Insurance Law Developments

With the potential addition of autonomous cars and trucks to commercial fleets, commercial insureds should reassess coverage under their commercial auto, products liability, and cyber insurance policies. Automation, particularly the move toward fully autonomous vehicles, raises new coverage questions with new risk exposures for insureds and new opportunities for insurers.

This post is the first in a series examining potential coverage issues under different lines of coverage. We begin here with commercial auto insurance policies. Future posts will examine products liability and cyber insurance policies.

ISO Commercial Auto Form

Many commercial insureds’ auto policies incorporate the Business Auto Coverage Form (CA 00 01 10 13) (“Commercial Auto Form”) promulgated by the Insurance Services Office, Inc. (ISO).  The Commercial Auto Form provides coverage for “bodily injury” and “property damage” caused by an “accident” and “resulting from the ownership, maintenance or use of a covered ‘auto.’”  Although numerous cases have interpreted the scope of this coverage in cases involving vehicles other than cars and trucks, such as in accidents involving mopeds, 4x4s, riding lawnmowers, and other vehicles, courts have not yet determined whether this coverage extends to accidents involving autonomous vehicles.

Autonomous Vehicle Classifications

In a sense, today’s cars and trucks all offer some autonomous features. Some features, such as cruise control or self-parking, can operate independently once engaged by a driver. Only highly automated and fully automated vehicles can operate without driver control, however.

In its current operating guidance for autonomous vehicles — Automated Driving Systems 2.0:  A VISION FOR SAFETY, released in September 2017 (Voluntary Guidance) — the U.S. Department of Transportation’s National Highway Traffic Safety Administration (NHTSA) categorized autonomous vehicles using the International Society of Automotive Engineers’ (SAE) classification of autonomous vehicles levels between Level 0 and Level 5:

SAE Automation Levels
Source: NHTSA, Automated Driving Systems 2.0: A Vision for Safety.

NHTSA’s Voluntary Guidance describe vehicles that incorporate SAE automation Levels 3 through 5 as “Automated Driving Systems” (ADSs). Level 3 Conditional Automation ADSs require drivers to monitor and take control when necessary. Level 4 High Automation vehicles can be driven by a human, but are self-driving and do not require a driver. Level 5 Full Automation vehicles can perform all driving functions under all conditions. Level 5 vehicles include those vehicles with driver controls, as well as vehicles without driver controls, for example vehicles that lack a steering wheel or pedals. Level 5 vehicles without driver controls could incorporate seating spaces designed for conversation or work spaces with tables – but not controls that permit human occupants to assume any driving function. Let’s call these Level 5 vehicles “Personal Mobility Units” or “Level 52” (Level 5 Squared) vehicles.

Are Personal Mobility Units Considered “Autos” under the Business Auto Coverage Form?

ISO’s Commercial Auto Coverage Form identifies “autos” by numerical symbols 1-9, and 19.  Each insurance policy’s declarations page will identify the insured “autos” using those symbols.

Symbol 1 includes “Any ‘auto’” while symbols 2-9 narrow the definition of “auto” to exclude certain categories. ISO also offers the Covered Auto Designation Symbol endorsement (CA 99 54 10 13), which allows insurers to designate Symbol 10 “autos” to meet their insureds’ specific needs.

Is a Level 52 vehicle a Symbol 1 auto (“Any ‘auto’”)?  That depends on the definition of “auto.”  The Commercial Auto Form defines an auto as “a land motor vehicle” or “any other land vehicle” governed by state insurance law:

“Auto” means:

  1. A land motor vehicle, “trailer” or semitrailer designed for travel on public roads; or
  2. Any other land vehicle that is subject to a compulsory or financial responsibility law or other motor vehicle insurance law where it is licensed or principally garaged.

But “auto” does not include “mobile equipment.” CA 00 01 10 13, Section V –Definitions B (page 10 of 12).

Turning to part 1 of the “auto” definition, is a Personal Mobility Unit a “land motor vehicle?”

Of course, no court has considered this question. Those courts that have construed this definition in other contexts have considered whether the vehicle included customarily required features, whether the vehicle “resembled” a vehicle designed for use on public roads, and whether the vehicle was required to be registered by state law.

So, a construction vehicle known as a “Georgia Buggy” was not an “auto” because it: (1) did not resemble an auto; (2) was operated from a platform using “hand controls affixed to bicycle­-like handlebars;” (3) lacked key components, such as a steering wheel, a windshield, a separated driving compartment, lights, turn signals, and mirrors; and (4) was not required to be registered by the state. Harlan v. United Fire and Casualty Company, 208 F. Supp. 3d 1168, 1172‑73 (D. Kan. 2016), appeal dismissed, No. 16-3310, 2017 WL 4863142 (10th Cir. Jan. 13, 2017).

A photograph submitted during the litigation surely shows that the buggy was not an auto:

Georgia Buggy Exhibit
Georgia Buggy Exhibit

Of course, a Level 52 vehicle might not “resemble an auto,” would not have any type of hand controls, and would lack some (but not all) key components, such as a steering wheel.

