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Merit Insurance Co. v. Colao

decided: August 7, 1979.


Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 75 C 899 -- Julius J. Hoffman, Judge.

Before Swygert, Lay*fn* and Wood, Circuit Judges.

Author: Swygert

This diversity suit was started in 1975. The complaint, as amended, contained three counts. Count I alleged negligence; Count II gross negligence; and Count III fraud. At the pretrial stage, the district court dismissed the negligence counts for failure to state a claim and proceeded to try the fraud issue to a jury. For four months, November 1, 1977 to February 28, 1978, the plaintiff presented its case. On March 1, 1978 the trial judge granted motions for directed verdict in favor of all the defendants. From these adverse rulings, plaintiff appeals.


Merit is an Illinois casualty insurance company. It and its predecessor have been engaged in writing automobile liability insurance since 1968. The defendants are being sued individually and also as partners in Joseph Froggatt & Co., an accounting firm located in New Jersey but also operating in Philadelphia and New York City.

Two other entities are involved: General Auto Placement, Inc. and Leatherby Insurance Company. General Auto was, before it became bankrupt, a New Jersey corporation selling automobile insurance policies to high risk drivers. It did not issue the policies; rather, it marketed policies that were written by licensed casualty insurance companies. Leonard Lebowitz, owner of eighty-five per cent of General Auto's stock, was president of the company and controlled its operations. Leatherby Insurance Company, a California-based casualty insurance company, started to underwrite policies for General Auto in May 1969. It was replaced by Merit in 1972.

The instant dispute centers on General Auto's financial arrangements with its underwriters. A distinctive feature of these arrangements was that General Auto was paid commissions by the underwriter on a "retrospective" basis. Rather than receiving a flat percentage of the policy premiums as its commission (the ordinary practice), General Auto earned its commission on a fluctuating scale; that is, after a review of its loss experience on the policies it had sold, General Auto received a profit (if any) gauged on the difference between the premiums paid by policyholders and amounts paid on claims. The underwriter received a fixed percentage of the premium as an "underwriting fee." Thus, General Auto functioned in large part as an insurance company without actually being one. It assumed most of the risks even though the underwriters were ultimately liable to the policyholders.

In general terms, General Auto's business was conducted as follows:

(1) General Auto agents received a commission of 15-20 percent of the premium collected by them on the policies sold.

(2) General Auto would report to the underwriter the policies it had sold and remit the premiums, less the agents' commissions.

(3) General Auto would give notice to the underwriting insurance company of any claims on the policies it had sold along with estimated settlement costs. The underwriter would place on its books the estimated settlement costs as "claim reserves," awaiting the actual amount of the claims paid.

(4) When the claims were settled, General Auto would issue drafts drawn on the underwriter to those entitled to share in the settlement.

(5) Every four months, General Auto would be paid by the underwriter a retrospective commission calculated on the basis of its earned premiums. General Auto was paid the total of earned premiums less:

(a) the fixed underwriting fees,

(b) the loss reserves, and

(c) the amounts paid on closed claims.

By virtue of this formula the lower the loss reserves were the more General Auto was paid on each quarterly settlement between General Auto and its underwriter.

In order to evaluate the financial well being of General Auto at any particular time, it was necessary to look at the "loss ratio" of the total policies it had sold. This ratio could be calculated by comparing the combined amount of reserves and losses paid against the total amount of earned premiums. If General Auto had too high a loss ratio, the premiums would be insufficient to cover the losses on claims filed on the policies and the underwriter would be required to cover the deficiency. To protect itself against such a contingency, the underwriter required a guarantee from General Auto to cover any deficiency in premiums available to pay claims. Thus, so long as General Auto's loss ratio was low enough or was able to make up any deficiency, the underwriter had a guaranteed profit from its fixed fee.

General Auto was formed in 1969 and soon thereafter entered into a retrospective commission contract with Leatherby. The contract provided that General Auto was to be paid by Leatherby the amount of earned premiums generated by General Auto less (1) 17.5 percent as a fixed underwriter fee, (2) the amount set aside as reserves on open claims, and (3) the amounts paid out on claims. The retrospective commission was to be calculated by Leatherby on a quarterly basis. The contract gave General Auto the right to suggest the amount of loss reserves, but Leatherby retained ultimate control over setting the amount of these reserves.

By August, 1970, Leatherby and General Auto were in dispute over the amount of loss reserves. Leatherby maintained that the reserves set by General Auto were forty percent less than what they should have been. General Auto thought thirty percent was more accurate. Leatherby insisted that the reserves should be increased by at least $85,000. An increase of that size would have created a severe cash flow difficulty for General Auto. President Lebowitz decided to find a replacement for Leatherby. Accordingly, he met in September 1970 with William A. F. Smith, head of the Philadelphia office of Joseph Froggatt & Co. They discussed the possibility of Froggatt providing General Auto with an audited financial statement which Lebowitz could use either to obtain public financing for purchase (or formation) of an insurance company or to induce another insurance company to supplant Leatherby.*fn1

Smith said that a financial statement would aid in dealing with other insurance companies and indicated an interest in making such an audited statement. During the meeting Lebowitz told Smith about his policy of setting reserves as low as possible. Smith agreed that Froggatt would furnish the audited statement and in February 1971 telephoned Lebowitz, saying the audit for the ...

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