Courts continue to struggle with claims where the policyholder may not have provided notice as soon as one might have liked, and the coverage litigation typically centers on whether the dispositive argument is “no harm, no foul” — that is, policyholders will argue that coverage is not lost unless the insurer has been prejudiced in some fashion from the allegedly “late” notice. The Illinois Supreme Court and a Texas appellate court both have confronted this question recently, and these are largely consistent with recent holdings from New York’s highest court finding that the notice provision must be enforced as written – no ifs, ands or buts.
I dare say that policyholders – and most insurer-side representatives – are astonished by this seeming trend vitiating coverage where insurers have suffered no harm from noncompliance. The clear “modern” trend has been to move away from a forfeiture approach to one that requires a showing of harm to the insurer before coverage will be lost – and most properly then only to the extent of the harm. (Different courts have assigned the burden of proof differently, but the undisputed trend has been towards liberality.) Usually, this trend is called the “notice-prejudice” rule, the idea being that unless the insurer has been prejudiced from the late notice coverage is not forfeited.
Policyholders promise to notify their insurers of loss, or circumstances that may lead to loss, and insurers will deny coverage if they believe that obligation has been breached. Accordingly, the first question is whether notice is “late” at all or whether the policyholder’s performance of its obligation to provide notice has complied with the policy terms. Most courts supply a reasonableness of time requirement, taking into account the purpose of the policy and the function of the notice policy therein. E.g., Blanton v. Vesta Lloyd Ins. Co., (Tex. App. Dallas March 9, 2006) (“an insured’s failure to give notice of an accident or occurrence is excused, that is, there is no duty to report it, when the insured has complied with his full duty to acquaint himself with all the facts surrounding an accident, and it appears from such investigation that the occurrence was of such a nature that it could not reasonably be expected to result in any claim or liability.”); Mighty Midgets, Inc. v. Centennial Ins. Co., 47 N.Y.2d 12 (N.Y. 1979).
Carriers often purport to justify forfeiture based on the notice provision’s placement in the conditions section of the policy.. Yet, the “conditions” section contains numerous provisions that are not conditions precedent or even conditions at all. The Premium Audits provision, for example, contains peripheral promises made by both insured and insurer. The Bankruptcy clause cannot plausibly be considered a condition to performance at all. Other provisions may be considered at best conditions subsequent, such as the other-insurance clause. The conditions section in fact collects boilerplate provisions that do not neatly fit in the Insuring agreement, Definitions, or Exclusions section. That the notice provision appears in this section is not significant because the title of a contractual section does not determine the legal effect of its contents so as to be a basis to deny coverage. E.g., Zimmerman v. Continental Life Ins. Co. 99 Cal. App. 723, 726 (1929); Cock-N-Bull Steak House, Inc. v. Generali Ins. Co., 466 S.E.2d 727, 729 (S.C. 1996). Moreover, nowhere in the notice provision does it state that the policyholder waives coverage for costs incurred before notice is given.
Courts typically treat the insured’s notice obligation not as a condition precedent, but rather as a covenant (i.e., a separate promise of performance.) E.g., Abrams v. Am. Fidelity & Cas. Co., 32 Cal. 2d 233 (1948); Sherwood Brands, 698 A.2d 1078. This treatment is significant because one party’s breach of a covenant excuses the non-breaching party’s performance only when the breach is material to the contract as a whole. A breached condition precedent, by comparison, excuses performance entirely. Restatement (Second) of Contracts 224, 237 (1981). The converse also must be true: if the breach of a provision does not discharge the non-breaching party’s obligation to perform as a matter of right and in all cases, that provision cannot be considered a true condition precedent.
