The California Court of Appeal issued an innovative decision that fills in important gaps in the analysis of issues concerning providing notice under “claims made and reported” liability insurance policies. The case, Root v. American Equity Specialty Ins. Co., available at http://caselaw.lp.findlaw.com/data2/californiastatecases/g033818.pdf (Cal. Ct. App. June 28, 2005), involved an insured who faced falling between two stools: not having coverage under consecutive liability policies because the claim was made during one policy period and its report was made in the second. The Fourth Appellate District (Division Three) emphasized that its holding was narrow: it was not invalidating claims-made-and-reported policies but rather was implying an equitable grace period to report a claim under an expired policy.
Root is different from the litigation in the 1980s where policyholders swung for the fences and ultimately struck out: policyholders had early success, especially in New Jersey and California, arguing that claims-made-and-reported policies were in their nature against public policy. (This had been the result in France which effectively invalidated claims-made policies in 1990 until legislation reversed the decision a couple of years ago.) These early cases – which in California were wiped from the books by the California Supreme Court through its practice of “depublication” (see Rule 976(b)) – generally held that the disjunction between policyholders’ expectations of coverage and the forfeiture of coverage stemming from “late” notice (different from the no-loss-of-coverage-from-late-notice-unless-the-carrier-has-been-prejudiced rule) was so extreme as to warrant invalidating the reporting requirement (virtually) altogether.
As was obvious at the time, these decisions lacked sound analytical footing legally and failed to come to grips with the fundamental reality that the policy says what it says – coverage is triggered if a claim is made and is reported during the policy period. (Policies that are simply “claims made” are different inasmuch as the policyholder covenants to provide notice but the notice provision is not part of the insuring agreement itself.) Moreover, insurers did a good job in convincing courts – without evidence – that claims-made policies were inherently cheaper than are occurrence policies (but compare Tip’s Package Store, Inc.,. v. Commercial Insurance Managers, Inc., 86 S.W.3d 543 (Tenn. Ct. App. 2002) (occurrence policy implicitly cheaper than claims-made on facts presented)), and the courts ultimately adopted a “you get what you pay for” stance, holding that the notice-prejudice rule does not apply to claims-made policies and thus that notice provisions in such policies are strictly enforced.
It is against this historical backdrop that Root becomes particularly important, because the Root court was well aware of this history and the California Supreme Court’s penchant for de-publishing decisions mitigating the notice provisions of claims-made policies, and the Root court strove in its lengthy opinion to lay out an analytical framework that was consonant with fundament principles of California practice and with the reasonable expectations of both sides of the insurance transaction. The key to the court’s decision was its embrace – following the argument of Professor Bob Works in particular and the Restatement 2d Contracts § 229 – of the principle that non-occurrence of a condition, which would otherwise suspend or excuse the counter-party’s contractual performance, should be excused where a disproportionate forfeiture otherwise will result.
The facts in Root involved a suit’s being filed with three days to go in the policy period, the suit not being served until the last day of the policy, the policyholder’s having been called by a reporter the day suit was filed asking about a possible malpractice action, and the insured’s prompt provision of notice once he had actual knowledge of the suit against him.
The policy at issue was a claims-made-and-reported policy but which did not contain any “extended reporting period” (that is, a contractually established grace period to report claims that were made during the initial policy term based on conduct occurring before the expiration of the policy), and the insured never was given the opportunity to purchase an extended reporting period. As the court described the facts, “the late report was made a de minimis time after the expiration of the policy and [ ] the insured had not been given the opportunity to be protected under an extended claim reporting endorsement.” (Slip op. at 14.)
The court then framed the question before it: “The central issue in this case, then, is whether the policy period reporting requirement is a condition precedent of coverage that may be equitably excused when it works a forfeiture.” (Slip op. at 17)
The court’s framing of the issue required that it determine whether the notice provision was a condition or something else. (Generally, contract law presumes that provisions are covenants and not conditions, in order to avoid forfeitures.)
The Root court found some diverging signals between whether the notice provision was a true condition precedent or was something else, in part because the notice obligations appears more than once in the policy. The court nicely captures its own thinking, saying “[s]uperfluity does not vitiate, and in fact there are occasions when it defines.” (Slip op. at 19), which it also characterized as the policy’s “contain[ing] the seeds of its own cognitive dissonance on the problem of whether the policy period reporting requirement is a element of coverage or a condition.” (Slip op. at 20.)
To try to understand what the policy drafters were seeking to accomplish the court sought to understand the fundamental commercial context for the introduction of – and hence the drafting of – claims made policies. As the court explained this: “The key is the pricing of premiums. The core idea behind the move to claims made insurance policies was to close the gap between the time when insurer prices a risk and the time when the insurer may incur an obligation to pay on that work.” (Slip op. at 20 (citing Prof. Works)).
