Brad Nakase, Attorney
The relationship between an insurer and insured is primarily of contractual nature, with the insurance policy serving as the principal source of the obligations of the parties. As with other kinds of insurance, the duties and privileges of the parties and the consequences of their breach are affected by government regulation – mainly in the form of state statutes addressing the conduct of the insurer and the insured. Another source of law affecting insurance obligations is the judiciary.
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More than a majority of court’s cases involves insurance policies e.g., car accidents, trip and fall, malpractice, employment issues. The insurance cases have produced a significant spread of common law regarding the obligations of insurers and policyholders. Nonetheless, in any study focusing on the obligations of the insurer and insured from a liability coverage perspective, there is no escaping the frequently used insurer caution, “Read your policy.” The contract language primacy has significant consequences for any bid to examine the parties’ obligations. Primarily, this means the obligations will differ from case to case due to the variation in the wordings.
This challenge is however ameliorated to some extent by the insurance industry’s primarily using standard forms, developed by rate-making organizations such as the Insurance Services Office, for writing liability insurance. Perhaps the “commercial general liability (CGL)” is the most widely used document of these forms. Previously, it was known as the “comprehensive general liability” form.
The primary purpose of CGL insurance is the protection of the policyholder against loss incurred by third-party liability claims. It is therefore not surprising that the most significant and controversial obligations of insurer and policyholder, especially in the context of coverage disputes, are those which are invoked when a claim (or the potential for a claim) arises. Having said that, the policies governing commercial general liability do impose certain obligations on insurers and policyholders which are independent of claims. The most obvious of those is perhaps the policyholder’s obligation to pay premiums at the due dates.
Under a standard CGL form, the policyholder is also required to allow the insurer to inspect their business premises and examine their records as well as undergo premium audits. The insurer, on the other hand, also has some obligations other than paying claims, such as the obligation to provide a cancellation notice or a notice of intent regarding non-renewal.
1.2 What are the insurance company’s obligations
The insurer’s obligations under a CGL policy primarily emanates from the “insuring agreement(s)” of the form. Existing forms contain separate insuring agreements for liabilities in case of (A) physical injury and property damage, (B) personal and advertising injury, and (C) medical claims, depending on the nature of the insurer’s basic undertaking.
The insuring agreement imposes the following obligations on the insurer. The insurance company will pay on behalf of the insured all sums which shall become legally binding on the latter as damages caused by an occurrence involving (A) bodily injury or (B) property damage, as would fall in the purview of this insurance. And, the company shall have the right and duty to defend any such damages suit against the insured, even if any of the suit allegations are false, fraudulent or groundless. Also, it may make such investigation and settlement of any claim or suit as it deems expedient. But, the company shall not be duty-bound to pay any claim or judgment or be obligated to defend any suit after the relevant limit of the company’s liability has been exhausted due to payment of judgments or settlements.
Thus, the insuring agreement imposes two distinct duties on the insurer:
- The duty to pay all sums the policyholder becomes “legally obligated to pay as damages” because of injury or damage wherein the insurance applies. This is commonly referred to as the duty to indemnify.
- The duty (as well as right) to defend any suit against the insured involving a covered liability.
It also confers on the insurance company the prerogative to probe and settle any potentially covered claim or suit, a right the insurer is obligated to exercise reasonably. These four insurer duties/privileges—to defend, indemnify, investigate, and settle—are examined in detail in the following sections.
1.2.1 Does the insurance company have a duty to defend a lawsuit?
The CGL policies’ defense provisions have been rightly referred to as “litigation insurance.” As ruled by the Supreme Judicial Court in RUBENSTEIN v. ROYAL INSURANCE COMPANY OF AMERICA: [T]he promise to defend the insured, as well as the promise to indemnify, is the consideration received by the insured for payment of the policy premiums. Although the type of policy here considered is most often referred to as liability insurance, it is “litigation insurance” as well, protecting the insured from the expense of defending suits brought against him.
The obligation here is not merely one of reimbursement. The undertaking of “responsibility for defending” the policyholder is essential to the CGL defense concept. This means taking the burden of retaining, supervising, and compensating the whole defense team, including the defense lawyer.