One area where late notice has been played out concerns recovery of defense costs incurred before notice. Sometimes this dispute has been called coverage for “pre-tender” defense costs, introducing a double incoherence given that nothing in the insurance policy requires that the insured “tender” the defense. Policies do not require that the policyholder use “magic words” to seal its right to obtain a defense; policies require only that the insured provide notice. E.g., Samson v. Transamerica Ins. Co., 30 Cal. 3d 220, 239 (Cal. 1981) (“Transamerica argues that it . . . did not refuse to defend the lawsuit, since [the insured] never demanded a defense. The same argument was rejected [previously] as ‘sheer sophistry.’”); Cincinnati Cos. v. West Am. Ins. Co., 701 N.E.2d 499, 505 (Ill. 1998) (noting that the ‘tender’ rule “requires an insured to jump through meaningless hoops toward an absurd end: telling the insurer something it already knows. . . [T]he only benefit of such a rule is to create a possibility – where none would otherwise exist – for an insurer to escape an obligation it otherwise owes its insured.”).
The issue in these pre-notice coverage cases is not whether the insurer is to be entirely excused from performance, but rather whether the insurer may refuse to pay for defense costs incurred in the period before notice was provided. Courts will sometimes then say that notice is a condition to performance, and therefore the carrier cannot possibly have an obligation to pay prior to notice. See, e.g., Towne Realty, Inc. v. Zurich Ins. Co., 548 N.W.2d 64 (Wisc. 1996) (finding tender of defense was condition precedent to a duty to defend). That characterization is a bit too pat, which many courts have recognized. See Stephen A. Klein, Insurance Recovery of Prenotice Defense Costs, 34 Tort & Ins. L. J. 1103 (1999). That the carrier cannot breach its obligation to defend before it receives notice is different from whether, once it has received notice, its policy requires it to pay for all defense costs of the suit, including pre-notice defense costs. Sherwood Brands, Inc. v. Hartford Acc. & Indem. Co., 698 A.2d 1078, 1083 (Md. 1997).
The notice-prejudice nomenclature is inapt, for it’s hard to reconcile a prejudice prerequisite to a “condition” (because breach of a condition suspends or vitiates the counterparty’s performance), but just because the nomenclature is less that perfect does not mean that the result is not sound. This is an example where plain old contract-law doctrines were adequate to the task but insurance law got bollixed up by adopting its own rule. As a result, a conceptual incoherence and thus instability was introduced that has led several courts to tack back. But if one looks at the question as notice being a covenant and the counterparty’s not being excused unless the breach of covenant constitutes a material breach of the particular contract then the notice-prejudice cases are sound. This analysis applies equally to questions of “tender,” pre-tender defense costs or pre-notice defense costs, and late notice itself. See TPLC, Inc. v. United Nat’l Ins. Co., 44 F.3d 1484, 1493 (10th Cir. 1995). The majority rule stands on the broader principle too that a carrier should not be permitted to deny its policyholder the benefit of the bargain based on a technical breach that does not harm the carrier’s interests, a principle consistent with the carrier’s well-recognized duties to deal with its insured fairly and in good faith. When the insured’s noncompliance does not significantly prejudice the insurer’s ability to perform, the insurer is not disadvantaged by that breach, and “there is no reason to excuse the insurer from its promise.” Roberts Oil Co. v. Transamerica Ins. Co., 833 P.2d 222, 233-34 (N.M. 1992). Denying coverage when the insurer in no way has been prejudiced would frustrate “the consumer’s reasonable expectation that coverage will not be defeated on arbitrary procedural grounds.” Estes v. Alaska Ins. Guar. Ass’n, 774 P.2d 1315, 1318 (Alaska 1989).
When an insured’s breach of its obligations prejudices the carrier, the carrier may be entitled to relief flowing from and commensurate with the breach. A carrier should be allowed to show the marginal impact from the insured’s breach (which may be a counterclaim or set off for the “damages” the insurer incurred or the insured’s failure to mitigate or unreasonable incurrence of costs that would have been avoided by the carrier). See Alaska Energy Auth. v. Fairmont Ins. Co., 845 P 2d 420 n.5 (Alaska 1993). Otherwise, the injury to the carrier is only theoretical: its right to control the defense may be temporarily impinged but in no significant way are its rights harm.
