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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

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

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

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

January 16, 2006

Gelding the Pollution Exclusion: Welding Exposure Claims Not Barred

For the past several years, the plaintiffs’ tort bar has sought to make workplace-exposure claims by welders the proverbial “next asbestos.” These cases typically allege a Parkinson’s Disease-like syndrome (“Parkinsonism”) or other neurological impairments (all generally referred to as “manganism”) allegedly stemming from the welder’s exposure to manganese while working. Whether this is a mass-tort with legs is certainly not clear, and the defense has had successes (even in what are considered to be plaintiff-friendly jurisdictions). Naturally, this litigation has produced insurance cases too, and the Maryland Court of Appeals (its highest court) recently ruled that an absolute pollution exclusion did not apply to bar coverage. Clendenin Bros. v. United States Fire Ins. Co. (Md. Jan. 6, 2006).

The Clendenin decision is significant in part because it disagrees with a prior Fourth Circuit decision, National Electrical Manufacturers Association (NEMA) v. Gulf Underwriters Insurance Company, 162 F.3d 821 (4th Cir. 1998). The NEMA case found that a pollution exclusion applied to the bodily injury claimed in the welding-rod litigation. The Maryland high court disagreed. (The Fourth Circuit is a bit of a recidivist in this regard, inaccurately predicating that state law would rule for insurance companies only to have the state later expressly go the other way. Compare Mraz v. Canadian Universal Insurance Company, 804 F.2d 1325 (4th Cir. 1986) (holding that Maryland law mandated a “manifestation” trigger of coverage) with Harford County v. Harford Mutual Insurance Co., 610 A.2d 286 (Md. 1992) and compare Maryland Casualty Co. v. Armco Co., Inc., 822 F.2d 1348, 1352-54 (4th Cir. 1987) (predicting that Maryland would refuse to recognize CERCLA response costs as “damages” under CGL policies) with Bausch & Lomb, Inc. v. Utica Mut. Ins. Co., 625 A.2d 1021, 1032-33 (Md. 1993).)

The Maryland court recognized that the substance at issue had a useful purpose and only allegedly was harmful where a person was exposed to undue levels. As the court ruled: “Therefore, reading this definitional provision as a whole, we conclude that to qualify as a pollutant under the contractual definition the substance must be understood to be an irritant or contaminant.” (Slip op. at 13) The court distinguished prior authority (where the insured had conceded that carbon monoxide was a contaminant) on the basis that the manganese might or might not be considered a pollutant depending on the circumstances. (Id. at 14) This should strongly counsel to policyholders that they need (in good faith) to dispute in the liability case, and certainly in the coverage case, that the substance to which the plaintiff was exposed is malum in se.

The court further embraced the standard creation-story of the absolute pollution exclusion to confirm that its linguistic, contextual construction allowing for coverage was not inconsistent with the policy intent. (Slip op. 18-20; slip op at 21 (“We conclude also that the current construction of the total pollution exclusion clause drafted by Insurer was not intended to bar coverage where Insureds ' alleged liability may be caused by non-environmental, localized workplace fumes.”).

And the court confirmed that this type of product-liability risk – though it takes the form of contamination of exposed persons – is reasonably thought to be comprehended by the product-liability insurance provided by CGL policies. As the Maryland high court explained: “Welding fumes emitted during the normal course of business appear to be the type of harm intended to be included under coverage for routine commercial hazards.” (Slip op. at 19). Indeed, the court expressed its overall rationale more broadly and powerfully: “The specific language used in the total pollution exclusion clause, when read in its entirety, supports the conclusion that noxious workplace fumes were not intended to be excluded.” (Slip op. at 20)

Well aware of the continuing litigation over application of the absolute pollution exclusion to workplace- and product-exposure claims, the court recognized: “We expect that, our decision notwithstanding, interpretation of the scope of pollution exclusion clauses likely will continue to be ardently litigated throughout state and federal courts.” (Slip op at 21).

Posted by Marc Mayerson at 3:55 PM | Comments (0) | TrackBack

December 1, 2005

E Pluribus Plures: More on Number of Occurrences

Courts continue to confront the question of the “number of occurrences” involved in mass-tort situations. The issue is important because policy limits are expressed in dollars per occurrence, with some policies having unlimited or uncapped retentions on a per-occurrence basis. For a policyholder with a large and uncapped per-occurrence retention, a ruling that each claim against the policyholder is a separate occurrence results in multiplying the amounts retained by the policyholder, oft times pushing insurance out of reach. On the other hand, for a policyholder with no or low retentions, a finding of multiple occurrences can multiply the available coverage.

The number-of-occurrences questions also will determine the responsibility of the primary- versus the excess-layer carriers. A single occurrence in a mass tort situation means that the primary will pay one policy limit (plus defense costs) and the remaining claims will be pushed up to the excess carriers. Sometimes, a single-occurrence ruling can result in the policyholder’s picking up the cost of loss in excess of the top line of its coverage. On the other hand, if more than one occurrence is found, the policyholder may be able to wring more money out of the insurance program, depending on the aggregate limits of the coverage it purchased.

Recent cases continue to reach divergent results, even though the courts involved all purport to apply the same “cause” test, that is, the number of occurrences is determined by the cause(s) of the loss. (Some courts from time to time have found that the number of occurrences is determined by the “effects” that is, how many victims there are; this is not the majority approach, and most jurisdictions for at least the past 80 years have employed the cause test. Hyer v. Inter-Insurance Exchange of Automobile Club, 77 Cal. App. 343 (1926)).

