It is surely no overstatement to declare that allocation disputes have pervaded insurance coverage litigation since the 1990s. Although much of the focus of the allocation debate has been on interpolicy disputes arising out of environmental, toxic tort, and other “long-tail” claims, intrapolicy allocation issues involving “mixed” cases have also emerged as a potent source of controversy. These include:
- Covered vs. noncovered theories of liability. Where a civil suit alleges theories of conduct or liability that are demonstrably not covered (i.e., intentional acts, breach of contract, etc.), may an insurer restrict its payment obligations to the covered counts?
- Covered vs. noncovered defendants. If common counsel are being used to provide a consolidated defense to several parties, including some that are not insureds, must the insurer pay the full freight?
- Covered vs. noncovered damages. Where the plaintiffs allege damages that are partially outside the scope of an insurer’s indemnity obligation, may the insurer similarly prorate the scope of its obligations?
Alongside these questions are issues of proof. For instance, if an insured agrees to pay $1 million over the objections of its insurer to settle a mixed case, who has the burden to show what portion of this payment is allocable to the covered claims? Similarly, if there is an undifferentiated verdict in a mixed case that an insurer is defending under a reservation of rights, whose burden is it to allocate the verdict between covered and noncovered claims? Finally, who has the burden of proving “reasonableness” in a case where the insured enters into a consent judgment with the underlying plaintiff? The scope of these problems and some possible solutions for resolving them are illustrated by several recent intrapolicy allocation rulings.
Allocating the Mass Tort Settlement
How should an insurer respond to the settlement of a mass tort case when it has either denied coverage or reserved rights based upon allegations of intentional conduct or the applicability of various exclusions to coverage? That was the issue that Judge Richard Mills of the Northern District of Illinois confronted in Cincinnati Insurance Co. v. H.D. Smith Wholesale Drug Co.1 Unlike other courts that have looked to the relative exposure that the insured faced with respect to covered and noncovered claims, the district court in this case ruled that the insured was not required to allocate between covered and noncovered claims if it could demonstrate that the primary focus of the underlying action was a “covered loss” and it settled in reasonable anticipation of liability.
H.D. Smith was a target defendant in the suit that West Virginia brought against numerous drug manufacturers, wholesalers, and distributors that it blamed for the opioid crisis that has ravaged the Mountain State in recent years. The complaint accused H.D. Smith of “literally thousands of wrongful acts,” including 12,400 transactions with a single pill mill pharmacy in Mingo County.2 The state argued that the sheer volume of tablets or pills shipped by H.D. Smith demonstrated the suspicious nature of the distributions and represented a gross violation of H.D. Smith’s legal duty to not distribute controlled substances for nonlegitimate purposes. The suit alleged that H.D. Smith had “willfully and repeatedly violated the Uniform Controlled Substances Act and corresponding regulations” and had otherwise “turned a blind eye” to what was happening.3 It sought recovery on six separate theories of liability: (1) injunctive relief for violations of responsibilities and duties under the West Virginia Uniform Controlled Substances Act, (2) damages resulting from negligence and violations of the West Virginia Uniform Controlled Substances Act, (3) violation of the West Virginia Consumer Credit and Protection Act, (4) public nuisance, (5) negligence, and (6) unjust enrichment.
H.D. Smith tendered the defense of these claims to its commercial general liability (CGL) carrier (Cincinnati), which refused to defend and instead commenced a declaratory judgment action in Illinois, where H.D. Smith is headquartered and where its policies were issued. In its complaint, Cincinnati argued that the underlying lawsuit did not allege an “occurrence” and that the state’s claims were for economic loss only and not “bodily injury” or “property damage.”4 Although the district court ruled in Cincinnati’s favor in 2015, the Seventh Circuit Court of Appeals reversed, declaring that the state’s suit presented potential liability for H.D. Smith in relation to damages because of “bodily injury” incurred by West Virginia in relation to hospital services and costs related to the diagnosis, treatment, and cure of addiction, and that it was irrelevant whether the state was seeking damages on behalf of itself or its injured citizens.5 However, the court left open the issue of whether Cincinnati would be required to indemnify H.D. Smith in the event of a settlement or adverse judgment in the underlying action.
