SC Supreme Court Says Insurers Can’t Cloud Allocation of Covered and Non-Covered DamagesThe South Carolina Supreme Court’s decision in Harleysville Insurance Co. v. Heritage Communities, Inc., modified July 27, 2017, continues a trend of decisions aimed at preventing an insurer from acting in its own interest to the detriment of its insured when the insurer controls the defense of underlying claims against the insured. Although the far-ranging opinion in Harleysville tackles a number of important coverage issues, perhaps the most salient is a renewed emphasis on the insurer’s duty to inform its insured of the need to allocate damages in underlying litigation to differentiate between covered and non-covered losses in a jury award.

In Harleysville, the jury awarded $10.75 million in actual damages against a developer in two suits arising from defective condominium construction. These damages were based on the cost to repair defects, and included costs to replace faulty workmanship, as well as costs to repair damage to the condominium from water intrusion. The verdict did not distinguish between these costs. Because replacement of faulty workmanship was not covered under the developer’s liability insurance policies, in the ensuing coverage litigation, the insurer contended that it was not obliged to provide coverage for this portion of repairs. The court, however, found that the insurer lost the right to contest this issue when it failed to notify the policyholder of the need to allocate the verdict in the underlying suits.

The problem of parsing covered and non-covered losses in a verdict is not new. Since at least Duke v. Hoch, 468 F.2d 973 (5th Cir. 1972), courts have complained that it is virtually impossible to “determine the particular amount that happened to be in the jury’s mind” in subsequent coverage litigation. Where there was no effort in the underlying suit to determine the jury’s intent in making the award, assignment of the burden of proof between the insurer and policyholder is therefore potentially dispositive of the allocation. While it is typically the insured’s burden to show that damages fall within the coverage grant, a number of courts have recognized the inherent conflict of interest where the insurer controls the defense of the litigation but fails to obtain an allocated verdict. If the burden remained with the policyholder under these circumstances, the insurer could obtain a windfall from its own failure to clarify the composition of the award.

Some courts have responded to this problem by shifting the burden to allocate covered and non-covered losses from the insured to the insurer when the insurer fails to either obtain an allocation of the verdict in the underlying litigation or notify its insured of the need to do so. In Magnum Foods, Inc. v. Continental Casualty Co., 36 F.3d 1491 (10th Cir. 1994), the Tenth Circuit held that where the insurer controlled defense of the litigation but failed to request special interrogatories or a special verdict to allocate damages, it bore the burden of demonstrating that the basis of the award fell outside coverage. In Duke v. Hoch and Harleysville, the courts did not mandate that the insurer must itself seek an allocation, but found that the insurer must provide notice to the insured of the need for allocation in its reservation of rights. Harleysville found that the insurer’s blanket reservation of rights letter did not meet this standard, as it did not “inform the insureds that a conflict of interest may have existed or that they should protect their interests by requesting an appropriate verdict.” The insurer therefore lost the right to contest this issue and was required to cover damages for faulty workmanship that would otherwise have fallen outside of the policy.

Left unresolved by the opinion is precisely how, and by whom, the allocation of the verdict will be accomplished. In Duke v. Hoch, obtaining an allocated verdict would have been fairly simple, since the non-covered damages related to a particular claim against the insured; thus, the jury could have been asked to specify the portion of damages awarded on the basis of that claim. But in Harleysville, parsing out the covered and non-covered damages would have required specific findings as to which costs were required to replace the insured’s faulty work product, and which costs pertained to repairs for water intrusion. For the jury to make an informed decision on these issues, defense counsel would need to tailor the testimony of its witnesses, and possibly even modify its closing argument.

In a given case, the facts relevant to such allocation might well be contested between the insurer and the policyholder, and it is doubtful whether defense counsel retained by the insurer will be able to navigate this potential conflict of interest. Because Harleysville focused on the insurer’s duty to notify the policyholder of the need for an allocated verdict in its reservation of rights, insurers may argue that it is the policyholder’s responsibility to engage independent defense counsel if it wants to obtain such an allocation. But if the insured must pay for its own attorneys to handle the litigation, it has been deprived of a key benefit of coverage, namely the insurer’s duty to provide a defense. The policyholder could obtain independent counsel of its own choosing, and ask the insurer to reimburse reasonable fees. A policyholder, however, can expect the insurer to resist any arrangement under which it would pay for litigation expenses exceeding those of its regular insurance defense counsel, or for expenses incurred to present evidence adverse to the insurer’s own coverage position. As insurers modify their reservation of rights letters to meet the prescriptions in Harleysville and similar cases, policyholders must be vigilant for an insurer’s communication that allocation is needed, and insist that insurers discharge their defense obligations under the policy.