One case arises in the asbestos bodily injury context, Uniroyal, Inc. v. American Re-Insurance Co., No. A-6718-02T1(N.J. App. Div. Sept. 13, 2005). In that case, the policyholder had spent well over $300 million in responding to asbestos claims arising from its products. The court found that “occurrence” means an “unfortunate event,” and the question presented was whether each exposed-worker constituted a separate occurrence (in which event the excess insurer would have no obligation to perform in view of the large, uncapped retention borne by Uniroyal). The appellate court reversed the trial court decision and elected not a follow a decision by a federal court in prior case involving Uniroyal, dealing with Agent Orange, which held that the mass-liability injury claims there arose from a single occurrence. In a lengthy opinion construing New York law, the New Jersey court held that “the [defining] event is not the corporate decision to engage in the product line but rather it is the individual exposure of each claimant to the product that resulted in the injury.” (p. 30-31)

(The whole Uniroyal decision was a train wreck for the policyholder – or whatever its opposite is for the insurance carriers: (i) the court also ruled that only one per-occurrence limit is available under a three-year policy, whereas separate annual limits would have applied had the policyholder purchased successive one-year policies; (ii) the court held that an excess carrier owes no obligation to reimburse defense costs except as an incident to a covered indemnity claim, meaning that unlike primary policies potentially covered claims are not covered by the defense obligation but only actually covered claims are and that successfully defended cases are not covered at all; (iii) the court held that a “stub” policy did not afford separate policy limits but instead merely extended the policy period of the expiring policy; (iv) the court ruled that amounts should be allocated to Uniroyal as a self-insurer beginning in the mid 1970s because asbestos coverage was still “available” in theory and thus Uniroyal was deemed to have consciously self-insured its multi-hundred million dollar asbestos exposures and should therefore be allocated a share as if it were a commercial insurer; and (v) the court largely reversed the trial-court’s award of attorneys’ fees to Uniroyal, remanding for further evaluation and substantial reduction of the trial-court’s original award. Uniroyal lost every single issue on appeal in the court’s 65-page opinion.)

In contrast to the Uniroyal court’s multiple-occurrence ruling, the South Carolina Supreme Court recently addressed the number-of-occurrence question not in the context of asbestos bodily injury claims but in connection with another mass-tort: the exterior insulation finishing systems (EIFS) cases. EIFS is a fake stucco used to decorate the exterior of buildings, mainly houses; this finish was quite popular for a while last century, but many EIFS installations allowed water to penetrate in a manner where it was trapped, leading to rot and mold. Fixing buildings with faulty EIFS requires significant remediation and significant expense, spawning an entire mass-tort cottage industry and naturally follow-on insurance-coverage disputes.

The question presented in Owners Ins. Co. v. Salmonsen (S.C. Nov. 7, 2005), was whether a company that distributed Parex, one of the EIFS systems, was entitled to coverage for one limit only or whether it could collect for as many occurrences as the aggregate limit permits. The federal district court ruled that coverage applied generally, but certified the number-of-occurrences question to the South Carolina Supreme Court.

Reframing the question from whether state law applies the majority (cause) or minority (effect) rule for determining the number of occurrence, the South Carolina high court identified the issue as “Is each individual sale of a defective product an occurrence or is the general act of distribution a single occurrence.”

The court rejected articulating any single rule and instead focused “narrowly on the issue at hand.” The court characterized the facts as involving the “distribution of inherently defective goods” and not the “defective distribution of otherwise satisfactory goods.” In the latter instance, each defective distribution – or independent act of negligence – would constitute a separate occurrence (as in Michigan Chem. Corp. v. American Home Assur. Co., 728 F.2d 374 (6th Cir. 1984), where a distributor shipped the wrong product on several, unrelated occasion producing losses to its customers). Reasoning that “the distributor has taken no distinct action giving rise to liability for each sale, we conclude . . . . that placing a defective product into the stream of commerce is one occurrence.”

Accordingly, the insurer carrier was liable only for one per-occurrence limit of $1 million rather than being exposed to pay its entire aggregate limit.

In both the Uniroyal and Salmonsen cases, the courts reached opposite number-of-occurrence rulings but in each instance the ruling favored the insurance companies. The appellate decision from the Third Circuit earlier this year in Treesdale was a one-occurrence result for asbestos bodily injury claims and had the result, like the opposite holding in Uniroyal, of favoring the insurance company. In the World Trade Center litigation, the court concluded that there was but one occurrence, again a result favoring the insurance carriers. In these cases, the policyholder has already run the gantlet of coverage defenses and has proved that coverage applies -- only to find no or little (or less-than-expected) coverage based on the court’s number-of-occurrences ruling. While I am not prepared to pronounce a trend that the carrier always wins, for many years the assumed result among insurance-coverage practitioners (both carrier-side and policyholder attorneys) was that the court would adopt the number-of-occurrence result that would maximize coverage for the policyholder. Surely that assumption can no longer be made so facilely.

Posted by Marc Mayerson at 12:52 PM | Comments (3) | TrackBack

November 6, 2005

Insurance for Goods in Transit

Companies that make things need to get those things to their customers, and they face the risk of loss while the goods are in transit to the customer. Via contract, one can shift or retain the risk of loss during transit, such as having title pass to the customer once the item leaves the company’s facility or to wait until the customer accepts the item at its location. In addition to shifting to one party or the other the risk of loss via the sale contract, the company can obtain insurance to protect itself against loss. Recent cases have addressed both liability coverage – insurance against the risk of loss to goods for which title has passed to the buyer – and first-party coverage – insurance against loss in transit while title remains vested in the seller.

In a recent case, Rad Source Technology Inc. v. Colony National Insurance Co. (Fla. App. Nov. 2, 2005), a manufacturer of blood irradiation machines shipped one to a customer, a university medical facility. During transit, the machine was damaged, and the customer sued. The manufacturer turned to its liability insurer and asked for a defense, which was refused. The Florida Court of Appeals, however, held that the insurer had a duty to defend the suit. One basis for the carrier’s coverage denial was the injury-to-products (or “own products”) exclusion. That exclusion bars coverage for property damage to “your product” arising out of it (or any part of the product). As the court found, the exclusion is meant to bar coverage for “situations wherein the product itself is defective.” Slip op. at 4. The court found the exclusion inapplicable because there was no allegation that the product itself was the source of whatever damage occurred. Because the allegations were not confined to a claim that an endogenous risk led to the damage, one could reasonably construe the complaint to allege exogenous risk, which is covered.