Around the same time, H.D. Smith agreed to pay $3.5 million to West Virginia to resolve its claimed liability. The insured’s decision to settle followed a number of adverse legal rulings and setbacks in the underlying action. At the point that it settled, H.D. Smith was one of only a few remaining defendants and was projecting that the cost of a trial would be $2.4 million. The state had been seeking $12 million in damages from H.D. Smith. There was evidence that the settlement amount was proportionally similar to other settlements, taking into account the volume of pills that each defendant had allegedly been responsible for distributing.
On remand from the Seventh Circuit, the Northern District of Illinois considered the parties’ arguments with respect to Cincinnati’s duty to pay indemnity on behalf of its insured. Despite Cincinnati’s argument that H.D. Smith had not shown that it had paid damages on account of any covered loss, Judge Mills agreed with earlier Illinois state courts that had declared that if “an insured enters into a settlement that disposes of both covered and non-covered claims, the insurer’s duty to indemnify encompasses the entire settlement if the covered claims were ‘a primary focus of the litigation.’”6
As a preliminary matter, the court found that H.D. Smith had settled in reasonable anticipation of liability. In particular, the court determined that H.D. Smith had vigorously defended itself but “faced a potential for significant liability for those claims as a nonresident defendant in front of a jury in an unfavorable jurisdiction.”7 The court ruled that an insured does not have “to refute liability in the underlying lawsuit and then, after obtaining a settlement, turn around and prove its own liability in order to succeed in a subsequent insurance coverage action.”8
Further, the court rejected Cincinnati’s contention that H.D. Smith’s settlement did not involve reasonable anticipation of liability for covered claims. Despite the inclusion of noncovered claims for statutory violations and intentional acts, the district court concluded that “H.D. Smith’s primary risk of liability was due to the negligence allegations.”9 In finding that these negligence claims were the primary focus of the state’s case, the court observed:
H.D. Smith has never been found to be in violation of any state or federal regulations or guidelines concerning the distribution of controlled substances in West Virginia. Additionally, the settlement agreement stated that the funds paid by H.D. Smith did not represent any type of penalties. No evidence in the underlying lawsuit suggested that H.D. Smith could have been liable for any claim involving statutory violations or intentional conduct. Rather, the focus of the plaintiff’s complaint was on alleged negligence in distributing more pharmaceuticals in West Virginia than were medically necessary.10
In rejecting Cincinnati’s argument that its duties should be apportioned between covered and noncovered claims, the district court ruled that it was
not required to apportion its liability for different claims because that would either require the coverage trial to be a retrial of the merits of the insured’s underlying lawsuit [or trial, in case of a settlement] and/or would discourage settlement because the insured would essentially have to prove its own liability for the underlying conduct even if it had not made that concession in arriving at a settlement.11
Although it is only a district court case, H.D. Smith may prove significant as it offers trial courts a path to resolution without the fact-intensive inquiry required to portion a settlement amount between covered claims or damages. Such a result permits an insured to obtain reimbursement for the full amount of the settlement so long as it could show that the “primary focus” of the underlying suit was a covered cause of action, even where the settlement resolves claims that are not otherwise covered.
Allocating a Mixed Claim Judgment
Alternatively, what rules and procedures should courts follow in assessing whether an undifferentiated verdict may be parsed by primary or excess insurers to limit their obligations to the payment of the covered part of the judgment? Those were the issues in RSUI Indemnity Co. v. New Horizon Kids Quest, Inc., a recent Minnesota case in which the Eighth Circuit Court of Appeals ruled that an excess liability insurer was not necessarily bound to pay the excess portion of a jury verdict against its insured and was free to challenge whether a portion of the damages awarded were subject to a sexual misconduct exclusion in its policy.12
In 2011, the guardian of J.K. sued New Horizon, alleging that negligent employee training and supervision resulted in the child being physically and sexually assaulted by another child at the day care facility. At the time of the incident, New Horizon had a $3 million CGL policy with Travelers and an $8 million umbrella policy with RSUI. The RSUI policy included a sexual abuse or molestation exclusion.