A crop sprayer that collided with a motorcycle was considered an “auto” under the same policy language because it was subject to compulsory insurance and financial responsibility laws, had four wheels, was self-propelled, had headlights, taillights, turn signal, and “other components similar to road‑ready vehicles.” Berkley Regional Specialty Ins. Co. v. Dowling Spray Service, 864 N.W.2d 505, 508 (S.D. 2015). Under this reasoning, a Personal Mobility Unit is an “auto.”

Turning to part 2 of the “auto” definition, is a Personal Mobility Unit “subject to a compulsory or financial responsibility law or other motor vehicle insurance law? Is it licensed? Is it “principally garaged” in any state?

All ADSs are self-propelled and, like other self-propelled vehicles, will be subject to compulsory insurance or financial laws in most states (with certain exceptions). For example, in Delaware, motor vehicles include all “self-propelled” vehicles except farm tractors, elective personal assistive mobility devices (electric two-wheeled vehicles for one person, limited to 15 miles per hour or less), and off‑highway vehicles. Del. Code Ann. tit. 21, § 101. In Michigan, industrial equipment, electric personal assistive mobility devices, electric patrol vehicles, electric carriages, and commercial quadricycles are not “motor vehicles.” Mich. Comp. Laws § 257.33. In California, self‑propelled wheelchairs, motorized tricycles, and motorized quadricycles are not motor vehicles if operated by a person who, by reason of physical disability, is otherwise unable to move about as a pedestrian. Cal. Veh. Code § 415. Under these and other regulatory regimes, all ADSs should be subject to existing compulsory insurance or financial laws in most states (pending any change in regulatory regimes to accommodate ADSs).

No state excludes autonomous vehicles from registration. An auto is generally licensed in the state where it is registered. At the time of registration, the state will issue the appropriate number of license plates, which the owner or registrant is then required to display. See, e.g., Cal. Veh. Code § 6700. A tractor-trailer that displayed Nebraska insurance plates was indisputably licensed in Nebraska, despite being registered in multiple locations under the International Registration Plan.  See Berg. v. Liberty Mut. Ins. Co., 319 F.Supp.2d 933, 938 (N.D. Iowa 2004). Thus, the proper question is not whether an ADS is licensed, but rather whether it is required to be registered, and if so, it will likely be licensed as well.

What about the location of a Personal Mobility Unit? A vehicle is generally “principally garaged” in the physical location where it is kept most of the time. A vehicle that is kept in a single location for four months was “principally garaged” in that location even though the owner did not intend to reside there permanently. Chalef v. Ryerson, 277 N.J. Super. 22, 28, 648 A.2d 1139, 1142 (App. Div. 1994). A vehicle was not “principally garaged” in Michigan because it was not kept in Michigan “most of the time.” Frasca v. United States, 702 F. Supp. 715, 718 (C.D. Ill. 1989). But a rental truck leased for a three-day period was “principally garaged” in Virginia, not Maryland where it was licensed and registered, because the leasee kept the truck at its Virginia facility during the lease period. Hall v. Travelers Cas. Ins. Co. of Am., No. 1:16-CV-00173 (GBL), 2016 WL 5420571, at *5 (E.D. Va. Sept. 27, 2016). If the manufacturer owns the autonomous vehicle and leases it to different individuals in different states, where will that vehicle be principally garaged, and will it be subject to a compulsory or financial responsibility law or other motor vehicle insurance law in that state?

Finally, “auto” excludes “mobile equipment.” “Mobile equipment” encompasses an array of land vehicles, from bulldozers to power cranes to air compressors to any vehicle “maintained primarily for purposes other than the transportation of persons or cargo.” By definition, any autonomous vehicle, including a Personal Mobility Unit, is used to transport people and cargo and therefore will not constitute “mobile equipment.” In addition, the Commercial Auto Coverage Form excludes from the definition of “mobile equipment” those “land vehicles that are subject to a compulsory or financial responsibility law or other motor vehicle insurance law where it is licensed or principally garaged.” Those land vehicles are “autos.” As discussed above, autonomous vehicles, including Level 52 vehicles, will likely satisfy this exception to the definition of “mobile equipment” and will be considered “autos.”

Does Teleoperation Affect Coverage?

As of April 2018, California mandates a remote operator for autonomous vehicles testing on public roads without drivers. Cal. Code Reg. § 227.38. Remote operators must: (1) have the appropriate driver’s license for the type of autonomous vehicle; (2) not be seated in the driver’s seat of the vehicle; (3) engage and monitor the autonomous vehicle; and (4) be able to communicate with occupants in the vehicle by a communication link. The remote operator may also have the ability to “perform the dynamic driving task for the vehicle or cause the vehicle to achieve a minimal risk condition.”  Cal. Code. Reg. § 227.02(n).

At least one company will offer that remote control to assist with the testing and development of autonomous vehicles. Phantom Auto states that it provides a remote driver seated in a control room who can operate the vehicle remotely (described as “teleoperation”). Phantom Auto describes its services as “a teleoperation-as-a-service safety solution for all autonomous vehicles that includes an API [application program interface] for real time assistance and guidance, an in-vehicle low latency communication device, and a remote operator service.”  Phantom Auto enables a remote human operator to operate an autonomous vehicle when it encounters a scenario that it cannot handle on its own, allowing for optimally safe testing and deployment of autonomous vehicles.

