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The Brief

Fall 2024 | Shipowners' Limitation of Liability

Nasty Surprises or Necessary Protections? Insurance Policy Terms Policyholders Should Avoid and Insurers Should Seek

Susannah Christiana Carr, Franklin Dennis Cordell, Katie Henry, David Daniel Friedrich Pryce, and Terri Sutton

Summary

  • Policy language can allow recoupment of uncovered defense costs, determine the standard applicable to the duty to pay defense costs, and permit extrinsic evidence to eliminate the duty to defend.
  • A prior knowledge exclusion can use the inception date of the first policy issued by the same insurer rather than the policy’s reference date to measure the insured’s knowledge of potential claims.
  • Excess policy terms that require the insured to act reasonably to settle claims within the self-insured retention substantially alter the excess insurance relationship.
  • In some states, arbitration and law-selection clauses are void by statute, but the New York Convention may trump state anti-arbitration clauses for policies issued by foreign insurers.
Nasty Surprises or Necessary Protections? Insurance Policy Terms Policyholders Should Avoid and Insurers Should Seek
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Insurance coverage lawyers typically become involved only after a claim has been presented. However, coverage counsel can also play a valuable role in the process of placing or renewing coverage. Coverage lawyers develop an understanding of the recurring sources of disputes between insurers and policyholders, and the often-critical—but superficially subtle—differences among the various policy forms utilized in the insurance industry. Two categories of policy terms can dramatically impact the scope of coverage:

  • After many years of relatively few changes to the mainstay coverage forms—general liability, all risk, management liability, professional liability, and builder’s risk—the last decade has introduced a variety of new terms, often in the form of endorsements. Many of these terms undo long-standing policyholder-friendly rules created by the courts under traditional policy wordings.
  • Certain other terms, while not newly developed, are poorly understood (at least among the insurance-purchasing business community) and lead to an outsized share of coverage disputes.

These policy terms may be subject to negotiation at the time of underwriting—insureds often find that some of them can be removed or modified if they simply ask. Other terms are of greater importance to insurers and may be modified only through negotiation and adjustment of premium, if at all. An experienced insurance broker can provide valuable guidance as to which such changes are available in the marketplace, and at what cost. This article discusses the top “nasty surprises” or “necessary protections” that should be negotiated at the time of placement.

Duty to Defend Issues

Recoupment of defense costs after a finding of no coverage. In most jurisdictions, insurers have had a duty to defend if the underlying claim against the insured, or any part of it, could result in a liability that falls within the indemnity coverage. Under this standard, if there is any factual or legal uncertainty as to whether the claims could lead to a covered liability, the insurer is obligated to provide a defense under a reservation of rights and encouraged to seek a declaratory judgment. Often, the declaratory judgment action will be stayed pending resolution of the underlying litigation.The result is that the insurer often must pay for much or all of the insured’s defense before it can obtain a ruling that the claim is not covered.

Insurers that successfully obtain a declaration of no coverage may seek to recoup from the insured the defense costs paid prior to the ruling. Traditionally, standard liability insurance policy forms did not address whether the insurer could recoup defense costs. Most jurisdictions hold that where the policy language is silent, insurers may not recoup defense costs.

In recent years, in response to such judicial decisions, more insurers are adding recoupment provisions into their policies. Policyholders have challenged these provisions but thus far have been unsuccessful, except in Alaska and Arkansas, where the courts have interpreted state statutes to prohibit such provisions. In other jurisdictions, policyholders should be on the lookout for policy terms that would override state case law and allow recoupment of defense costs. Experience teaches that insurers are willing to negotiate and, often, eliminate such terms.

Duty to defend vs. duty to pay defense costs. The case law establishing the parameters of the insurer’s duty to defend generally has involved insurance policies providing that the insurer “will have the right and duty to defend the insured.” However, some policies do not require the insurer to defend, but instead provide that defense costs are to be advanced or reimbursed by the insurer. For example: “We have no duty to defend under the coverage agreement, but only to reimburse covered defense costs . . . incurred by Insured. . . . Insurer shall advance on behalf of Insured claims expenses which they have incurred in connection with claims made against Insured, prior to disposition of such claims . . . .”

A recurring issue under such “duty to pay” language is what standard applies to determine whether a claim’s defense costs are covered under the policy. Does the insurer have a duty to pay costs for claims that are potentially covered under the policy, as is the rule in most jurisdictions under the duty to defend? Do other policyholder-friendly rules apply, such as that requiring underlying allegations to be broadly construed in favor of a duty to defend?