Besides the liability insuring agreement quoted above, the insurance company’s “litigation insurance” obligations also flow from the so-called Supplementary Payments clause. In addition to all defense expenses, this clause, in its current standard form, requires the company to pay the following items.
- Costs taxed against the policyholder
- Prejudgment interest awarded against the policyholder on the part of the judgment the insurer pays
- All post-judgment interest on the whole amount of the judgment until the insurer pays or tenders their part of the judgment
- Premiums on appeal bonds to release attachments
- Expenses incurred by the policyholder at their request
In fact, it is the Supplementary Payments section of the standard CGL policy which makes it clear that the costs of defense—and of the other items listed above—do not reduce the policy limits of liability.
(a) Scope: The “Comparison Test”
The defense obligation on part of the insurer arises when a defense is needed by the insured: at the outset of the suit.
It means that unlike the duty to indemnify (which depends on the “true” facts as determined in the underlying action), the duty to defend arises from the facts as alleged in a complaint.
The process for determining the defense duty (often called a “comparison test”) is one of “envisaging what kinds of losses may be proved as lying within the range of the allegations of the complaint, and then seeing whether any such loss fits the expectation of protective insurance reasonably generated by the terms of the policy.”
Once the defense duty arises, it usually continues until the suit is resolved—though the facts proved at trial ultimately may show the liability to be outside the insurance scope.
The question of the initial duty of a liability insurer to defend third-party actions against the policyholder is decided by matching a complaint with the policy provisions. If the allegations of the third-party complaint are “reasonably susceptible” of an interpretation that they state or foreshadow a claim covered by the policy, the company must undertake the defense.
For the defense duty to arise, the underlying complaint need only to show, through general allegations, a possibility that the liability claim falls in the ambient of the insurance policy. The facts alleged in a complaint need not specifically and unequivocally make out a claim within the insurance coverage.
The insurer normally cannot rely on information and facts from sources outside of the complaint to avoid its defense duty. Even solid information reaching the company from the insured, and indicating that claimed losses are uninsured, could itself not relieve the insurer of its duty to defend. This means that the insurer will defend the suit, even if the injured party makes a baseless claim, which, qua claim, is for an injury ‘covered’ by the policy. In other words, the company is required to do its duty to defend despite receiving such information from the insured, or anyone else, as indicates, or even demonstrates, that the injury is not in fact covered by the policy terms.
(b) Insurer Obligation of “Reasonable Performance”
The Supreme Judicial Court has made it clear that in undertaking the duty to defend the insurer impliedly assumes a duty of “reasonable performance” of that obligation. In the court’s words, an insurer, “by undertaking the defense of its insured as mandated by contract, engage[s] in affirmative action, and that action expose[s] its insured’s legally protected interests to the risk of harm. The insurer’s action, therefore, [gives] rise to a duty of reasonable performance.
(c) Termination of the Defense Obligation
If the allegations of the complaint against the insured “find apparent lodgment in the effective coverage of the policy” or facts omitted from the complaint indicate that the claim may be covered then the insurer is obligated to defend the policyholder as long as there is no conspiracy to defraud the company.
However, in case an insurer believes that the claimant and insured have conspired to defraud it then, even if an accident has actually occurred, the insurer can disclaim defense duty, and file declaratory action against the policyholder and the claimant seeking to establish fraud. But, as noted earlier, the insurer cannot be relieved of this duty “by dint of its own assertion that there is no coverage in fact”. The insurer can terminate a defense obligation by confining the claimant’s case to one not falling within the policy coverage. Until this is achieved, the insurer’s “initial” duty to defend must be honored and performed.
To sum up, the “initial” duty to defend under a liability policy is essentially based on allegations rather than facts. If the allegations made in the complaint or additional information available to the insurance company indicate a potential that the insurer ultimately will be required to indemnify the policyholder, then, the duty to defend is invoked irrespective of insurer’s belief about the claim’s veracity until it is proved that it falls outside the policy coverage.
In some situations, an insurer may be able to ultimately terminate its defense duty by means of a declaratory action or otherwise, but it is recognized that in most cases such a determination “may not come until the third-party action is fully tried, and in that case the duty to defend continues to the end, even if the result of the action is favorable to the insured and there is no judgment against the insured that the insurer needs to make good.”