The ISO Commercial Auto Form covers accidents “resulting from the ownership, maintenance or use of a covered ‘auto.’” Will insurers contend that an error in teleoperation does not “result from” the “ownership, maintenance or use of a covered ‘auto’” but instead “results from” remote operator negligence? Will they argue that other insurance policies should respond instead of a commercial auto policy?

We don’t yet know the answers to these questions, but insureds testing autonomous vehicles can determine the proper allocation of liability for remote operator error and tailor their policy language to address any liability. If teleoperation survives beyond the testing phase, all insureds using this service will need to assess the parties’ risk allocation and coverage options.

What about Exclusions?

As with the commercial liability policy, ISO’s Commercial Auto Form excludes coverage for “Expected or Intended Injury,” which it defines as “‘Bodily injury’ or ‘property damage’ expected or intended from the standpoint of the ‘insured.’” If the insured cannot operate the vehicle, can any circumstance arise that could arguably trigger this exclusion? At least from an operational standpoint, an insured could not expect or intend injury if the insured cannot operate the Personal Mobility Unit. Will insurers seize on allegedly defective maintenance rather than negligent operation to trigger this exclusion? Will they remove the exclusion as no longer applicable in an autonomous vehicle world? Only time will tell, but insureds and insurers alike should consider the impact of this exclusion.

What about Premium?

In February 2015, NHTSA reported that 94% of auto accidents are caused by human error.    Pundits predict that the frequency and severity of accidents will dramatically decline as autonomous vehicles become more prevalent (despite a messy intervening period when human drivers and partial and fully autonomous vehicles share the road). As frequency and severity falls, so does risk, thus potentially impacting premium. The complexity of autonomous vehicles may impact premium in the other direction, as early model autonomous vehicles will likely be extremely expensive to repair and replace. Insurers are no doubt (or should be) assessing autonomous vehicle’s potential impact on auto premium.

Where Next? Products Liability Insurance? Cyber Insurance?

Even as auto accident frequency and severity declines with increased automation, and premium eventually drops as repair costs normalize, commercial auto insurers may need to turn to other lines of coverage, such as products liability and cyber coverage, for revenue streams, and insureds may need to turn to these same policies for coverage for autonomous vehicles. We will discuss those policies in subsequent posts with a focus on Level 52 vehicles.

Can You Hear Me Now? Tenth Circuit Rejects Coverage for Telephone Consumer Protection Act ClaimsA recent Tenth Circuit decision undercut policyholder arguments that Telephone Consumer Protection Act (TCPA) claims are insurable under a standard CGL policy. Policyholders should take note of this decision but should not assume that all TCPA claims are necessarily uncovered.

On February 21, the Tenth Circuit affirmed a finding of no coverage on appeal from the District of Colorado. In Ace American Insurance Company v. Dish Network, LLC, the Tenth Circuit held there was no duty to defend Dish in a lawsuit alleging various violations of state and federal laws relating to telemarketing phone calls. The court held that statutory damages and injunctive relief sought under the TCPA were uninsurable penalties instead of insurable “damages” under the relevant liabilities policies. The court also rejected Dish’s argument that the TCPA’s provisions governing actual monetary loss qualified as a remedial provision that could be insured under Colorado law. Finally, the court rejected Dish’s argument that the underlying claims for equitable relief could constitute insurable damages.

Policyholders should take note of this case for several reasons:

  1. Rising TCPA Claims. TCPA claims continue to gain popularity on court dockets across the country. Insurers will undoubtedly lean on this case as a basis for denial of coverage in similar cases. That said, TCPA policyholders should not simply assume that all hope is lost. For example, the Tenth Circuit’s decision relies heavily on aspects of Colorado law that may not be controlling in other jurisdictions.
  2. Claims for Equitable Relief May Still Trigger Duty To Defend. This case is a good reminder of the importance of a detailed analysis relating to the particular damage allegations in an underlying lawsuit when considering the duty to defend. The Tenth Circuit did not shut the door on the possibility of a duty to defend claim seeking equitable relief. Instead, the decision is limited to the particular allegations in the underlying complaint.
  3. TCPA Exclusions Becoming More Common. The court noted that several later policies contained specific exclusion endorsements for TCPA claims. Policyholders that may face TCPA allegations should consider whether their current liability policies contain such exclusions and, if so, whether additional coverage may be necessary to protect against such future allegations.
  4. Some Coverage Arguments Not Fully Addressed. Unfortunately, the Tenth Circuit did not reach some of the other interesting coverage questions that could have played a role. For example, I would have been interested to see the court’s analysis of whether “bodily injury” or “property damage” was alleged in the underlying litigation.

This case is not the death knell for coverage for TCPA defendants, but it may prove a hurdle even in jurisdictions beyond Colorado. Companies that face this risk should consider their current coverage portfolio, particularly with respect to any exclusions that may expressly or implicitly apply to TCPA claims. In the event of a claim, companies should analyze each case independently, including consideration of choice of law and the particular policy provisions and allegations at issue.

