The point of punitive damages is to punish, but a little-known insurance loophole is taking the sting out of contrition for many big U.S. corporations.

Policies known in the industry as "Bermuda wraparounds" are designed to solve a problem for U.S. companies in the 17 states where it's illegal to sell insurance against punitive damages.

Such prohibitions, which are the law in California, New York, Florida and Pennsylvania, are designed to prevent blank-check indemnification for wrongdoers who might otherwise think twice if faced with a stiff penalty.

Bermuda wraparounds are a creative way for corporations to thwart the will of both legislatures and juries via rules that allow them to buy policies from the Bermuda subsidiaries of most major U.S. insurance companies.

These offshore punitive-damages policies, which are enforceable under Bermuda law and can be sold only by Bermuda-based brokers, fill a potentially big gap in coverage for many companies.

Critics, however, contend that these policies, which are seldom disclosed to a jury, are thinly disguised schemes to get around the state prohibitions and effectively immunize a company from any big verdict.

"I've been screaming about this for years," says Eugene Anderson, a partner with Anderson Kill & Olick, a New York law firm that specializes in insurance litigation. "This whole thing is just a way to make something look like something it's not."

In some respects, Bermuda wraparounds are close cousins of the "finite" insurance policies that are used by companies and insurers to bolster their financial statements by transferring liabilities from one company to the underwriter. New York Attorney General Eliot Spitzer and the

Securities and Exchange Commission

have launched a broad-based assault on the most controversial finite policies, which are used by companies to report lower quarterly losses.

Critics say regulators should add Bermuda wraparounds to the growing list of unsavory business practices in the insurance industry that are drawing scrutiny.

For companies that buy them, the policies are a win-win proposition. Not only do they provide protection against a costly jury verdict, companies can deduct the premiums from their taxes as an ordinary business expense.

There's no way to determine the size of the market for such products, in part because it's an obscure form of insurance and companies are reluctant to say if they own it. But Anderson estimates that about 80% of the nation's largest corporations have purchased some level of coverage.

"I think a lot of companies are buying it," says J. Paul Newsome, an A.G. Edwards insurance analyst. Still, the figures are hard to come by.

One reason Bermuda has became a haven for so many insurers is that the country's liberal regulations permit insurers to underwrite a broad swath of policies that are either prohibited or limited in the U.S.

A number of Bermuda-based subsidiaries of big insurers such as

Ace

(ACE)

and

Chubb

(CB) - Get Report

openly market Bermuda wraparounds on their Web sites. The Bermuda insurance brokering arm of

HSBC

(HBC)

, the big British bank, touts the wraparound policies as a way to avoid turning a "bad suit into a catastrophic one."

Officials with all three insurance companies could not be reached for comment.

Bermuda wraparounds are often sold as a complement to a company's general liability policy. But some insurers also sell a special finite insurance policy case-by-case, permitting a company to immunize itself by purchasing coverage only after a lawsuit seeking punitive damages has been filed.

The use of Bermuda wraparounds by corporations to negate punitive damages awards recently surfaced in a pending case before the California Supreme Court involving

Ford Motor

(F) - Get Report

and the alleged sale of faulty used cars.

The lawsuit focuses on a $10 million punitive-damages judgment decided by a jury against Ford in 2002. The following year, an appellate court reduced the punitive award to $53,000, calling the original amount excessive. The injured party, Greg Johnson, wants the California high court to reinstate the original verdict, claiming the case exposed Ford's practice of selling "lemons" to the public.

Anderson's law firm recently weighed in on the California dispute, filing a so-called friend of the court brief, arguing that the issue of punitive damages is a red herring, because Ford likely has a Bermuda wraparound policy to limit its exposure.

In the brief, filed on behalf of the California Consumer Health Care Council, a consumer advocacy group, the lawyers say the court should hold off on deciding the case until Ford first comes clean about its insurance coverage.

"Industrial companies, such as Ford, regularly buy punitive-damage insurance from Bermuda, London and other places not subject to California laws," the lawyers write. "This court should not decide this case without knowing about Ford's insurance."

A Ford spokeswoman referred questions about the case to the company's outside attorney. Theodore Boutrous, an attorney with Gibson Dunn & Crutcher in Los Angeles, couldn't say whether Ford had purchased a Bermuda wraparound policy. But he added that it doesn't matter, because excessive punitive damages are harmful no matter who is footing the bill.

"What I look at is the costs imposed on our legal system," says Boutrous. "If insurance is available to cover punitive damages, that doesn't mean reform isn't needed to fix the system. Insurance costs money, and it imposes costs on the company."