The carrier also denied coverage on the ground that the contractual-liability exclusion applied. This exclusion bars coverage in the event that the insured assumes via contract liabilities that it would not otherwise have at tort (in other words, it applies to circumstances where the policyholder for consideration becomes an insurer for someone else). Here, the manufacturer had agreed to assume the risk of loss until the product was delivered to Atlanta (“F.O.B.”), and the facts of the case showed that that product was damaged after it had reached Atlanta. As a result, the seller had not assumed the risk of the loss at issue via its sales agreement, and therefore the contractual liability exclusion did not apply. Thus, the court concluded there was a duty to defend.

The Rad Source Technology case addressed liability insurance coverage; as noted, manufacturers may insure against the risk of loss while they retain title in their products during transit under first-party coverage. The case for insurance recovery is straightforward where the goods are destroyed; but sometimes goods can be affected by conditions during shipment that affects their value such that the insured will claim loss.

In a recent case, American Home Assur. Co. v. Merck & Co., Inc., __ F. Supp. 2d __, 2005 WL 22206797 (S.D.N.Y. Sept. 12, 2005), a pharmaceutical manufacturer claimed losses in three unrelated circumstances arising from its decision to destroy products that were either damaged or exposed to inappropriate shipping conditions during transit.

The policyholder, Merck, engages in a highly regulated business, and it faces a high risk of legal-liability claims. For any pharmaceutical manufacturer, the risk of third-party liability and claims for punitive damages is severe if it is lackadaisical about knowledge that components of product have been contaminated, damaged, or inappropriately stored. Given the legal environment in which it operates, Merck must be sensitive also to managing its risk of regulatory violation stemming from any alleged lack in care in the stewardship of its products. Accordingly, in purchasing its first-party property policy, Merck sought to retain control of the decision of what to do when there was a risk that its products were damaged or degraded during shipping.

The clause at issue in particular

(i) assigned to Merck a right of possession for any damaged goods and to retain control over them,
(ii) made Merck the “sole judge” as to whether the goods were “fit for use”,
(iii) vested in Merck the power to dispose of the goods as it saw fit (subject to the insurer’s right of salvage).

Goods were deemed to have suffered a loss that triggered the coverage

(i) if the product in fact was condemned by government authority, or
(ii) if Merck concluded that a reasonable construction of the applicable law would require that the goods no longer be considered fit for sale, or
(iii) if the only means to determine whether the goods were unfit is through destructive testing.

Moreover, the policy included a “sue and labor” clause, that is, a clause that affords the insured the opportunity to obtain reimbursement for the costs it incurs in avoiding further loss to covered property.

The losses involved three unrelated situations, but each had in common that Merck had shipped a component of a pharmaceutical product and during shipment some untoward event occurred that led Merck to conclude that part or all of the shipment no longer could be used. For one of the claims, a temperature indicator showed that for part of its journey the product had been exposed to temperatures below what had been prescribed. Concerned that the product (vaccine) had been frozen, Merck concluded that the product in the truck could not be used or resold. (This conclusion was based on its interpretation of 21 C.F.R. 211.208.) The insurance company, however, disputed that any of the vaccine had been frozen in fact, that the regulation applied to vaccine, or that the regulation prohibited testing and rehabilitation of vaccine even if a portion was not usable.

Another of the claims concerned the shipment in the same truck of a poison with pharmaceutical product; Merck concluded that FDA regulation prohibited such transport, and it ordered destruction of the entire shipment even though there was no evidence of actual contamination of its product. Again, the insurer challenged the reasonableness of Merck’s conclusion and conduct.

The final claim involved product that was shipped in fiberboard drums. Four drums that were shipped by airplane were thought to be damaged; for two drums, the plastic liner containing the active pharmaceutical ingredients (“APIs”) was breached, but for the other two drums, which were themselves damaged, there was no evidence of any injury inside of the drum (e.g., the plastic liner was intact). Merck did not test the material in any of the four drums and instead destroyed all four on the grounds they had been subjected to improper storage conditions within the meaning of 21 CFR 211.208. The insurer questioned Merck’s actions here, too.

The court refused to grant summary judgment, in part criticizing Merck for its failure to involve its insurer, particularly in determining whether there might be salvage value to the affected product. The court did not seem comfortable with the idea that the insurer was subsidizing Merck’s (reasonable) decision to be conservative in handling its product by destroying it whenever there was objective evidence calling into question the product’s integrity during shipment. Because the interest of the insurance company was implicated, the court seems to imply that Merck needed to be attentive to the interest of this constituency too. While Merck plainly was vested with considerable discretion, the court seemed to question whether Merck was acting as a “prudent uninsured” throughout the process or whether it destroyed the material prophylactic ally in part in the belief that its insurance would cover the loss.

When it purchased the coverage, Merck had sought initially to amend the policy form to afford it broader latitude than its rights and responsibilities under the policy language ultimately agreed. Accordingly, while it was entirely sensible to place Merck in charge of the product and of ensuring its own compliance with FDA regulation, the provision gave the insurer some interest in the disposition of damaged product for which it was expected to pay. The lesson here is that managing the relationship with the insurer needs to be accounted for in the insured’s business processes of handling situations like these. The risk-management department must ensure not only that coverage is purchased but also that the company’s business practices conform so that the right to insurance recovery is safeguarded – and the risk of litigation with one's insurer is reduced.

Posted by Marc Mayerson at 6:20 PM | Comments (3) | TrackBack

October 3, 2005

The Faulty Workmanship of the Courts

A common criticism of courts dealing with insurance issues is that they forget they are dealing with a contract. Where courts don’t like the economic incentives that (they fear) they might create by affording coverage, they sometimes make up coverage-limiting postulates that are nowhere expressed in the policy.

This is what happened in the South Carolina Supreme Court recently, which confronted a question common in the construction context – namely, is a contractor’s faulty construction a covered occurrence. L-J Inc. v. Bituminous Fire and Marine Ins. Co. (S.C. Sept. 26, 2005). If that kind of event can never be an "occurrence," then insurance companies never have an obligation to pay for the defense of claim alleging resulting injury and damage or to fund the cost of any settlement or, if the case gets tried, any judgment.

