Insurance Scrawl: Products Archives

August 29, 2007

Product Recalls

Product-recall expense can prove increasingly expensive in this time of international distribution, just-in-time inventories, far-flung shipping, and the like. Of course, the current poster child is Mattel, which seems to be doing a very good job in managing the recall of some of its Chinese-made toys. Policies today routinely seek to exclude the cost of product-recall expense, which can be staggering and life-threatening to a company -- both in terms of cost and perhaps more importantly in reputation of the producer. Speciality policies exist to deal with various types of recalls, and there has been litigation concerning product-tampering coverage and the more traditional liability insurance coverage and the scope of the product-recall exclusion (known in the trade as the "sistership" exclusion). The current wave of recalls involving Chinese-made products may well stimulate demand for this product, but I would not be surprised to see provenance exclusions developed or warranties required from assured as to quality control and quality assurance from their foreign contractors.

Posted by Marc Mayerson at 11:55 AM | Comments (0) | TrackBack

Product Recalls

Posted by Marc Mayerson at 11:55 AM | Comments (1) | TrackBack

October 26, 2006

Trigger and Allocation for Asbestos, Other Bodily Injury, and Property Damage: Recent Cases and the Policyholders' Winning Argument

“Who pays” and “how much” continue to be central questions in insurance-recovery litigation by policyholders for asbestos, environmental clean up, pharmaceutical, lead-paint, toxic-tort and other conditions that produce loss over time. Because insurance contracts are governed by state law, the coverage wars apparently will continue until each inch of turf is won or lost. Most recently, the Delaware Supreme Court has weighed in on the question of trigger of coverage (“who pays”) for asbestos- liability claims, the Minnesota Supreme Court has addressed allocation of loss (“how much”) among triggered policies, and the New Hampshire Supreme Court has now been asked to address the allocation question, too.

The Delaware and Minnesota cases suffer from an overly conceptualist approach to looking at the questions presented; instead of applying the contract language, these courts have applied “models” of how the coverage should apply. As these cases show, misframing the question to be answered results in answers that are not entirely satisfactory or coherent.

Starting with Delaware: The question presented in Shook & Fletcher Asbestos Settlement Trust v. Safety National Cas. Corp. (Del. Sept. 26, 2006) was what event must occur during the policy period in order for an occurrence policy to be activated (triggered). An insurer has no obligation to perform unless the claim against the insured triggers (or potentially triggers) its coverage. Shook & Fletcher was decided under Alabama law. As noted by the Delaware court, in prior coverage litigation “after full briefing and argument, the Alabama court held that the ‘exposure coverage theory’ would apply, instead of the ‘continuous trigger’ or ‘triple trigger’ theory.” Slip op. at 3-4.

The Delaware Supreme Court in trying to predict Alabama law sought to resolve the question in part by counting noses among state Supreme Courts and federal appellate courts. As the court explained: “We have analyzed the cases where the parties disagreed upon which trigger theory the court actually adopted. Our analysis shows that the exposure trigger is the majority rule.” Slip op. at 9. The court found that Pennsylvania, New Jersey, Delaware, and the Third and D.C. Circuit’s have adopted a continuous trigger; but the Court’s analysis of the other cases led it to conclude that the following jurisdictions have adopted an exposure trigger for asbestos bodily injury claims: Louisiana, Massachusetts, Maryland, Illinois, Fourth Circuit, Fifth Circuit (Texas), Fifth Circuit (Louisiana), Sixth Circuit (Ohio), Sixth Circuit (Michigan), Eleventh Circuit (Alabama), and the First Circuit.

Holding aside that I quarrel with the court’s table and analysis of cases, the court thus concluded: “We rely on the rationale of those cases and the fact that the exposure trigger is the majority rule.” Slip op at 11.

The Delaware court offers no analysis of the issue on its own but rather tries to predict what the Alabama Supreme Court might do. In this context, it is passing strange that the court does not address on the merits its own prior continuing-injury trigger decisions or come to grips with the rule of construction – applicable in Alabama – that if the policy language admits of more than one reasonable construction the court is to construe the language in favor of coverage. Compare Hercules Inc. v. AIU Ins. Co. (Del. Aug. 15, 2001) (finding plain language compels an “all sums” allocation as do equitable considerations). Is the Delaware court now saying that its own prior decision was unreasonable?

In Shook & Fletcher, no effort was made to look at the policy language. And the language is straightforward: insurance policies like those in Shook & Fletcher are triggered if injury occurs during the policy period. Trigger is the issue of what event must take place during the policy period, and the policy is clear – it is not the occurrence, the exposure, or the accident: trigger is “injury.” While “injury” may follow from “exposure,” the difference is one between cause and effect, and typically liability policies are triggered by the effect. (The number of occurrences is determined by causes, but that is a different legal and contractual issue.)

Policyholders should not argue, as I have sometimes seen them do, that there are as many as eight different trigger theories out there and the job of the court is to pick one. Rather, the policy language is absolutely clear that injury is the trigger, and the only question is whether, in the particular context before the court, can whatever happened during the policy year under scrutiny reasonably be construed to be “injury.”

So, the right way for policyholders to argue is not to serve up the question as “which trigger applies: exposure, manifestation, continuous”? The right question is: “Because the trigger is injury, did injury occur during this policy period?” For policies in effect during the period of exposure, one argues that following exposure the body suffers injury. For policies in the period after exposure but while the asbestos fibers persist in the body, one argues that the continued presence of asbestos in the body produces a reaction such that that further effect constitutes injury that year. For policies in effect during the period that an asbestos-related disease is diagnosed, one argues that under the definition of bodily injury – which includes “bodily injury [and] disease” – there is disease and thus injury during the policy period.

It doesn’t matter whether we are arguing about asbestos, or pharmaceutical, or lead paint, or toxic torts: the question of trigger under “occurrence” CGL policies is injury.

A policy’s being triggered does not answer the question of how much the triggered policy is required to pay for the insured’s loss. The “how much” question is known variously as “allocation” or “scope of coverage.” The Minnesota Supreme Court recently weighed in on allocation of coverage, but in doing so it had to deal with prior authority holding that a continuing-injury scenario triggered multiple policies across time and that presumptively each insurer’s obligation to perform was dependent on the quantum of injury that occurred in its policy year. So for illustration, if damage occurred in a steady-stream way for 10 years and caused $10 million in damages, then $1 million would be allocated per year, no matter that in some years the insured bought much more coverage or that in other years the primary layer was, e.g., $200,000 and in other years it was $50,000.

In Wooddale Builders, Inc. v. Maryland Cas. Co. (Minn. Oct. 8, 2006), the court confronted a number of questions concerning the implementation of this kind of scheme: if the damage occurs during only part of a year, does the carrier have to pay its full limit? What happens for years in which there is no coverage? Can the insured buy more coverage once it has knowledge of the problem?