Travelers provided a defense to J.K.’s lawsuit. Although the first trial resulted in a $13 million jury award, it was set aside and a new trial ordered. At the second trial, New Horizon again conceded liability but contested J.K.’s claims of injuries and damages, and the jury awarded total damages of $6,032,585, segregating its award into four damage categories. The jury was not asked to find whether J.K. suffered sexual as well as physical assault, and its total award of $6,032,585 was not allocated between those two claims.
After the second trial, Travelers paid its $3 million policy limits, plus interest, without contesting coverage, despite the inclusion of a sexual molestation exclusion in its primary policy. New Horizon paid the remaining $3,224,888.59 and demanded indemnity from RSUI under its excess liability policy. RSUI disputed this claim and brought an action for declaratory relief against New Horizon, claiming that its sexual abuse or molestation exclusion barred coverage for that part of the award above Travelers’ policy limits.
Although the Minnesota district court found for New Horizon, declaring that RSUI could not prove that the jury’s unallocated award was subject to the exclusion, the Eighth Circuit reversed and remanded. The appellate court concluded that because RSUI, as an excess liability insurer, had not controlled the defense of its insured in the underlying suit, it must be afforded an opportunity to prove in a subsequent coverage action that the jury award included damages for uncovered as well as covered claims. The court found that if RSUI “sustains that burden, the district court must then allocate the award between covered and uncovered claims.”13
As a preliminary matter, the Eighth Circuit emphasized that an insurer’s right to demand allocation of an undifferentiated award in a posttrial coverage proceeding depended on whether the insurer had claimed a right of allocation prior to the verdict being rendered. If the evidence in a post-award coverage action establishes that the third-party action included both covered and uncovered claims, then the total award must be allocated, by the court in the coverage action if necessary. However, if the insurer accepted defense of the third-party action under a reservation of rights but failed to disclose to the insured its interest in obtaining an allocated award, then the insured’s burden to allocate the award between covered and uncovered claims is shifted to the insurer in the post-award coverage or declaratory judgment action.
In this case, RSUI had not communicated a coverage position before the first trial and did not attend the first trial. After the first trial, RSUI sent New Horizon a coverage position letter noting that damages awarded may be barred by its sexual abuse or molestation exclusion. During the second trial, RSUI retained a jury consultant to work with defense counsel, and its claims representative attended the first two days of trial. Following the second verdict, RSUI again issued a reservation of rights letter and refused New Horizon’s demand for indemnity of the unpaid balance of J.K.’s judgment.
In reversing the district court’s ruling that RSUI was unable to prove “that the jury determined sexual abuse had occurred or that one cent of the award was based on such a determination,” the Eighth Circuit ruled that the trial judge had improperly conflated two distinct concepts: the excess liability insurer’s right to defend a post-award coverage action by proving that the award was based at least in part on an uncovered claim, and the failure to allocate the award between covered and uncovered claims.14 In this case, the Eighth Circuit found that the issue of whether J.K. had suffered a sexual assault was a coverage issue that RSUI was entitled to litigate and that having the court in a post-award coverage action determine whether J.K. presented and proved a claim of sexual assault would not impugn the jury’s verdict, as the jury was not asked to address that issue.
Interestingly, the Eighth Circuit declined to declare whether RSUI or J.K. would bear the burden of proof on allocation, finding that this was a fact-intensive inquiry that the district court should decide on remand consistent with the principles set forth in Remodeling Dimensions, Inc. v. Integrity Mutual Insurance Co.15 In Remodeling, the Minnesota Supreme Court considered the allocation issue in the context of a primary insurer that refused to indemnify its insured for an arbitration award that included both covered and uncovered claims. The court discussed at length whether the insured’s duty to prove coverage by allocating the award shifted if the primary insurer controlling defense of the third-party action did not give the insured proper notice of the need to allocate. In remanding for a determination of this issue, the court instructed that, whichever party has the burden to allocate, “both parties may present evidence and the district court must, as best it can, establish the allocation the arbitrator would have made if allocation had been requested.”16
Allocating between Insured and Uninsured Entities
Allocation issues may also arise in cases involving insured and uninsured entities, although the dispute in such cases typically is only whether insurers may prorate defense costs to reflect the involvement of an uninsured defendant. In such cases, the insurer argues that the uninsured entity should not receive a windfall, whereas the insured typically argues that the insurer can only refuse to pay defense costs that are solely attributable to the uninsured party.