The commonly stated axiom is that injury to third-party property is covered but damage to the contractor’s own work is not. I have no quarrel with this general notion as a statement of underwriting aspiration, but the question is whether this limitation is a result of express language in the insurance policy or is it something inherent in the nature of insurance?

The South Carolina court ruled that CGL policies afford coverage where “faulty workmanship causes a third party bodily injury or damage to other property, [but] not in cases where faulty workmanship damages the work product alone.” Slip op. at 23 n.4 (emphasis in original). The result is not so controversial as is its ratio decidendi: the court finds this formula inheres in the very idea of what an occurrence is. But why?

In the South Carolina case, the contractor’s work – a road – began to develop cracks, which resulted from errors in constructing the road. The cracking clearly is damage to property. Once title passed to the road (really, the materials the road comprised), the physical material became third-party property. On its facts, the claim involved damage to property of a third party.

Whether there is coverage for that kind of injury turns on whether that property damage was caused by an occurrence. The court finds that “faulty workmanship is not something that is typically caused by an accident or by exposure to the same general harmful conditions.” Id. Yet, the court concedes that the same conduct – were it to have resulted in some other injury or damage – would be considered to have arisen by accident, i.e., would constitute an occurrence.

In some ways, the court’s distinction is reminiscent of arguments about inherent vice and similar “off the contract” premises about why something is by its nature uninsurable. The problem with these arguments always is that these constitute sub silentio exclusions, ones that are created through argument at the time of claim and then apply necessarily to all claims.

Usually, courts apply the plain meaning of contract terms, and the ordinary meaning of "accident" or "occurrence" is broad enough to pick up unintentional results of even conscious poor workmanship. See David Mellinkoff, The Language of the Law 377 (1963) ("'accident' remains a 'blob of jelly' as a legal construct). The court’s decision might rest on stronger ground were it to have held that the damage on the particular facts was expected/intended by the insured and therefore excluded. Alternatively, the court’s exposition should have waxed more broadly on where the burden of proof should lie and why proof of unintended injury is a sine qua non to coverage vel non such that it should be part of the insured’s prima facie case. But none of this is the essence of the case, for the decision turns on what the court thinks of as first principles going to the heart of insurance.

But at the level of first premises there is nothing illegal about insuring against the risk of faulty workmanship and subsequent breach-of-contract and warranty claims. This risk can be insured because there is uncertainty as to whether, when, or how much liability will be found. See generally Bob Hedges, Back-Dated Coverage as Insurance, 34 CPCU J. 181, 181 (1981).

Nevertheless, one can understand that insurance companies do not want to create economic incentives for the insured not to do a good job in the first place, knowing that insurance will come to the rescue if the insured later has to pay the piper. (Whether such “moral hazard” exists at all in liability policies is doubtful even in theory let alone in reality.) But the issue is how should we set up systems of contract so companies can transfer the risk of loss without insurers picking up costs they do not wish to absorb.

If one were to embrace the objective of not insuring against the risk of faulty workmanship that results in losses to the worked-on property, how should that be expressed and enforced?

One answer lies in the underwriting and selection of insureds to which to sell policies: insurance companies should not sell policies to companies that deliberately would perform poorly. An insurance company has the right to continue to inspect the insured’s operations and, if it believes the insured routinely is engaging in shoddy workmanship, the insurer can cancel the policy (prospectively). (Given that the trial court and the Court of Appeal both sided with the insured, one can be somewhat confident that it is not a total fly-by-night operation.) If the insurer sold the policy nonetheless, then the insurer should own up to its commitment of coverage (and presumably it priced its policy to do so). The South Carolina decision thus undermines the economic incentives of insurers to police the quality of their insureds’ operations.

The manner to circumscribe the risks transferred in the contract is via its terms – not via conceptualist arguments about the nature of insurance, about liabilities that arise only ex contractu versus ex delicto (contract versus tort), or economic loss. None of these is a persuasive, predictable foundation for applying insurance policies by claims people in the field (or by courts). These off-the-contract limitations are not made clear to policyholders – who are admonished to read their policies to know what’s insured and not. Accordingly, the better-reasoned decisions hold that the terms of the contract govern, and if insurers do not want to accept these risks they are required to spell out in the contract the restrictive gloss they would place on the policy terms. See American Fam. Mut. Ins. Co. v. American Girl Inc., 2004 WI 2 (Wis. Jan. 9, 2004).

Besides promoting clarity and administrability of the coverage – and advising insureds ex ante about what is and is not covered – requiring insurance companies to state limitations such as that desired by the South Carolina Supreme Court allows state insurance regulators the opportunity to scrutinize the terms of the policy and the consistency and fairness of an insurer’s handling of claims. Requiring insurers to state these limitations moreover allows policyholders to choose not to do business with them, but rather to shop their premiums to other insurance companies willing to insure the valid, lawful risk that working on a project (where they perhaps might render substandard performance) may end up causing damage to the project.

It is clear that insurance companies do not wish to pick up the risk of damage to the property worked on by the insured. But shouldn’t that be written down in the policy -- or at least more clearly and prominently than making the word on which coverage pivots be one that has long been derided as a "blob of jelly"? The now-reversed South Carolina Court of Appeal cogently reasoned: “'The [insurance] industry has now taken to arguing that whenever a claim of defective construction is alleged against an insured, the claim is automatically barred from coverage as not constituting an ‘occurrence.’ This position is nothing more than a rehash of the ‘business risk’’ doctrine, whose success depends entirely on courts ignoring the actual language of the CGL policy.'” L-J, Inc. v. Bituminous Fire & Marine Ins. Co., 567 S.E.2d 489, 492 n.8 (S.C. Ct. App. 2002) (citation omitted); accord Erie Ins. Exch. v. Colony Dev. Corp., 736 N.E.2d 941, 947 (Ohio Ct. App. 1999). It is unfortunate that the South Carolina Supreme Court has excused insurance companies forever from saying what they mean on this point in the insurance policy or even requiring them to try.

Posted by Marc Mayerson at 11:21 AM | Comments (5) | TrackBack

September 11, 2005

Absolute Nonsense

What we once conceived of as the environmental coverage wars continue in a new, broader form where insurance companies seek to deny coverage for the liabilities of their policyholders whenever they stem from toxic exposures.