(d) The Duty to Defend and the “Mixed Claim”
The insurer under a CGL policy must defend the insured if the complaint shows a possibility that the claim eventually may fall within the scope of the policy’s coverage, even if it initially may not appear so. Most often a complaint will assert multiple claims or at least will be pleaded in multiple counts, some of which are within and some clearly outside the scope of coverage. Should the insurer then perform its duty to defend? The answer appears to be yes. The courts have held that, “the general rule in California in the general liability insurance context is that ‘an insurer must defend the entire lawsuit if it has a duty to defend in any of the underlying counts in the complaint.”
(e) Control of the Defense
The insuring agreement confers on the insurance company not only the duty but also the right, to conduct the defense of the insured. This is a valuable right as it reserves to the insurer the functions of selecting and supervising the defense team and the defense counsel, providing it “control” over the conduct of the defense. However, most often an insurer’s reservation of a right to disclaim coverage will place its own interests in conflict with the interests of the policyholder, making it inappropriate for the company to insist on retaining defense control.
The classic example is that of a complaint alleging that the claimant was bodily hurt as a result of the insured’s negligence or by an intentional tort on their part. Since liability policies exclude coverage for injuries intentionally caused to someone by a policyholder, it will be in the insurance company’s financial interest for the claimant to prove the intentional tort (which may not invoke the indemnification obligation), rather than negligence (which usually will call upon the insurer’s duty to indemnify). In such cases, the policyholder will obviously be reluctant to surrender control of the defense to the insurer.
Can the policyholder insist on retaining control as well as retain the financial benefit of the insurer’s duty to defend?
Well-established California case law answers this question in the affirmative.
Where the insurer has a conflict of interest with the insured due to a reservation of a right to disclaim coverage, the policyholder will be permitted to pick counsel of their choice, and the company will be obliged to pay the reasonable costs of that defense.
(f) Defense Expenses and Policy Limits
The “Supplementary Payments” provision (of the standard CGL policy) shows that the defense costs are in addition to indemnity amounts (i.e., they do not deplete the limits of the policy liability). A distinct question is when the insurer is permitted to stop defending. The earlier quoted liability insuring agreement states that “the [insurance] company shall not be obligated to pay any claim or judgment or to defend any suit after the applicable limit of the company’s liability has been exhausted by payment of judgments or settlements.”
For so many times the insurers have also raised the question that whether they can tender to the claimant or pay into court the full amount of their potential indemnity obligation (i.e., the amount of the applicable limit) and hence escape from any further duty to defend. The answer in California, as in the majority of other jurisdictions, is “no”. Such a payment will not cut off the defense duty. The defense obligation ends only when the company has paid its liability limit to satisfy (in whole or in part) a court judgment against the insured or reached a settlement with the claimant.
Moreover, the duty to defend generally encompasses an obligation to appeal from a judgment against the insured, if there are reasonable grounds to believe that the policyholder’s interest might be served by the appeal. (To trigger insurer’s duty to appeal, “[a]t a minimum, the insured must point to a particular appellate issue and explain why the trial court committed an error and why this error was sufficiently prejudicial that judgment for the plaintiff might be reversed”)
(g) Consequences of Breach of the Duty to Defend
When an insurer breaches a duty to defend an insured against a suit, the policyholder has the right to file a breach of contract claim against the insurance company. In such cases, the insured is entitled to recover contract damages, i.e., “those that cannot be reasonably prevented and arise naturally from the breach, or which are reasonably contemplated by the parties.”
The most obvious part of such damages is the reasonable sum incurred by the insured in providing for their own defense. The debate on the further consequences of the breach of duty to defend by the insurer has focused on two key questions: the effect of the breach on the indemnity obligation, and the recoverability of lawyer’s fees.
Effect of Breach of Duty to Defend on Duty to Indemnify
An insurance company which wrongly refuses to defend a policyholder and fails to seek a declaratory judgment about the coverage will be “estopped” from raising policy limitations or exclusions to avoid an indemnity obligation, regardless of the merit of its coverage defenses as well as the expenses incurred by the insured in establishing the insurer’s duty to defend.