The Court framed the basic issue as follows:

The relationship [among the policies] can be expressed – and perhaps best understood – in terms of a simple equation: A/B x C = D. In this equation, A is each insurer’s time on the risk, B is the total period over which liability is allocated, C is the total damages to be allocated, and D is the damages allocated to each individual insurer.

The court first addressed whether the coverage period is cut off at some moment due to the insured’s knowledge of the risk of liability. In Wooddale, the case involved damage to a number of homes that had been built, and the court ruled that once the insured had knowledge that a home had been damaged no further insurance available. The court ruled – in error – that damage was expected or intended (and thus excluded) once the insured had knowledge that some homes had been damage: “The practical effect of the policy language excluding expected damage and the rationale behind the known loss/loss in progress doctrine is that no additional insurance policies are triggered by continuing damage to homes for which claims had been made before those policies took effect. . . . We therefore hold that only insurers that provided coverage to Wooddale between the closing date of a particular home and Wooddale’s receipt of notice of claim with respect to that property are on the risk for that claim.” (fn. omitted).

(The court’s cutoff based on these theories is wrong because expected/intended damage is meant to stop the insured from acting or setting in motion the chain of events leading to damage rather than policing the insured’s knowledge of a ticking time bomb – the right mechanism to protect insurers on this point is nondisclosure; and known loss is not properly applied here either because from an insurance perspective there is insurable risk, and thus no known loss, so long as there is uncertainty as to whether, when or how much liability will be found – again, all subject to non disclosure rules. See Transamerica Ins. Group v. Meere, 694 P.2d 181, 186 (Ariz. 1984) (“"The exclusion 'is designed to prevent an insured from acting wrongfully with the security of knowing that his insurance company will "pay the piper" for the damages.'''); Bob Hedges, Back-Dated Coverage as Insurance, 34 CPCU J. 181, 181 (1981). And the court does not address equities such as whether the policyholder paid premium in effect for this risk exposure that the carrier gets to pocket under the court’s analysis.)

The court further examined the consequence on an insurer’s obligation to pay from the trigger cutting off during its policy period, or put differently is the insurer that provides coverage for only part of a policy year required to pay its full limit? Here, the court got the answer right, but because its rationale is embedded within the pro-rata-by-quantum-of-damage methodology its reasoning is a bit unsatisfactory. The court offered only the rationale that it was aware of no basis for concluding that a full limit does not apply. “Instead, each of the policies provides coverage for ‘property damage’ that ‘occurs during the policy period,’ indicating that the insurer has agreed to indemnify the insured for damages that occur during the entire policy period, including the part of the policy period that runs after notice of the claim.”

The court does not address the case law on “stub policies,” that is, the limits available in a part year policy by analogy (as opposed to a full year policy with only part damage). Stub policy case law uniformly recognizes that the carrier’s policy limits are at risk every day of the policy, and that the premium is paid for the availability of the full limits each day. See United States Mineral Products Co. v. American Ins. Co., 792 A.2d 500, 502 (N.J. Super. App. Div. 2002); Stonewall Ins. Co. v. ACMC, 73 F.2d 1178, 1216-17 (2d Cir. 1995); Cadet Mfg. Co. v. Am. Ins. Co., 391 F. Supp. 2d 884, 890 (W.D. Wash. 2005). More importantly, the allocation method that the court has previously embraced does suggest only a partial limit for part-year damage, and the court does little to explain other than offer its ipse dixit.

The court reached the parallel conclusion for policies in effect during the year in which damage first occurred, likewise holding that the full limits were available in the allocation formula.

Finally, the court considered whether periods of no insurance counted in the allocation formula, and the court divided periods of no insurance into (i) periods where the insured elected not to purchase insurance voluntarily (self-insurance) and (ii) periods where due to market forces there was no insurance to be purchased. The court concluded that allocating to periods of self-insurance was fair but that allocating to periods of no insurance was not, and so periods where there was no insurance get removed from the denominator of the allocation formula.

This has always been an unsatisfying approach, in part because it makes the contractual obligations of a party with a closed period dependent upon failures in insurance markets years later perhaps (because if a later period of no insurance is not included in the allocation formula each insurer’s relative share of the pie goes up). It accomplishes the objective of avoiding penalizing the insured for no “fault” of its own, but it also is somewhat naïve in its assessment of insurance markets and whether some underwriter somewhere might be willing to insure some risk for some ridiculous price (as the London market saying goes, there is no bad risk, just a bad price). So even though there was a worldwide conspiracy among insurers and reinsurers to cut off asbestos coverage in the mid 1980s, if an underwriter wanted to sell asbestos insurance doing so would not violate any positive law or prohibition against meretricious contracts. These are, to my way of thinking, too unstable of bases to support a rationale for how to apply an insurance contract that may have been written decades before.

Overall the Minnesota court made the following simplifying assumptions in its mathematical formula:

a. Each policy in effect during when any damage occurred is exposed for its whole limit.
b. Policies incepting after the insured expected claims have no obligation to perform.

c. A policyholder should be treated as if it were an insurance company if it voluntarily elected not to purchase insurance in the commercial markets.

d. A policyholder should not be treated as an insurer if the reason it did not purchase insurance is through no fault of its own.

Based on these elaborations, the court held that as to the duty to indemnify each carrier’s obligation to pay can be derived. (The court however embraced a per-capita allocation for defense.)

The Minnesota court recognized that its elaborations meant that its formulaic approach was becoming unmoored from the principles from which it derived. (No matter; such is the privilege of being the last word.) As the court said:

We are aware it is possible under our construction of factor B that an insurer is liable for more than those damages than would otherwise be deemed to have occurred during its policy period. This is possible because our definition of factor B, the period over which damages are to be allocated, excludes periods during which the insured lacks coverage because no such coverage was available. We are also aware that this result may be contrary to the broad language we used in [prior authority] to describe the ‘actual injury’ [trigger] rule, namely, that under this rule each insurer is liable ‘only for those damages which occurred during its policy period.’ [citation omitted] However, as we [there] indicated . . . ., the allocation of liability between insurers requires a flexible approach. [citation] Further, as we noted [previously], it is inaccurate to conclude that a CGL insurer can never be liable for damages occurring outside of a policy period. [citation] We deem the facts of this case to justify a departure from the typical ‘actual injury’ approach.

So is there a principled way to come to grips with the language of the insurance policy and figure out a principled manner to determine the obligation of each carrier where a single loss situation produces damage and injury both during and outside of its policy period? This is now the question that the New Hampshire Supreme Court has been asked in an environmental-coverage case. See EnergyNorth Natural Gas Inc. v. Certain Underwriters at Lloyd's Underwriters, 2006 U.S. Dist. LEXIS 73468 (D.N.H.)

I believe there is an approach to the contract language that takes the language seriously yet produces results that are (I submit) intellectually consistent.