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.

Beware of Prior Act Exclusions and Retroactive Dates When Procuring or Renewing CoverageAn 11th Circuit decision issued earlier this year serves as a reminder of the importance of carefully evaluating time-based exclusions and retroactive dates when procuring or renewing coverage. Liability policies such as directors’ and officers’, private entity, and professional liability policies provide coverage for claims made and reported during the policy period (or an extended reporting period) regardless of the date of the underlying alleged wrongful act. This coverage is not unlimited, however, and an insurer selling a policy with a Prior Acts Exclusion may well deny coverage for alleged wrongful acts that purportedly “arise out of” even tangentially connected conduct that first happens before the policy’s retroactive date. Insurers will do so even though a reasonable insured would not make any connection between the otherwise covered wrongful acts and prior conduct. In Zucker v. U.S. Specialty Insurance Co., the 11th Circuit endorsed this very approach. The court relied on a broad “Prior Acts Exclusion” combined with a retroactive date to eliminate coverage for actions that occurred after the retroactive date and that led to a claim first brought during the policy period.

Zucker (the bankruptcy plan administrator) alleged that corporate officers fraudulently transferred monies from BankUnited because they transferred the money while the bank was insolvent. The insolvency and the alleged fraudulent transfers occurred during the policy period, and the officers timely submitted their claims for coverage after Zucker sued them for the fraudulent transfers. The insurer denied coverage for the lawsuit on the grounds that the fraudulent transfer claims required the insolvency, and the insolvency resulted from the officers’ mismanagement of the bank before the retroactive date. Using a broad “Related Claims” exclusion, the insurer connected the insolvency with the mismanagement and denied coverage. The 11th Circuit agreed. Broadly construing the phrase “arising out of” in the Prior Acts Exclusion under Florida law, the court described the insolvency as an “essential element” of Zucker’s claim that “has a connection to some wrongful acts” of the officers and directors that “occurred before the policy’s effective date.” The court concluded that the Prior Acts Exclusion barred coverage:  “Given that, Zucker’s fraudulent transfer claims do share ‘a connection with’ wrongful acts covered by the Prior Acts Exclusion.” The court noted that the governing Florida law broadly construed “arising out of” to encompass virtually any connection and imposes a standard that “is not difficult to meet.”

Tellingly, the 11th Circuit recounted the bank’s decisions regarding placement of the coverage. When offering the coverage to the bank, the insurer offered a choice between two policies:  “one with a Prior Acts Exclusion (barring coverage for losses attributable to conduct of the officers before November 10, 2008) and one without the exclusion.” The premium with the exclusion was $350,000; the premium without the exclusion was $650,000. Although the bank purchased other coverage enhancements and doubled the policy limits, resulting in a final premium at $700,000, the bank’s decision to accept the exclusion proved fatal to coverage.

This case should serve as a stark reminder to policyholders to carefully examine their policies and insurers’ coverage proposals. Policyholders should resist or limit as much as possible any terms designed to restrict the time period relevant to coverage, including Prior Acts Exclusions and retroactive dates. Certain seemingly innocuous terms can result in an unexpected and painful outcome that far overshadows any upfront premium savings.

The Perils of Late NoticeAs every policyholder should know, purportedly “late” notice under claims-made insurance policies can eradicate coverage – even if the policyholder purchases successive policies from the same insurer. Alaska Interstate Construction, LLC (AIC) faced this very situation, and lost coverage in a recent unpublished Ninth Circuit decision (Alaska Interstate Construction, LLC. V. Crum & Forster Specialty Insurance Company, Inc.). AIC purchased successive professional errors and omissions liability policies from Crum & Forster Specialty Insurance Company, Inc. (C&F). C&F issued an initial policy for the policy period of December 1, 2011, to May 1, 2013, and then a renewal policy with a policy period of May 1, 2013, to May 1, 2014. Thus, for the period from December 1, 2011, until May 1, 2014, C&F insured AIC. On January 10, 2013, during the initial policy period, a third party made a claim against AIC. AIC did not report the claim during the initial policy period but instead reported the claim on June 19, 2013, during the renewal policy period. The court found no coverage because AIC received the claim in one policy period but reported the claim in the subsequent policy period.

In a creative attempt to avoid this outcome, AIC argued that the policies’ vague definition of “policy period” as “the period shown in the Declarations” did not limit the “Declarations” to one specific policy period, and that the policy period could reasonably be interpreted as encompassing both the initial and renewal policy periods. The Ninth Circuit unequivocally rejected this argument and instead treated the policies as two separate contracts without a continuous policy period.

Ironically, AIC’s renewal of the policy placed it in a worse position than had it walked away. The initial policy, which expired on May 1, 2013, included a 90-day automatic extended reporting period (ERP) when the policy “is canceled or not renewed by [C&F] for any reason except non-payment of premium.” AIC argued that if the policies are viewed separately for purposes of determining the policy period, then the initial policy was effectively cancelled when its policy period ended, thus invoking the automatic ERP, which was in effect when AIC reported the claim to C&F. The Ninth Circuit rejected this reasoning: “the plain language of the policy states that cancellation and non-renewal are the events that trigger the ERP. Thus, because AIC renewed its policy, the ERP did not apply.”

