Penalty Default Rules in Insurance Law

Abstract

A default rule tells a court how to fill a gap in a contract. A penalty default tells a court to fill the gap in a way that is undesirable to at least one of the parties. The threat of a penalty default rules is meant to induce parties to reveal information, to each other or the courts, by contracting around the penalty. Since the concept was first introduced by Ian Ayres & Robert Gertner in Filling Gaps in Incomplete Contracts: An Economic Theory of Default Rules, 99 YALE L.J. 87 (1990), major scholars have argued over which rules, if any, might qualify.

A prime candidate has been nominated but never elected. Contra proferentem, the doctrine that ambiguities in a contract should be construed against the drafter, is mentioned as a likely penalty default repeatedly, including in the original Ayres & Gertner article and in a major critique by Eric Posner in 2006. Surprisingly, despite the shared intuition that contra proferentem is a penalty default rule, this article is the first to seriously take it on.

Insurance contra proferentem provides an unusual test case because it is actively conceived of by many courts as punitive, aimed at producing more information in the form of a redrafted contract clause. If contra proferentem is not a penalty default, prospects look dim for the rules’ existence. The doctrine is predominately applied in the insurance context and I am the first insurance scholar to fully take the field.

By scrutinizing the candidate, this article makes two contributions. To the study of contractual gaps, it proves there is at least one penalty default rule in the world, but one that does not operate in either of the two ways the existing literature envisions. This new category sharpens our understanding of the remaining defaults. To the interpretation of consumer contracts, and insurance contracts in particular, this article sounds a warning about the dangers of penalty default rules. Contra proferentem operates as a regrettable penalty default, and for reasons that hold for consumer contracts more broadly. In short, the rule does not consistently force the sophisticated party to better inform the consumer but it does exact consumer cost. In a non-trivial subset of cases, the rule widens the misunderstanding between contract drafter and consumer.

There is a fundamental difficulty with information-forcing rules in insurance, at least to the extent the information is meant to be revealed to the policyholder and not the courts; the less informed party is tough to inform. In addition, the incentive to inform — the incentive to escape the penalty — is anemic when applied unilaterally to a class of drafters who are indifferent to a penalty as long as (a) it applies to its competitors equally and (b) the costs of the penalty are ultimately paid by the buyer.

Conclusion: The nature of insurance interpretation makes contra proferentem and related doctrines excellent candidates for a penalty default rule, descriptively, and poor candidates for the rules normatively. Parallel problems can be expected if a penalty default is applied to boilerplate consumer contracts.

Keywords: contract, contract interpretation, penalty default rules, insurance law, contra proferentem