The first principle is that insurance policies create rights in the insured, and it is the insured’s right to exercise. Insurance policies are not issued in dependence on the existence of coverage in other years; no credit is given on the premium from having more coverage in the past year than not or coverage from carriers with better credit ratings. Policyholders don’t promise carriers to purchase insurance policies in the future. And insurers are not understood to be third-party beneficiaries of each other’s contract, even though those contracts are with the same party, the policyholder. See Signal Co., Inc. v. Harbor Ins. Co., 27 Cal. 3d 359, 369 (1980); L.E. Myers Co. v. Harbor Ins. Co., 394 N.E. 2d 1200 (Ill. 1979).

The second, and more important, principle is that insurance policies insure against the risk that the insured will be held liable for injury or damage during the policy period; policies do not insure against the risk of injury or damage occurring per se. As one leading treatise explains, “[t]he hazard insured against under the liability feature is not injury or loss . . . but liability or responsibility of the insured for loss or injury.” 6B J. Appleman & J.A. Appleman, Insurance Law and Practice §4254 at 26-27 (Rev. ed. 1979). The policy language makes this plain. CGL policies contain a broad promise to pay “all sums” that “the insured shall become legally obligated to pay as damages because of bodily injury . . . to which this insurance applied caused by an occurrence.” In other words, subject to the applicable limit of liability, the policy covers the totality of damages incurred by an insured “because of,” i.e. “by reason of” or “on account of,” bodily injury within the policy period. The question then is, what is the insured’s liability because of the injury during the policy period. This is key and shows both where Minnesota law goes wrong and creates the hydraulic pressure on the court to backfill we see so clearly in Wooddale.

These two principles illuminate the right way to argue the point for policyholders (and I submit the right way for courts to resolve the question). Instead of the Minnesota court’s mathematical formula, one takes a single policy and asks the following question: Is there bodily injury or property damage that occurred during the policy period, and if so what is the insured’s liability for the bodily injury or property damage that happened? (Contrary to what some insurers have argued, the “Policy Period; Territory” provision does not alter the question, because that provision ensures that the trigger is damage, not the negligent act, see State v. Glens Falls Ins. Co., 609 P.2d 598, 600-01 (Ariz. App. 1980), and while the language in the insuring agreement referring to property damage “to which this insurance applies” refers implicitly to the “policy period; territory” provision, that does nothing to the question on which I focus, viz., what is the insured’s liability “because of” the property damage to which the insurance applies.) I don’t need to reflexively or exclusively rely on the insurance policy’s promise to pay “all sums” or “those sums” – that is handy language but is not the key issue. The key is always and only, what is the insured’s liability because of bodily injury/property damage during the policy period.

As a matter of tort (not insurance) law, in most of the situations we deal with the answer to that question is this: for bodily injury or property damage that occurred during the particular carrier’s policy period, the insured’s liability is equal to the entirety of the plaintiff’s claim. This is the result of the rule of tort law that imposes joint and several liability upon tort defendants. John Crane v. Scribner, 800 A.2d 727, 741 (Md. 2002) (“it is as impossible to ascertain which fiber ultimately caused which cell, over time, to escape the body’s defenses and turn cancerous, as it is to determine when that occurred”).

Note that I am not saying that insurers are jointly and severally liable under their policies; that would be to import a tort concept to the contract context, and I don’t think that is quite precise enough. But what is central is that the insured is jointly and severally liable, and such liability is imposed where the injury or damage at issue is indivisible from injury or damage that occurred in other policy periods (or from other tortfeasors). See United States v. Alcan Aluminum Corp., 964 F.2d 252, 268-69 (3d Cir. 1992); Matter of Bell Petroleum Services, Inc., 3 F. 3d 889-896 (5th Cir. 1993); O’Neil v. Piccillo, 883 F.2d 176 (1st Cir. 1989) (interesting discussions all re indivisible damage/injury and the imposition of joint-and-several liability under tort law).

Nothing in the policies reduces the carrier’s obligation to pay simply because injury may also have occurred outside the policy period; the sole determinant of the extent of coverage is what is the insured’s liability because of injury during the policy period. The policy language addressing the application of the policy limits for a covered claim nowhere confines the carrier’s obligation to pay to some aliquot share based on the quantum of injury occurring in its policy years. E.g., ACandS v. Aetna Cas. & Sur. Co., 764 F.2d 968, 974 (3d Cir. 1985) (Even where sums paid by the insured party are partly attributable to injury that occurred in another policy period, “the language of the policy makes [that fact] irrelevant.”).

This is made particularly clear in the “Limits” section of standard liability insurance policies. The “Limits of Liability” section of policies typically provides that, for a covered bodily-injury (or property damage) “occurrence,” the policy will pay for “all damages . . . because of bodily injury sustained by one or more persons as the result of any one occurrence.” The sole limitation on each policy’s obligation to pay is that the payout on the claim “shall not exceed the limit of bodily injury liability stated in the declarations as applicable to ‘each occurrence.’” The Limits provision further elaborates by stating:

For the purpose of determining the limit of the company’s liability [under the policy], all bodily injury . . . arising out of continuous or repeated exposures to substantially the same general conditions shall be considered as arising out of one occurrence.

Here the policy language unambiguously favors coverage: The amounts any given CGL policy pays are expressed in dollars “per occurrence.” The insuring agreement and the limits-of-liability provisions together teach that, where there is covered injury in the policy period, the policy pays “all sums” for “all damages sustained by one . . . person . . . as the result of any one occurrence,” subject only to the per-occurrence limit.

In fact, even if the policies were uncertain as to the proper method of allocation, a reasonable interpretation of the policies requires an “all sums” approach. And of course insurers have been in the position to protect themselves by drafting clear and explicit language that addresses how the obligation to perform should be measured where there is indivisible damage triggering their coverage. Compare Rochester German Ins. Co. v. Schmidt, 175 F. 720, 725-726 (4th Cir. 1909). Principles of insurance law, therefore, require that the interpretation of uncertain or ambiguous policy provisions favoring the insured must govern.

This contract-based approach to allocation also “solves” the question of horizontal versus vertical exhaustion: that is, where policies are triggered across time, must the insured collect first from all the primaries before tapping any excess coverage (and thus absorb cumulated deductibles and insolvent primary layers) or may the insured select a single year of coverage and access the triggered primary and overlying excess (either in a single year or in more than one). General-liability policies do not speak to this issue, and so we return to the principle that the contract rights belong to the insured; consequently, the insured has the option to select or target its triggered policies however it sees fit. In each instance, one asks the same questions: is the policy triggered, and if so how much does the policy pay per occurrence for the insured’s liability because of the (indivisible) damage/injury that year? Any targeted policy may seek to pursue equitable contribution against other carriers that could have been targeted but were not. Indeed, I submit that part of the peace of mind offered by broad CGL insurance is precisely the insured’s ability to collect its full per-occurrence limits and then go home – leaving further redistribution to the carriers to sort out.

This approach also gives the framework to address stacking or cumulation of policy limits, for looking at each contract the stacking or cumulation of policy limits again is straightforward. See United Services Automobile Ass’n v. Riley (Md. June 1, 2006). Until the insured is fully indemnified for its damages because of injury/damage during the policy year, the insured is entitled to collect on its coverage. In other words, stacking is only an issue if an insurer has clear anti-stacking language in its policy.

