The Conflict Between Choice-of-Law Provisions in Insurance Policies and a State’s Fundamental Public Policy
Many contracts include a choice-of-law provision in which the parties agree to use a particular jurisdiction’s set of laws to govern the contract. These provisions promote predictability. No matter where a dispute may arise under the contract, the contract will always be interpreted under the laws of the chosen jurisdiction. This practice of including choice-of-law provisions extends to policies of insurance.
However, these choice-of-law provisions are not always enforceable. Section 187 of the Restatement (Second) of Conflict of Laws indicates that the parties’ choice-of-law provision would not govern if it conflicts with a state’s fundamental public policy, and if that state has a materially greater interest in the determination of the issue than the contractually chosen state.
Recently, the Supreme Court of California addressed this issue as it pertained to a choice-of-law provision in an insurance policy in Pitzer College v. Indian Harbor Insurance Co., 8 Cal. 5th 93 (Cal. 2019). In this matter, the insurer, Indian Harbor, denied coverage to Pitzer College following an environmental remediation of land conducted by the school.
The insurance policy at issue contained a choice-of-law provision that indicated New York law would govern the policy. Additionally, the policy included a notice provision requiring Pitzer College to provide notice to Indian Harbor of any pollution condition it discovered, which resulted in a loss or remediation expense as a condition precedent to coverage. Finally, the policy included a consent provision requiring that no “costs, charges, or expenses shall be incurred, nor payments made … without [Indian Harbor’s] written consent.” However, the consent provision did provide an exception that Pitzer College could incur costs on an emergency basis, so long as it notified Indian Harbor “immediately thereafter.”
During the policy period, Pitzer College discovered lead contamination in the soil on land where a new dormitory was being constructed. Approximately two months after discovery of the pollution, Pitzer College remediated the land itself, at a cost of about $2 million. However, Pitzer College did not notify Indian Harbor of the remediation until six months after the discovery of the pollution. Ultimately, Indian Harbor denied coverage for the loss on the basis that Pitzer College did not timely notify it of the loss, or the costs incurred, which was in breach of both the notice and consent provisions of the policy.
Pitzer College brought suit in federal court against Indian Harbor for alleged breach of contract. Specifically, Pitzer College alleged that under California law, an insurer can only deny coverage for an insured’s failure to timely notify of a loss if the insurer can show that it was substantially prejudiced by the delayed notice.
The district court disagreed with Pitzer College’s argument that Indian Harbor had the burden of showing that it was substantially prejudiced by the delayed notice. The court held that because New York, pursuant to the choice-of-law provision in the policy, had a strict no-prejudice law for policies of insurance delivered outside New York, Indian Harbor was not required to show prejudice in its denial of coverage to Pitzer College due to lack of timely notice. As such, the court granted summary judgment in Indian Harbor’s favor. Pitzer College appealed to the Ninth Circuit Court of Appeals.
On appeal, the Ninth Circuit certified two questions to the Supreme Court of California: (1) whether California’s notice-prejudice rule was a “fundamental public policy” for choice-of-law analysis; and (2) whether the notice-prejudice rule applied to the consent provision of the insurance policy.
In determining whether California’s notice-prejudice rule was a fundamental public policy, the Supreme Court of California noted that a rule is a fundamental public policy when it: (1) cannot be contractually waived; (2) protects against otherwise inequitable results; and (3) promotes public interest.
In this matter, the court found that all three elements existed to establish the notice-prejudice rule as a fundamental public policy of the state. For the first prong, the court noted that the notice-prejudice rule could not be waived, because it restricted freedom of contract and prevented the enforcement of a contractual term (technical forfeiture).
As for the second prong of its analysis, the court noted that insurance contracts were “inherently unbalanced” and “adhesive” and that the notice-prejudice rule protects an insured against inequitable results based on an insurer’s superior bargaining power. What is particularly interesting about this part of the court’s analysis is that it did not draw any distinction between the type of policy in this matter (between a large, sophisticated entity such as the Claremont University Consortium and Indian Harbor) and a more common type of insurance policy (between an individual without any bargaining power and a carrier).
As to the third prong, the court found that the notice-prejudice rule promoted objectives that are in the general public’s interest because the rule protected the public from bearing the costs of harm that an insurance policy purports to cover. In other words, by requiring an insurer to show that it incurred substantial prejudice because of untimely notice, the rule lessens the likelihood that a loss covered by the policy would be denied by the insurer based on a technicality. Essentially, the notice-prejudice rule helps to prevent an insurer from “reap[ing] the benefits flowing from the forfeiture” of an insurance policy with a strict notice provision and lessens the risk of placing the burden of the costs of the loss on the public.
As to the second question certified by the Ninth Circuit to the Supreme Court of California, the court held that the consent provision, as it regarded first-party claims, had much of the same effect as the notice provision. Both provisions had the underlying purpose to “facilitate the insurer’s primary duties under the contact and speak to minimizing prejudice in performing those duties.” Because both provisions were inherently the same to the court, the rationale of the notice-prejudice rule would also govern the consent provision. As such, Indian Harbor would have to show that Pitzer College’s failure to obtain consent, as prescribed under the policy, would not be grounds for denying coverage unless it could show that the failure to obtain consent substantially prejudiced Indian Harbor.
It is important to note that the court drew a distinction between first-party claims and third-party claims as it regards consent provisions. Because third-party claims involve liability coverage and the insurer assumes the defense of the matter once defense is tendered by the insured, the rationale behind the notice-prejudice rule would not apply to consent provisions in third-party claims.
By holding that the choice-of-law provision in the Indian Harbor policy would not be enforceable as it relates to the notice and consent provisions, the Supreme Court of California essentially ruled that California courts would not enforce any notice provisions in insurance policies unless the insurer can show that it suffered substantial prejudice due to the lack of timely notice by the insured.
This holding introduces considerable uncertainty in choice-of-law analysis, which is already fraught with complications about where contracts are formed, the location of the risks insured, etc. Sometimes, the difference between certain jurisdictions’ laws are dispositive in insurance disputes. Moreover, not all states rely on the Restatement approach for conflict of laws, and thus the question of “conflict” with that state’s “fundamental polices” may not even come into play. However, if other states adopt the approach in Pitzer College, it may ultimately render choice-of-law provisions moot.