Debate Over the ALI’s “Principles of the Law of Liability Insurance” Continues – Advisers Slated to Discuss Contentious Portions

by Nelson Brown & Co.

At its 2013 annual meeting, the American Law Institute (ALI) voted to adopt sections 1 through 15 of its “Principles of the Law of Liability Insurance.” However, extensive criticism during the floor debate prevented the ALI from voting on some of the more contentious sections presented at that time. As a result, the ALI’s Advisers and Members Consultative Group is scheduled to meet on March 27, 2014, to continue debate on these contentious sections.

The majority of the Principles on which the ALI delayed its vote relate to the scope of an insurer’s duty to defend. One of the more controversial Principles to be debated would require defense counsel retained by an insurer to explain the insurer’s reservation of rights to all policyholders, except large commercial ones. (Draft § 17). This proposed requirement has understandably drawn criticism from many in the industry because it would create ethical concerns for defense counsel retained by insurers. For example, requiring defense counsel to explain to the policyholder whether the insurer’s reservation of rights is of such a nature that the policyholder should hire other counsel is fraught with peril. Additionally, this requirement proposed by the ALI ignores the fact that many defense counsel are not trained or necessarily qualified to provide coverage advice, potentially exposing defense counsel to malpractice claims by disgruntled policyholders.

Another controversial Principle that will be discussed and debated provides that an insurer is estopped from contesting indemnity if it breaches its duty to defend. (Draft § 21). Under the ALI’s proposed Principle, if it is found that an insurer wrongfully failed to defend a claim, the insurer not only loses the right to defend or associate in the defense of the claim, but also the right to contest indemnity coverage for the claim. In proposing this Principle, the ALI is clearly adopting a minority rule. The majority of jurisdictions hold that an insurer’s breach of its defense obligation has serious consequences (i.e., precluding the insurer from challenging the determination of its policyholder’s liability or the reasonableness of settlement). However, the vast majority of jurisdictions have declined to impose an automatic indemnity penalty as proposed by the ALI because such a rule is overbroad, unfairly punitive and interferes with the parties’ contractual rights.

This automatic indemnity rule proposed by the ALI was recently cited by an amicus brief in support of the policyholder’s position in K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co. (N.Y. Sept. 3, 2013) (re-argument granted). It was argued in the amicus brief that the Principles “make clear” that estoppel is “the trend of the law.” While the amicus brief in K2 Investment was unsuccessful, the significance of the Insurance Law Principles project is becoming clear as the Principles gain traction in case law. As the ALI continues to work on the Principles, it will be important to monitor its progress. Although the project’s Advisers are fixed—and only members of the ALI can participate in debate and ultimately vote to adopt or reject the draft Principles as they presented—outside stakeholders can and should help shape what will certainly become an influential text in the area of insurance law by coordinating their efforts with those ALI members affiliated with the project.

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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