The bottom line of all of this is that policyholders should look hard at the contract without preconceived notions and see how each individual insurance contract’s obligation to perform is measured. Bearing in mind the crucial question of divisible versus indivisible harm and damage – and its impact on answering what is the insured’s liability for injury or damage during the policy period – insurance policies require insurers to perform if any “injury” occurred during the policy period and to pay their entire per-occurrence policy limit until such time as the insured has been fully indemnified or the insurance policy’s limits exhausted.

We confront the particular language of particular policies every time we settle a claim or file a complaint. Each contract should be analyzed using the toolkit I’ve sketched out here, and then you should move on to the next contract. Shampoo. Rinse. Repeat.

Posted by Marc Mayerson at 4:24 PM | Comments (4) | TrackBack

Trigger and Allocation for Asbestos, Other Bodily Injury, and Property Damage: Recent Cases and the Policyholders' Winning Argument

It doesn’t matter whether we are arguing about asbestos, or pharmaceutical, or lead paint, or toxic torts: the question of trigger under “occurrence” CGL policies is injury.

The Court framed the basic issue as follows:

The relationship [among the policies] can be expressed – and perhaps best understood – in terms of a simple equation: A/B x C = D. In this equation, A is each insurer’s time on the risk, B is the total period over which liability is allocated, C is the total damages to be allocated, and D is the damages allocated to each individual insurer.

The court reached the parallel conclusion for policies in effect during the year in which damage first occurred, likewise holding that the full limits were available in the allocation formula.

a. Each policy in effect during when any damage occurred is exposed for its whole limit.
b. Policies incepting after the insured expected claims have no obligation to perform.

c. A policyholder should be treated as if it were an insurance company if it voluntarily elected not to purchase insurance in the commercial markets.

d. A policyholder should not be treated as an insurer if the reason it did not purchase insurance is through no fault of its own.

Based on these elaborations, the court held that as to the duty to indemnify each carrier’s obligation to pay can be derived. (The court however embraced a per-capita allocation for defense.)

We are aware it is possible under our construction of factor B that an insurer is liable for more than those damages than would otherwise be deemed to have occurred during its policy period. This is possible because our definition of factor B, the period over which damages are to be allocated, excludes periods during which the insured lacks coverage because no such coverage was available. We are also aware that this result may be contrary to the broad language we used in [prior authority] to describe the ‘actual injury’ [trigger] rule, namely, that under this rule each insurer is liable ‘only for those damages which occurred during its policy period.’ [citation omitted] However, as we [there] indicated . . . ., the allocation of liability between insurers requires a flexible approach. [citation] Further, as we noted [previously], it is inaccurate to conclude that a CGL insurer can never be liable for damages occurring outside of a policy period. [citation] We deem the facts of this case to justify a departure from the typical ‘actual injury’ approach.

I believe there is an approach to the contract language that takes the language seriously yet produces results that are (I submit) intellectually consistent.

For the purpose of determining the limit of the company’s liability [under the policy], all bodily injury . . . arising out of continuous or repeated exposures to substantially the same general conditions shall be considered as arising out of one occurrence.

Posted by Marc Mayerson at 4:24 PM | Comments (4) | TrackBack

April 5, 2006

What You See Is Not What You Get: Renewal Policies

One aspect of insurance practice that I like is the seemingly unlimited number of nooks and crannies in insurance law. But like a tree falling in the forest, the existence of one pro-policyholder rule or another in a given state has little impact on human behavior -- or trial outcomes -- unless that rule is called upon. One such rule is the "renewal rule."

When a policyholder renews an insurance policy with its carrier, the insurer must provide prior notice to the insured if it intends to reduce coverage under the newly issued policy. In one of my cases, a corporate client had purchased a primary-layer CGL policy from one insurer in 1969, renewed it in 1970, and then renewed it again. The sudden-and-accidental pollution exclusion was introduced in early 1970 (see Mayerson, Affording Coverage for Gradual Property Damage Under Standard Liability Insurance Policies: A History, 8 Coverage 3 (Sept./Oct. 1998)), so for the final policy the insurer issued its then-standard CGL form and stapled to it the pollution exclusion. The question presented was whether the pollution exclusion in this last policy -- which had been provided to the policyholder, a large multinational chemical company -- was to be given effect.

For a first policy with an insured, the insurer does not have the same duty to point out a limitation on the coverage. Generally speaking, insureds are charged with knowledge of the content of their insurance policies, even if it is undisputed that the insured never actually read the policy at the time it was issued. See generally Western World Ins. Co. v. Stack Oil. Co., 922 F.2d 118, 122 (2d Cir. 1990); Metzger v. Aetna Ins. Co.,, 125 N.E. 814, 816 (N.Y. 1920). (By the way, did you read the insurance policy issued to you before completing the purchase?) But this general rule that insureds are charged with knowledge of the terms of their policies does not overcome the application of the more particular rule regarding renewal of insurance policies. If this were not so, then the well-established notice-of-reduction rule would be without effect. See Davis v. USAA, 273 Cal. Rptr .224, 227 (1990); Magness Constr. Co. v. Ohio Farmers Ins. Co., 261 A.2d 537, 539 (Del. Super. 1969); Walton v. Sterling Fire Ins. Co., 197 N.Y.S.2d 277, 280 (N.Y. App. 1960) ("Implicit in such renewal is that the terms of the existing policy are to be contained in he absence of a contrary intention.").

The renewal rule is not a matter of reformation, see 91 ALR 2d 546, 549 & n.10, or fraud in the factum, and is not subject to a contractual limitations period. The insured may defend against the effort to enforce a coverage-reduction in a renewal policy without pleading and proving the elements of reformation; instead, the (purported) coverage reduction is of no effect. The insurer must prove that in renewal it gave notice before the policy took effect of the desired coverage restriction (and it is not enough for the insurer to send along a notice enclosed with a copy of the renewal -- the insured must be given the opportunity ex ante to object to its inclusion, negotiate its elimination, or take its business elsewhere).

Insureds are under no obligation to disabuse the carrier of a belief that its limitation or exclusion was effective. There is no authority of which I am aware that holds that, when a carrier attempts to reduce coverage in a renewal policy without notice, the insured can be prevented from objecting to enforcement of the unauthorized reduction. Otherwise, an insured would be required to be forever vigilant, guarding against the risk that its carrier might slip an unannounced new exclusion into the renewed policy.

In the case I handled mentioned above, we were litigating the question more than two decades later (the 20-year-old policy nevertheless having been triggered), and no peep was ever made by the insured or its broker at the time. No matter, though. Neither contemporaneous objection nor (detrimental) reliance by the insured is an element of this legal doctrine. In my case, because in the renewal process the insurer did not provide specific advance notice of the reduction in coverage the court had little trouble in concluding that the exclusion -- physically a part of the policy -- was of no legal effect.