This case is just one of many decisions depriving policyholders of coverage under claims-made policies due to the timing of notice. To avoid this outcome, commercial policyholders should ensure that they report all claims asserted against them during the operative policy period. They should also carefully evaluate potential liabilities to determine whether to give notice of circumstance under a policy before the end of the policy period. This due diligence is essential – for with claims-made policies, late is not better than never.

Recent Case Highlights Insurance Recovery Strategies and Pitfalls for Commercial PolicyholdersA recent Minnesota coverage decision provides guideposts for a commercial policyholder’s proper handling of an insurance claim as well as a cautionary tale regarding an excess insurer’s attempt to readjudicate liability in a subsequent coverage action.

In RSUI Indemnity Company v. New Horizon Kids Quest, Inc., the commercial policyholder (1) promptly and properly notified its primary insurer and its excess insurer (RSUI)  of a potentially covered claim; (2) involved those insurers in the underlying defense strategy; and (3) stipulated to liability in a manner that avoided a potentially applicable exclusion (and with the insurers’ consent). Nevertheless, after the verdict, the excess insurer attempted to readjudicate liability in a coverage action by arguing that an exclusion applied. The court, in a thoughtful decision, rejected the excess insurer’s arguments and granted summary judgment to the policyholder.

The Underlying Case

In the underlying case, a child’s parents sued the policyholder alleging that their 3-year-old son was physically and sexually assaulted by a 9-year-old child while both were under the policyholder’s care, custody, and control. In consultation with both the primary insurance insurer and the excess insurer, the policyholder did not contest liability, conceded that an “assault” occurred, but disputed the “nature, type, and extent of” the injuries sustained by the minor child.  The jury awarded $13 million in damages against the policyholder (later reduced to $6 million after a second trial), but did not determine whether a “sexual assault” occurred because it was not asked to do so. After the jury award in the underlying case, the excess insurer filed a coverage action seeking to avoid paying the excess verdict by invoking a sexual abuse exclusion.

The Coverage Litigation

In the coverage litigation, the court determined that although the jury was presented with evidence of sexual assault in the underlying case, the presentation of evidence alone was insufficient to support the excess insurer’s exclusion defense because the jury was not asked to determine whether a sexual assault occurred. The court explained, “With no insights into the jury’s method of awarding damages, and no effort by anyone—including RSUI—to ask the jury to parcel out its award, any conclusion at this stage that same or all of the damages arose from sexual abuse—whether by the undersigned or a new jury—would constitute pure and unfettered speculation.”  Additionally, the court noted that the excess insurer participated in both trials in the underlying litigation (more substantially in the second trial) and consented to the policyholder’s admission of liability.

Guideposts and Warnings for Commercial Policyholders

Promptly and Properly Notify All Insurers Potentially on the Risk

Providing prompt notice to all insurers on the risk, including excess insurers that may be impacted by a judgment or settlement, can avert unnecessary coverage litigation or at least place the policyholder in a better position if coverage litigation later ensues. In this case, the policyholder promptly and properly notified both its primary insurer and its excess insurer, thus avoiding a preemptive challenge to coverage based on late notice or failure to comply with applicable notice provisions. Although not apparent from the court’s decision, providing prompt notice better positioned the policyholder in the later coverage litigation as well by focusing the insured on its insurance coverage as it formulated its defense to the lawsuit. In addition, an insurer’s failure to assert certain defenses or, conversely, its participation and endorsement of particular defense strategies, may estop the insurer from raising particular defenses in a subsequent coverage litigation, as occurred in this case.

Mitigate Risks Arising from Different Defenses Asserted by Excess Insurers

As this case demonstrates, primary and excess insurers may take different coverage positions, even when the excess policy follows form or incorporates language similar to the primary policy. This decision does not reveal whether the excess policy followed form or included a different exclusion.  If the former, the excess insurer adopted a coverage position different than the primary insurer based on similar policy language. A primary insurer with the duty to defend must support defense strategies that are in the policyholder’s best interest even if those defenses are detrimental to the insurer’s potential coverage defenses. This conflict – which must be resolved in favor of the policyholder where the duty to defend is concerned ­– may preclude the primary insurer from asserting certain exclusions that require a liability determination. In contrast, an excess insurer with no defense obligation may not face the same conflict of interest and therefore may be better positioned to assert certain coverage defenses not available to the primary insurer bearing the defense obligation.

A savvy policyholder can mitigate certain excess insurer coverage defenses by involving the excess carrier in the defense of the underlying claim (or providing an opportunity for the excess carrier to decline to be involved). In this case, the policyholder promptly notified the excess insurer, consulted the excess insurer during the underlying litigation, and obtained the excess insurer’s approval of the admission of liability – critical facts that the court relied on when ruling in favor of coverage. By involving the excess insurer, the policyholder preserved coverage under both policies. Policyholders should be aware that different insurers may take different coverage positions – even on the same policy language – and take steps to mitigate that risk, as did the policyholder in this case.