In 1986, the “absolute” pollution exclusion was widely introduced. There is agreement that Superfund-type claims and other true environmental liability claims are barred under the various guises of the absolute pollution exclusion. But the insurers have not limited their claim denials to that context.

The question of the proper scope of the absolute pollution exclusion typically is characterized as whether it applies only to “traditional” environmental claims or whether it applies to any toxic-exposure case. Disputes have proliferated, with the main groups of disputes concerning: (i) worker-exposure claims where a worker is, for example, doused with a toxic substance or exposed to toxic fumes; (ii) product-liability claims where the injury produced by a defect in a product involves the exposure to toxic substances; and (iii) landlord-tenant and similar premises claims where a tenant is exposed to fumes through the negligent act of the landlord or of a contractor it hired.

The New Jersey and Washington State Supreme Courts have reached conflicting results on this question this year. Nav-Its, Inc. v. Selective Insurance Company of America (N.J. April 7, 2005); The Quadrant Corporation, et al., v. American States Ins. (Wash. April. 28, 2005) The New Jersey Court, like the Washington Court, recognized that “read literally, the exclusion would require its application to all instances of injury or damage to persons or property caused by . . . any solid, liquid, gaseous, or thermal irritant or contaminant.” (Slip op. at 19) But the court rejected this construction saying that it would be “overly broad, unfair, and contrary to the objectively reasonable expectations of the . . . regulatory authorities” who approved it. (id. at 20). The New Jersey court found that when presented for approval the insurance industry did not say that the exclusion would bar coverage for toxic exposures but rather characterized it as a pollution exclusion, and applying its former ruling on the sudden-and-accidental exclusion the New Jersey court confined the reach of the absolute pollution exclusion to pollution activities. (The New Jersey approach is sometimes called “regulatory estoppel” but it is really a form of “estoppel in pais” and its variants such as Cal. Evid. 623.)

Seemingly mindful of its reputation with insurers as a court that runs roughshod over policy language (or, more charitably, negates the application of policy terms without quite finishing the intellectual edifice to support the result, e.g., Spaulding Composites v. Aetna Cas. & Sur. Co., 819 A.2d 410 (NJ 2003), the New Jersey Supreme Court ended its unanimous opinion stating:

As a final observation, the insurance industry has revised its policies in the past to provide for the exclusion of certain coverages. We will review each change on the record presented. We emphasize that industry-wide determinations to restrict coverage of risks, particularly those that affect the public interest, such as the risk of damage from pollution, environmental or otherwise, must be fully and unambiguously disclosed to regulators and the public.

(Slip op. at 25)

In justifying its holding, the New Jersey court sought comfort in numbers and cited a number of other courts that similarly confined the application of the exclusion to “traditional” environmental claims. One of those jurisdictions it relied on was Washington State, whose highest court ironically held three weeks later that an absolute pollution exclusion was not limited in this manner.

Both the New Jersey and the Washington cases involved remarkably similar facts: tenants who inhaled fumes from chemical sealants and claimed various ailments as a result. While recognizing the split in the case law, the Washington court’s nose-counting exercise convinced it that “a majority of courts have concluded that absolute pollution exclusions unambiguously exclude coverage for damages caused by the release of toxic fumes.”

The key to the Washington court’s rationale was the manner in which it sought to distinguish its own prior authority where the absolute pollution exclusion was held not to apply to the claim by a worker who was doused with gasoline. Essentially, in Quandrant the court holds that if one breathes fumes the pollution exclusion does apply but if one bathes in the source it does not apply.

The court further posits that the reasonable expectation of an insured would naturally be that the policy would not respond to a fume case caused by the negligence of a third party. And while the court assiduously claims to be applying the plain meaning of the exclusion, it never once comes to grips with the fact that the exclusion is for “pollution.” In other words, the court would be on stronger ground in my opinion were the exclusion simply to apply to the discharge, release, etc. of any irritant or contaminant – but the exclusion bars coverage for liability due to “pollution,” which in turn is defined to include irritants and contaminants. A reasonable insured may be charged with understanding the titles of the various exclusions (though the terms govern), but it is absurd to posit that the title indicating a limited context – pollution – is irrelevant to hypothesizing what a reasonable insured would understand. Compare Tektrol Ltd. v. International Ins. Co., [2005] EWCA Civ. 845 at para. 22 (July 21, 2005) (Opinion of Sir Martin Nourse) (''Loss' is a word whose meaning varies widely with the context in which it is used. If a man said to you: 'I have lost my wife', you would understand him to mean one thing outside the maze at Hampton Court and another outside an undertakers in the high street.").

The landlord is being held liable on straightforward premises liability (there being no suggestion of the landlord’s contributory negligence or negligent supervision or hiring); the landlord’s conduct in the circumstances is no different from where a painter negligently spilled paint on a tenant passing by. (Under the Washington decision, that claim would be covered, but if the passerby inhaled the latex in the paint that would be excluded as a polluting event.)

Posted by Marc Mayerson at 3:58 PM | Comments (1)

August 11, 2005

Walks and Quacks like a Duck: The Reach of Insurance Regulation to a Seller’s Provision of Insurance-Like Benefits – Of Warranties, Requirements Contracts, & Other Benefits

State regulation of insurance applies if the transaction in question is found to be “insurance.” If something is “insurance,” the entity providing it generally must be a licensed insurance company. If not licensed, then the entity exposes itself to fines and potential criminal liability, in addition to the invalidation of the “insurance” it provided. Many manufacturing, service, and retail companies can find it in their interest to package an insurance-like benefit along with the sale of its product or provision of its service. What are the legal risks to the company from providing this type of benefit to its customers and how can the benefit be structured to minimize the risk yet achieve business objectives?

