Defense-cost expense in major litigation – either one-shot cases or related, serial cases – can accumulate to rather substantial amounts, so naturally policyholders look to their liability-insurance policies for coverage. While most defense-cost coverage disputes concern primary-layer policies, excess insurers, too, may have obligations to perform. As discussed below, a recent Indiana appellate decision addressed coverage for defense costs under a primary-layer policy written on an excess policy form and held that the coverage was restricted to after-the-fact payment as an incident to covered indemnity amounts.
Defense costs will be sought under excess-type policies when the primary coverage is exhausted or where the insured maintains a self-insured retention with an “excess” policy sitting above the retention. (Calling a policy above an SIR an “excess” policy is a bit of a misnomer, since it is excess to no-insurance but such policies are written commonly on excess-type forms with the obligation to perform characterized in terms of “ultimate net loss,” the common wording in excess policies. Cf. Nabisco, Inc. v. Transport Indemnity Co., 143 Cal.App.3d 831 (1983)).
The typical issues for defense coverage under excess policies are:
1. Is there an obligation to pay defense costs at all (once the underlying is exhausted)? See Aetna Cas. & Sur. Corp. v. Certain Underwriters at Lloyd’s, 129 Cal. Rptr. 47 (Cal. App. 1976); State Farm Mut. Auto Ins. Co. v. Foundation Reserve Ins. Co., 431 P.2d 737 (N.M. 1967); Maryland Cas. Co. v. Marquette Cas. Co., 143 So. 2d 249, (La. App. 1962).
2. Is the obligation to pay defense costs only an incident to paying covered indemnity claims (such that there is no coverage if the insured wins the liability case or to the extent that defense costs relate to potentially covered claims rather than to actually covered ones)?
3. Relatedly, does the obligation to pay defense costs arise at the outset of the liability case or only after the insured has lost the liability case (meaning both that the insured fronts the costs of the defense and that the defense costs are covered not based on the allegations of the complaint but only based on the facts as proved at trial)?
4. Where the insurer does not have an obligation to defend but has a right to associate in the defense or to consent to the incurrence of defense costs, does the insurer have the unfettered power to refuse to contribute to defense costs for a covered claim?
5. Where an insurer does not have an obligation to assume control of the defense, may it still have an obligation to reimburse the costs of defense as they are incurred? Gon v. First State Ins. Co., 871 F.2d 863 (9th Cir. 1989).
6. Where an excess policy does not expressly set forth a defense obligation but “follows form” to an underlying policy with a defense obligation, does the following-form carrier presumptively have an obligation to contribute to the defense costs? Monsanto Co. v. American Centennial Ins. Co., 1991 WL 35714 (Del. Super. Ct. Feb. 20, 1991); Ford Motor Co. v. Northbrook Ins. Co., 838 F.2d 828 (9th Cir. 1988).
7. Are defense costs paid by the excess carrier in addition to policy limits or within its policy limits (sometimes referred to as “defense inclusive” policies)? Alternatively, if policy limits are expressed in terms of “ultimate net loss” and defense costs are carved out of ultimate net loss, does that mean that costs are not payable at all or are they still payable but outside of policy limits? Affiliated FM Ins. Co. v. Owens-Corning Fiberglas Corp., 16 F.3d 684 (6th Cir. 1994); North River Ins. Co. v. Cigna Re Co., 52 F.3d 1194 (3d Cir. 1995); Home Ins. Co. v. American Home Prods. Corp., 902 F.2d 1111 (2d Cir. 1990); Continental Cas. Co. v. Pittsburgh Corning Corp., 917 F.2d 297 (7th Cir. 1990); Planet Ins. Co. v. Mead Reinsurance Corp., 789 F.2d 668 (9th Cir. 1986).
[The above-cited cases touch on some of these issues both pro and con (depending on one’s perspective). Lawyers for both policyholders and insurers should be mindful that some cited cases are inter-insurer disputes where the policyholder perspective – and supporting facts – were not presented, e.g., Crown Center Redevelopment Corp. v. Occidental Fire, 716 S.W.2d 348 (Mo. App. 1986) (and compare this holding to my note, An Insurance Company’s Duty to Consent , or are reinsurance disputes where the factual record may not have been developed or where there is a deferential standard of review of an arbitration decision, e.g., North River, 52 F.3d at 1208-1217.]