This all brings us to several reasonably recent cases on notice. One ruling is from the Illinois Supreme Court, Country Mut. Ins. Co. v. Livorsi Marine, Inc., (Ill. May 18, 2006). In Livorsi, the Illinois court concluded:
[W]e hold that the presence or absence of prejudice to the insurer is one factor to consider when determining whether a policyholder has fulfilled any policy condition requiring reasonable notice. We also hold that once it is determined that the insurer did not receive reasonable notice of an occurrence or a lawsuit, the policyholder may not recover under the policy, regardless of whether the lack of reasonable notice prejudiced the insurer.
The policyholder in Livorsi case largely sought to convince the court based on what it claimed the majority rule was; the problem with these arguments is that they do not preponderate — they are observation of what (non-governing) courts did when faced with similar circumstances; but those arguments don’t ask why is the rule sensible here. The second argument was framed in terms of “public policy,” which is subject, as in Livorsi, to the cogent rejoinder that balancing public policy is a job for the legislature, not the courts. N.H. Indem. Co. v. Budget Rent-A-Car Sys, 148 Wn.2d 929 (Wash. 2003) (“An insurance policy will not violate public policy unless the challenged provision is ‘prohibited by statute, condemned by judicial decision, or contrary to the public morals’”). Further, the court stated that the policyholder could protect its own interests.
This should not be taken to imply that the policyholder’s points were wrong; rather, the way in which the points were argued detracts from their persuasiveness because they do not come to grips with the fundamentals of (insurance) contract law.
One case that did address these contract law points is PAJ, Inc. v. Hannover Ins. Co. 170 S.3d 258 (Tex. Civ. App. 2005). PAJ is a bad case for policyholders not only because it embraces a no-prejudice approach (but see Hernandez v. Gulf Group Lloyds, 875 S.W.2d 691 (Tex. 1994); Shelton v. Ray, 570 S.W.2d 419 (Tex. 1978)), but also because it addresses expressly the ordinary rule that contact provisions should be construed as covenants rather than conditions so as to avoid forfeiture and to preserve the benefit of the bargain. Crucially, PAJ was decided by an intermediate appellate court, and for which a petition for review is pending, so the panel was constrained by existing precedent that routinely referred to the notice provision as a “condition,” even if there was not a governing holding requiring construing the provision that way.
A recent New York trial court decision seeks to reconcile the ordinary contract law rules of condition versus covenants and material versus immaterial breach of contract with the insurance law rule in New York that prejudice is not required for a carrier to be excused from performing on late notice grounds. In American Transit Ins. Co. v. B.O. Astra Mgmt. Corp., 2006 WL 1152506 (N.Y. Sup. April 17, 2006). B.O. Astra presented good facts from the policyholder perspective, given that it involved an accident victim whose attorney provided notice directly to the tortfeasor’s insurer, thus providing notice of occurrence and notice of potential claim (and attorney involvement). Moreover, that attorney provided a copy of his motion for a default judgment to the insurer once the tortfeasor failed to answer the complaint. The insurer rather than moving to prevent entry of default (which it could have done under New York procedure) instead chose to file a declaratory-judgment action against its insureds saying no coverage because of late notice.
What is notable about the B.O. Astra decision for purposes here is how it characterized New York’s prevailing rule that an insurer need not show prejudice in order to deny coverage for late notice. The judge characterized this rule as the “‘no-prejudice’ exception”, going on in a footnote to explain:
The ‘no-prejudice’ rule is ‘a limited exception to two established contract principles: (1) that ordinarily one seeking to escape the obligation to perform under a contract must demonstrate a material breach or prejudice; and (2) that a contractual duty (requiring strict compliance) ordinarily will not be construed as a conditional precedent absent clear language showing that the parties intended to make it a condition.’
2006 WL 1152506 at n.3. The no-prejudice exception to the rules requiring materiality (prejudice) to avoid all performance and construe-as-a-covenant-when-possible was justified to allow the insurer to investigate claims while fresh, to protect itself against fraud and collusion, to set reserves, and to facilitate early settlement with claimants. Id. at *3. In the circumstances, those concerns had been adequately protected through the action of the plaintiff’s attorney provision of notice and alerting the insurer to the impending default judgment.