An hoary case in this area concerned a bicycle store that guaranteed to replace bike tires for a period, no questions asked (i.e., regardless of the cause of loss). The bicycle-tire guarantee provided a remedy broader than a simple warranty against defect; innumerable events exogenous to product failure could trigger the bike shop’s obligation to perform (to replace the tire). The Ohio Supreme Court found the transaction to constitute “insurance”, such that it had to be provided by a licensed insurance company or not at all. As the Court explained:

If the contracts of indemnity involved here are not violative of the insurance laws, then every company may, in consideration of the purchase price paid therefor, furnish its product and also undertake to insure it against all hazards for a specified period. Even if such a contract is an incident in the sale of merchandise and its use therein does not constitute the business of insurance, it is in effect a contract ‘substantially amounting to insurance’ within [the statute].

Ohio ex rel Duffy v. Western Auto Supply Co., 16 N.E.2d 256, 259, 119 A.L.R. 1236, 1240 (Ohio 1938). See also Ollendorff Watch Co. v. Pink, 17 N.E.2d 676, 677 (N.Y. 1938) (a watch replacement policy included with the sale of a watch was insurance).

We see similar transactions where, for example, for a fixed annual fee a company will provide maintenance to a fleet of trucks. See Transportation Guarantee Co. v. Jellins, 174 P.2d 625 (Cal. 1946). Or take the example of a supplier of medicines to a dispensary, where the supplier agrees to provide all pharmaceuticals required annually in exchange for a capitated price (i.e., a fixed dollar fee per participant). Compare Group Life & Health Ins. Co. v. Royal Drug Co., Inc., 440 U.S. 205 (1979). These transactions transfer the risk of greater demand by third parties, price spikes, and other risks outside the parties’ controls, but also involve incentives to provide the service or to produce the medications at lower costs to actualize the profit in the known revenue stream. Usually, to mitigate their exposure, the sellers concurrently maintain several programs, so as to decrease the likelihood that one site would prove to be particularly prone to loss or claims. (Sometimes, sellers will purchase an insurance product -- or what may be characterized as a reinsurance product depending on how the antecedent transaction is characterized -- to fund their obligations. E.g., Ollendorff Watch, 17 N.E. 2d 676.) For a price these transactions both transfer and distribute risk, key badges of insurance transactions. Are these types of transactions “insurance”? Should they be considered to be insurance and unlawful unless approved by the insurance commissioner?

A recent New York trial court decision confronted these issues in connection with a heating fuel oil company’s provision, for a fee, to its fuel-oil customers of clean-up services for spills up to $100,000, an amount well in excess of the value of the fuel oil provided or any service performed. In Petro, Inc. v. Serio, 2005 WL 1792866 (N.Y. Sup. July 29, 2005), the insurance commissioner sued for an injunction barring continuation of the program.

The Petro case is different from the bicycle-tire or watch-replacement cases above in that the New York legislature had passed a statute expressly exempting at least some such fuel-oil clean-up programs from insurance regulation. (The rationale includes that this is an important consumer benefit that protects the environment and thus should be encouraged.) New York law defines an insurance contract (which may be offered only by regulated insurance entities (with some exceptions not pertinent here)) as a contract that confers pecuniary benefit “dependent upon the happening of a fortuitous event.” N.Y. Ins. Law 1101.

The New York insurance department focused on the fact that the clean-up agreement would respond to losses on a much broader basis than merely those consequent to a defect in the fuel-oil system or some poor service that was performed. Particularly to the extent that the clean-up program would respond to losses having no relationship to the product or service that the fuel-oil company provided, the New York insurance department argued, the transaction constituted “insurance.” Compare Anstine v. Lake Darling Ranch, 233 N.W. 2d 723, 728 (Minn. 1975) (“[A] contract which requires the indemnitor to indemnify an indemnittee for losses with which the indemnitor had no connection and over which it had no control would be a contract of insurance.”), overruled on other grounds, 281 N.W.2d 838, 842 n.4 (Minn. 1979).

The court recognized that where a seller provided for the maintenance or repair of products made by others such an arrangement was more akin to insurance than it was to a warranty. 2005 WL 1792866 at *8. Yet, the court recognized that sometimes, where the other product was so closely tied to the seller’s product that its failure impugns the quality of the seller’s product, the relationship is sufficiently close as to fall outside the insurance box. Id. at *9. This is particularly true where the seller exercises some degree of substantial control over the circumstances that might give rise to covered loss.

While conceding in effect that the spill clean-up arrangement at issue does provide “insurance” where unrelated or exogenous events occur – such as third-party negligence, vandalism, or an animal’s intervention – the Petro court found these to be incidental to the arrangement rather than characteristic of it, especially because the fuel oil company made the showing that of the 1750 claims it had handled to date not a single one resulted from some catastrophic event or act of God. See id.

The court further recognized the limitations in the program for losses from the customer’s negligence or recklessness and from war and revolutions, all of which were reasonable efforts to limit the indemnification provided to those circumstances where the fuel-oil company’s product or service were substantially related. As a result, the court found the transaction to be more like a warranty, and thus outside the scope of regulated insurance contracts.

While the Petro case involved several parts of the New York Code that specifically exempted certain programs offered by fuel-oil companies from the reach of insurance regulation (and given this the NY Department's decision to prosecute is somewhat surprising), the reasoning of the court applies more broadly to companies that wish to offer some form of protection to their customers along with the sale of product or services. Petro is helpful in that it allows considerable fuzziness at the edges of transferring risks that are not associated with the product or service. In other words, the New York department was undoubtedly correct that many aspects of the risk transferred were exogenous to the relationship and thus insurance-like; the Petro court, however, resisted the invitation to focus on theory and the abstract, particularly where the company made a factual showing (having sold these instruments for a while) that the insurance aspects were incidental.

For companies interested in providing similar benefits, Petro suggests that this type of program can be offered where some reasonable effort is made to tie the obligation to indemnify to those risks of loss over which the seller has some substantial control – particularly, the quality of its product or its services. To the extent these programs pick up liabilities outside of these, the more insurance-like the transaction becomes.

Another way to approach this issue from a company’s perspective is to focus on the fact that in all cases that I’m aware of the transaction found to be insurance constituted an extra benefit conferred on the customer. In other words, the customer still possessed whatever remedies it had under the law for product defects or the like, but in addition possessed a contractual right to some pecuniary benefit, replacing the bike tire or watch, for example. (Tangentially, an extension of a manufacturer's warranty has withstood challenge as not being insurance, GAF Corp. v. County School Board of Washington County, 629 F.2d 981 (4th Cir. 1980), and under the view I'm suggesting can be conceived of as a waiver of the statute of limitations for claims that would otherwise be subject to tort or contract remedies.)

