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The foundation of a policyholder’s agreement to pay premiums for a standard commercial general liability policy (CGL) is the insurer’s agreement to defend the policyholder against lawsuits and shoulder the costs of the defense. The insurer has “the right and duty to defend any ‘suit’” containing any allegation that potentially falls within the policy’s coverage. In other words, the insurer has agreed to defend the entire suit, even if it also includes non-covered claims. But along with that duty, the insurer has the valuable right to control the defense and use its resources to combat a finding of liability against the policyholder that would trigger its duty to indemnify. (Note that an insurer may have a conflict of interest in a “mixed action” alleging both covered and non-covered claims, requiring the insurer to pay for the policyholder’s choice of independent counsel, which we’ve covered previously.)

What a standard CGL does not give the insurer the right to do is seek recoupment of defense costs. Period. Yet insurers often attempt to do just that if it is later determined (usually through a declaratory judgment action) that none of the claims in the suit was covered.

Reserving a Non-Existent Right Doesn’t Make It So

In a mixed action or when potential coverage is doubtful, the insurer is obligated to reserve the right to later deny coverage and explain the reservation to the policyholder. These so-called reservation-of-rights letters may also include the insurer’s assertion of a “right” to seek reimbursement of defense costs for claims ultimately determined to be non-covered, including those claims with the potential for coverage that triggered the defense duty in the first place.

Despite the absence of any such right in the wording of the insurance contract and lack of additional consideration, some courts, most notably in California, have upheld a right of recoupment based on the equitable doctrines of implied-in-fact contract and unjust enrichment. Their theory is that the policyholder (1) could have objected to recoupment and instead impliedly consented to that condition by accepting the defense, or (2) was unjustly enriched because it ultimately turned out the insurer had no defense duty.

These rationales turn the insurer’s broad duty to defend on its head, permitting insurers to retroactively narrow the CGL’s principal benefit to policyholders. The result is certainly not equitable given that insurers could readily resolve the issue by amending policy wording to specifically enshrine a right to recoupment. Fortunately, the number of courts rejecting insurers’ recoupment arguments now predominates, perhaps in part due to the American Law Institute’s position in the Restatement of the Law of Liability Insurance that recoupment is unavailable absent an express right in the policy itself.  

When a CGL insurer elects to defend a claim subject to a reservation of rights, policyholders should challenge unwarranted assertions of a right to recoup defense costs as nothing more than a unilateral attempt to diminish the very benefit the insurer agreed to provide.

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A law recently passed by the New York State Assembly and signed by Gov. Kathy Hochul puts significant limits on the flood insurance that lenders can require borrowers to purchase on loans secured by residential real property. Commentary in the weeks since the law went into effect has focused on potential conflicts between the law and the federal Flood Disaster Protection Act or the potential for loans and properties to be underinsured for flood. Another hidden problem may occur, however, if policyholders opt to purchase coverage for significantly less than the building replacement cost on a policy that includes a coinsurance penalty.

Signed by Gov. Hochul on December 13, 2024, and effective immediately, Assembly Bill A5073A prohibits mortgage lenders from requiring borrowers to obtain flood insurance on improved residential real property at a coverage amount exceeding the outstanding principal mortgage balance as of the beginning of the year for which the policy shall be in effect, or that includes contents coverage. The bill additionally requires lenders to provide clear and conspicuous notice to borrowers that the required flood insurance will only protect the lender’s interest and may not be sufficient to pay for repairs or other loss after a flood.

Of course, purchasing coverage for less than full replacement cost of the insured building carries the risk that coverage will be insufficient to rebuild or repair in the event of a loss. But policyholders who consider taking this chance should also consider whether their flood policy has a coinsurance penalty. These provisions can limit payouts to insureds who purchase coverage for substantially less than the building replacement cost by paying only a fraction of the full loss. For example, both the FEMA and ISO personal flood policies have the potential to pay only a specified portion of the loss or the actual (depreciated) cash value, whichever is greater, when insurance limits are less than 80% of full replacement cost. Even if the policy pays the actual cash value, however, the policyholder and their lender may come in for a nasty shock if the depreciated cash value of the building is many thousands of dollars less than what is needed to complete repairs. 

If a coinsurance penalty applies, purchasing coverage at the amount of the outstanding mortgage principal balance under New York’s law thus does not necessarily translate into an insurance payout in that amount. Notably, the notice required to be given to mortgagors by New York does not include a specific warning to the property owner of this possibility. 

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On December 13, the North Carolina Supreme Court gave policyholders a partial victory in long-running litigation over business interruption coverage for shutdowns during the COVID-19 pandemic. In North State Deli v. Cincinnati Insurance Co., the court unanimously agreed with the plaintiff restaurants and bars that their insurance coverage for “direct physical loss” included the effects of COVID-19 government orders restricting the use of and access to the restaurants’ physical property because “direct physical loss” includes loss of the physical use for which their properties were insured. This ruling is notable as it goes against the grain of decisions in other jurisdictions finding that such orders depriving access to properties do not, by themselves, result in direct physical loss. The decision in North State Deli highlighted the absence of a virus exclusion in the insured’s policy, however, and on the same date the court refused to find coverage in a companion case, Cato Corp. v. Zurich Am. Ins. Co., involving an express exclusion for viral contamination. Taken together, the decisions emphasize insurers’ obligations to establish that unambiguous exclusions or limitations in their policies allow them to deny coverage.