At a minimum, even in those states like New York that effectively presume prejudice from late notice, the courts should not create an absolute rule of law but instead should allow a policyholder to show that on the facts of a particular claim the prejudice presumption can be overcome. In other words, where a state presumes prejudice from late notice, the policyholder (the breaching party) nevertheless should be permitted to disprove that the insurer has suffered any prejudice to its legitimate interests and thus preserve the benefit of the bargain (i.e., indemnification in exchange for the premium already collected). See Aetna Cas. & Sur. Co. v. Murphy, 538 A.2d 219 (Ct. 1988) (“[A] proper balance between the interests of the insurer and the insured requires a factual inquiry into whether, in the circumstances of a particular case, an insurer has been prejudiced by its insured’s delay in giving notice of an event triggering insurance coverage. If it can be shown that the insurer suffered no material prejudice form the delay, the nonoccurrence of the condition of timely notice may be excused because it is not, in Restatement [of Contracts] terms, ‘a material part of the agreed exchange.’”); see also Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture, 5 Conn. Ins. L. J. 505 (1988-89).
The manner in which the B.O. Astra court describes the notice as not being subject to the ordinary rules re conditions and materiality reminds one (well, reminds me) of the manner in which some recent English cases have tried to conceptualize the late-notice question. In Alfred McAlpine plc. v. BAI (Run-Off) Ltd.,  1 L1.R. 437 the leading opinion ruled that notice was an “innominate” term, which as will be seen is roughly how the New York (and Illinois) courts seem to have considered it. But the innominate notion was not accepted in the more recent case of Friends Provident Life & Pensions Ltd. v. Sirius Int’l Ins.,  EWCA Civ. 601 , wherein the Court of Appeal, with a leading opinion from Lord Justice Mance, addressed whether notice was a condition precedent, a covenant, or something else (viz., an innominate term). As the leading judgment explained:
In that case my Lord identified a possibility that a claims notification provision such as clause 5 might be neither a condition precedent to liability for the claim nor a clause all breaches of which sounded simply in damages. It might be an innominate term, the consequences of which, he said, might be so serious as to entitle an insurer to reject the claim albeit that the breach was not so serious as to amount to a repudiation of the whole insurance contract.
The Friends Provident court considered whether the breach of a notice provision could result in the repudiation of the entire insurance contract or rather only the contractual obligation of the insurer as it related to the claim at issue. The court concluded that notice was an “ancillary” obligation, the breach of which would not repudiate the contract. The court considered and did not accept the BAI rule that a breach with serious consequences for the insurer could excuse the insurer’s performance entirely.
Lord Justice Mance characterized insurance policies as “composite” contracts or contracts with divisible performance as respect claims. Id. at para. 18 (“The primary quid pro quo for insurers’ obligation to pay claims under the insurance is the premium, which is incapable of being severally allocated to any particular risk or claim.”). As respects the notice obligation, the court could not justify construing it as a condition precedent as a matter of law or an innominate term (of an aleatory contract):
A claims notification clause [ ] is an ancillary provision. Breach of such a provision is capable of sounding in damages. But I am unable as a matter of construction or implication to find in [the] clause … any provision that insurers will be free of liability in the event of a serious breach and/or a breach with serious consequences. Even if one assumes that it might or would have been reasonable for the parties to agree such a provision, reasonableness is not the test for implying a term. . . . A test of “serious breach” and/or “serious consequences” [as in an innominate term] might have some drastic and unfair consequences. Suppose a year’s delay, in consequence of which insurers lost the opportunity to make or (e.g. because of insolvency) to recover a reinsurance claim or a subrogation claim worth £50,000. That would be a breach serious in nature and consequences. But suppose the insurance claim was itself for £1 million or £100,000 or even £75,000. Why should insurers have the right to reject the whole claim? Further, if the test in BAI is applied, insurers must prove serious consequences, as well as a serious breach. If they can prove serious consequences, then these will often be capable of quantification, in one way or another, even if only as losses of a chance or opportunity, and can be set off against the claim.
Id. at para. 32.