Given the state of the law, the outcome we obtained was hardly surprising (to me at least, I'm not so sure about how the insurer thought about it). A more difficult question was presented in a Sixth Circuit case decided in 2003 where a follow-form excess insurer sought to rely on a coverage restriction that was included in the underlying policy, which in turn was a renewal. See Amway Distributors Benefits Ass'n v. Northfield Ins. Co. (6th Cir. 2003). By way of definition, a following-form insurer issues a couple-page policy that principally adopts the terms of the underlying wording and incorporates it as its own. Coca-Cola Bottling Co. v. Columbia Cas. Ins. Co., 11 CA 4th 1176,1182-83, 14 Cal. Rptr. 2d 643, 647 (1992) ("Following form policies 'are typically written on the same terms and conditions as the coverage provided by the underlying primary coverage. They are generally short, consisting of one or two pages, with an endorsement or provision that incorporates by reference the underlying policy coverages, except for the premium, the liability limits, and the obligation to investigate, defend, or pay costs of defense'."); Monsanto Co. v. American Centennial Ins. Co., 1991 WL 35714 (Del. Super. Ct. Feb. 20, 1991); Ford Motor Co. v. Northbrook Ins. Co., 838 F.2d 828 (9th Cir. 1988); following-form carriers may add additional terms and coverage restrictions per other endorsements in the policies they issue. See Home Ins. Co. v. American Home Products, 902 F.2d 1111, 1113 (2d Cir. 1990).

In Amway, here's how the court framed the dispute:

The real question, then, is whether an excess carrier . . . is bound as a matter of law by the underlying carrier's failure to comply with the renewal rule. We believe that the answer is "yes," because the "follow form" linkage between an excess insurer and the primary insurer should logically apply to procedural as well as substantive obligations to their common insured. In effect, an excess insurer who lives by the sword must die by the sword.

Id. The majority rejected the insurer's implicit argument that the insured's position was really the invention of its lawyers and that the coverage -- which would otherwise be barred for the particular claims being fought over -- were not all that important to the insured at the time it bought the policy. Seeming to the relish being confronted with this unusual insurance-law rule, the court states:

This type of extra-contractual argument, if successful, would require those purchasing insurance to affirmatively validate the importance of each and every coverage purchased. We find no authority supporting such an obligation. Furthermore, we suspect that any such obligation would turn the world of insurance upside down, since one has to be either super-diligent or a masochist to read an insurance policy with a fine-toothed comb.

Id. Furthermore, the Sixth Circuit rejected the argument that the presence of a broker as an intermediary on behalf of the insured negates application of the renewal rule. See id. (Kennedy, J., dissenting) ("Where brokers are involved in negotiating the terms of the policy, the rationale for a 'renewal rule' such as Michigan's is diminished, since there would be less need to protect unknowing insureds from the passive misrepresentations of their insurers."). The rejection of the insurer's argument that the renewal rule does not apply if a broker is involved means that just because the insured and its agents are "sophisticated" or possess "bargaining power" does not negative application of the rule, nor is it relevant that the brokers may know (as in the case I handled) that the new exclusionary language was "in the air" as it were, being discussed in trade publications, speeches, industry-form-drafting-organization [now, ISO] press releases, and other vectors of inculcation.

Both the majority and the dissent agreed further that, if an excess insurer was to be bound by the misdeeds of the primary that failed to provide notice of the reduction in coverage, the excess insurer would have recourse against the primary. As the court explained,

This triangular relationship between the primary insurer, the excess insurer, and the insured presents the classic problem of which one of the two relatively "innocent" parties must suffer when the "wrongdoer" causes a loss. IN the present situation, we believe that . . . the excess insurer ] was in a much better position than the insureds to analyze unannounced changes in the underlying policy that it had agreed to follow. As between [the excess insurer] and the insureds, therefore, [the excess insurer] should be bound to provide the greater coverage and be the one to seek indemnity back against the [primary].

This assumption -- which serves as what I tend to call an existential escape valve for the court -- may not be so straightforward; the question whether a primary insurer owes any legal duties directly to excess insurers and the theory under which such a claim is pursued is highly controverted, with much of the judicial commentary falling into obiter dicta rather than ratio decidendi. The nature of the duty and its limits may not be so clear. E.g., Continental Casualty Co. v. Reserve Ins. Co., 307 Minn. 5,10 239 N.W. 2d 862,865 (1976); Certain Underwriters at Lloyd's v. The Fidelity and Casualty Ins. Co. of N.Y., 4 F.3d 541, 547 (7th Cir. 1993). One can imagine such an action being pursued as an equitable contribution or indemnity claim by the excess insurer, but I have not puzzled through how that outcome would be resolved in a well-presented case by both sides. (In turn, the tagged excess or primary might make an claim under its insurance company professional-liability or errors-and-omissions (E&O) coverage or its reinsurance under, in particular, a follow-the-fortunes clause (and then be greeted with negligent underwriting claims as in Bonner v. Cox., known as the Aon 77 case).)

The focus here, of course, from the perspective of the policyholder lawyer, is the renewal doctrine, or the rule that in renewal policies that coverage restrictions are not effective if the insured had no prior notice from the insurer itself of their inclusion. In the case I handled, a chemical company presented with a standard-form CGL policy in 1970 that had a pollution exclusion included. That exclusion was "accepted" by the broker and the insured without objection -- no one ever pointed out any error or confusion about the terms of the coverage. Yet, two different courts looked at the same facts (why two courts is a different story) and each concluded independently that the renewal rule unquestionably applied, and so a primary policy with defense (in additional to limits) coverage was found to apply to several major environmental-liability, site clean-up, natural-resources damages, and toxic-tort administrative and court proceedings, liabilities the carrier would have skated out of (it claimed) if this particular exclusion applied. What we saw -- what both sides saw -- in the file as the actual, bona fide copy of the policy was indeed what we ended up with -- sans an outcome-determinative exclusion.

While the notice-of-reduction-in-a-renewal-policy rule is a favorable one that policyholders should press when presenting or litigating claims against their insurance company, it cannot do so unless the policyholder's counsel is aware of this particular rule; if not, then the insured's lawyer better be an insured lawyer.

Tags: Insurance, Blawg, Renewal Policy, Reduction in Renewal Policy, New Exclusions, Insurance Litigation, Insurance Coverage, Policyholder Lawyer

Posted by Marc Mayerson at 12:11 AM | Comments (3) | TrackBack

What You See Is Not What You Get: Renewal Policies

In Amway, here's how the court framed the dispute:

The real question, then, is whether an excess carrier . . . is bound as a matter of law by the underlying carrier's failure to comply with the renewal rule. We believe that the answer is "yes," because the "follow form" linkage between an excess insurer and the primary insurer should logically apply to procedural as well as substantive obligations to their common insured. In effect, an excess insurer who lives by the sword must die by the sword.

This type of extra-contractual argument, if successful, would require those purchasing insurance to affirmatively validate the importance of each and every coverage purchased. We find no authority supporting such an obligation. Furthermore, we suspect that any such obligation would turn the world of insurance upside down, since one has to be either super-diligent or a masochist to read an insurance policy with a fine-toothed comb.