The Indiana Court of Appeals recently addressed some of these matters, Cinergy Corp. v. St. Paul Surplus Lines Ins. Co.., (Ind. App. Dec. 13, 2005). The court described the question presented as “Whether a policyholder of a first-layer liability insurance policy is entitled to payment of defense costs as they are incurred when the insurance policy does not contain a duty to defend clause or express language authorizing a delay in payment of those costs until determination of whether the underlying claims are covered.” The policy at issue provided that the insurer was obligated “to indemnify” sums the insured becomes liable to pay “as Ultimate Net Loss by reason of the liability imposed upon the Insured by law or liability assumed by the Insured under Contract.” The case did not go off on the language that the insurer was to “indemnify . . . by reason of the liability imposed” but instead turned on the ultimate-net-loss provision.
“Ultimate Net Loss” was defined as “the total of the following sums . . . to which this Policy applies: (1) all sums which the Insured shall become legally obligated to pay as damages . . . and (2) all expenses incurred by the Insured in the . . . defenses of any claim or suit seeking such damages.”
The court ultimately seized on the use of the term “total” in the ultimate-net-loss provision, reasoning that one cannot know the “total” ultimate net loss until both the defense costs and the damages were determined. Slip op. at 11 (“The pivotal requirement in the payment of the defense costs lies in the definition of ultimate net loss as a total of incurred defense costs and damages which h the insured becomes legally obligated to pay.”) From this, the court found it plain and unambiguous that there was no obligation to pay defense costs until covered damages were awarded. The court further stated that until the policyholder was found liable, one cannot know that a covered occurrence or wrongful act took place, and thus (?) ultimate net loss does not “even exist,” slip op. at 10. Because the carrier’s obligation is to indemnify ultimate net loss, there was no duty to pay for defense costs before the insured was found liable for a covered act.
Probably the court’s strongest rationale is that, unless one waits until the underlying liability case is over, it is possible that the carrier will pay defense costs for a matter found ultimately to be outside of coverage (even if that prejudice might be mitigated by the insurer’s obtaining reimbursement of the amounts expended. See In re Kenai Corp., 136 B.R. 59 (S.D.N.Y. 1992)). (And the split of authority regarding whether insurers may recover defense costs from their own insureds – or trend away from permitting such claims – serves to strengthen the equities favoring insurers.) Note that directors’ and officers’ insurance policies may disclaim an obligation to defend but provide for the advancement of defense costs subject to reimbursement, which often makes those cases of little use in this context.
The Cinergy court’s holding principally is predicated on the use of the term “total” in the ultimate net loss definition and the language “to which this policy applies” (in that definition). While this language may support the court’s conclusion, other language does not: in the ultimate-net-loss provision, the coverage for defense costs is defined as expenses incurred in the defense of “any claim or suit seeking such damages.” In this context, the word “seeking” is key. A suit “seeking” such damages is judged ex ante – that is, is judged by what the complaint alleges. If the carrier intended for defense to be reimbursed only where a covered indemnity claim was adjudged, the defense language should say something like “all expenses incurred by the Insured in the defense of any claim or suit where such damages are awarded” or “have been awarded”. These formulations, especially the latter, would make clear that a truly retrospective approach was intended.
At a minimum, the policy language should be found to be unclear on this point, and while the carrier’s argument that it might have to pay for potentially uncovered claims has some force, the overwhelming practice for “first layer” insurers is to pay for defense costs on a allegations basis. Further, the court’s construction creates a gap in coverage for cases where the insured wins the liability case (since no “wrongful act” or “occurrence” took place), a gap in coverage that surely would be unexpected by any reasonable policyholder. In this light, the insurer should have utilized language making it clear that defense costs are reimbursed only as an incident to covered indemnity claim. Indeed, I think that the insurer should make express its negative intention not to pay defense costs unless and only if the policyholder loses a suit for a covered wrongful act.
Part of the difficulty in this entire area is the dearth of case law and the superficiality of much of the analysis in the cases. The keys to successfully litigating these issues for policyholder counsel are: (i) focus on the policy language; (ii) think about what happens if the policyholder wins the liability case; (iii) considering the overwhelmingly common practice of carriers’ funding the defense, argue that the burden of dispelling the expectation of coverage is on the carrier to negate defense coverage; and (iv) recognize that while the incurrence of defense costs can be a catastrophic exposure to the policyholder it can also be so for the carrier, meaning that the policyholder must sensitively respond to the equitable force of the insurer’s arguments and not simply rely on “punish the drafter” arguments or what the Nabisco court characterized as “‘mom and pop’ grocery store argument[s]” (unless one has to). Of course, sometimes the excess policy really will have no or quite limited obligations to pay defense costs, which the client needs to recognize is a consequence of the coverage it purchased (and possibly the insufficient advice provided by its broker – opening a different vista for recovering the unpaid defense costs).