In structuring a non-"insurance" program, a different approach would be to limit the customer’s legal remedies and channel all claims to the benefit sought to be conferred. If in Petro for example a customer could not sue the fuel oil company for negligence resulting in an oil spill but instead was limited to its $100,000 clean-up right, that type of election of remedies provision should not be found to constitute insurance. Instead, it represents a reasonable, ex ante compromise of potential legal uncertainty that if its terms are disclosed clearly and is substantively fair is likely to withstand challenge. At a minimum, such arrangements should withstand challenge from insurance regulators; the question becomes then whether they withstand challenge from the customer who has a claim for greater than the contract-limited amount.

Posted by Marc Mayerson at 11:16 PM | Comments (0) | TrackBack

March 11, 2005

Silica Bodily Injury Claims: 'Polluting' the Injured ?

The California Court of Appeal recently held that bodily injury claims arising from workplace silica exposure were the result of pollution, the coverage for which was barred by an absolute pollution exclusion. Garamendi v. Golden Eagle Ins. Co. (March 9, 2005). Importantly, and a distinction that will be lost in the sands of time, the decision effectively employs an abuse-of-discretion standard to evaluate the decision of a claims determination of an insurer in liquidation.

In 2003, the California Supreme Court held that residential spraying of pesticide was not within the scope of the pollution exclusion, MacKinnon v. Truck Ins. Exchange, 31 Cal. 4th 635 (2003). The present case involved a defendant in two actions, filed in Mississippi, that alleged that the plaintiffs were exposed to silica through their employment, stemming from the sale of silica products, the use of defective respiratory equipment, and sandblasting. The nature of the claim against the insured sounded in product liability. The court did not hold that silica dust fell within the meaning of the specifically excluded “soot,” but instead found it to be within the more broadly descriptive “irritant or contaminant.” The court ex cathedra states that “the widespread dissemination of silica dust as an incidental by-product of industrial sandblasting operations most assuredly [?] is what is ‘commonly though of as pollution’ and ‘environmental pollution.’” (slip op. at 5, citing MacKinnon) (emphasis added).

Moreover, the court rejected the contention, often urged by policyholders, that applying the exclusion to this type of claim unreasonably and inappropriately cuts back coverage for the insured’s products liability, without the insured’s having been provided with fair notice of the need to buy back the exclusion when purchasing the policy. In other words, the policy as construed here negates the most substantial exposure to bodily injury claims that a maker of, e.g., sandblasting equipment might face. Compare West American Ins. Co. v. Tufco Flooring East, Inc., 409 S.E.2d 692, 699 (N.C. App. 1991) (“To allow West American to deny coverage for claims arising out of Tufco’s central business activity would render the policy virtually worthless to Tufco. If this Court accepted West American’s interpretation of the CGL policy, we would be allowing an insurance company to accept premiums for a commercial general liability policy and then to hide behind ambiguities in the policy and deny coverage for good faith claims that arise during the course of the insured’s normal business activity.”); American States Ins. v. Kiger, 662 N.E.2d 945 (Ind. 1996). Many courts – though assuredly not all – have reasoned that such an construction would need to be particularly plain and unmistakable before it can be enforced, given that it so goes against the reasonable expectations of a purchaser of product-liability coverage. Compare Haynes v. Farmers Insurance Exch., 32 Cal.4th 1198 (2004). The recent decision in Haynes is instructive in this regard inasmuch as the Court there held that even though policy language literally applied to limit coverage the limitation was not reasonably called to the insured’s attention due to its placement in the policy and other indications that coverage would be afforded.

The argument of policyholders regarding products and the pollution exclusion is not that there is a sub silentio limitation on the scope of the exclusion’s (overly) broad reach, but rather that a construction that would negate the core coverage for products liability must be one that is ineluctably compelled and particularly clear to a lay person, since it does such violence to the purpose of buying product-liability insurance. The new California appellate case grounds its reasoning in part on federal regulations that classify silica dust as a contaminant (slip op. at 5), yet it simultaneously concedes that in some circumstances silica dust should not be considered an irritant or contaminant. Given MacKinnon and Haynes, the court’s bottom-line no-coverage ruling (as distinct from its rationale) can best be harmonized by its employing abuse-of-discretion review (but even then the denial of coverage plausibly is beyond that even what that deferential review should uphold); at all events, this is the type of decision that would seem to be appropriate for the California practice of depublication, given that its most legitimate rationale does not have significance outside the insurer-liquidation context and that its loose language is irreconcilable with governing California Supreme Court precedent (MacKinnon and Haynes).

Posted by Marc Mayerson at 4:19 PM | Comments (0)

March 9, 2005

Insurer Subrogation Against Product Manufacturers

When an insurance company pays a first-party claim, it ordinarily is thought to succeed to the insured’s rights as against others who may be responsible for the loss. This is known as subrogation, and virtually all policies expressly provide in the insurance contract that the insured’s rights are transferred to the insurance company. (This is legal subrogation; a claim for subrogation may be found by dint of the insurer’s payment even in the absence of a contract provision, which is called equitable subrogation.)

That an insurance company later might bring a subrogation claim is important for a product manufacturer to understand. If a manufacturer settles with tort claimant who provides a complete release of all claims for damages and reimbursement, it still is possible that the claimant's insurer may still be able to bring a claim against the manufacturer for reimbursement of costs it has paid (such as for medical expenses it covered), where the manufacturer knows that an insurance company is involved in the matter prior to the settlement. In this way, subrogation is different from the commonly held notion that subrogation is just the insurance company “standing in the shoes” of its insured; the insurance company is in a better position than is its insured in these circumstances because facially the insured/tort-victim has provided a complete release favoring the manufacturer.