This triangular relationship between the primary insurer, the excess insurer, and the insured presents the classic problem of which one of the two relatively "innocent" parties must suffer when the "wrongdoer" causes a loss. IN the present situation, we believe that . . . the excess insurer ] was in a much better position than the insureds to analyze unannounced changes in the underlying policy that it had agreed to follow. As between [the excess insurer] and the insureds, therefore, [the excess insurer] should be bound to provide the greater coverage and be the one to seek indemnity back against the [primary].

Tags: Insurance, Blawg, Renewal Policy, Reduction in Renewal Policy, New Exclusions, Insurance Litigation, Insurance Coverage, Policyholder Lawyer

Posted by Marc Mayerson at 12:11 AM | Comments (3) | TrackBack

February 4, 2006

Fettering the Insurer’s Privilege to Control the Defense It Is Duty Bound to Provide

For more than fifty years, policyholders and their insurers have been struggling over the insurer’s promise to defend and the insurer’s control the defense. Policyholders properly have been concerned that an insurance company that controls the defense of an action potentially covered by the carrier’s duty to indemnify will use that control to avoid that very same indemnity obligation. While in egregious cases where a lawyer hired by the carrier has abused his or her relationship with the insured, the client, so as to favor the lawyer’s source of income – the insurance company – the courts have responded to protect the insured’s interests. But most courts have ruled that such after-the-fact remedies are insufficient: they do not adequately compensate for the injury; meritorious claims are not pursued (in part because insureds may not discover the abuse); and the potential for this abuse alone undermines the dominant purpose of the insurance relationship to afford protection and peace of mind for the insured.

As a result, most jurisdictions have fashioned a number of rules affording remedies in cases of actual abuse – by allowing bad-faith actions to proceed against insurers, by barring insurers from using the fruits of the poisonous tree, by allowing malpractice claims against the lawyer, and other measures. But most furthermore have held that where there is a situation of potential abuse a prophylactic approach is appropriate; thus the insured is permitted to select the lawyer to defend it and the carrier continues to have the obligation to pay for that defense. This is usually referred to as the "independent counsel" rule (or in California, the Cumis or 2860 rule).

Rarely do I see as a policyholder lawyer a insurance provision that expressly addresses this problem – something that is incomprehensible given that for more than two generations this struggle has been waged. Since at least the 1950s, the courts have made clear to insurers that, because their policies do not set out how these circumstances should be handled, the courts themselves will fashion rules designed to balance the interests of policyholders and their insurers. In general, the courts have looked to the dominant promise of the insurance contract to defend (and to indemnify) the insured and held that the correlative responsibility of the insurer to defend can yield to safeguarding that dominant purpose of the insurance contract. In part this stems from the contract drafting in which two words – “right and” -- in the insurance policy are what carriers rely on: they have the “right and duty to defend” (plus the insured’s duty to cooperate set out in the boilerplate portion of the policy).

Because insurers are well aware of the rule that uncertainties in the contract will be construed against them and the rule in the overwhelming majority of jurisdictions that their right to defend and its entailed privilege of selection and control of counsel has to yield to protect the benefit of the bargain the insured struck to obtain both defense and indemnity, the courts generally have held that insurers forfeit their privilege of control.

The paradigmatic circumstance where the insurer’s privilege of control yields to its duty to defend, to protecting the insured’s expectations of coverage, and to subordination to the insured’s interest is where a complaint alleges more than one claim arising out of a single event and the case can be lost on either a covered basis or an uncovered one. Take as an example where an during a pickup basketball game an elbow is thrown: if that occurred because of gross negligence, there will be coverage, but if it occurred because the player sought to intentionally injure the recipient, there won’t be. Trial of the case involves the same facts and testimony either way, and ultimately it’s up to the jury to weigh the testimony and the facts. The insurer if it is to lose the case would prefer to lose it on intentional-injury grounds, for then it won’t have to pay the judgment.

Another example: assume there is a technical defense available to the covered claim; should the lawyer file a motion for summary judgment on the covered claim, which will effectively pretermit the carrier’s ongoing obligation to defend (since the case no longer can eventuate in a judgment covered by the duty to indemnify)? Does the lawyer have an obligation to leave the weak claim hanging around just to preserve the defense or does the lawyer – whose bills are being paid by the insurer – have the obligation to clean out the dross and thus allow the carrier off the hook?

Insurers have pooh-poohed such concerns by contending that lawyers act ethically so the courts’ concerns are unfounded. And the United States Court of Appeals for the Fourth Circuit – a court that has a penchant for mispredicting state insurance law by siding with insurance companies – recently agreed with the insurers in what should become carrier-side lawyers’ favorite case to cite on these issues. In a well-written, well-analyzed, but erroneous ruling, Twin City Fire Ins. Co. v. Ben Arnold-Sunbelt Beverage Co. (4th Cir. Dec. 27, 2005), the Fourth Circuit rejected the argument that an insurer’s reservation of the right to deny coverage called for prophylactic protection of the interest of the insured by allowing it to select counsel of it choice to defend at the insurer’s expense.

Of course, Ben Arnold involves reasonably favorable set of facts for carriers and overbroad argument by the policyholder, but the court’s ruling is not so confined. The court sets up the question presented as follows:

When a party with insurance coverage is sued, the insured notifies the insurance company of the suit. The insurance company, in turn,typically chooses, retains, and pays private counsel to represent the insured as to all claims. If the suit involves some claims that are covered under the insurance policy and some claims that are not covered, the insurance company typically will send a reservation of rights letter to the insured stating what claims the insurance company believes are covered and what claims it believes are not covered. In this case, we examine whether, under South Carolina law, such a reservation of rights letter automatically triggers a conflict of interest entitling the insured to reject counsel tendered by the insurance company and instead to choose and retain its own counsel and to have the insurance company pay for that counsel.

Slip op. at 1. The proposition offered by the insured was that any time an insurer issues a reservation-of-rights letter it is still required to provide a defense but the policyholder gets to select counsel to defend it and control the course of the defense.

The Fourth Circuit rejected the policyholder’s argument, noting correctly that courts tend to require that the insured show there to be a conflict of interest between it and the insurance company before wresting the defense from the carrier. This is sensible, of course, given that in the insurance policy the policyholder delegated to the insurance company the right to defend the case. Insurance companies issue reservation-of-rights letters in response to case law in the 1950s and 1960s that a carrier that defends a suit cannot turn around at the end of the case and tell the insured that it won’t pay for the judgment – at least without alerting the insured of this possibility earlier; as a result, insurance companies issue reservations of rights to prevent the insured from having detrimental reliance (or claiming waiver). National Mut. Ins. Co. v. McMahon & Sons, 356 S.E. 2d 488, 493 (W. Va. 1987); Safeco Ins. Co. v. Elllingshouse, 725 P.2d 217, 221 (Mont. 1986); Richmond v. Georgia Farm Bureau Mut. Ins. Co., 231 S.E.2d 245 (Ga. 1976); Royal Ins. Co. v. Process Design Associates, 582 N.E.2d 1234, 1239 (1st Dist. 1991).

