The Duty To Defend: What Insurers, Insureds And Their Counsel Need To Know When Faced With A Liability Coverage Dispute - ABA YLD 101 Practice Series

By Eliot M. Harris

Practically every business and homeowner obtains insurance to protect against losses, i.e., direct damage to property or business caused by an unforeseen event. However, many policyholders do not realize that perhaps the most important aspect of their insurance policy can be the liability section, which protects them from certain damages sought in third-party claims asserted against them. For business owners, this coverage is typically obtained under a commercial general liability ("CGL") policy, which provides protection against certain risks that may arise during the course of conducting business. For homeowners, their liability protection against a lawsuit or other claim is contained in the liability section of their homeowner's policy.

The Insurer's Duties to Indemnify and to Defend
Most policies, regardless of whether it's a CGL or homeowners policy, include at least two liability-related promises by the insurer. The first promise, which is commonly referred to as the duty to indemnify, is the insurer's agreement to pay for the insured's legal liability up to the stated policy limits. The second promise, which is broader than the first promise, is referred to as the promise to defend, and it means that the insurer agrees to hire legal counsel to defend the insured against a covered suit. The duty to defend also includes a promise to cover all legal fees and costs. Therefore, if a policyholder is faced with a covered third-party claim, the insurer has a duty to defend against the claim, in addition to a duty to pay any monetary award entered against the insured for covered claims.

Of course, the practical application of these rules is not so straightforward. The rights and obligations of the insurer and insured in this context are controlled by numerous rules and exceptions, only some of which are explicitly stated in the applicable insurance policy. Disputes over whether a civil lawsuit, or other legal proceeding, triggers an insurer's duty to defend are common. These disputes are unique in that two parties, jointly defending against a third-party lawsuit, are directly adverse to each other in a separate lawsuit regarding which one of them is responsible for covering the costs of the third-party lawsuit, as well as any resulting judgment. Below is an overview of common issues that can arise during such disputes.

Analysis Of Whether The Claim Falls Under The Policy
When determining whether a liability insurer has a duty to defend, the first inquiry is whether a "suit" exists. The term "suit," which became a defined term under most CGL policies in 1986, means a civil proceeding, such as the filing of a complaint. Though most commonly thought of as a civil lawsuit, most liability policies contain a broad definition of "suit" that could be interpreted to include other claims against an insured, such as arbitration demands or other alternative dispute resolution proceedings, as well as administrative challenges and petitions. In certain circumstances, the term "suit" may even include a governmental agency proceeding. For example, governmental agencies sometimes issue a potentially responsible party ("PRP") letter to an entity that it suspects is causing, or at least contributing to, an environmental contamination. While the Courts are mixed so far as to whether this constitutes a "suit," some Courts have found that such a demand falls under the usual meaning of "suit" in the context of a CGL policy. 1 Conversely, an example of a proceeding that is generally not considered a "suit" is a criminal complaint for trespassing or negligent homicide, which would not trigger a duty to defend as the relief sought is a criminal penalty, not necessarily monetary damages.

Assuming the definition of "suit" is satisfied, the next hurdle is determining whether the "suit" seeks damages caused by an "occurrence," which is typically defined as an "accident," and includes the continuous or repeated exposure to the same harmful condition. The term "accident" generally is defined as a fortuitous circumstance, event, or happening that is neither expected nor intended by the insured. To clarify the definition of "occurrence," insurance policies typically contain a specific exclusion for damages caused by intentional acts. However, many courts have broadly construed the terms "occurrence" and "accident." For example, the Texas Supreme Court recently ruled that unintended construction defects may constitute an "occurrence" or "accident" under a CGL policy even if the act causing the defects was deliberate, so long as the act was also negligent and, "the effect is not the intended or expected result; that is, the result would have been different had the deliberate act been performed correctly." 2

Conversely, a suit may not involve an "accident" or "occurrence" when the insured intended the injury, or when the resulting damage was the natural and expected result of the insured's actions, regardless of whether the insured was negligent. 3 Under this analysis, the inquiry is focused on whether the insured intended to cause the damage, and not whether the damage resulted from the intentional act.

Another major issue to arise is whether the damages sought in the "suit" are the types of damages covered under the policy. For example, it is common for "property damage" and "personal injury" to be covered under most policies, but issues arise as to the appropriate interpretation of these claims. Also, because most insurance policies provide broad coverage subject to a myriad of limitations and exclusions that restrict coverage to certain circumstances, questions regarding coverage for certain claims, but not others, often cannot be resolved by simply reviewing the policy and the Complaint. This issue is discussed more fully below. Moreover, it is important to have a solid understanding of the specific exclusionary language contained in the policy, as well as sufficient knowledge of how the applicable policy language has been previously interpreted by courts in the relevant jurisdiction, in order to properly determine whether the insurer's duty to defend is triggered by the Complaint.

