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Do you know what your insurance covers?

This is a deceptively simple question — risk managers rightfully expect to know the scope of their coverages when they build their insurance programs. Unfortunately, judicial interpretation of common policy terms can turn what should be a straightforward question into a morass of uncertainty.

This uncertainty is exemplified in recent case law interpreting cyber insurance policies. Many commercial cyber policies provide coverage for damages “resulting directly from” some underlying action, be it fraud, hacking, theft, etc. For example, ISO’s commercial cyber insurance policy states that “We will pay for ‘loss’ resulting directly from a ‘security breach’ ‘discovered’ during the policy period.”

Unfortunately, those three words – “resulting directly from” – can cause many complications. Insurers often interpret them to require an immediate connection between the breach and the loss (e.g., a hacker breaching a bank account to steal money). Under this restrictive interpretation, however, necessary and substantial costs associated with the hack could be left uncovered, such as crisis response costs, ransomware payments, and root cause analysis. Policyholders (rightfully) read the plain language of their coverage to include these costs, which are impossible to decouple from the underlying security breach.

Addressing this dispute, courts nationwide are split into two opposing camps: The “proximate cause” camp interprets a “direct” loss broadly to require only proximate causation. In contrast, the “direct means direct” camp interprets a “direct” loss strictly to require no intervening acts. For example, federal courts applying Pennsylvania, New Jersey, Louisiana, and Maryland law have all come down in the “proximate cause” camp. Meanwhile courts applying California, Virginia, Illinois, and Wisconsin law have come down in the “direct means direct” camp.

While differing substantive interpretations of the same policy language across different jurisdictions frustrates the goal of consistency for policyholders, it is at least foreseeable given the patchwork of jurisdictions applying the laws of 50 different states.

A Momentum Shift

In some jurisdictions the momentum may be shifting in favor of expanded coverage. In 2019 in Principle Solutions Group, LLC v. Ironshore Indemnity, Inc., the 11th Circuit rejected the “direct means direct” approach and applied the “proximate cause” standard under Georgia law to a commercial crime policy, finding that the “ordinary meaning of the phrase ‘resulting directly from’ requires proximate causation between a covered event and a loss, not an ‘immediate’ link.”

So, what does your policy cover?

The answer depends on what law applies. The inconsistent application of this common policy term creates a conundrum for policyholders that may have vastly expanded or constricted coverage under identical policy language. Therefore, it is critical for policyholders to be proactive, both when purchasing coverage and when bringing a claim, to understand the standard a reviewing court might apply to coverages, and plan accordingly by, for example, negotiating language consistent with the proximate cause approach or designating favorable governing law. When neither option is available, policyholders must be prepared for insurer attempts to narrowly interpret the phrase “directly resulting from” and recognize that the available coverage may be limited if the insurer prevails on the narrow interpretation. 

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Parties to a lawsuit may have vastly different perspectives on the validity and value of a claim, but as a matter of course, the issue of settlement will arise. Trial is an exceedingly expensive endeavor with an uncertain result. From a risk management perspective, the decision to settle is critical. Yet under liability policies that give the insurer sole control of the defense, the settlement decision often rests exclusively with the insurer as well.

The insurer’s exercise of this control becomes problematic when (1) the insured’s liability could exceed the policy limits, and (2) a settlement offer within the policy limits is on the table. Like an insurer providing a defense under a reservation of rights (discussed in Part 1), in this recurring situation, the insurer and the policyholder have conflicting incentives. The insurer may prefer to roll the dice for a judgment that’s less than the limit of liability. Settlement within the policy limits, on the other hand, is often in the policyholder’s best interest because it eliminates the risk of incurring uninsured liability.

Standoff at the Settlement Corral

Tensions between the policyholder and the insurer about a policy-limits settlement demand intensify as the trial date inches closer. At this point, the evidence and analysis developed in the litigation should be sufficient to fully assess whether uninsured liability is a real possibility. If the plaintiff’s demand is time limited, the policyholder-defendant’s window of opportunity for settlement could be missed. The potential impact of an excess verdict is suddenly front and center. What is the policyholder’s recourse?