1.2.2 Does the insurance company have a duty to “Indemnify”
The two prime obligations of the insurer under a CGL policy are usually referred to as the ‘duty to defend’ and the ‘duty to indemnify’. Though the latter designation may be a bit of a misnomer, to the extent that an “indemnity” obligation is generally considered to be the obligation merely to reimburse the policyholder for the amounts they have already paid. The promise of the CGL policy is to “pay on behalf of the insured all sums which the insured shall become legally obligated to pay as damages.”
Thus, the policy entails that the insurance company’s obligation will be invoked when its legal obligation to pay damages is established and that the insurer will then make the payment on behalf of the insured, such that the latter is never “out of pocket.” This can be very beneficial for the insured, particularly in cases where the damage award is of such magnitude as could threaten the policyholder’s solvency.
As opposed to the duty to defend, the duty to indemnify is determined by reference not to allegations but to “facts.” The scope of the duty to indemnify is therefore said to be narrower than that of the duty to defend. This is so because one is no longer interested in the various sets of facts the claimant might prove (in line with his or her allegations). The inquiry now is into the only those facts which the claimant has proved.
In practice, however, the coverage question cannot always be answered on the basis of the findings of fact or a jury verdict from the underlying case. The underlying case may settle, of course, and in that scenario, no “facts” will have been established. Even if the case is fully litigated, the coverage question may be more concerned about the facts that are not determined in the underlying action because they are not relevant to the policyholder’s liability. Much of the law relating to the determination of the indemnity obligation addresses this problem.
(b) Limits of Liability; Insurer Responsibility for Interest and Costs
The scope of the indemnity obligation of an insurance company is determined by the insuring agreements, and definitions and exclusions of the policy applied to the facts of the claim made by the third-party. It is determined in light of the principles discussed in the preceding section. The magnitude of the indemnity obligation is measured by the size of the claimant’s recovery and limited by the liability limits as stated in the policy “declarations”. Standard CGL policies may contain several kinds of limits, including the so-called “per occurrence” and “aggregate” limits. These limits can operate in various ways, depending on when the policy was written and whether it was written on a standard form.
Generally, a “per occurrence” limit sets the maximum amount the insurance company will be required to pay for all damages coming out of one event or resulting substantially from the same injurious exposure. In the case of “bodily injury” and “property damage” liability, the present standard form “per occurrence” limit applies, irrespective of the number of policyholders or claims made, or the number of persons or organizations making the claims. The policy may have separate “per occurrence” limits for “bodily injury” and “property damage” claims, or it may provide a “combined single limit” for all liability coming out of a single “occurrence.” Limits for “personal and advertising injury” may operate on a “per occurrence” basis or (as in the present standard form) by reference to the total number of persons or organizations suffering injury as a result of an “offense” (described in the policy definitions). An “aggregate” limit of liability is the highest amount the insurance company will pay during a designated term, irrespective of the number of otherwise covered “occurrences”, for which the company is liable. The term is usually a 12-month period, with the aggregate limits of annually renewing multi-year policies.
Limits of the liability provisions tend to refer to the amount of “damages” the insurance company will pay. The question has arisen whether or not the term “damages” includes prejudgment interest incorporated into an award.
An insurer may be liable to its insured for a negligent failure to settle a claim for an amount falling within the policy limit. In such a case the damages awarded can include prejudgment interest the insured must pay because of the company’s breach of its duty to settle the matter.
1.2.3 The Insurer’s Duties to Investigate and to Settle
Under the CGL policy, the insurer undertakes to defend any lawsuit alleging a liability that potentially falls within the policy ambit and to indemnify the policyholder for damages he or she must pay for a claim that is, in fact, covered. In the same insuring agreement, through the language which has changed little over the past six decades, the insurance company also reserves for itself the prerogative to “make such investigation, negotiation, and settlement of any claim or suit as it deems expedient.”
However, it has been seen that an insurer’s failure to use these prerogatives with proper regard for the interests of the insured can result in undue prejudice to the latter.
Therefore, the courts have held that the insurer’s keeping a privilege to control investigation and claims settlement “imports a reciprocal obligation for its exercise”—i.e., a duty to investigate and settle claims in line with its implied covenant of good faith and fair dealing.
Although often paired together, the duty to investigate and the duty to settle claims deserve separate analysis, because a breach of one does not necessarily involve a breach of the other. Although there is no precise formulation of the duty to investigate, it is clear that an insurance company must conduct some independent investigation before denying coverage, as the failure to do so would encourage the practice of unfair claim settlements.