The time gap between the collection of the policyholder’s performance – its payment of the premiums it promised – and the carrier’s being required to perform services or pay money following a casualty is what makes the pricing of policies and operation of insurance companies a tricky business. (See generally Richard Stewart and Barbara Stewart, The Loss of the Certainty Effect, 4 Risk Management & Ins. Rev. 29 (2002), and Insurance Scrawl, Economics of Property-Casualty Insurance Business). “Insurers like all businesses in a free market, have the fundamental problem of making decisions now that depend on future events, and their survival depends on guessing right often enough to be profitable. . . . Professional malpractice insurance underwriting is  likewise particularly vulnerable to gaps between the time of pricing and the time obligation.” (Slip op. at 21). According to the court, this changes the nature of the transaction in a claims-made-and-reported policy: “With pure ‘claims made policies, that risk is shifted to the insured, who pays present dollars for protection against claims that will themselves be paid in those same dollars, that is, without regard to inflation and at a time relatively close to the insurer’s pricing decision.” (slip op. at 22)
While the court’s discussion of the economic rationales of claims-made policies gives some context to its ratio decidendi – though court pronouncements of the nature of insurance markets are in my judgment invariably simplistic and, frankly, inaccurate – what is more interesting and important to the decision is the court’s identification of the consequences of the reporting requirement in claims-made-and-reported policies and its impact on the contractual risks assumed by the parties inter sese.
The court found that the insured’s obligation to report claims affects the carrier’s ability to monitor potential payouts under the policy. (The court then leaps the chasm to speculate about the economic impact of this in hypothesizing, again without evidence and surely subject to challenge empirically and theoretically, that the insurer’s gaining administrative closure by learning of the existence of claims more promptly yields a benefit that “is passed on to the insured in the form of lower premiums.” Slip. Op. at 22.) The court recognizes that how much a particular claim will cost is unknown at the moment of its report, but knowing of the existence of the claims sooner is better than its opposite. (Slip op. at 22-23).
The court also found salient that the reporting requirement can be understood as a simple election provision, that is, a contractual hook to ensure that if the insured elects not to exercise its rights to coverage that that election is irrevocable (or what the court characterizes as a “naked forfeiture clause”, slip op. at 23). Considered either as an information-forcing provision or as an election clause, the court found that the reporting requirement thus operates as a true condition to coverage. As the court explains, “[t]he addition of a reporting requirement therefore doesn’t go to risk of a claim against the insured (i.e., what sort of claim might fall within the ambit of the costs the insurer promises to cover), but to the logically independent risk that the insured simply will not report the claim in time.” (Slip op. at 23)
Having found the reporting requirement to be a condition, the court then confronts the consequence of that characterization, for the failure of a condition can result in a forfeiture of contractual rights (or more strictly, the failure of a condition results in the other party’s contractual obligations not becoming mature). The Root court next considered the notice/prejudice rule, where the notice “condition” has been mitigated by requiring the carrier to prove that it was prejudiced from late notice before it could avail itself of the protection the notice condition provided; the court found that that approach was too blunt an instrument, especially in the context of a claims-made-and-reported policies, since a prejudice rule would effectively transmute such policies into simple “claims made” policies, which are different. “Application of the rule thus fundamentally rewrites the claims made and reported contract into a pure claims made contract.” (Slip op. at 24)
Instead, the court applied the well established, if little known, rule providing for the equitable excuse of the failure of a condition, finding this rule to be “more flexible, nuanced, and does no violence to the claims made and reported nature of the policy.” (Id.) Applying the rule to the case before it the court reasoned:
[I]n the present case, the fact that the insurer did not give the insured the opportunity to buy an extended reporting endorsement which would . . . have given him an extra 60 days to report any claims may be of significance. Had Root been given that opportunity, for example, equity might not require excuse of the condition, because its excuse would, in effect, be to give Root the benefit of something he had the opportunity to buy and passed up. The same might be said if Root had had sufficient time to conduct an investigation as to whether a claim had indeed been made against him, or had delayed reporting the claim beyond the day on which he received confirmation of the claim. But given this record the facts are sufficient to support the equitable excuse of the reporting condition. . . . In the [California Supreme Court’s] phrase, given these facts it would be ‘most inequitable’ to enforce the condition precedent of a report during the policy period.
(slip op. at 25, footnote omitted).
The Root court’s holding is narrow on the facts and the court cautions that its ruling should not be extended unduly. As is often the case, in these types of forfeiture cases, one wonders why the carrier pressed the issue as it did, when the facts are so compelling and the harm to the insurer non-existent. A modicum of good claims judgment would have avoided litigation and avoided what is for insurers a bad decision that opens the space for new arguments on claims-made-and-reported policies and, the court acknowledges, fewer summary-judgment rulings for carriers on late reporting (at least in reasonably compelling circumstances).
Root is important not just in terms of its impact on claims-made-and-reported policies but more generally in its embrace of the doctrine of equitable excuse of conditions precedent. The Root decision also supports the idea that one needs to analyze closely whether something that is labeled a condition is truly a condition – as opposed to a covenant (as I’ve elsewhere pointed out, ) and even if a provision is a condition whether noncompliance should be excused to avoid a disproportionately harsh result, as Restatement 2d of Contracts § 229 supports. See generally Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture: Claims-Made Formats as a Test Case, 5 Conn. Ins. L.J. 505 (1999).