Coordinate Defense and Insurance Recovery Strategies

Commercial policyholders can minimize uninsured losses by coordinating defense and insurance recovery strategies. While an insurance recovery strategy should not drive the defense of an underlying claim, coordination of the best available defenses to the underlying case with available insurance recovery strategies can minimize a commercial policyholder’s ultimate exposure. In this case, the policyholder coordinated its defense and insurance recovery strategies by admitting liability but disputing damages. This approach is an important strategic option available for policyholders seeking to maximize insurance recovery in litigation that involves both covered and uncovered claims. Admitting liability to avoid an unfavorable jury finding on an uncovered claim can help preserve insurance coverage for the entire liability. While asserting a strong liability defense for the uncovered claim or settling the entire matter may be a preferable option when available, an admission of liability can be an effective risk mitigation strategy. In a minority of cases, policyholders may adopt defense strategies that maximize insurance recovery at the expense of the underlying defense. To minimize liability and maximize insurance recovery, policyholders should carefully consider the risks and rewards of available insurance recovery strategies early in the defense of the underlying litigation (if not before).

Follow Form Coverage Does Not Always Follow Form

This case also highlights the discrepancies that can sometimes arise between different layers of insurance. Although the primary insurer defended under a reservation of rights and subsequently paid its share of the judgment, the excess insurer disputed coverage based on the sexual assault exclusion. The court’s decision does not specify whether the primary insurance policy included a sexual assault exclusion, but does note that the primary insurer defended under a reservation of rights. Assuming that the primary policy did not incorporate a sexual assault exclusion, the policyholder could have avoided the coverage with its excess insurer by ensuring that its excess policy followed the primary policy form without any additional exclusions. Although there are exceptions to every rule, policyholders rarely benefit from excess coverage that is more restrictive than their primary coverage. Commercial policyholders should carefully review their coverage towers to ensure that their insurance protection is coordinated across the primary and excess layers.

Past Insurer Cooperation Does Not Guarantee an Insurance Recovery

Finally, an insurer’s cooperation in the defense of an underlying claim does not preclude that insurer from later disputing coverage, especially when the insurer issues a reservation of rights letter. Disputes can arise despite an ongoing business relationship between the policyholder and the insurer. In this case, the excess insurer received prompt and proper notice of the claim, monitored the litigation through the first trial, consented to a defense strategy, actively participated in the defense of the second trial, and then denied coverage only after the second trial. These events underscore the need to proceed carefully when seeking insurance coverage. The outcome in this case may not have been the same if the policyholder had not complied with its notice obligations and involved the excess insurer in the underlying case.

erosionA recent Fifth Circuit case highlights the potential risks of purchasing a defense-within-limits policy: If an insurer is obligated to hire independent counsel due to a conflict of interest, that counsel’s fees may erode your policy limits.

When an insurer accepts coverage of a liability claim, the insurer typically has the right to choose counsel to defend the policyholder as well as to control the defense. When an insurer defends under a reservation of rights, however, a conflict of interest arises between insurer and policyholder. Many states obligate the insurer in this situation to pay for independent defense counsel selected by the policyholder to obviate the conflict. For example, in Mississippi, a policyholder’s right to independent counsel paid by the insurer is known as the “Moeller” rule.

The Fifth Circuit recently decided just how far the rule extends. In Federal Insurance Co. v. Singing River Health Systems, the insurer agreed to defend a public hospital system, Singing River Health System (SRHS), and various officers, under a reservation of rights in multiple lawsuits stemming from alleged underfunding of a pension plan. The policy and policy application clearly stated that defense costs would erode the limits of liability. SRHS nevertheless argued that defense costs paid under Moeller should not erode the policy limits.

The policy defined covered “loss” to include defense costs that SRHS was “legally obligated to pay.” Because the insurer, not SHRS, is “legally obligated to pay” for Moeller counsel, SRHS reasoned that such costs should fall outside the limits. The federal district court agreed, holding that at a minimum, the phrase “legally obligated to pay” was ambiguous and should be construed in favor of SRHS.

During oral argument before the Fifth Circuit, the insurer reported that it had expended over $3 million in defense costs on a policy with $1 million limits.

The panel held that the district court’s ruling pushed the Moeller rule too far. The court cited a more recent Mississippi Supreme Court decision holding that the policyholder must meet the policy’s deductible requirement before the insurer’s Moeller obligation is triggered. The Fifth Circuit held that the insurer’s duty to pay for independent defense counsel is similarly subject to the terms of the policy, including the policy limits. The court also rejected SRHS’s public policy arguments against enforcement of the defense‑within-limits provision.

At oral argument, one of the judges quipped that perhaps SRHS underfunded its insurance coverage. While not apropos from a legal perspective, as a practical matter it is a valid point. SRHS had the option to purchase a separate limit of liability for defense costs and chose not to do so. However, even if there had been a separate limit, defense costs were triple the policy limit with the underlying litigation still ongoing. Failure to realistically assess risks and secure sufficient insurance coverage for those risks can be the ultimate peril.

