance, set forth at G.L. c. 175, § 2. I. Current Definition of Insurance Insurance is defined in the Commonwealth of Massachusetts as follows: A contract of insurance is an agreement by which one party for a consideration promises to pay money or its equivalent, or to do an act valuable to the insured, upon the destruction, loss or injury of something in which the other party has an interest. G.L. c.175, § 2. This definition is wide in scope and potentially encompasses a broad range of products. A 1959 Opinion of the Attorney General recites five elements which define contracts of insurance: 1. The insured possesses an interest of some kind susceptible of pecuniary estimation, known as an insurable interest; 2. The insured is subject to a risk of loss through the destruction or impairment of that interest by the happening of designated perils; 3 . The insurer assumes the risk of loss; 2 In a memorandum submitted by HSA in conjunction with your request, HSA suggests that a determination that the Plan is insurance would conflict with the position of twenty-three states where it currently markets the Plan. While these statistics are interesting, regulation of insurance is left to the individual states, and we are not compelled to adopt this view. According to HSA's memorandum and copies of correspondence supplied by HSA from various state insurance departments, four states (Arkansas, Connecticut, Kentucky, and Vermont) regulate used-home warranties as insurance and Oregon directed HSA to apply for a certificate to do business as a "home protection insurer" pursuant to ORS 731.164. Also, Maine and Texas regulate used-home warranties as insurance when they are sold by insurance companies. Finally, in New York, used home warranties are subject to regulation as insurance whenever the company selling them is "in the business of insurance," and is offering warranties as a vocation, not merely incidental to another business or activity. Electronic Realty Associates v. Lennon, 94 Misc.2d 249, 404 N.Y.S.2d 283, 287—288, off 'd as mod., 67 A.D.2d 997, 413 N.Y.S.2d 728, /v. to appeal den., 47 N.Y.2d 705, 417 N.Y.S.2d 1026 (1979). N.Y. Ins. Law § 1101 (b)(1)(B) (McKinney) [recodification of former N.Y. Ins. Law § 41(3)(b)]. P.D. 12 127 4. Such assumption is part of a general scheme to distribute actual losses among a large group of persons bearing similar risks; 5. As consideration for the insurer's promise, the insured makes a ratable contribution to a general insurance fund, called a premium. 3 1959 Op. Att'y Gen., Rep. A.G., Pub. Doc. No. 12, at 72 (1959). The Opinion further states that if a contract contains only the first three elements, it is simply a risk-shifting device, and therefore not a contract of insurance. If it contains the last two elements as well, the contract then becomes a risk-distributing device, and would therefore be a contract of insurance.^ Although the presence of "risk" is an essential element^, it is not 3 This formulation thereby defines a "premium" as a "ratable contribution to a general insurance fund." The term "ratable" is defined as "proportional." Black's Law Dictionary (5th ed.). The premium (or "proportional" contribution) measures each insured's distributive share of the risk of all similarly situated insureds plus a proportional share of the expenses of the insurance company, and is paid into a general insurance fund maintained by the insurer. The losses of the policyholders and the expenses of the business are paid from this general insurance fund. W. Vance, Handbook on the Law ofInsurance § 1 at 4—6 (3d ed. 1951) . In Massachusetts, it is not necessary that the contribution be itemized separately from the overall charge of a retail contract. Attorney General v. C. E. Osgood Co., 249 Mass. 473, 476 (1924). 4 This Opinion concluded that an independent corporation which marketed used- car warranties to auto dealers, which were in turn given to used-car purchasers by the dealers, was selling insurance in the Commonwealth of Massachusetts. The contracts promised indemnification for pre-approved repairs. The General Court apparently agreed with this analysis and conclusion as it has explicitly added "mechanical breakdown" or "mechanical failure" of automobiles as a peril which can be insured. St. 1980, c.386, § 1, amending G.L. c.175, §54C. * A concern has been raised that the 1959 Opinion is in conflict with prior Opinions. While the 1959 Opinion does not cite prior Opinions of the Attorney General discussing the definition of insurance, it is in fact fully consistent with them. The 1959 Opinion, as did prior Opinions, identifies contracts as insurance where: the covered peril and consequential loss are not "inevitable," but pose only a "risk" of occurrence within the life of the contract; a "premium" is charged in some fashion for the coverage; the insurer does not provide services itself but rather pays indemnification when the insured suffers a loss; the "insurer" is not an actual seller or manufacturer of goods who is warranting them to be of such quality as to survive wear and tear for a specified period of time; and the "insurer" is not really just providing ongoing (therefore inevitable) inspection and maintenance for equipment. By way of illustration of these principles, a year-long contract for automobile 128 P.D. 12 alone sufficient to establish a contract as insurance.