A recent New York case held that an insurer pursuing a subrogation claim is in fact worse off than is its insured/tort-victim. In this case, an insured submitted a first-party claim to its auto insurer which paid the claim and then pursued subrogation against the car manufacturer on a product-liability theory. The Nassau County District Court held that, though the insured himself might have been able to bring a product-liability claim, the insurer was not permitted to do so. Progressive Ins. Co. v. Ford Motor Co., 6 Misc. 3d 568 (Dist. Ct. Nassau Cty. 2004). The fire damage at issue was caused by a defective part in the car, but the court ruled that an insurer in subrogation was too remote a victim to permit tort recovery. The court found that the insurance company in effect was a remote purchaser. Conceptually, the insurance policy effected the compulsory sale of the damaged vehicle to the insurance company (though at a high price (i.e., the pre-damaged value)), and thus the insurance company took ownership with the manifested damage already in place. Similarly, the court found that the insurance company had been paid to assume this risk already, so that permitting recovery would be a windfall. “The [insurer] accepted premiums in consideration of an assumption of risk that the vehicle might be destroyed by a variety of factors.” Even if one offers the rejoinder that in at least some circumstances there may be a tortfeasor against whom the insurer could pursue a claim (as opposed to where the fire is caused by a lighting strike), an insurer is unlikely to have significantly figured in the possibility of a subrogation recovery in pricing its assumption of risk. Even where there is a theoretical subrogation claim, there may be an unidentified or impecunious tortfeasor. Accordingly, at least in the absence of evidence to the contrary, the court reasoned that the insurer was seeking a windfall and denied recovery (and thus took a category of claims out of the courts).

One might suggest that cutting off subrogation creates a disincentive for an insurer to pay the insured’s claim to begin with. On reflection, however, that does not seem to be true: the insurer has a contractual obligation to indemnify, and therefore it is duty-bound to pay (regardless of any potential subrogation recovery). By barring subrogation, the court may have successfully limited a category of cases on its dockets, and it is hardly uncommon for auto insurance companies to bring subrogation actions against the automakers. See, e.g., http://www.state.in.us/judiciary/opinions/archive/06060101.trb.html (discussing whether the economic-loss rule bars the standing-in-the-shoes claim pursued by auto insurer against product manufacturer). From the policyholder’s perspective, the peace of mind of prompt indemnification following a casualty however caused is a sine qua non of the insurance transaction. Insurance companies could respond to cutting off subrogation claims by writing in a new type of “escape clause,” saying in effect that if there is a tort claim the insured must first exhaust its tort claims before turning to its insurer. Whether such a policy would be purchased (let alone approved by insurance commissioners) is doubtful; moreover, as a litigation matter, such a provision (if enforceable at all) would likely be considered to be a condition subsequent, meaning that the insurer would need to prove the existence of the condition in order to refuse to perform, which would have the practical consequence of negating the efficacy of the provision since the insurance company could not refuse to pay in the first instance by pointing to a potential tort recovery.

Posted by Marc Mayerson at 4:20 PM | Comments (0)

March 8, 2005

Food-Related Losses and Insurance

The courts continue to construe insurance coverage very broadly regarding food-related losses. See Mayerson, Insurance Recovery for Losses from Contaminated or Genetically Modified Foods, 39 Tort Trial & Ins. L. J. 837 (2004), available at http://www.spriggs.com/news/pdfs/ACF6453.pdf Insurance companies need to be mindful in handling claims that the courts for decades have approached these coverage disputes this way.

Two recent examples consistent with the existing case law: one involves what is covered damage to property and the other involves what is (not) excluded contamination.

In one case, a warehouse company inadvertently was not rotating stock as it should with the result that cans of juice were being held in inventory longer than intended. Once the mistake was realized, the juice was sold to retailers; the problem was that the “sell by” date was fast approaching (put differently, although the juice cans were being delivered such that they could be sold before the sell-by date, the retailer had a shorter time period than ordinarily was the case within which to sell the product). Consequently, retailers were unwilling to pay the regular cost of the product. The question presented was whether the reduction in price – caused by depression on the demand side rather than by tangible degradation – was tantamount to loss from injury to the property. The New Jersey appellate court said yes. http://lawlibrary.rutgers.edu/decisions/appellate/a1586-03.opn.html
As the court explained:

“Here, what occurred was that the Splash beverage changed. Granted, it was not a change in material composition but in how the product was perceived by Campbell’s customers as a result of an undue passage of time. The change stemmed from [the warehouser’s] alleged fault in handling the task of product rotation. In our view, such a change is the functional equivalent of damage of a material nature or an alteration in physical composition. By reason of this change, and of the ensuing new perception of the covered property and its nature, the product lost value as much from the outdating as if it had turned sour or gone bad in some more tangible or material way. It occurred essentially in the same manner and with virtually the same effect. We conclude that the policy is clear as a matter of law in this respect.” (p. 11)

This case is an example of how broadly courts construe what I have elsewhere termed “prong 1” property damage coverage, that is, physical damage claims. See generally S. Wallace Edwards v. Cincinnati Ins., 353 F.3d 367, 375 (4th Cir. 2003) (exposure of hams to ammonia gas caused physical damage even if ammonia levels were not harmful). Had the court not found prong 1 coverage, coverage would have been triggered by prong 2 of the typical property damage definition, viz. loss of use of tangible property that is not physically injured. See Lucker Mfg. v. Home, 23 F.3d 808, 815 (3d Cir. 1994) (non-food context but key discussion on how a impact on demand for a product constitutes covered loss of use). The insured may have shied away from making the prong 2 arguments (which turned out not to be necessary), because there was a loss-of-use exclusion (though the context is such that it may not have applied even if the reduced price were considered as loss-of-use property damage).

In another case, a soft-drink manufacturer’s product had been contaminated with a substance that made it displeasing but not toxic. The manufacturer destroyed the affected bottles, and the court found there was damage to covered property and that a contamination exclusion in the policy did not apply. http://www.courts.state.ny.us/reporter/3dseries/2004/2004_09611.htm This is consistent with earlier case law. E.g., Allianz v. RJR Nabisco, 96 F. Supp. 2d 253 (S.D. N.Y. 2000).

Posted by Marc Mayerson at 10:00 AM | Comments (3)