RIMS 2017: Risk Revolution is less than two weeks away… are you going? Bradley’s Policyholder Insurance Coverage team is!

When: April 23-26, 2017

Where: Philadelphia, PA

What: Visit us at Booth 2734 (map of exhibit floor) to meet some of Bradley’s coverage attorneys and learn about key issues facing policyholders in today’s complicated insurance landscape. We look forward to seeing you at RIMS 2017.

For more information about the event visit the RIMS 2017 website.

Are Federal Courts Increasingly Likely to Grant Rescission of Insurance Contracts?Recent court decisions across a variety of industries highlight the importance of submitting complete and accurate insurance applications and renewals. When submitting an application for insurance, the applicant should accurately and completely answer all application questions and fulfill all document and data requests. Oversights, misstatements, and missing documents can lead to rescission of the insurance policy and leave the organization or individual without any coverage for a claim.

When faced with a claim or potential claim, insurance companies can and will review both the applicable policy, policy applications, and the underwriting files to determine potential defenses to coverage. After a claim arises, an insurer that discovers a discrepancy in the application, renewal, or underwriting file will likely attempt to rescind the policy and deny coverage for the claim, potentially unraveling the organization’s risk management planning and creating substantial, unexpected liabilities.

Under the wrong circumstances, insurance company rescission arguments can persuade a judge or jury because the insurance company may create the impression that the organization misled or misrepresented key details to obtain lower premiums. The insurer’s ability to frame a coverage dispute as a referendum on the policyholder’s honesty, rather than a simple contract dispute, can profoundly impact the course of the litigation. Some courts’ apparent willingness to more liberally permit rescission presents a worrying trend that should be closely monitored, coupled with a thorough review of policy applications to mitigate the potential of rescission.

Five Best Practices to Minimize Rescission Risk

  • Carefully review the reported values and conditions of assets in other company documents, especially publicly reported documents (because these documents are often incorporated by definition into the application), and ensure that the values and conditions reported on insurance applications are consistent and accurate.
  • Assess and review the scope of the organization’s operations during policy renewal to disclose all relevant business activities and avoid inadvertent omission of related business operations and new business operations to avoid an insurer contention that the organization misrepresented the scope of its operations in its renewal application.
  • Disclose prior related incidents or losses to ensure that an insurer cannot use an earlier claim or loss to rescind the policy.
  • Do not rely on good intentions as a defense to rescission. Under some state laws, courts may uphold rescission based on the insured’s material misrepresentation even if the alleged misrepresentation was accidental and not intentional.
  • Be aware of differing legal standards for disclosure of material information in insurance applications. An applicant should always answer questions fully and accurately and provide all requested supporting documents. In certain circumstances, however, such as the marine market and some foreign markets, the applicant may have an affirmative duty to disclose all material information, regardless of whether the underwriter requested the information. An insured must know whether a heightened duty to disclose applies under the governing law.

Recent Cases Underscore the Need for Accurate Applications and Disclosures

Failure to Report Prior Losses Leads to Rescission of Policy 

Just this month, the Third Circuit Court of Appeals affirmed a lower court decision rescinding a product contamination insurance policy based on four material misrepresentations in the policyholder’s application upon which the insurer relied.  In H.J. Heinz Co. v. Starr Surplus Lines Insurance Co., following an advisory jury’s determination that the policyholder failed to disclose at least two prior incidents involving contamination of baby food, the federal judge upheld rescission even though the insurance company purportedly ratified the policy by invoking the policy’s choice‑of‑law provision. On appeal, the policyholder argued that the insurance company’s attempt to enforce the choice‑of‑law provision in the policy ratified the policy and precludes rescission. The policyholder also argued that the insurance company knew of the prior product contamination issues through news reports in the insurance company’s file. The appellate court rejected both of these arguments and in strong language criticized the insured for failure to disclose prior losses: “For the ten-year period identified in the Application, Heinz disclosed only one loss in excess of a $5 million SIR. In reality, however, Heinz experienced three losses exceeding a $5 million SIR, totaling more than $20 million, a figure far exceeding the single $5.8 million disclosed loss. Heinz’s misrepresentations were of such magnitude that they deprived Starr of ‘its freedom of choice in determining whether to accept or reject the risk upon full disclosure of all the facts which might reasonably affect that choice.” The appellate court also found that the evidence established the insurer’s reliance on these misrepresentations: “Starr underwriters testified that they looked to Heinz’s loss history in calculating the appropriate risk and conducting their loss ratio analysis.”

This appeal presents an interesting test case: The policyholder’s position that rescission is inappropriate because the insurance company ratified the contract is legally sound, but the insurance company’s argument that the omission of two potentially related prior incidents from the application highlights the risks of incomplete disclosures in insurance applications. The Third Circuit held oral argument on December 6, 2016, and took the matter under advisement.

Failure to Disclose Additional Business Activities Leads to Rescission of Policy

The Seventh Circuit Court of Appeals recently upheld the rescission of an insurance policy sold to a doctor and a related MRI center because both made material misrepresentations in their insurance policy applications. In Essex Insurance Co. v. Galilee Medical Center S.C., the court, applying Illinois law, upheld rescission because the applications stated that the doctor and the MRI center did not perform non‑traditional weight loss procedures or treatments, but a post-claim investigation indicated otherwise.