^ Other types of contracts repairs necessitated by either wear and tear, or from accident, collision or negligence, was considered insurance, 8 Op. Att'y Gen. 40, 41-42 (1926), while a contract of insurance was not created where a seller of apparently new tires warranted the tires would survive ordinary wear and tear for a specified period of time, but specifically excluded accidental damage and made no additional charge or premium for the warranty beyond the cost of the tires. 1940 Op. Att'y Gen., Rep. A.G., Pub. Doc. No. 12 at 39 (1940). The 1959 Opinion is also consistent with prior opinions which distinguish between insurance contracts and service contracts. For example, when the need for maintenance, service and repairs is an inevitable result of the operation of electrical equipment, a contract which provides for complete and ongoing inspection, maintenance and repair services by the contractor is a service contract, and not insurance. 1 Op. Att'y Gen. 544 (1898). Finally, the 1959 Opinion also concluded that an independent inspection company's promise to indemnify covered purchasers of automobiles on the occurrence of a designated peril causing a loss, rather than directly perform repairs, would create an insurance contract. This was consistent with a 1918 Opinion which concluded that where an Automobile Association provided indemnification to members who hired their own attorneys, an insurance contract was created, while the direct provision of legal services to members by the association's own attorneys, was not insurance. 5. Op. Att'y Gen. 206 (1918). " If the contemplated contingency which is required to create a contract of insurance is certain of occurring within the term of the contract, or if the "insurer" can fully control and thereby completely avert the contemplated contingency, the "risk" that the contingency will occur during the life of the contract is eliminated insofar as its occurrence is converted to either a certainty or an impossibility. If all risk is thus eliminated, an insurance contract cannot exist. 7 HSA asserts that insurance protects against "hazards." The term "risk" has historically been used interchangeably with the term "hazard." "Hazard" has been defined as "risk," or, "the likelihood or probability of loss." See e.g., Ballentine's Law Dictionary (3d ed. 1969). See also, Black's Law Dictionary (5th ed.). Past Opinions have stated that an essential element of a contract of insurance is "hazard." See, e.g., 8 Op. Att'y Gen. 40, 41 (1926). However, recent formulations define hazard more narrowly as "anything that increases the likelihood of a loss or the possible severity of a loss." B. Smith, J. Trieschmann, & E. Wiening, Property and Liability Insurance Principles 21 (1987). In other words, a "hazard" is now defined as anything that enhances the possible risk of a loss or the possible severity of a loss. Consequently, insurance is now seen to protect against "risks." P.D. 12 129 may protect against "risk" as well, such as a warranty. Where an insurer assumes a "risk" of loss from the occurrence of a designated peril during the life of the insurance contract, a warrantor similarly assumes a risk that a warranted item will fail during the life of the warranty.** However, while both insurance and warranties are "risk-shifting" devices, only insurance also contains the element of "risk distribution." Under the five-part analysis of the 1959 Opinion, the combination of "risk-distribution" with a plan of "risk-assumption" serves to create an insurance contract, assuming the other enumerated factors are also present.