With the stakes this high, the insurer’s duty to the policyholder rises to a fiduciary level in many jurisdictions. The insurer must seriously consider a settlement offer within policy limits as if the insurer itself would be liable for any excess judgment. The kicker is, if it fails to do so, the insurer actually can be held liable for the excess judgment, as well as consequential damages. In other words, the duty to settle within policy limits when warranted is backed up by a very big stick that can provide the policyholder with needed leverage at a time when it may feel most powerless.

Reasonableness Is the Watchword

States have different formulations of the level of insurer failure required to succeed on what’s known colloquially as a bad-faith-failure-to-settle claim, ranging from negligence to recklessness to intentional wrongdoing. However, in every case, reasonableness is the watchword. Was there a reasonable probability of an excess judgment based on the facts, applicable law, and what’s known about the jurisdiction? Given those circumstances, was the plaintiff’s policy-limits settlement offer reasonable? Did the insurer conduct a reasonable (i.e., good faith) evaluation in response to the offer? These are fact-intensive questions that generally cannot be decided as a matter of law and place the insurer’s conduct under a microscope.

A Formal Demand in Favor of Settlement Can Expedite Resolution

When faced with an insurer’s recalcitrance or delay in deciding whether to accept a pending settlement offer within policy limits, policyholders should make a formal demand in favor of settlement. Appointed defense counsel should provide any analysis and documentation generated during the litigation that the policyholder may need to show the insurer that the risk of an excess judgment is real, and that settlement is prudent. Reminding the insurer of its heightened duty to accept a reasonable settlement offer within policy limits can expedite a resolution that benefits all parties involved.

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This is the first in a series of discussions about issues that arise on a regular basis after policyholders file an insurance claim.

Many liability insurance policies require the insurer to defend the insured. This “duty to defend” usually includes the right to select defense counsel – typically “panel counsel” from a list of pre-approved law firms – and control the defense. The relationship between the insurer, defense counsel, and the policyholder is known the “insurance triangle” (think Bermuda triangle) because it is laden with pitfalls.

Specifically, when an insurer reserves its right to later deny coverage, the interests of the policyholder and insurer are not aligned. The policyholder is not only confronted with potentially uninsured liability, but the possibility that at any point, the insurer may cease paying attorneys’ fees and costs, and perhaps assert it is entitled to reimbursement of the fees and costs already paid.

Conflicts That Can Arise from a Reservation of Rights

A reservation of rights may also create a conflict of interest that entitles the policyholder to select its own counsel paid for by the insurer. Conflicts most frequently arise when a complaint alleges a mix of claims, with some claims covered and others not. Mutually exclusive claims are especially problematic – for example, if negligence is established, the insured has coverage, but if intentional conduct is proved, there is none. 

The crux of the problem is the insurer’s financial interest in a result supporting non-coverage. The chief concern is “steering” – the possibility that defense counsel could steer the litigation in favor of non-coverage by developing facts or pursuing a strategy that leads to judgment on an uncovered cause of action. The insurer and panel counsel likely have a long-standing relationship and panel counsel has a personal financial interest in continuing to get the insurer’s work. If the insurer believes there will ultimately be no coverage, defense counsel may mount a less than robust defense.

When Is Independent Counsel Required?

States have taken different approaches to determining when a reservation of rights triggers the right to independent counsel. In a few states, like Mississippi, the right arises automatically when an insurer reserves rights. On the opposite end of the spectrum, there is no right to independent counsel in Hawaii, where defense counsel are solely responsible for managing conflicts of interests under rules of ethics. Some states, like Washington and Alabama, impose an enhanced obligation of good faith on both appointed counsel and the insurer.

Most states, like Texas, require a case-by-case examination of the facts and a showing of an actual, present conflict of interest. The analysis focuses on how the potential coverage issues intersect with the issues of fact in the underlying litigation. Generally, if coverage depends on the same facts to be decided in the underlying suit, the insured is entitled to independent counsel. Another relevant factor is whether the insurer could obtain privileged information from defense counsel that could be used to defeat coverage. When there is a conflict of interest, the insured’s contractual duty to cooperate with the insurer does not require waiver of the attorney-client privilege.

Policyholders should routinely consider potential conflicts of interest upon receipt of a reservation of rights letter and reassess periodically as the underlying litigation progresses.  Insurers are unlikely to raise the issue unprompted.

Invoking the independent counsel rule, when warranted, not only prevents entanglement in a conflict of interest, but it may ultimately prevent a second litigation between the policyholder and insurer over coverage.