But it is not the insurance company’s fault that a suit may involve both covered and uncovered amounts, and coverage is not to be expanded beyond the terms of the policy through application of principles of waiver. As a result, it is entirely appropriate for an insurance company that is contractually obligated to provide a defense to a policyholder to alert it to the possibility that the judgment in the case might not be covered. D.E.M. v. Allickson (North Star Mut. Ins. Co.), 555 N.W.2d 596 (N.D. 1996). In this way, the policyholder can act to protect its own interest, including in some states choosing to settle the lawsuit against it in a fashion that camouflages whether the payment is also on account of uncovered amounts or claims. See generally Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982).

So, unless some other interest or question is involved, the mere fact that an insurer sends a reservation-of-rights letter should not alter the parties’ preexisting rights and powers (since all the insurer is trying to do is to avoid waiver/estoppel from its assuming the defense).

Against this background, the Fourth Circuit rejected the notion that a reservation-of-rights letter per se creates some sort of conflict between the interests of the insured and its insurer such that the insurer is divested of its contractually bargained-for right to defend. But the court went on to recognize that there are circumstances where the interest of the insured and the insurer in the development of the defense can diverge, which has led most courts to express concern about insurer-appointed and insurer-directed counsel.

The Ben Arnold court reviews the law in a number of jurisdictions (having found that South Carolina law applies and was without governing precedent) and concludes that some courts allow the insured to select counsel paid contemporaneously by the insurer whereas other courts permit the insurer to select “independent” counsel who in turn may have heightened professional duties to safeguard the insured’s interest. Because a strong undercurrent in those cases vesting the choice of counsel in the hands of the insured questions the ethical integrity of the insurance-defense bar, e.g., Howard v. Russell Stover Candies, Inc., 649 F.2d 620, 625 (8th Cir. 1981) (requiring independent counsel for fear that counsel for insurer “would be inclined, albeit acting in good faith, to bend his efforts, however unconsciously” in insurer’s favor), the Fourth Circuit was highly reluctant to impugn with such a broad brush the integrity of an entire swath of the bar. Slip op. at 11 (“We are equally unable to conclude that the Supreme Court of South Carolina would profess so little confidence in the integrity of the members of the South Carolina Bar. Rigorous ethical standards govern South Carolina attorneys.”).

The Fourth Circuit concluded that the ethical rules and discipline, “coupled with the threat of bad faith actions or malpractice actions if a lawyer violates these rules, provide strong external incentives for attorneys to comply with their ethical obligations.” Slip op. at 12. Accordingly, the Ben Arnold court refused to find that, where there was a conflict of interest between the insured and the insurer in the development of the facts at issue in the liability case, the insured had a right to counsel of its choice, paid for contemporaneously by the insurer.

The court furthermore adopted a strict forfeiture rule in this regard, finding that if an insured rejected counsel tendered by an insurance company it forfeits the right to defense coverage. In other words, the policyholder is precluded from seeking coverage even if the insurance company cannot show that it was in any way was harmed by the policyholder’s selection of counsel (e.g., competent counsel at the same rate, for example, who obtains an outstanding result). The court rejected the policyholder’s contention that the insurers must show substantial injury or prejudice or at least some detriment in order to be excused from providing the policyholder any of the benefit of the bargain. Slip op. at 13-15.

Ben Arnold is sure to be relied on by insurance companies as a cogent statement of their position in favor of rejecting the policyholder’s selection of counsel of its choice. Nevertheless, the court need not have reached out to proclaim its own, pro-insurer prophylactic rule because the facts of the case and the conduct of the insurers at issue merit no such prolegomenon.

In Ben Arnold, the insurers retained qualified counsel to defend the covered counts and in addition offered to pay for separate counsel to represent the insured’s interests with respect to uncovered counts. Moreover, with respect to a different insured in the case where there was a conflict of interest in the development of the facts, both the trial court and the Fourth Circuit found that independent counsel was required to be appointed at the carriers’ expense. And even with respect to the principal insured for which there was no conflict at issue in the development of the underlying facts, the trial court recognized that at the time of settlement independent counsel might be required due to the conflict that then would be manifest. 2004 WL 2165971 (D.S.C. July 26, 2004), at n. 14.

What is lamentable about the Fourth Circuit’s opinion is that the court could easily and more properly have held that, given the absence of a conflict of interest between the insured and insurer in the development of the underlying facts, independent counsel was not required and in any event the insurers satisfied their obligations by offering to pay for two sets of counsel. This is the rule in “independent counsel” states where most courts recognize that merely sending a reservation-of-rights letter – without more – is insufficient to oust the insurer of the control of the defense. National Union Fire Ins. Co. v. Hilton Hotels Corp., 1991 WL 405182 (N.D. Cal. 1991). In fact, wresting control whenever a reservation of rights is sent ironically defeats the purpose for why such reservations were sent in the first place.

But Ben Arnold should not be rejected just because it is overly broad, for even were the facts to match the very broad rule adopted that rule still would be ill advised and erroneous under principles both of insurance law and of contract law. Perhaps because the issue has been in dispute for so long (half-a-century), the footings of the independent-counsel rule seem to have become beclouded.

Let’s look first at the consequences of the Ben Arnold court position. The court makes clear that, while there might a perception of discomfort by the policyholder in the carrier’s selected lawyer being in charge (and thus having the ability to steer the defense toward uncovered grounds), the insured’s interest is adequately protected because of legal-ethics rules, attorney-malpractice liability, and insurance bad-faith principles. This rejoinder to the policyholder position really does not withstand scrutiny.

The Fourth Circuit’s remedies render nugatory the peace of mind and security the insured is supposed to receive by paying a premium to the insurance company for the broad protection afforded by insurance policies. See Rawlings v. Apodaca, 151 Ariz. 149, 154-55 (1986) (“Although the insured is not without remedies if he disagrees with the insurer, the very invocation of those remedies detracts significantly from the protection or security which was the objection of the transaction.”). The court envisions requiring policyholders to endure bad faith or ethical breaches, and then seeking recovery only at the end of the underlying litigation by suing for legal malpractice or bad faith. Ben Arnold thus replaces the security that insurance is supposed to provide with a chose in action against the insurer-appointed lawyer, requiring the policyholder to (a) sue for legal malpractice, requiring a showing both of breach of the standard of care and a showing that the outcome would have been different (the “trial within the trial” of such malpractice actions), (b) undertake that action at its own expense (since the insurer is not paying, and there’s no attorneys’ fees recovery in malpractice cases), (c) in the meantime front the money for the adverse judgment in excess of policy limits or even the entire judgment if it is based on an uncovered claim (and subsequently, if successful, refund to the carrier in subrogation any amounts recovered after the policyholder was made whole), and (d) expose itself to an uncollectible judgment because the lawyer may not have assets sufficient to cover the judgment that resulted from his malpractice.