Courts addressing which standard applies to an insurer’s duty to advance or reimburse defense costs have reached different results. Some apply the “potential coverage” standard to the insurer’s duty to advance defense costs. Other courts have concluded that the duty to defend’s broad “potentially covered” standard does not apply. A few of these have adopted a middle standard: the claim must fall within the policy’s “basic scope of coverage” for defense costs to be covered. The insured has the burden to show the claims fell within the policy’s basic scope of coverage, and then the burden shifts to the insurer to show that a specific exclusion applies. Other courts have declined to apply either the potentially covered standard or the basic scope of coverage standard, instead considering only whether the claim was actually covered under the policy.

In sum, where possible, policyholders should opt for the traditional language, under which the insurer has “the right and duty to defend.”

Endorsements permitting extrinsic evidence to eliminate duty to defend. The starting point for determining whether an insurer has a duty to defend is the complaint filed against the insured. The allegations in the complaint are compared to the policy, and if the complaint asserts claims that are potentially covered, the insurer must defend.

Some jurisdictions strictly adhere to the “four corners” rule—evidence extrinsic to the complaint may not be considered to trigger or deny the duty to defend. A majority of jurisdictions, however, allow evidence extrinsic to the complaint to be considered to determine the duty to defend. Within this category, a subset of jurisdictions permit extrinsic evidence to be considered only to trigger the duty to defend, not to deny it.

To attempt to circumvent the rule that extrinsic evidence may be used only to trigger the duty to defend, insurers have been adding extrinsic evidence endorsements to their policies. These endorsements provide that the insurer “may look to extrinsic evidence outside of the allegations and/or facts pleaded by any claimant” and may “rely on extrinsic evidence to deny the defense and/or indemnity of a ‘suit.’” Policyholders in these “one-way-street” jurisdictions should avoid these endorsements.

In Developers Surety & Indemnity Co. v. Alis Homes, LLC, the court declined to reach the issue of whether the endorsement was invalid because it conflicted with Washington law. Other courts have enforced similar language as written. In Atlantic Casualty Insurance Co. v. Value Waterproofing, the court concluded that a policy term stating the insurer’s “determination regarding a defense obligation under this policy may be made on evidence or information extrinsic to any complaint or pleading presented” was an enforceable contract term:

In order for an insurer to be relieved of the duty to defend, there must be “no possible factual or legal basis on which an insurer’s duty to indemnify under any provision of the policy could be held to attach.” Since the duty to defend is a purely contractual obligation, however, parties to an insurance contract may modify the duty to defend. They may, for instance, agree that extrinsic evidence may be considered in an examination of the duty to defend.

In a subsequent case involving Atlantic Casualty, the policy had the same endorsement stating that Atlantic Casualty could consider extrinsic evidence to determine its defense obligation. Atlantic Casualty agreed to defend its insured and then filed a declaratory judgment action. Based on the endorsement, Atlantic Casualty was permitted to offer extrinsic evidence to establish facts pertinent to disclaiming the duty to defend. The court did impose an important limitation: the evidence could not require the court in the declaratory judgment action to determine “an issue that is material to resolution of the underlying lawsuit.”

Policy Terms Reversing the Prejudice Rule

Most jurisdictions require an insurer to establish that it has been prejudiced before an insured’s breach of a policy condition will relieve the insurer of its coverage obligation. Washington courts provide an example of a robust form of the prejudice rule: to avoid coverage because of an insured’s breach of a policy condition, an insurer must demonstrate that it suffered “actual and substantial prejudice.”Insurers must establish “affirmative proof of an advantage lost or disadvantage suffered as a result of the delay, which has an identifiable detrimental effect on the insurer’s ability to evaluate or present its defense to coverage or liability.” In considering whether the insurer has demonstrated prejudice, courts may consider factors such as whether: (1) the damages were concrete or nebulous; (2) there was a settlement or whether a neutral decision-maker calculated damages and the circumstances surrounding the settlement; (3) the court approved the settlement; (4) a reliable entity did a thorough investigation of the incident; (5) the insurer could have eliminated liability if timely notice had been given; or (6) the insurer could have proceeded differently in the litigation.

A minority of jurisdictions presume prejudice resulting from breach of a condition but allow the insured to rebut that presumption. An even smaller minority of jurisdictions continue to require strict compliance with the policy conditions and do not require a showing of prejudice by the insurer.

In recent years, insurers have taken steps to negate the prejudice rule, either by moving conditions to the insuring agreement or adding terms that void coverage in the event of any breach of a condition. Policyholders argue that such terms are unfair and unnecessary because if the insurer is actually prejudiced by the breach of the policy condition, there is already an adequate remedy in either a forfeiture or denial of coverage or a limitation of coverage to exclude damages actually caused by the breach of condition.

