When Do “Duty to Defend” Principles Apply to a “Duty to Pay” Policy?

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[author: Richard Robinson]

If an insurer promises to advance “claim expenses” (including attorneys fees) arising from covered claims, does California’s broad duty to defend principles apply, such that the insured need only show the potential for coverage or must the insured show that the expenses were actually incurred defending a covered claim?  Many policyholder-side attorneys may have assumed that – at least in the Ninth Circuit – the law is clear: the same principles typically apply to both “duty to pay” and “duty to defend” policies.  A court in the central district, however, recently refused to apply the broader duty to defend “potentiality” test to a duty to pay policy.  As a result, policyholders need to be ready to explain why this holding should not apply to their particular case.   

In Petersen v. Columbia Cas. Co., the insured Petersen sought to recover “claims expenses” under a professional indemnity policy that promised to advance such expenses on a proportionate basis before the final disposition of a claim.  Petersen, citing the Ninth Circuit decision in Gon v. First State Ins. Co., argued that the duty to advance claims expenses was sufficiently analogous to the duty to defend that the same standard should apply.  Thus, Columbia had a duty to advance so long as Petersen could “show a possibility that there is a covered claim.” 

The court disagreed, noting that Gon addressed when an insurer needs to pay the expenses, rather than how to determine whether expenses arise from covered and non-covered losses.  Instead, the court chose to follow two district court decisions that focused on whether the policy (1) imposed conditions on the insurer’s duty to defend, (2) used the term “alleged” to modify “damages,” or (3) “explicitly” disclaimed the duty to defend.  The court found that the policy’s conditions (that the insurer approve of the attorneys fees and any settlement), as well as its explicit disclaimer of the duty to defend, were “not consistent with the broader duty to defend.”  The court also stated that the policy in question did “not reference ‘alleged’ damages.”  As a result, the court refused to “apply any legal rule  . . . based on a duty to defend policy.”

Any policyholder seeking to establish coverage under a duty to pay policy needs to be ready to distinguish Petersen.  Fortunately, there are a number of arguments available to policyholders as to why Petersen should not apply to their particular case.

The Duty to Pay and United Western Grocers

The most straightforward way to distinguish Petersen is to raise the tried and true principle that a third party complainant’s excluded allegations should not be the sole arbiter of coverage.  Indeed, in United Western Grocers, Inc. v. Twin City Fire Ins. Co., 457 F.3d 1106 (2006), the Ninth Circuit explicitly applied this principle to a duty to pay policy.  In United Western Grocers, the insured had sought coverage for a suit seeking restitution and alleging fraud and breach of fiduciary duty.  The district court held that California’s policy prohibiting coverage of willful acts and claims for restitution was sufficient to bar coverage completely.  The Ninth Circuit panel reversed, noting that the underlying complaint also included potentially covered claims.  Since the breach of fiduciary duty claim was not barred by California’s public policy statute, and the plaintiff’s allegations were not restricted solely to restitution, the insurers had a duty to pay the defense costs.  The court, citing Gon and Gray v. Zurich noted that even in a case that did not involve the duty to defend, “the third party complainant, who may overstate the claims against the insured, should not be the arbiter of the policy’s coverage.”  Id. at 1112.

Does the Policy Cover “Alleged” Damages?

Another option is to focus on the language of the policy.  In Petersen the court explicitly noted that the policy in question did not cover “alleged” damages.  This makes sense, because the broad duty to defend arises from the typical policy language in which the insurer promises to defend suits “seeking” covered damages.  It is understandable, then, for a court addressing the duty to pay question to look at whether the policy defines covered claims in terms of “alleged” damages.  If a policy simply defines coverage in terms of the claims that it will indemnify, then arguably the coverage question should come down to whether a claim is actually covered or not.  If, on the other hand, the policy includes language regarding what the plaintiff “alleges” or “seeks” then the test should be potentiality.  Thus, even under Petersen, one would assume that if your policy defines a covered claim or act in terms of “alleged” damages, you should still be able to assert “duty to defend” arguments, since the principles are essentially the same.

Policyholders have other arguments for distinguishing Petersen.  For example, Petersen reasons that an insurer’s right to approve only reasonable expenses prior to advancing defense fees is at odds with duty to defend principles.  Policyholders should be quick to point out, however, that an insurer defending under a typical GL policy will invariably retain the right to question the reasonableness of the fees charged by independent counsel.  Furthermore, it appears as though the insured in Petersen would have not have been covered even if the court had applied duty to defend principles.  As a result, arguably the entire duty to defend analysis is dicta.  

In the final analysis, policyholders have a number of strong arguments that Petersen is a peculiar case that should be limited solely to its facts. 

Published In: General Business Updates, Insurance Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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