You also must determine if the "suit" occurred during the effective period of the policy. If the claims arose outside of the policy period, the insurer has no duty to defend. Common issues in this context arise when the policy has been cancelled and/or reinstated repeatedly, either for nonpayment or late payment of policy premiums. Another context where these issues arise is when the claimed damage is progressive and ongoing over a series of years. It is important to review the policy language to determine if the policy covers suits based on when they occur or when the claim is made. For "occurrence-based" policies, there may be coverage for suits brought years after the underlying events occurred, provided that the covered "damage" and events occurred during the policy period. For "claims-made" policies, coverage is only available if the claim is brought or reported during the policy period. 4 Therefore, it is important for all policyholders and insurers to understand the policy period and how it applies to the asserted claims to determine if the "suit" falls outside the policy period.

Review Of Materials Beyond The Complaint
The insurer's duty to defend is controlled by the allegations contained in the Complaint. Thus, the first step is a careful reading of the Complaint to determine the nature of the underlying allegations. Most jurisdictions require that even if only one claim in a suit is potentially covered by the policy, the insurer has a duty to defend the entire suit. Therefore, all allegations in the Complaint must be analyzed for potential coverage, even if clearly non-covered claims are included.

Because most jurisdictions allow notice pleadings, which require only a short and plain statement of the facts supporting the relief requested, the allegations in the Complaint sometimes do not, by themselves, provide sufficient information to determine the full extent of the claims being made. Therefore, the next step is looking outside the Complaint when evaluating whether there is a duty to defend. There are two common approaches to this issue, and certain jurisdictions may follow one, or even both, of these approaches depending on the circumstances involved.

Under the "Four Corners" test, 5 Courts will look only at the allegations contained in the Complaint initiating the suit to determine if the allegations are covered under the policy. Under this test, a jury will be asked to examine only the allegations in the underlying Complaint, as well as the insurance policy, to determine whether the allegations are covered under the policy. An important rule to remember in this context is that the jury will not usually see the pleadings or discovery from the underlying suit. In addition, the jury will likely be instructed to assume that all of the allegations in the Complaint are true when deciding if the claims are covered under the policy.

The second test allows "extrinsic evidence" to be considered during a coverage evaluation. Evidence outside the Complaint may include evidence obtained during the pre-suit investigation by the insured and/or the coverage investigation by the insurer. Oftentimes, an insurer will attempt to resolve coverage issues prior to the filing of a suit, but the admissibility of evidence obtained during pre-suit investigation will depend on the jurisdiction and the circumstances involved. Some Courts have recently allowed "extrinsic evidence" to evaluate coverage when the case contains readily ascertainable facts, relevant to coverage, that do not overlap with the merits of, or engage the truth or falsity of, any facts alleged in the underlying case. 6 Admitting such evidence at trial allows a jury to more closely approximate the insurer's knowledge at the time it decided to accept or deny defense of the underlying suit. Admission of this additional evidence is important not only as it relates to the actual dispute, but also as to any claims of bad faith based on an insurer's denial of coverage. The "extrinsic evidence" test also avoids providing coverage for claims that are clearly not covered under the insurance policy despite the allegations that appear on the face of the Complaint. For example, a Complaint that merely contains the word "negligence" will not change a generally noncovered breach of contract action into a generally covered tort action.

Reimbursement of Defense Costs
An insurer will generally not be able to recover from an insured the cost of defending any claim. Therefore, even after defending the insured, and later proving that the allegations against the insured were not covered by the policy, the insurer still is unlikely to recover from the insured any money already paid for the insured's defense.

This is significant when the cost to defend a claim may equal, or even exceed, the policy limits under the policy. In other words, the insurer may pay over $1 million dollars to defend against a lawsuit where the policy limits are only $500,000. Thus, for the insured, the value of appointed defense counsel could far outweigh the value of indemnity from any monetary award entered against it. Not only does this illustrate the potential value of a liability insurance policy to the insured, it also demonstrates the insurer's potential risks of not diligently conducting a pre-suit coverage investigation to resolve coverage issues before it assumes defense of a suit.