However, from the insurer’s standpoint, it has assumed a contractual right and obligation to defend the insured, and this includes a right to control the defense and to appoint defense counsel of its choosing (subject to state requirements for independent counsel). It is also essential to an insurer’s rate-making functions that it be able to predict the losses that it will be required to pay so it can set premiums at an adequate rate.

Prior Knowledge Under Claims-Made-and-Reported Policies

One aspect of claims-made and claims-made-and-reported liability policies is responsible for an outsized proportion of coverage disputes and, frequently, complete forfeitures of coverage. A typical such exclusion applies to “any claim arising out of a wrongful act occurring prior to the policy period if, prior to the effective date of the policy, the insured had a reasonable basis to believe that it had committed a wrongful act that the insured could reasonably have expected to give rise to a claim.”

Such terms can easily be implicated in what is a common fact pattern in the case of liability claims asserted against lawyers and other professionals: an adverse development in the representation—a missed deadline, lost motion, or the like—comes to the attention of the insured and its client, but the loss does not immediately lead to a claim, i.e., a written demand for monetary or nonmonetary relief. Instead, such potential errors, and any consequences, often play out over months or even years before the client ever asserts a “claim.”

In this situation, many insureds are unaware of the ability, and practical requirement, to provide the insurer with notice of a potential claim during the policy period in which the error is detected. Failure to notify the insurer with notice of a potential claim often leads to the insurer on the risk at the time of reporting having a strong coverage defense under the prior knowledge exclusion.

This application of the prior knowledge exclusion is a major trap for the unwary. The scenario seems even more of a trap in the common situation where the policyholder was insured by the same insurer, renewal after renewal, from the time of the discovery of the error through the eventual assertion of the claim. Under the most commonly available prior knowledge exclusions, however, that insurer still may be relieved of its obligation.

However, a more policyholder-friendly version of the prior knowledge exclusion is available from many insurers. Under this exclusion, the reference date—i.e., the date on which the insured’s knowledge of a potential claim is measured—is not the effective date of the policy, but rather the inception of the first policy issued to that insured by the same insurer. It is important to note that this term does not relieve the policyholder from the strict obligation to notify the insurer of the claim within the same policy period in which the claim is asserted (or within 60 days after the conclusion of the policy period). However, it avoids the risk of forfeiture under the above-described fact pattern.

Coverage Disputes Under Multilayer Towers

In Zeig v. Massachusetts Bonding & Insurance Co., the Second Circuit held that the excess coverage was triggered even though the insured settled with the primary, underlying insurer for less than the full limits of that coverage, where the insured paid the difference between the settlement and the excess carrier’s attachment. The court rejected the insurer’s argument that its policy was not triggered because the policy required the excess carrier to contribute “only after all other insurance herein referred to shall have been exhausted in the payment of claims to the full amount of the expressed limits of such other insurance,” and the primary insurance had not been “exhausted” when the insured settled with the primary carrier for less than the primary carrier’s full limits. The court held that the insurer “had no rational interest in whether the insured collected the full amount of the primary policies, so long as it was only called upon to pay such portion of the loss as was in excess of the limits of those policies.” The court observed:

Nothing is said about the “collection” of the full amount of the primary insurance. . . . The claims are paid to the full amount of the policies, if they are settled and discharged, and the primary insurance is thereby exhausted. There is no need of interpreting the word “payment” as only relating to payment in cash. It often is used as meaning the satisfaction of a claim by compromise, or in other ways.

However, the Zeig court did leave open the possibility for a different result “when the terms of the contract demand it.”

In Qualcomm, Inc. v. Certain Underwriters at Lloyd’s London, the court, relying on the language of the excess policy, reached the opposite result when the insured settled with its primary insurer for less than full limits and sued its excess carrier after the excess carrier denied coverage. The excess policy provided that the insurer “shall be liable only after the insurers under each of the Underlying Policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.” The court, noticing the opening left by Zeig, held that the unambiguous language of the excess policy required the primary policy to be exhausted by actual payment, and the court held that the policy language should be enforced as written. The court required that the primary, underlying insurer exhaust by payment of judgment or settlement, and refused to allow the insured to make up the difference between the amount of the insured’s less-than-policy-limits settlement with the underlying insurers and the excess policy’s attachment point.

Policyholders argue that it should not matter to the excess carrier who pays the underlying limits so long as the excess carrier is not called upon to pay either more than it bargained for or prematurely. Refusing to allow an insured to obtain the benefit of the excess coverage it purchased because it settled with the primary insurer for less than policy limits dissuades settlement, results in delays, and leads to unnecessary litigation.