^ ° It has been suggested that an insurer can exercise meaningful control over the "risk" of the contingency that repairs will be needed by performing a precoverage inspection of the insured item or premises. However, the extent of control exercised by the insurer is relevant only insofar as the risk can be totally eliminated. The 1959 Opinion rejected pre-contract inspections as conclusively demonstrating any meaningful indicia of control, likening such assertions to the equally fallacious statement that a medical examination of a person could eliminate the fortuitous event of physical impairment or death. Such inspections only uncover existing conditions, and do not serve as reliable predictors of future failure, even more so where the covered items are imbedded in walls, such as wiring and plumbing, or otherwise hidden from view, such as the motor of a dishwasher. Precoverage inspections will not therefore eliminate the risk of failure during the life of the contract. If a precoverage inspection was deemed sufficient to remove a contract from the definition of insurance, then title- insurance, wherein a title company engages in a full precoverage title search, would also fail to meet the definition of insurance. " HSA argues that insurance can only protect against "external forces" because "internal forces" are subject to the control of the insurer. Presumably, the point HSA makes is that an insurer can exercise total control over "internal forces" which can potentially cause a loss, thereby eliminating the element of "risk." However, as stated above, even a warrantor assumes a risk of failure during the life of the warranty. HSA cites Claflin v. United States Credit System Co., 165 Mass. 501, 502 (1896) for the proposition that a contract of insurance involves the application of an external force to create a "hazard." The conclusion HSA draws is that the term "hazards" implies the presence only of "external forces." The Claflin decision does not support this interpretation. The Claflin court neither discusses a distinction between "external" and "internal" force, nor does it conclude that insurance can only exist when an "external force" is involved in creating a hazard [risk]. As discussed in n. 6, supra, the term "hazard" neither was formerly nor is presently defined as "external force." Neither does the statutory definition of insurance distinguish between the application of "external" or "internal" force. G.L. c. 175, §2. Such a distinction has explicitly been rejected insofar as "mechanical breakdown" and "mechanical failure" of automobiles, regardless of cause, is a peril which may now be insured against in Massachusetts. G.L. c. 175, §54C. Furthermore, in an analogous situation, life 130 P.D. 12 II. The Plan is a Contract of Insurance The provisions of the Plan make it clear that it is a contract of insurance.^ The Plan falls within the statutory definition set forth in G.L. c. 175, § 2: The Plan is an agreement by which the HSA for the consideration of the purchase price, promises to pay money to the seller or buyer of residential real estate, upon the destruction, loss or injury to something in which the purchaser has an interest. The Plan also falls squarely within the five-point test enumerated in the 1959 Opinion. First, the seller, and subsequently the buyer, of the residential real estate own equity in the property and its components, thus creating an insurable interest. Second, the seller and the buyer are both subject to risk of loss through the occurrence of the designated peril: "operational failure" of covered components. 11 Upon such operational failure, the seller or buyer will be subject to a monetary loss. Third, HSA agrees to assume the risk of loss. HSA promises upon the occurrence of a covered "operational failure" to indemnify the seller or buyer for all or part of the cost of repairs or replacement. Fourth, the assumption of this risk by HSA is part of a general scheme to distribute actual insurance insures against death from any cause, whether external or internal. Commonwealth v. Wetherbee, 105 Mass. 149 (1870). 10 It has been suggested that the Commissioner follow the contrary conclusion in the New York decision in Electronic Realty Associates v. Lennon, which discusses the narrow New York statutory definition of insurance, and finds the home repair contract being reviewed to be a warranty rather than insurance. See n. 2, supra . In contrast, the 1959 Opinion observes that insurance is defined broadly in Massachusetts. Furthermore, Massachusetts case law has rejected one of the principal premises relied on by the Electronic Realty Associates court, i.e. : Massachusetts deems it irrelevant whether a particular activity is the chief business of a company or whether it is merely ancillary in determining if the activity falls within the statutory definition of insurance. Attorney General v. C. E. Osgood Co., 249 Mass at 477. 