There are exceptions to this general rule, one of which is where a Complaint contains arguably covered allegations and undisputedly non-covered allegations. In this context, insurers have successfully sought reimbursement from an insured for defense costs paid to defend against non-covered allegations. 7 It should be noted that reimbursement is unlikely as a practical matter because the burden is on the insurer to demonstrate the specific defense costs allocated to the covered versus non-covered claims. Conversely, there are an increasing number of insureds successfully obtaining reimbursement for "pre-tender" defense costs, i.e., costs the insured incurs before the insurer becomes involved in the defense. 8

Termination Of The Duty To Defend
It is a common misconception that the duty to defend lasts only until the limits of the insurance policy have been exhausted. In other words, many people tend to agree that an insurance company can simply tender the policy limits up front to avoid paying the defense costs. One common example of this issue arising is when the policy limits are clearly insufficient to cover the potential liability. For example, if an insured has only $1 million in liability coverage, but is faced with liability for a catastrophic injury or massive environmental cleanup, the settlement or judgment will almost certainly exceed the policy limits; however, the insurer may still have a duty to defend the insured even after it tenders the policy limits to satisfy the claim.

Simply tendering the policy limits without retaining defense counsel runs counter to the concept of separate duties to defend and indemnify. In fact, numerous Courts have repeatedly found this practice in violation of the insurer's duty to defend, and consequently the insurer's duty of good faith. 9 Therefore, insurers must be cautious when denying or withdrawing defense of an insured before the underlying action is resolved or there is a showing of no coverage for the claim. 10

Of course, an insurer is free to deny or withdraw defense of a previously accepted claim. As a practical matter, only a fraction of claims actually result in the payment of damages. Thus, if the damages being sought are clearly not covered by the policy, the insurer has no duty to defend. However, the potential consequences for refusing to defend an insured for even an arguably covered claim can be severe. It must also be noted that any doubt regarding the duty to defend will likely be resolved in favor of the insured. Insurers should be aware that a denial of coverage could cause a breach of the insurance contract, which, as discussed below, can also lead to a bad faith claim against the insurer.

Bad Faith Claims
Generally, bad faith occurs when the insurer unreasonably breaches the insurance policy, i.e., fails to defend its insured without a reasonable belief that the underlying suit is not covered. However, if a claim is even arguably covered under the policy, the insurer may act in bad faith even if it has a reasonable basis for denying the claim. In a recent case, an insurer was found to have acted in bad faith when it refused to defend a dentist for claims arising from a practical joke during surgery. 11 While performing a dental procedure, the dentist inserted flippers shaped like boar tusks into the patient's mouth and took pictures. After the successful surgery, the patient learned of the photographs and filed suit against the dentist for various claims including outrage, medical negligence, and negligent infliction of emotional distress. The dentist tendered the claim to his professional insurance carrier, who denied coverage finding that the claims were not covered under the policy. The Washington Supreme Court found that the claims were potentially covered as "dental services" and stated the following: "[t]he acts that comprised the practical joke were integrated into and inseparable from the overall [dental] procedure." 12

The Woo case also illustrates the severity of the risks for breaching the duty to defend. Because of its bad faith conduct, the insurer had to pay $250,000 to the dentist as reimbursement for the underlying settlement with the patient. In addition, the insurer had to pay the dentist $750,000 as bad faith damages. Therefore, the result of the case is that the insurer was ordered to pay the dentist and his attorneys "a million dollars more than the amount that his traumatized ex-employee was compensated for this cruel 'joke.'" 13

When faced with defending against a non-covered claim, the insurer appears to be faced with two choices: (1) accept defense of a dubious claim and pay the defense costs; or (2) deny the claim and risk losing the coverage determination, which would inevitably lead to a bad faith claim. As discussed below, there are alternative options available to the insurer, however.

Reservation of Rights and Declaratory Judgment Actions
An insurer's first option is to disclaim its duty to defend and reserve all of its rights. This must be done at the outset to avoid potential waiver and estoppel effect of its coverage defenses. An effective reservation of rights letter (often referred to as a "ROR" letter) should include all of the insurer's potential coverage defenses, including whether the claim meets the definitions of "suit," "occurrence," and "accident" under the policy, as well as whether the suit seeks appropriate damages, typically "personal injury" or "property damage." The ROR letter should also include a notation regarding the policy limits, and any other applicable limitations or exclusions to coverage. An insurer that fails to assert all potential defenses in the ROR letter may be viewed as having waived these defenses during a subsequent coverage dispute.

