On September 22, 2011, an appellate court in California issued a ruling that is troublesome, but instructive. Both the Court and the insurer seriously confused the interrelationship of three compatible provisions in the insurer's Commercial General Liability policy, but in different ways. These are the duty to defend as provided for in the insuring agreement; the application of the deductible to defense expenses, as explained in an endorsement; and the inclusion of defense expenses in the Supplementary Payments provision in the policy.

To carry the metaphor further, apples and oranges are both fruit, and like apples and oranges these policy provisions are related, but distinct. The duty to defend is related to and compatible with, but distinct from the application of a deductible to defense expenses. And defense expenses are supplementary payments.

In Zurich Specialties London, LTD v. Century Surety Company, 2011 Cal. App. Unpub. LEXIS 7192 (Cal. App. 4^th Dist. Sept. 22, 2011), Zurich sued Century for equitable contribution for the defense and indemnity it provided to their mutual insured, a sheet metal contractor, in six construction defect lawsuits involving the contractor's work at a number of housing projects in the 1990's.

Zurich had paid about $133,000 to defend the lawsuits. Both Century and Zurich had two policies each in play.

Any claims professional who handles construction defect and other types of long-term exposure, or continuous damage/injury claims, regularly confronts disagreements over allocation of defense and indemnity among carriers. It is not surprising given the number of variables encountered, like the differences among jurisdictions, different criteria applicable to the duty to defend and the duty to indemnify, i.e. potential vs. actual coverage, the trigger of coverage, number of occurrences, allocation theories or principles, the application of deductibles that can vary among the carriers and even among policies with the same carrier, etc.

In this case, Century argued that it had no duty to defend the sheet metal contractor in any of the lawsuits because its deductible of $5,000 per claim applied to supplementary payments which included defense expenses:[1]

Century … argued it had no obligation to participate in Star's defense because the defense costs did not exceed Century's deductible. According to Century, its $5,000 per claim deductible applied to each home included in a lawsuit. For example, one of the underlying lawsuits involved 26 homes and therefore Century argued its deductible for that lawsuit was $130,000-that is, $5,000 per claim multiplied by 26 claims.

The deductible endorsement in Century's policy stated:

“Our obligation under the Bodily Injury Liability and Property Damage Liability Coverages to pay damages on your behalf applies only to the amount of damages in excess of any deductible amounts stated in the Schedule above as applicable to such coverages”… “The terms of this insurance, including those with respect to: a. Our right and duty to defend any 'suits' seeking those damages … apply irrespective of the application of the deductible amount.” (Emphasis added.)

The Court correctly pointed out that the endorsement did not limit Century's duty to defend; that, in fact, Century had a duty (and right) to defend as provided for in the Insuring Agreement, “irrespective of the application of the deductible amount.” Simply, Century should have defended and then worried about the deductible after the payments were made.

So far, so good.

But then the Court went further … not so good because it mixed the apples and oranges and concluded that Supplementary Payments:

…are all expenses Century agreed to pay in addition to attorney fees and other ordinary costs associated with providing a defense. In other words, these expenses are not covered by Century's duty to defend provision. The “Supplementary Payments” coverage therefore supplements the duty to defend; it does not define or limit the duty to defend. Indeed, the “Supplementary Payments” coverage is set forth in a different section of Century's policy, separate and apart from the “Bodily Injury and Property Damage Liability” coverage that creates the duty to defend.