11 HSA claims that there is no "risk" inherent in the Plan because the need for repairs will be inevitable. This argument is contradicted by HSA's own memorandum which states that "since the components are in various states of aging, no one can know with certainty the remaining life of these components." HSA also claims that the required precoverage inspection eliminates the required "risk" that repairs will be needed. However, this inspection is unlike the inspections included in a service contract which trigger necessary maintenance and repairs. As noted above, this inspection serves only as a baseline to exclude pre-existing conditions from coverage, thereby eliminating the inevitability of the need for repairs. In truth, the need for home repairs during the life of the Plan while possible, is entirely fortuitous, thereby creating the "risk" to the insured. P.D. 12 131 losses upon a group of persons bearing somewhat similar risks: i.e., sellers, and subsequent purchasers of residential real estate to the extent their property and components meet certain age and inspection requirements. Fifth, the insured, here either the seller or buyer, pays a premium to a general insurance fund, insofar as they pay a fee to HSA which presumably retains at least part of the premium to cover future losses and expenses.^ III. The Plan is Neither a Warranty Nor a Service Contract HSA is not a warrantor. The 1959 Opinion defines a warranty as an affirmation, or collateral obligation, made by a seller, accompanying a contract of sale, which relates to the character, quality or fitness of the goods. 1959 Op. Att'y Gen., Rep. A.G., Pub. Doc. No. 12 at 74 (1959). 13 HSA is not the seller of the home and therefore cannot be said to be making a promise in connection with the sale of its goods. It therefore cannot assert that it acts in the shoes of a seller who warrants a home to a buyer. HSA neither built, manufactured nor owned the used home or the covered components, and therefore is in no position to attest to the quality of the materials or workmanship used in manufacturing or building them. 14 In addition, for the reasons discussed in n. 8, supra, HSA's precoverage inspection does not enable it to attest to the quality, character or 12 While HSA did not explicitly state that it retains part of the premium in a reserve fund to cover future claims from policy holders, it must be presumed it does so under ordinary accounting practices. Otherwise, akin to a pyramid scheme, future claims would only be funded out of future sales of new policies, and if such future sales were insufficient, the company would be unable to meet its obligation to pay claims. Regulation of such contracts as insurance by the insurance commissioner can protect the public, in part, by serving to insure that companies such as HSA retain sufficient reserves to cover future losses. 13 The 1959 Opinion recites a number of different, but similar formulations of the definition of a warranty. An express warranty is defined in G. L. c. 106, §2- 313 (.1) (a) as: "Any affirmation of fact or promise made by the seller to the buyer which relates to the goods and becomes part of the basis of the bargain creates an express warranty that the goods shall conform to the affirmation or promise." Black's Law Dictionary (4th ed.) is cited as defining a warranty as: "A statement or representation made by the seller of goods, contemporaneously with and as a part of the contract of sale, though collateral to the express object of it, having reference to the character, quality, or title of the goods, by which he promises or undertakes that certain facts are or shall be as he then represents them. 14 The home builders' and covered component manufacturers' or sellers' warranties will have most often expired at the time of sale by the homeowner. In those instances where the warranties have not expired, or where other insurance exists, the Plan provides only secondary coverage, placing primary reliance on the existing warranties or insurance. This is remarkably similar to the "coordination of benefits" clause common to insurance contracts. 132 P.D. 12 fitness of the premises. HSA is also not in a position analogous to a service contractor. HSA does not contract to provide regular inspections or to perform full maintenance of components. HSA performs no repairs itself, but merely authorizes the insured to contract for repairs or replacement, for which it will often provide indemnification (often only partial), or require the insured to exhaust other warranty or insurance coverage. Also, ordinary maintenance is explicitly excluded from coverage. The Plan is therefore not a service contract. IV. Conclusion The Plan falls within the statutory definition of insurance and the five-part test in the 1959 Opinion. As insurance, the Plan is subject to the regulation and supervision of the Commissioner of Insurance. * Such regulation may serve to protect the public from the purchase of worthless insurance from financially unsound companies or from purchasing actuarially unsound or otherwise questionable insurance products. The Commissioner of Insurance has the expertise and experience to regulate these products. In sum, the Plan constitutes a contract of insurance under Massachusetts law. Very truly yours, JAMES M. SHANNON ATTORNEY GENERAL 15 The regulation of the insurance industry is in the public interest. Attorney General v. Prudential Insurance Company of America, 310 Mass. 762, 765 (1942). P.D. 12 133