In Morgan, Lewis & Bockius LLP v. Hanover Insurance Co., a federal district court ruled that an insurer did not breach its defense obligation by only paying a portion of the insured’s overall defense bill where four of the eight counts in the underlying complaint were outside the scope of its coverage.17 Conversely, the Fifth Circuit Court of Appeals ruled in Lafarge Corp. v. Hartford Casualty Insurance Co. that a liability insurer may not prorate defense costs to reflect the involvement of uninsured parties where the costs arose out of the same accident.18
There is also a developing body of case law involving directors and officers (D&O) liability policies limiting the right of insurers to prorate their defense payments to reflect the fact that their defense is benefiting both insureds (the directors) and uninsured entities (the corporations).19 In the most recent such case, the Eighth Circuit ruled in Brand v. National Union Fire Insurance Co. of Pittsburgh that a Minnesota district court did not err in granting summary judgment to a D&O insurer on the issue of allocating defense costs between insured and uninsured parties.20
This dispute arose under a D&O policy that National Union had issued to Juhl Energy. Juhl Energy’s subsidiary, Juhl Energy Development Inc. (JEDI), contracted with Unison Co. Ltd., a South Korean wind turbine manufacturer, to purchase two wind turbine generators for a community wind farm developed and owned by Winona County Wind LLC (WCW). JEDI secured a financing loan from Unison for this purchase in the amount of $2,574,900. At the time the turbines were purchased, WCW was a subsidiary of the Winona County Economic Development Authority; however, JEDI purchased WCW after executing the contract with Unison. Following this purchase, Unison sued JEDI in the District of Minnesota, claiming that JEDI’s acquisition of WCW was in breach of the financing agreement. An amended complaint was filed, alleging 17 separate causes of action. The insured directors were named as defendants in three of these claims; the remaining 14 counts were asserted against various noninsured entities, many of which included Juhl Energy and its subsidiary companies.
National Union offered to pay 20 percent of the costs of defense, basing its estimate on the percentage of covered claims in the suit, but refused to pay anything for the prosecution of affirmative claims against Unison as they were not defense costs. Juhl Energy’s broker responded that the insured directors strongly disagreed with National Union’s 20 percent allocation, asserting that “the affirmative arbitration claims were ‘inextricably intertwined’ with the federal lawsuit against the directors and ‘necessary to the defense of the litigation as a strategic matter’ because JEDI’s breach of warranty claims constituted its principal defense to Unison’s claims in the federal lawsuit.”21 JEDI claimed that under these facts the arbitration was defensive in nature.
National Union disagreed with this analysis and asserted that 40 percent of the expenses and costs of the federal lawsuit was an appropriate allocation because the insured directors were four of the 10 defendants. National Union declined to reimburse any fees associated with the arbitration prior to the date when Unison filed its counterclaim. National Union offered to allocate 10 percent of the arbitration fees and costs incurred after that date because the arbitration primarily involved JEDI/WCW’s product defect and warranty claims against Unison, and only three of the 18 claims involved the insured directors. The insured directors rejected this proposal and sued National Union, claiming that they were entitled to an allocation of 100 percent of the fees, costs, disbursements, and expenses incurred by the insured directors in both the district court action and the arbitration.
In affirming the ruling of the Minnesota district court granting summary judgment to National Union and ruling that the insured directors could not recover any defense costs at all under this D&O policy, the Eighth Circuit emphasized that the directors had taken an “all or nothing” approach by asserting that they were entitled to be reimbursed for 100 percent of the defense costs and could not now make an intermediate demand alleging that they should be reimbursed for 40 percent or 82 percent based upon alternative theories of allocation.22
Establishing the Enforceability of Consent Judgments
A related issue of proof is presented by claims involving consent judgments. For years, courts in different states have wrestled with the problem of consent judgments. Some have barred recovery at all, finding that these agreements violate conditions to coverage. Others, such as California and Texas, allow recovery but only if the agreement was subject to independent scrutiny and approval by a trial judge. Still others apply far more lenient standards, especially if the agreement was entered into after the insurer refused to defend.
