Breaching the Duty to Defend: Remedy for Recovering Peace of Mind
Given the American Law Institute’s recent discussion at its May 2015 meeting, regarding Preliminary Draft No. 1 of the Restatement on Liability Insurance, Chapter 2, Sections 20 and 21, I would like to add my voice to those who support the adoption of the estoppel principle as a remedy for policyholders who have been wrongfully denied a defense by their liability insurers.
The rule that the duty to defend is triggered by unproven allegations, referred to as the “potentiality standard,” recognizes the reality that the insured has no control over how the allegations are plead in liability matters. Furthermore, with notice pleading rules in place in many jurisdictions, it is clear that an insurer’s obligation to defend should not be dependent upon the whims of the plaintiff’s drafting choices.
Contractually and by court interpretation, the right to a defense against unproven allegations is the benefit of the bargain of liability policies, or as Judge Karon O. Bowdre has designated it, “peace of mind” or “litigation insurance.” See also Judge Hamilton’s concurring opinion in CE Design Ltd., et al. v. King Supply Co., LLC, No. 12-2930 (U.S. Ct. App. 7th Cir. 6/30/15) (“When an insurer breaches its duty to defend or indemnify its insured, it’s not just any breach of contract. An insurer’s breach abandons its insured and deprives it of the peace of mind it has bought.”) The rules that have been developed to guide the courts’ analysis of whether a duty to defend exists are lengthy and oft-repeated.
The insured’s purchase of a defense is bundled with the insurer’s buying power for legal services and expertise in defending against the common risks covered by liability policies, be it personal or commercial lines, or specialty risks. It is relatively rare that other than large commercial insureds who handle their own defense within self-insured retentions, insureds rarely trust their own ability to mount a proper defense.
The value of a defense may be underestimated by insurers, but it is certainly calculated in the premium charged for liability policies. When a defense is denied, the insurer abandons the insured to not only defend itself, but to wage an unreimbursed battle against the insurer. The estoppel or forfeiture principle is a meek response to “require or pressure” the insurer to provide the basic “peace of mind” protection afforded by purchasing a liability policy.
The primary argument against forfeiture seems to be the protection of all insurance purchasers not to increase their insurance costs by “requiring the insurer to defend claims where there is clearly no coverage for claims where the probability of coverage is low enough that the probable costs of defending exceed the probable costs to be incurred if refusal to defend is found to be a breach.”
Surely, the “spreading of risk” factor should force the insurer to bear the burden of making the wrong decision, or of having to make a “hard” decision, regarding whether the duty to defend exists. The test turns on whether there is any doubt as to coverage. If the allegations in the underlying case clearly reflect, on the face of the complaint, that there is no coverage, then there is no risk to the insurer. Fairness would dictate that the insurer which is confident of its position that the duty to defend is not triggered by the allegations of the underlying complaint would stand by its decision and refuse to defend, and then not be burdened by any penalty. Insurers who are in the business of litigation never face the “bet the company” case or have to deal with shareholder or investor pressure to manage litigation budgets. And, if the insurer loses its coverage battle and is held liable for either contractual or extra-contractual damages, it just moves on. “Shifting the risk” is their business model. They can afford to lose some battles, because they will win others.
The rub, from the perspective of the insurer, is “what if we are wrong?” In other words, what if there is doubt as to the outcome, and therefore, it is not a situation “where there is clearly no coverage.” The obvious response is that “if there is doubt,” then the insurer should proceed cautiously, recognizing it has something to lose if it makes the wrong decision. It could balance the risk that it is wrong, with protecting the insured by filing a declaratory judgment action, if permissible, to adjudicate the issue which could terminate the duty to defend. As the Illinois Supreme Court noted in General Agents v. Midwest Sporting Goods, 215 Ill. 2d 146, 828 N.E.2d 1092 (2005), the insurer gains as much benefit from the declaratory judgment procedure as the insured gets in being protected, until such time as the insurer can establish, without doubt, that the duty to defend should be terminated. In those cases, in which the insurer’s coverage defenses cannot be litigated until conclusion of the underlying claims, then the insurer should offer to defend under a right of reservation.
It does not offend a common sense of fairness to have insurers face making hard decisions. If that is the common meaning of the word “pressure,” then it is a commercially reasonable and defensible position in which the insurer should be placed. If the “pressure” causes the insurer to provide the benefit of a defense until such time as it can prove to a court that there is no duty to defend, then it should be afforded that opportunity.
When an insurer refuses to defend, the policyholder no longer has the protection he purchased with his premium dollar, and his remedies for the insurer’s breach of the duty to defend can no longer put him in as good a position as he would have been in, if the contract had been performed. Coupled with discretionary standards for obtaining pre-judgment interest for liquidated damages, insureds cannot even count on being reimbursed for lost interest on the defense fees that they have incurred.
Under the American rule, there is no prevailing policyholder fee provision for breach of contract or, as interpreted by the courts, in the bargained-for supplementary payments coverage of a CGL policy. In many states, there are no legislatively mandated “prevailing policyholder” fee awards or only very limited allowable recovery. Courts do not typically award such fees under the declaratory judgment discretionary relief standard.
In fact, only few corporate insureds can afford to “pay and chase” the insurer, and it is the rare personal lines policyholder that can retain a contingency fee attorney with the expertise and resources necessary to engage insurers in coverage battles. Therefore, even the winning policyholder still loses the benefit of the bargain for coverage, since its benefits are diminished by the cost of having to chase and beat the insurer, usually not an inexpensive proposition.
Furthermore, in jurisdictions in which insurers have legislative influence, statutory remedies for bad faith are either non-existent or weak. The awarding of extra-contractual damages is discretionary and limited. Moreover, limited penalties are further diminished by the interpretation by the courts of the “vexatious and unreasonable” standards, which allow the insurer to defend against bad faith liability by arguing that even one plausible coverage defense supported a decision to deny coverage.
Therefore, the estoppel rule of the Restatement can serve to level the decision-making and litigation playing field and to limit the insurer’s unfair use of the ability to say no, where there are doubts as to coverage. If policyholders’ only remedy was to establish a breach, then the insurers have already won. Allowing insurers to refuse to defend and burden the policyholder with the financial commitment to pay for its own defense, pay to pursue or defend coverage litigation, and limit a recovery to contractual benefits, has already diminished the insured’s benefit of the bargain. The Restatement on the Law of Liability Insurance can serve to transfer that risk to the insurer in matters where there is doubt as to the insurer’s obligations.
Estoppel, or forfeiture of defenses against coverage, in the end, is the penalty for a wrongful breach of the duty to defend. If there were no estoppel or additional risk to the insurer, there would be no downside to the insurer for wrongfully denying the policyholder the benefit of its bargain. In fact, the “pay now” or “pay later” choice for insurers, before the estoppel rule was applied to insurers that failed to reimburse defense costs as incurred, was actually no choice at all. The insurer would ALWAYS choose to pay later, if there were no other consequences. The policyholder, on the other hand, is clearly out-of-pocket for the costs of defense as incurred, and is out-of-pocket for the costs of chasing the insurer for the bargained-for benefits under the policy. Without estoppel, the policyholder will not be made whole in situations in which the insurer mindfully decided against providing a defense, sat by the sidelines, and waited while the insured paid for its defense, brought a coverage action, and won the coverage battle.