Moreover, Lord Justice Mance concluded that insurers were in a position to protect themselves by making clear that the notice provision would need to be complied with punctiliously on pain of forfeiture. Id. (Any other result would be “a novel form of protection for insurers. If insurers consider that they want or need such protection, they can and should try to express it in their insurance contracts and see if insureds and the broking market will accept it.”). Finding that “English insurance law is strict enough as it is in insurers’ favor”, Lord Justice Mance effectively concluded that notice was a covenant the breach of which ordinarily can result in a commensurate remedy (damages or setoff) rather than a disproportionate forfeiture of coverage.
The author of the leading judgment in the BAI case was also on the Friends Provident panel, and he (Lord Justice Waller) was not entirely persuaded by his brother Lord Justice. Instead, he clung to the idea that if the notice obligation were breached by the policyholder “in a way which seriously prejudices the insurer [it should have the] right to reject a claim rather than leave the insurer simply with a claim for damages.” Id. at para. 38. Essentially, Lord Justice Waller’s view is that faced with uncertainty as to whether the insurer was concretely prejudiced or might be able to prove some damages or set off, the law should protect the insurer’s interest and allow it to reject the claim. Lord Justice Mance, not known as a pro-policyholder judge, instead struggled with fashioning an exception for the benefit of insurers alone to the ordinary rules governing contract (as the New York courts have done), particularly where the insurer can redraft its contracts to seek to impose expressly a forfeiture result (if it can be approved, sold, and enforced).
Insofar as US law is concerned, the BO Astra court got it right in saying that the ordinary rules (should) govern, and the question is whether some special exception to the rules of materiality and covenant need to be created for insurance companies. That the majority of states – or at least a substantial plurality – require prejudice alone indicates that “promptness” must not be all that important to carriers; otherwise, in those states they would have redrafted their policies to make clear that celerity of notice was essential on pain of forfeiture. That they haven’t done sone undermines the arguments that staleness, reserve setting, and the like are all that crucial, and if it were so crucial there is no mischief in making plain to policyholders that forfeiture will be the result of late notice. Lord Justice Mance is absolutely right in this regard.
Indeed, that English law, of all things, is not as harsh as is the law in New York and maybe Illinois and Texas (and some other states) alone would give anyone with knowledge of both legal systems some considerable pause. Particularly where insurers can otherwise protect their interests, it is baffling that courts tender to them the windfall of pocketing the premium for a covered claim where they suffer no harm from the foul of the policyholder’s tardy notice.
Of course, policyholders should assiduously avoid giving insurers this opportunity to deny coverage for a covered claim (and given the scope of exclusions few enough claims are covered to begin with). The advice I always give policyholders is this: “Notice is like voting in Chicago – do it early and often.” See generally Marc Mayerson, Pursuing and Perfecting Liability Insurance Coverage: A Primer for Policyholders on Complying with Notice Obligations, 32 Tort & Ins. L. J. 1003 (1997).
But when a policyholder for whatever reason has not provided notice as soon as one would like, then we need to frame the legal question properly for the courts to consider, and analytically the twin principles of “materiality” and “covenant” are key. Insurers are not at the mercy of their tardy policyholders, however, in that they may have a remedy commensurate with the breach. A carrier conceivably may be released from performance if it proves actual harm to its interests from the paths not taken that it would in fact have pursued. Cf. Clemmer v. Hartford Ins. Co., 22 Cal. 3d 865, 883 n.12 (1978) (insurer would need to demonstrate that it would have (i) actually exercised control over the litigation, (ii) plotted and executed a course of action materially different from that undertaken by the insured, and (iii) obtained substantially better results). An insurer may be able to prove its damages from late notice, such as the example Lord Justice Mance provides of losing the opportunity to obtain reinsurance recovery. And no doubt policyholders should act with alacrity in providing notice and getting their insurers involved, but the issue ultimately is whether the courts should mangle the rules of contract to protect insurance companies and deny coverage to policyholders at the time of loss – their time of need. Kicking a fella when he’s down usually is not what anyone considers to be proper, and it is thus all the more surprising indeed where the kicker is a quasi-fiduciary that was paid to be there for the insured precisely at his time of need.