Until 2019, it was unclear what standard of proof would apply to such disputes in Massachusetts. However, in Commerce Insurance Co. v. Szafarowicz, the Supreme Judicial Court of Massachusetts issued a significant new opinion imposing limitations on the ability of policyholders to assign rights to tort claimants pursuant to consent judgments in cases where their insurer is defending under a reservation of rights.23
The dispute in Szafarowicz arose out of an altercation outside a bar in which the insured’s son, Matthew Padovano, struck and killed David Szafarowicz with his car. Although Padovano only pleaded guilty to voluntary manslaughter, there was evidence that he had acted deliberately with the specific intention of harming Szafarowicz. Szafarowicz’s estate brought a wrongful death action against Padovano and demanded payment of his parent’s automobile policy limits with Commerce, which comprised $20,000 in mandatory coverage and an additional $480,000 optional limit. Commerce conceded its duty to pay the compulsory $20,000 limit but reserved rights with respect to whether it owed anything beyond that, citing the issue of whether this was an “accident” in light of evidence that Padovano had driven his car into Szafarowicz and dragged him for 40–50 feet, killing him.
On the eve of trial, Commerce sought to intervene in the underlying case, citing the risk that the issue of Padovano’s intentional conduct would be “underlitigated.” The court refused to allow Commerce to intervene, citing the risk of jury confusion and prejudice, but did rule that Commerce would be permitted to litigate any such concerns in a posttrial declaratory judgment action, following the procedure adopted by the Maryland Court of Appeals in Allstate Insurance Co. v. Atwood.24
Shortly before trial, Padovano and Szafarowicz’s estate entered into an agreement whereby Padovano admitted liability for gross negligence, assigned all of his coverage rights to the estate, and agreed to allow the issue of damages to be determined in a jury-waived proceeding. The superior court heard evidence and awarded $5.5 million in damages to the estate, to which an additional $2.2 million in prejudgment interest was later appended.
In a lengthy and complex opinion on direct appellate review, the Supreme Judicial Court of Massachusetts ruled that the trial judge had not abused his discretion in refusing to permit an automobile liability insurer to intervene in the underlying case given the risk of prejudice to the insured. The court held that it was sufficient that the insurer be given the opportunity to bring a postverdict declaratory judgment action in which it could challenge whether the determination that its insured acted negligently or intentionally had been “fairly litigated.” As a result, the court also ruled that the trial judge had not abused his discretion in denying Commerce’s motion to stay the proceedings in the wrongful death case until its parallel declaratory judgment action could be tried and the issue of coverage resolved.
The court further determined that Commerce’s effort to halt postjudgment interest from accruing on the $7 million judgment by offering to pay its $500,000 policy limit was ineffective because the offer was conditional on the money being repaid if Commerce prevailed on its coverage defenses. The court also refused to find that the insured’s prejudgment assignment of rights was necessarily collusive or unreasonable as matter of law. Rather, the court ruled that in such cases “the risk of collusion must be balanced against policy considerations that encourage settlement agreements.”25 The court thus concluded:
[A]n insurer who defends a claim under a reservation of rights is bound by the amount of a judgment arising from a prejudgment settlement/assignment agreement where (1) the insurer is given notice of the settlement/assignment agreement and an opportunity to be heard by the court before judgment enters; (2) the insurer contests the judgment; and (3) the insured, after hearing, meets his or her burden of showing that the settlement is reasonable in amount. . . . Because the consequence of a settlement/assignment agreement is that the plaintiff may collect damages only from the insurer, having released the insured defendants from personal liability, a reasonable settlement amount may not exceed the limits of the insured’s potential insurance coverage, because the plaintiff may recover in damages no more than that from the insurer.26
Moreover, the court determined that the issue of whether the resulting judgment was “reasonable” was not immunized from dispute merely because the parties stipulated to liability and allowed the trial judge to determine the amount of damages after a bench trial. The court declared that the amount of postjudgment interest that Commerce would eventually owe would run from the date of the original judgment in the amount that the court ultimately deemed to be reasonable.
In an unusual concluding section, Chief Justice Gants observed that whereas the trial judge would have to decide what was reasonable in this case, in future cases where a judge concludes that the amount of an assignment/settlement is unreasonable, the parties should be given an opportunity to renegotiate their agreement in an amount that is reasonable.
