Liability insurance originated solely as a protection for the interests of the insured against loss suffered through liability to third parties. It began in the area of employers‘ insurance against loss through liability to employees for work related injuries. Since indemnification of the employer/insured was the sole function of the insurance, the injured third party could not bring a direct action against the insurer even after obtaining a judgment against the insured. Even the insured could not bring action on the policy until he had sustained an actual loss by payment of the judgment debt to the third-party. If the insured happened to be insolvent and judgment proof, no claim could arise under the policy.
In subsequent years, legislation has radically transformed the function of liability insurance in many areas to make the injured third-party with a cause of action against the insured a quasi third-party beneficiary of the liability policy. One of the first areas under legislative attack was the inequity of allowing an insured to pay premiums to an insurer to keep liability insurance current and then to allow the insurer to hide behind the shield of the insolvency of the tortuous insured to prevent payment of the judgment debt owed to the third-party victim. Under these circumstances neither the injured victim nor the insured received any benefit from the insurance. Eventually, legislation in several states required the inclusion in liability policies of a clause to the effect that insolvency or bankruptcy of the insured would not prevent liability on the part of the insurer. When it became evident that legislatures across the country would adopt this approach, insurers decided to face the inevitable and voluntarily included as a standard term in liability policies the provision that ―Bankruptcy or insolvency of the insured or of the insured‘s estate shall not relieve the company of any of its obligations hereunder.‖
One major distinction to be drawn among the various types of policies that protect an insured from loss due to his causing harm to another person or property is that between a liability policy and a pure indemnity policy. Some policies provide that ―no action shall lie against the company‖ until the insured has actually suffered an economic loss by the actual payment to the third party of an amount fixed by a final judgment or an agreement between the insured, the third-party, and the insurer. Such a policy is considered a pure indemnity policy and generally gives rise to no cause of action by the third-party directly against the insurer. Courts have split over the question of whether an insurer that takes advantage of its contractual right to come in and defend the claim against the insured thereby waives its rights under the ―no action‖ clause to the extent that it becomes liable to satisfy the judgment against the insured. The majority rule is that no such waiver is to be inferred from defense of the action.
A second form of ―no action‖ clause provides that ―No action shall lie against the company until the amount of the insured‘s obligation to pay shall have been finally determined either by judgment against the insured after actual trial or by written agreement of the insured, the claimant and the company.‖ A policy containing this type of clause is considered a policy of liability insurance, meaning that the insured has a cause of action on the policy as soon as his liability to the third party is fixed as to amount. The next step was to recognize a right in the third-party, following a judgment or agreement fixing liability, to bring a direct action against the insurer on the policy under a theory of garnishment of the debt owed by the insurer to its insured, or occasionally a theory of subrogation of the third-party ―creditor‖ of the insured to the insured‘s cause of action against the insurer. Under either theory, the third party is afforded the position of a quasi third-party beneficiary of the insurance contract.
A third aspect in which legislation has created rights for the third-party victim in the insured‘s liability policy involves defenses against recovery on the policy. In the area of automobile liability insurance particularly, legislatures have generally provided in financial responsibility statutes for the protection of tort victims that defenses that would bar collection of the proceeds by the insured, such as fraud in the application, non-cooperation in defense of a tort action, or failure to notify the insurer of an accident, will be of no effect in a direct action by the third party tort victim against the insurer. This is particularly true of insurance intended to satisfy a statutory requirement such as compulsory automobile liability coverage. Automobile liability policies generally provide that in the event that the insurer is statutorily required to pay the proceeds of the policy to a third-party which it would not ordinarily be obligated to pay because of a defense available against the insured, it shall have a cause of action for reimbursement against the insured. In this way, the risk of non-payment because of insolvency of the insured is placed on the insurer instead of the third-party tort victim; and in this way also, the third-party becomes a quasi third party beneficiary with rights under the insurance contract.