Most important to insurers, however, is that the policy’s plain language should control. If the excess policy’s language does not require exhaustion by payment of loss, then the insured is entitled to settle with the primary insurer for less than policy limits, pay any difference between the policy limit and the settlement amount, and obtain the benefits of the excess policy. But if the plain, unambiguous language of the excess policy requires the primary policy to be exhausted by actual payment, that language should be enforced.

In today’s insurance market, policyholders can purchase forms that bring about either result, i.e., forms that require actual payment of the full limit by underlying insurers, or forms that expressly allow the policyholder to “make up the difference,” sometimes referred to as “infill.” It is important for both the policyholder and the insurer to know which type of policy form is being offered, and to negotiate for different language if so desired.

Arbitration and Law-Selection Clauses

Arbitration vs. litigation of coverage disputes. Traditionally, policyholders prefer litigating in court rather than being forced to arbitrate. The conventional wisdom is that judges and juries tend to be more sympathetic to policyholders than do arbitrators. While this notion may not be borne out in every case, experience teaches that, generally, the courthouse is indeed a friendlier environment for policyholders. This is even more likely to be the case where arbitration is conducted outside of the U.S., in Bermuda or London, as required by many policies issued to large businesses: foreign arbitrations have earned their reputation as being costly and generally disadvantageous to the policyholder. As a result, policyholders generally should seek to reject arbitration clauses during the placement process.

Law-selection clauses. A small but growing number of policies, particularly those issued in the surplus-lines market, contain clauses selecting the law of a jurisdiction other than that of the policyholder’s physical location or headquarters. Typically, the selected jurisdiction is perceived to be more favorable to the insurer; a common example is New York, which generally does not follow the prejudice rule when a policyholder has breached a post-loss condition. Some highly sophisticated policyholders may knowingly choose the law of another jurisdiction, but this should be done only after a thorough analysis of the law in the various candidate jurisdictions. Most policyholders should reject law-selection clauses where feasible.

Domestic insurers: inclusion of arbitration and law-selection clauses may be unenforceable. Most commercial insurance policies issued by U.S. insurers do not contain arbitration or law-selection clauses. However, in the last decade or so, the number of insurers that routinely include such clauses has increased substantially. Such clauses are often found in surplus-lines policies issued to large policyholders, or policyholders of any size whose business requires unusual, specialty coverage.

In a substantial minority of jurisdictions—some 16 states at last count—arbitration and law-selection clauses are rendered void by statute. Notwithstanding such statutes, some insurers persist in including arbitration and law-selection clauses in jurisdictions that have enacted these statutes. Counsel should be mindful of whether such clauses are enforceable in the relevant jurisdiction.

Foreign insurers: New York Convention may negate state-law prohibitions on arbitration clauses. The legal landscape is quite different for non-U.S. insurers. A substantial percentage of policies issued out of the London and Bermuda markets contain arbitration clauses, and a smaller but substantial number select the substantive law of New York. These terms, on their face, would be unenforceable under the above-cited state statutes.

However, policies issued by foreign insurers may be unaffected by state law that otherwise would ban arbitration and law-selection clauses. This is the result of a multination treaty, the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York Convention). The crux of the New York Convention as relevant here is this term:

The court of a Contracting State, when seized of an action in a manner in respect of which the parties have made an agreement within the meaning of this article, shall, at the request of one of the parties, refer the parties to arbitration, unless it finds that the said agreement is null and void, inoperative or incapable of being performed.

This section has sparked a debate over whether (1) the New York Convention, via the U.S. Constitution’s supremacy clause, trumps state statutes barring arbitration clauses; or, on the other hand, (2) the McCarran-Ferguson Act “reverse preempts” the New York Convention, and thereby preserves the state anti-arbitration statutes. The McCarran-Ferguson Act provides: “No Act of Congress shall be construed to invalidate, impair, or supersede any law enacted by any State for the purpose of regulating the business of insurance, . . . unless such Act specifically relates to the business of insurance.” It is the reason that the business of insurance in the U.S. is governed virtually exclusively by state rather than federal law.

Policyholders have vigorously challenged the proposition that the New York Convention trumps state anti-arbitration clauses. They argue that the McCarran-Ferguson Act reverse preempts the New York Convention. This debate has led to a circuit split; the majority of the circuits have held that the New York Convention is not reverse preempted and thus preempts state anti-arbitration statutes. A Missouri case working its way through the courts presents a rare opportunity for the U.S. Supreme Court to address an insurance-related issue.

Conclusion

A relatively small number of policy terms, some newly introduced in response to pro-policyholder rulings, generate an outsized proportion of coverage disputes. While insurers may desire the added protection offered by these terms, market forces are such that many of them can be modified or eliminated at the time of underwriting. Both insurers and policyholders are well served by understanding these recurring issues and knowing what is and is not being purchased.

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