A somewhat different approach was followed by the Montana Supreme Court in Draggin’ Y Cattle Co. v. Junkermier, Clark, Campanella, Stevens, PC.27 In Draggin’ Y, the Montana Supreme Court concluded that a trial court erred in sustaining a $10 million consent judgment in a case that a professional liability insurer had been defending under a reservation of rights. The trial court had ruled that the insurer’s failure to settle was equivalent to a breach of the duty to defend and that, having been “abandoned” by its insurer, the insured was to settle over the insurer’s objections. The supreme court ruled that the claimants’ remedy against an insurer for failure to settle was a statutory claim for bad faith under the Montana Unfair Trade Practices Act but that it was improper for the court below to make a finding that the underlying $10 million consent judgment was both reasonable and enforceable in this case, where the insurer was defending. Rather, the majority ruled that in such cases there is no presumption of reasonableness and the claimant must itself establish that the settlement was fair and reasonable. Three justices joined in a concurring opinion in which they argued that the liability insurer had a full and fair opportunity to challenge the reasonableness of the settlement amount and should not be permitted to relitigate that issue on remand.
The foregoing cases illustrate recent trends in an area that has long bedeviled policyholders and insurance company advocates alike. They are by no means an exhaustive list of the cases in these areas or even a complete list of the creative means by which lawyers have sought to address and resolve such problems of proof and recovery. It is hoped, however, that they may serve to highlight some of the problems that arise from the intersection of principles that may be in conflict with each other, such as the doctrine that an insurer must provide a full defense to a lawsuit if any part of it is covered but is only liable for damages actually covered under the policy, or courts’ conflicting concerns that an insured should be permitted to control its own defense where a conflict of interest exists with its insurer but that in doing so the insured’s counsel may withhold from the insurer true facts, “underlitigate” the case, and enter into unreasonable or collusive consent judgments.
1. 410 F. Supp. 3d 920 (N.D. Ill. 2019).
2. Id. at 924.
3. Id. at 925.
4. See id. at 934.
5. Cincinnati Ins. Co. v. H.D. Smith, L.L.C., 829 F.3d 771, 774–75 (7th Cir. 2016).
6. H.D. Smith, 410 F. Supp. 3d at 933.
7. Id. at 934.
8. Id. at 933.
9. Id. at 935.
10. Id. at 937.
11. Id. at 936.
12. 933 F.3d 960 (8th Cir. 2019).
13. Id. at 963.
14. Id. at 964–65.
15. 819 N.W.2d 602 (Minn. 2012).
16. Id. at 618.
17. 929 F. Supp. 764 (D.N.J. 1996).
18. 61 F.3d 389 (5th Cir. 1995).
19. See, e.g., Safeway Stores, Inc. v. Nat’l Union Fire Ins. Co. of Pittsburgh, 64 F.3d 1282 (9th Cir. 1995); Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424 (9th Cir. 1995).
20. 934 F.3d 799 (8th Cir. 2019).
21. Id. at 801–02.
22. Id. at 802–03.
23. 131 N.E.3d 782 (Mass. 2019).
24. 572 A.2d 154 (Md. 1990). In Atwood, the Maryland Court of Appeals addressed the issue of whether insurers might or must intervene in a tort case where the facts overlap the coverage issues, and if not, whether they could later dispute the basis for any award against their insured. The court held that an insurer generally should not be permitted to intervene and, moreover, that its failure to do so does not preclude it from later contesting the facts with respect to the claims against its insured in a posttrial declaratory judgment action. In such cases, the judge in the declaratory judgment action would first determine whether the issue resolved in the tort trial that determines insurance coverage was fairly litigated in the tort trial. If the judge decides that the issue was fairly litigated in the tort trial, there should be no relitigation of that issue in the declaratory judgment action. Instead, a final judgment would be entered declaring that the issue was fairly litigated in the tort trial and that the insurer is bound by the outcome of the tort case against its insured. On the other hand, if the judge determines that the issue was not fairly litigated in the tort trial, then the insurer should be permitted to relitigate the matter in the declaratory judgment action.
25. Szafarowicz, 131 N.E.3d 797.
26. Id. at 797–98.
27. 439 P.3d 935 (Mont. 2019).