Scholars and practitioners generally agree that any large enterprise must be run through a legal entity such as a corporation. While a minority view questions whether business entities are really necessary, the leading academic voices argue that the use of a legal entity confers benefits that would be ‘effectively impossible’ to obtain through other means. For example, entities reduce transaction costs to coordinate an enterprise’s many patrons, limit liability for shareholders, and protect a business from untimely dissolution. The widespread consensus is therefore that legal entities are essential to economic life as we know it.
So it may be surprising to learn about a domain of mass-commerce from which legal entities are substantially absent. In this domain, millions of people exchange trillions of dollars, and they do so without meaningful recourse to legal entities. That domain is insurance, as conducted by reciprocal exchanges.
A ‘reciprocal exchange’ is an insurance enterprise in which all insurance subscribers contract directly with one another, promising to pay a share of any losses the others suffer. A thick braid of contracts unites a circle of natural persons, each of whom participates as part of the enterprise, with no legal entity at the contractual core.
This is not an obscure way of doing business. Reciprocals provide almost 10% of America’s property & casualty insurance, and thus about 5% of all the nation’s insurance. Almost one in six US doctors buy malpractice insurance from a reciprocal. Moreover, some of America’s best-known insurance enterprises are, in fact, reciprocal exchanges. For example, USAA and Farmers Insurance, both among the ten largest insurers in the US, are reciprocals.
Reciprocals have gone unnoticed because they are so often conflated with mutual insurance companies, another enterprise form that stresses cooperation among customers. However, there are numerous legal and economic differences between these forms. Most crucially, mutuals and reciprocals differ in their use of legal entities. Like almost all business ventures, mutuals rely on a legal entity, often a corporation, to operate; it is just that the legal entity happens to be owned by its policyholders. Conversely, the reciprocal exchange is neither owned by policyholders nor anyone else, since there is no legal entity to own. Its members stand in direct contractual privity.
The viability of reciprocal insurance problematizes the entity-essentialism now dominant in the corporate law community and elsewhere. Without any entity, reciprocals were somehow able to secure or foreswear the supposedly essential functions that entities provide. It turns out that creative applications of contract law, agency law, and insurance law sometimes suffice to support broad coordination. How? An enterprise’s many patrons can appoint a common person (the ‘attorney-in-fact’) to act as their agent – authorizing the agent to quickly sign multifarious contracts in their names. Liability can be limited and prioritized within those contracts. These limitations are binding on third parties because insurance regulation puts potential creditors on constructive notice of these agreements. Entity-like functions follow, but sans entity.
My article ‘Enterprise Without Entities’ therefore questions the unique importance of entities, but it does not necessarily undermine all arguments of entity theorists. To the contrary, the fact that reciprocals seek and find many of the core functions provided by entities underscores the importance of those functions. Reciprocals have used agency law to overcome transaction costs, and they have alloyed contract law and insurance regulation to structure a pattern of creditors’ rights. Entity essentialism is therefore honored in the breach.
Indeed, even as reciprocals achieve those functions without entities, their circumnavigation traces the path of organizational law. Contractual limitations on liability or liquidation are usually binding only on those who have notice of them. Organizational law avoids this problem by conjuring fictional persons – entities. The reciprocal instead relies on insurance and agency law to co-configure fictional networks and fictional notice. Thus, reciprocals swap one set of legal fictions for another in the quest for certain key economic functions.
Reciprocal exchanges problematize the academic consensus that legal entities are somehow essential, but they nevertheless validate the underlying logic that led scholars to elevate entities in the first place. This conclusion in turn has implications for the responsibility of business to society, the viability of the ‘gig economy’ and other radical reorganizations of enterprise. In my article, I explore these implications and give reciprocals their first treatment other than by a few insurance specialists.
Andrew Verstein is Associate Professor of Law at the Wake Forest University School of Law