1.3 What are the insured’s obligations?
The insurance bargain, in reality, is the transfer of risk of loss to the insurer in exchange for the payment of premiums by the policyholder. The main obligation of the purchaser of insurance policy, therefore, is to pay premiums when due. Other obligations of the policyholder under a liability policy arise in two contexts i.e. underwriting and claims handling.
In the underwriting process, the obligation of the insurance applicant is to answer truthfully and completely all the questions put by the underwriter. Because only then the underwriter would be in a position to make an informed decision about issuing the policy and determining an appropriate premium if a policy is to be issued.
The obligations of the policyholder in the claims handling context are varied, but most of them are directed to one objective—placing the insurance company in an optimal position to determine its coverage obligations as well as perform those obligations (e.g., to investigate and defend or settle covered claims).
Thus the requirements that the policy imposes on the insured include the following:
- To notify the company of events or conditions (occurrences) which may result in claims
- To advise the insurer if a claim or lawsuit is brought
- To cooperate with the insurance company in its investigation and defense handling
Two additional claims-related obligations of the insured—the duty to mitigate damages and duty to preserve insurer subrogation rights—help the latter contain or spread the loss.
Insured’s Duty to be Truthful
As with any contract, in insurance contracts, each party is entitled to rely on the other’s warranties and representations and may be excused from the performance if made to enter the agreement through other’s false warranty or representation regarding a material matter. Though both parties are required, in principle, to avoid misrepresentations during the policy negotiation phase, as a matter of fact, the burden of disclosure falls largely on the insurance applicant, mainly because of their superior knowledge about the risk to be insured. Therefore, in California, as elsewhere, the case law regarding the misrepresentation in the policy formulation process is dominated by instances wherein the insurers have sought to avoid coverage on the basis of alleged misrepresentation by the insurance company in the policy application.
Insurers therefore frequently contend that the policyholder’s failure to disclose a material fact will void the policy, even where the insurer has made no inquiry seeking the information in question, so long as the “reasonable insured” would have believed a fact to be something the insurer would deem material. This argument typically goes together with citations to cases from the reinsurance context, wherein a duty to disclose, even absent a pertinent inquiry, is said to arise from the special relationship of “utmost good faith”.
Where a policyholder responds to an insurer’s request for information (whether or not that response is a misrepresentation) the consideration of the question becomes pertinent. And, just as with ambiguous policy terms, ambiguous underwriting questions are construed in the favor of the policyholder. Accordingly, where an insurer’s request for information “lends itself to more than one reasonable interpretation, an honest answer to one of those reasonable interpretations cannot be labeled a misrepresentation.”
Assuming that a misrepresentation has come to fore, it will excuse the insurer’s performance only if it was made with “actual intent to deceive” or if it “increased the risk of loss.” Also, a misstatement of the facts or a failure to disclose the requested information will be deemed material only if the disclosure would have resulted in a higher premium, irrespective of any after-the-fact argument by the policyholder that the actual risk of loss was not increased.
Does the insured have a duty to cooperate with the insurer?
Besides imposing an obligation on the insured to provide the insurer with prompt notice of any “occurrences,” “offenses,” or claims and suits, CGL policies also require the policyholder to cooperate with the insurance company in the defense and settlement of the claim as well as in the pursuit of any right of contribution or indemnity against third parties. In addition, the policyholder “must do nothing after loss” to harm or restrict the insurer’s subrogation rights.
Issues about the duty-to-cooperate arise frequently in two distinct scenarios. The first involves the information exchange that usually takes place soon after the insurance company has been notified of an “occurrence” or “claim.” Insurers often contend that Condition 4(c) makes it necessary for the policyholder not only to share information pertinent to a claim but also respond fully to detailed requests for information and the documents pertinent to coverage issues. For example, if the insured seeks coverage for underlying hazardous waste claims, the company often will seek information on whether the releases of contaminants on which the claim is based were “sudden and accidental” that would qualify them for pollution exclusion.
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Attorney Brad Nakase is a former insurance defense lawyer representing major insurance companies. If you received a Reservation of Rights letter from your insurer, you should consult with your own lawyer right away (not the lawyer the insurance company hired to defend you).
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