The Ben Arnold solution to the conundrum of insurer-appointed counsel further would do substantial injury to the attorney-client relationship; not only would the insured find it difficult to confide in counsel assigned to it, but counsel’s effectiveness would be undermined by its knowledge that the carrier has set it up for an impending malpractice action. And the same problems apply regarding suing the carrier for bad faith for some misconduct of the insurer-appointed lawyer or suing for negligent performance of the duty to defend by providing inadequate counsel.

The proposed remedy that the Ben Arnold court contemplates is a feeble substitution for the security and protection that the policyholder thought it was paying for. And if one looks at the cases decided forty or fifty years ago, these courts found it salient that the insurers’ policies did not spell out how this conflict situation would be handled. Standard insurance policies then (as now) were not written to state plainly and unambiguously that (i) interference with the right to defend forfeits coverage or (ii) the right to defend constitutes a material part of the consideration of the overall insurance transaction (which would be an overreach anyway given the aleatory nature of insurance contracts, that is, that the policyholder has fully performed its principal obligation of paying the premium).

Thus, the courts have applied the ordinary rules that where the policy language was uncertain and the insurer was in a position to clarify by drafting a provision clearly, the policy is construed in favor of coverage to achieve its purpose of indemnifying the insured, especially bearing in mind the reasonable expectations of insureds and avoiding the appearance of unseemliness from insurer-appointed counsel’s being in the position to steer the case to favor his or her source of future business. E.g., Employers' Fire Ins. Co. v. Beals, 240 A.2d 397, 402 (R.I. 1968); Magoun v. Liberty Mut. Ins. Co., 195 N.E.2d 514 (Mass. 1964); Prashker v. United States Guarantee Co., 136 N.E.2d 871 (N.Y. 1956); see also CHI of Alaska, Inc. v. Employers Reinsurance Corp., 844 P.2d 1113, 1116 (Alaska 1993). As a result, most courts ruled that the carriers’ right to control the defense – an ancillary part of the insurance contract – must yield to the predominate purpose of the contract to provide the policyholder a defense and to safeguard the policyholder’s peace of mind. See Jacobs & Youngs, Inc., 129 N.E. 889, 891 (N.Y. 1921) (Cardozo, J.) (“There will be no assumption of a purpose to visit venial faults with oppressive retribution.”). That carriers have not fixed their policy language after 50 years of litigation and instead require that the law be developed in each state and locality smacks of ineptitude or bad faith or some synergistic combination of the two.

Nevertheless, one dissembling rejoinder to this would be to contemplate a situation where the policyholder does erroneously reject the carrier’s offered defense (which approximates the actual facts in Ben Arnold). In that circumstance, so the argument goes, if the carrier remains responsible for funding the defense, the carrier that offers to perform properly is no better off than is the carrier that breaches its contract by refusing to provide a defense at all. In other words, a carrier that breaches its duty to defend by erroneously denying coverage is liable to pay the reasonable costs of defense; and according to this argument a carrier that offers counsel that is rejected by the policyholder is still obligated to pay the reasonable costs of defense.

This is a false counter, because it misstates the damages that are to be paid by a breaching carrier (that is, the contract-law damages it owes for breach of the duty to defend). It is not precise to say that a breaching insurer owes the reasonable costs of defense; rather, under Hadley v. Baxendale, the insurer owes all foreseeable damages. In the circumstances, the policyholder proffers in its prima facie case all defense costs it incurred (that were caused in fact by the carrier’s failure to perform), and the carrier may argue by way of affirmative defense (and for which it has the burden of proof) that the costs were so unreasonable as to constitute unforeseeable damages ( which when framed correctly is a difficult standard for the carrier to meet, especially in the light of the fact that the insured had every economic incentive to incur only reasonable costs since, at the time, it was paying them out of its own pocket with no certainty of recovery from the carrier). Moreover, a breaching carrier is not just liable for defense costs, it is liable for all damages incurred by the insured from the breach. Beck v. Farmers Insurance Exchange, 701 P.2d 795, 801 (Utah 1985).

Contrast this situation to that of the carrier that does offer a defense but which is rejected by the policyholder on the ground that independent counsel is required – though in this illustration the policyholder is wrong to do that. In that circumstance, the concepts of material versus immaterial breach are key (as are dependent versus independent covenants). Here, the carrier has not breached, but the policyholder has. But the policyholder’s breach – by interfering with the carrier’s right of control – exposes the policyholder to the carrier’s set-off claim because it is an immaterial breach of the overall contract. In other words, the carrier is still required to perform its contract – for the policyholder’s breach is not a material breach of the contract excusing the carrier’s obligation (especially when the policyholder has probably already paid the full premium). See generally Steakhouse, Inc. v. Barnett, 65 So.2d 736, 738 (Fla.1953)(defining dependent covenants). But because the policyholder did breach the contract, the carrier is entitled to show its damages from the policyholder’s breach. In this context, what that means is the additional cost of the defense that would not have been incurred had the policyholder not breached (i.e., not been in charged). So, if the defense counsel the insurer would have appointed charged only $300 an hour (because of say a bulk deal with the carrier) and the policyholder’s selected lawyer charges $400 an hour, the carrier is not obligated to pay the $100 an hour difference. (Unlike Ben Arnold where the carriers' to their mirth owe nothing.) Importantly, this is in contrast to the breaching carrier which is unlikely to be able to show that the $100 an hour delta is such an unreasonable cost differential as to constitute unforeseeable damages under Hadley v. Baxendale. Moreover, the carrier that properly offered counsel is not exposed to paying the insured’s full damages (sometimes pejoratively characterized as “consequential damages” (Machan v. Unum Provident Ins. Co., 2005 UT 37 (Utah June 17, 2005)), because it did not breach.

Thus, a carrier that properly tenders performance that is incorrectly rejected is not in the same (disadvantaged) position as is a carrier that breaches its contract. Accordingly, under this analysis, everyone is put in the position they would be in had the contract been properly performed – the benefit of the bargain is preserved.

Until such time, therefore, that insurers revise their contracts to specify that even in a conflict of interest situation the insurer still gets to appoint counsel (or whatever method it would propose, such as allowing the insured to pick from a list of five counsel suggested by the insurer), the uncertainty of the contract, and the disproportionality of the proposed remedy contemplated by the Ben Arnold court, confirms the rightness of the independent-counsel rule. See generally Restatement (2d) Contracts Sections 197, 229 (2004). If insurers do revise their contacts, then (i) insurance regulators would be in the position to weigh in, (ii) policyholders would know expressly what the process is for dealing with a conflict situation if it purchases the particular insurance policy, and (iii) policyholders could choose to purchase policies from other insurers that offer more generous terms. But it is folly to believe that policyholders contemplate the remedial scheme adopted by the Ben Arnold court. See Restatement (2d) Contracts Section 211(3).

Note: A version of this commentary was published in 5 Insurance Coverage Law Bulletin (May 2006) at 1

Posted by Marc Mayerson at 11:39 PM | Comments (0) | TrackBack