The Duty to Defend Irrespective of the Deductible

The right and duty to defend applies irrespective of the deductible, meaning that the insurer has the duty to defend from the get-go when there is a potential for coverage. The court betrayed its fundamental misunderstanding of what supplementary payments includes by confusing the duty to defend with the application of the deductible to the defense expenses:

Under the “supplementary payments” coverage, Century agrees to “pay, with respect to any claim or 'suit' we defend:” (1) all expense it incurs … These items are all expenses Century agreed to pay in addition to attorney fees and other ordinary costs associated with providing a defense…In other words, these expenses are not covered by Century's duty to defend provision. The “supplementary payments” coverage therefore supplements the duty to defend; it does not define or limit the duty to defend. Indeed, the “supplementary payments” coverage is set forth in a different section of Century's policy, separate and apart from the “Bodily Injury and Property Damage Liability” coverage that creates the duty to defend. Zurich 13-14

Using the “supplementary payments” coverage to apply the deductible to Century's duty to defend ignores the clear statement in the “Deductible Liability Insurance” endorsement that Century's duty to defend “appl[ies] irrespective of the application of the deductible amount.” …

Our interpretation of Century's policy is consistent with the generally accepted rule that deductibles apply to an insurer's duty to indemnify, not its duty to defend: “A 'deductible' is a portion of an insured loss for which the insured is responsible. It generally is 'a specific sum that the insured must pay before the insurer owes its duty to indemnify the insured for a covered loss.' A deductible relates only to the 'damages for which the insured is indemnified, not to defense costs. The insurer is fully responsible for defense costs regardless of the amount of the deductible so long as there is a potential for coverage under the policy.' Century argues that no statute, regulation, or other authority prevents an insurance policy from applying a deductible to the duty to defend. That argument, however, ignores the more pertinent point that Century's policy did not apply the deductible to the duty to defend. We therefore need not resolve the abstract question whether a policy can apply its deductible to the duty to defend because Century's policy simply failed to do so.

Contrary to the Court's assertion, an insurance policy can, of course, include defense expenses in the deductible.

The immediate duty to defend does not supplant the application of the deductible to the expenses incurred in the defense. These are distinct issues. As mentioned previously, if there is a potential for coverage under the policy the insurer has an immediate duty to defend, irrespective of the deductible. In other words, the insurer must defend regardless of whether the deductible is or will be satisfied. So to argue that the duty to defend is contingent on, or begins at the time of, the satisfaction of the deductible contravenes the Insuring Agreement in the policy and the language in the liability deductible endorsement.

Furthermore, supplementary payments clearly and unambiguously includes defense expenses. “All expenses we incur”, the first category of supplementary payments, is about as clear as one can get:

Both the Coverage A and the Coverage B insuring agreements of the CGL policy specify that, beyond the damages the insured is legally obligated to pay, “no other obligation or liability to pay sums or perform acts or services is covered unless explicitly provided for under supplementary payments-coverages A and B .” The supplementary payments section of the policy lists specifically the sums the insurer will pay in addition to the amount of the judgment assessed against the insured for covered injury or damage. The most important of these sums is the cost to defend the insured when a decision is made to contest the claim rather than pay it. Supplementary payments—attorney's fees, court costs, and other expenses—are paid “outside” the policy's limits. They do not reduce or exhaust those limits.

…

In the first category of supplementary payments, the insurer agrees to pay all expenses incurred by it with respect to any claim or suit investigated and settled or defended by the insurer. This would encompass all necessary costs incurred by the insurer, such as legal fees, private investigator fees, expert witness fees, court costs, and the like.[2] The insurer improperly denied a defense obligation based on the amount and application of its deductible. The Court, however, while correcting the insurer, failed to understand the interrelationship among the policy provisions. They are not in conflict with each other. Rather, they are complementary. The Insuring Agreement obligates the insurer to defend. The deductible endorsement specifies that supplementary payments are subject to the deductible but that the duty to defend is activated regardless of the amount of the deductible, or whether the deductible is satisfied. And, finally, supplementary payments include these defense expenses.

[1] Century also argued at the trial level that its policies were excess over Zurich's because of the other insurance condition in the Century policies. Century abandoned that argument on appeal.

[2] http://www.irmi.com/online/cli/ch005/1l05g000.aspx

Special Reports /

Apples and Oranges: CGL Policy Provisions Related, but Distinct

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