Background

In March 2020, the government of North Carolina responded to the outbreak of the COVID-19 virus by, among other actions, ordering the closure of bars with no food service and limiting restaurant operations to carry-out, drive-through, and delivery operations. As the understanding of the pandemic evolved, subsequent orders loosened these restrictions somewhat, but continuing limitations remained enforceable by criminal prosecution.

Unsurprisingly, these mandated closures and use restrictions caused severe declines in business income for restaurants and bars throughout the state, with many temporarily or permanently closing their doors. Fortunately for the businesses in this case, their commercial property insurance included business interruption coverage for a shutdown of operation due to “direct physical loss” not otherwise excluded by the policy. The extensive list of exclusions from the policy spanned six pages and included everything from war to local construction ordinances, but, importantly, it did not include viruses.

The Lawsuit

Concerned that Cincinnati Insurance would deny coverage for the losses, the restaurants filed suit. At issue was whether government COVID-19 orders constituted perils covered under the policies that caused “direct physical loss” to property and therefore required Cincinnati to pay the resulting lost business income and related expenses.

The trial court agreed with the restaurants that “direct physical loss” included the COVID-19 government orders, which were not expressly excluded from the policy. Cincinnati appealed to the court of appeals, which unanimously reversed the trial court’s order and found for Cincinnati on the basis that “loss of business” did not constitute “direct physical loss” because no physical harm had been done to the restaurants’ properties. The restaurants appealed to the Supreme Court of North Carolina.

Supreme Court Decision

At the Supreme Court, the restaurants maintained their argument that “direct physical loss” included government orders targeting individual conduct on their properties, limiting the functions of their properties, and controlling how the restaurants could physically access and occupy the spaces. In essence, they had lost their direct, physical use of their property, which they argued plainly constituted a direct physical loss covered by their insurance policies. Cincinnati responded that “direct physical loss” cannot simply mean “loss of physical use,” and government COVID-19 orders regulated the activities of people rather than property, resulting in no physical changes to the restaurant properties themselves. Cincinnati compared the restaurants to a grounded teenager who lost car privileges and therefore only lost use of the car – not the car itself.

The Supreme Court rejected Cincinnati’s argument and responded with an analogy of its own: A “homeowner who cannot live in their house due to irremediable cat urine odor is not placated that their property is not ‘lost’ because it could be used as a home for cats.” According to the court, a “direct physical loss” of a property should include loss of the physical use for which that property is insured. When a property is no longer usable for its insured purpose, a “loss” has occurred. The court explained that the “overlap between property ‘use’ and ‘loss’ follows from a contextual and common-sense expectation that insurance should protect from threats to property that make it unusable for the purpose for which it is insured.”

In its ruling, the court emphasized North Carolina’s rules of contract interpretation favoring policyholders, including the need to follow the “reasonable expectation of the policyholder” and resolve ambiguities in the insured’s favor. The court noted that the insurer could have adopted language that clearly excluded the pandemic loss at issue. Cincinnati chose to be bound by terms that did not exclude viruses, despite 82.83% of business insurance policies containing such exclusions.

Ultimately, the court ruled for the restaurants because it could not determine that “the restaurants’ policies unambiguously bar coverage when government orders and threatened viral contamination deprived the policyholder restaurants of their ability to physically use and physically operate property at their insured business premises.”

The Impact

The North State Deli decision is the first decision from the Supreme Court applying North Carolina’s interpretive rules to the COVID-19 shutdown orders and reaffirms, even in that extraordinary context, that “provisions granting coverage must be read expansively, and provisions excluding coverage must be read narrowly.” In this way, North Carolina continues its reputation as a relatively policyholder-friendly jurisdiction. The court acknowledged that its broad interpretation of “direct physical loss” to include the impact of COVID-19 government orders takes a different path from other jurisdictions holding that “direct physical loss” requires some form of physical destruction of tangible property.

The absence of a virus exclusion in North State Deli was unmistakably critical to the outcome. Indeed, the Supreme Court addressed the other side of the coin the same day in the North State Deli companion case, Cato Corporation v. Zurich American Insurance Company. That case involved an all-risk commercial property insurance policy with nearly identical language covering “direct physical loss” of property, but the policy also included an exclusion for “contamination,” including “any condition of property due to the actual presence of any … virus.” The court reasoned that because a reasonable policyholder would read this language as including government orders compelling closure of the policyholder’s physical store, the policy in Cato Corp. did not cover losses resulting from COVID-19 shutdown orders.

The lesson could hardly be clearer: North Carolina policyholders are entitled to coverage under their insurance policies absent unambiguous policy exclusions limiting coverage for an otherwise covered peril.