After a patient sued the doctor and the MRI center for complications from a non-FDA approved weight loss treatment, the court found that the doctor recommended non‑traditional weight loss procedures and treatments to a client while at the MRI center and then completed those treatments at a different location. The court rejected the MRI center’s argument that the doctor performed the non-traditional weight loss procedure at another location and that the doctor’s actions at the MRI center were limited to making a referral to himself for the non‑traditional weight loss procedure.

Incorrect Reporting of Property Condition Leads to Rescission of Policy

The Second Circuit Court of Appeals affirmed a lower court’s decision to rescind two insurance policies for misrepresentations regarding the condition of a dry dock that sank after the policyholder attempted to repair the structure. In Fireman’s Fund Insurance Co. v. Great American Insurance Co., two insurance companies, an excess property insurer and a marine pollution insurer, sought rescission of their respective insurance contracts because the policyholder’s insurance application and renewals valued a dry dock owned and operated by the policyholder at several million dollars, when internal documents show that, due to deterioration and lack of repairs by a prior owner, the dry dock had no monetary value.

Applying admiralty law, which requires a heightened duty of “utmost good faith” of disclosure on the part of the applicant, the court rescinded the marine policy because the policyholder, over a period of multiple years, reported that the value of the dry dock as if it were in good condition when it was in need of repairs. The court upheld rescission despite the policyholder’s argument that it provided all the information requested on the insurance application and the underwriter did not request surveys or additional information about the condition of the dry dock. This holding highlights the need to ascertain when a heightened duty to disclose applies for certain types of policies.

Similarly, applying Mississippi law, the court upheld rescission of the excess property policy because the applicant reported the value of the dry dock as if it were in good condition and reported the likelihood of a maximum probable loss – the dry dock sinking – as an “extremely low probability.” The court rejected the applicant’s arguments that it did not complete an application, but rather provided a property insurance submission of its own creation, and that the insurer did not request additional information about the condition of the dry dock in light of the “material misrepresentation” of the condition of the dry dock in the insurance submission. The court rescinded the policy even though the insurer did not intend to deceive the insurer. The court did not require intent or a reckless disregard of the facts often required for a misrepresentation defense.

More States Applying “No-Prejudice Rule” on Notice to Claims-Made PoliciesIn a majority of states, an insurer cannot deny coverage based on a policyholder’s late notice of a claim without showing that the delay prejudiced the insurer. This “notice-prejudice rule” is an advance over the traditional “no-prejudice” rule that allows insurers to deny claims based on late notice regardless of the circumstances leading to the delay. The Wyoming Supreme Court, the most recent court to adopt the notice-prejudice rule, described the rationale for the rule in Century Surety Company v. Jim Hipner, LLC: most policyholders lack the leverage to negotiate for better policy terms; forfeiture of coverage on a mere technicality gives an unwarranted windfall to the insurer; and states have an interest in ensuring that accident victims are compensated. The court also held that a policy provision attempting to “contract around” the notice-prejudice rule violated public policy.

Nevertheless, more states are limiting the notice-prejudice rule to occurrence policies and applying the no-prejudice rule to claims-made policies. The New Jersey Supreme Court  applied the no-prejudice rule to a claims-made policy that required written notice of a claim “as soon as practicable” in Templo Fuente De Vida Corp. v. National Union Fire Insurance Co.  The court agreed with National Union’s contention that the policyholder’s notice of a D&O claim more than six months after service of the lawsuit violated the notice provision. Despite longstanding precedent in New Jersey following the notice-prejudice rule, the New Jersey Supreme Court refused to apply the notice-prejudice rule to claims-made policies with clear and unambiguous terms. The court discounted the equitable concerns behind the notice-prejudice rule because purchasers of claims-made policies are “knowledgeable insureds, purchasing their insurance requirements through sophisticated brokers.”

Despite this court’s application of the no-prejudice rule to a claims-made policy, policyholders should not presume this is a blanket rule, even in New Jersey. In Templo Fuente, the policyholder gave no reason for its delay in providing notice. An explanation could have dissuaded the court from denying coverage. In addition, not all purchasers of claims-made policies are “sophisticated.” Finally, the goal of avoiding an unwarranted windfall to the insurer appears to equally apply to a claims-made policy. Unlike an occurrence policy, which can be triggered years after the policy period expires, coverage under a claims-made policy is limited. In order for coverage to apply, the policyholder must give notice of the claim within the policy period or any applicable extended period, as did the policyholder in Templo Fuente.

To avoid a forfeiture of coverage, policyholders should establish a protocol for giving notice of claims and potential claims under all potentially applicable insurance policies, including umbrella and excess policies. In Century Surety, the policyholder had notified the primary insurer but not the umbrella insurer, perhaps believing that the claim would not exceed the primary policy’s limits. The policyholder’s failure to notify the umbrella insurer did not forfeit coverage in that case, but would have under the no-prejudice rule.