To avoid confusion, the ROR letter should clearly state that the insurer is disputing coverage for the claim, but is still providing a defense for the insured subject to any and all policy defenses, regardless of whether they are specifically included in the ROR letter or not. This may prevent waiver and estoppel of any other coverage defenses. It is also important to advise the insured that it has the right to retain its own coverage counsel, and in some states, retain separate defense counsel as well. 14

Either in lieu of, or in addition to, submitting the ROR letter, the insurer can file a declaratory judgment action. This is a separate lawsuit requesting a determination as to coverage for the underlying suit. Essentially, a declaratory judgment is a court order declaring the rights and liabilities of the parties under the insurance policy. A policyholder may also file a declaratory judgment action.

Filing a declaratory judgment action is not without risks for the insurer, however. There is the potential that if the insurer loses the declaratory judgment action on its merits, the insurer could be held liable not only for defense costs of the underlying lawsuit (assuming the insurer continues to provide defense after commencing the declaratory judgment action), but also for the cost incurred by the insured in the declaratory judgment action. Courts have awarded costs to the insured in the declaratory judgment actions regardless of whether the declaratory judgment action was filed in good faith or was the subject of a legitimate dispute. 15

In sum, given the potential pitfalls for both insurers and insureds in duty-to-defend disputes, it is critical that both sides research the applicable law in the relevant jurisidiction before taking a position that could affect their rights and responsibilities to each other if a coverage dispute arises. Given the broad coverage afforded under many liability policies, issues involving the duty to defend could potentially arise in almost any area of litigation. Thus, it is important that potential litigants and liability insurers protect their rights from the outset of the underlying litigation, and if necessary, take steps to protect their rights and defenses under the relevant insurance policies.


1 R.T. Vanderbilt Co. v. Continental Cas. Co., 462, 870 A.2d 1048 (Conn. 2005) (finding that policies providing coverage for "suits" will always be construed to cover Environmental Protection Agency administrative actions initiated by a PRP letter).
2 Lamar Homes, Inc. v. Mid-Continent Cas. Co., 242 S.W.3d 1 (Tex. 2007).
3 Id.
4 Claims-made policies, however, may also cover claims arising from events that occurred prior to the effective date of the policy when they contain what is commonly called "prior acts coverage."
5 This is also referred to as the "Eight Corners" or the "Complaint Allegation" rule.
6 See Ooida Risk Retention Group, Inc v. Williams, No. 08-10381, 2009 WL 2461850 (5th Cir. Aug. 12, 2009).
7 See Buss v. Superior Court, 16 Cal.4th 35 (1997); see also Aerojet-General Corp. v. Transport Indem. Co., 17 Cal.4th 38 (1997).
8 See, e.g., Sherwood Brands, Inc. v. Hartford Acc. & Indem. Co., 698 A.2d 1078, 1083 (Md. 1997).
9 See Viking Ins. Co. v. Hill, 787 P.2d 1385 (Wash. Ct. App. 1990). Other jurisdictions are in accord. See, e.g., Samply v. Integrity Ins. Co., 476 So.2d 79 (Ala. 1985); Conway v. Country Cas. Ins. Co., 442 N.E.2d 245 (Ill. 1982); Delaney v. Vardine Paratransit, Inc., 504 N.Y.S.2d 70 (1986).
10 In some jurisdictions, an insurer may even have a further duty to appeal if there are reasonable grounds for an appeal. See, e.g., Truck Ins. Exch. v. Century Indem. Co., 887 P.2d 455 (Wash. Ct. App. 1995).
11 Woo v. Fireman's Fund Ins. Co., 164 P.3d 454 (Wash. 2007).
12 Id. at 57. The Court also refused to adopt a "reasonable expectations" test, under which an insurer has a duty to defend if the insured would reasonably expect coverage under the policy. Id. at 53, n.5.
13 Id. at 73.
14 See San Diego Federal Credit Union v. Cumis Ins. Society, Inc., 162 Cal.App.3d 385 (1984). Some states view the issuance of a ROR letter as creating a possible conflict of interest between the insurer and the insured. Thus, under these circumstances, the insured may have the right to appoint separate independent counsel to represent the insured.
15 See, e.g., Rubenstein v. Royal Ins. Co. of America, 708 N.E.2d 639 (Mass. 1999).

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About the Author

Eliot M. Harris is an attorney in the Seattle office of Williams Kastner & Gibbs, PLLC. Mr. Harris has represented residential and commercial insurers, as well as businesses and individual insureds, involved in insurance coverage disputes throughout the Pacific Northwest. He practices in the areas of insurance coverage, mass torts, product liability, and catastrophic personal injury. He can be reached at eharris@williamskastner.com.

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