The “notice-prejudice” rule gives a pass to policyholders who breach the notice or cooperation provisions of their policies, if the breach is found not to have prejudiced the insurer. Sometimes, the late notice does not arrive until after the policyholder has settled an underlying claim; even in those cases—and even where the policy contains a “no voluntary payments” or a “consent-to-settle” clause—dozens of cases have found that the notice-prejudice rule applies. Last month, however, in Travelers Property Casualty Co. v. Stresscon Co., No. 13SC815 (Colo. April 25, 2016), Colorado’s Supreme Court stood against this trend. In a 4-3 decision, it ruled that a “no voluntary payments” clause is enforceable in strict accordance with its terms. The majority’s rationale was at least as important—and as controversial—as the ruling itself: it based its decision on the ground that a “no voluntary payments” clause is “a fundamental term defining the limits or extent of coverage.”

Unilateral Settlement And The Notice-Prejudice Rule

The notice-prejudice rule generally provides that “breach by an insured of a cooperation or notice clause may not be asserted by an insurer [as a defense,] unless the insurer was substantially prejudiced thereby.” Service Mgmt. Syst., Inc. v. Steadfast Ins. Co., 216 Fed. Appx. 662 (9th Cir. 2007), quoting Nw. Title Sec. Co. v. Flack, 6 Cal.App.3d 134 (1970).

Some courts have found that the rule is a natural outgrowth of contract law—specifically, the “fundamental principle” that only a material breach by one party to a contract can excuse performance by the other. E.g., Hernandez v. Gulf Group Lloyds, 875 S.W.2d 691 (Tex. 1994).

Others have rationalized it on grounds that are specific to insurance contracts. Some decisions stress that many policies are “contracts of adhesion.” E.g., Las Vegas Metropolitan Police Dept. v. Coregis Ins. Co., 256 P.3d 958 (Nev. 2011) (“equity principles support placing the burden to prove prejudice on the insurer because it is trying to deny its obligations under a contract of adhesion”). Others find that the rule is necessary to protect “the insured’s reasonable expectation that coverage will not be denied arbitrarily.” E.g., Roberts Oil Co. v. Transamerica Ins. Co., 113 N.M. 745 (1992). See also Zuckerman v. Transamerica Ins. Co., 650 P.2d 441 (Alaska 1982) (“When enforcement [of a policy term protecting an insurer] does not serve the reasons for the provision’s inclusion in the policy, the insured’s reasonable expectation that coverage will not be arbitrarily denied must be given effect”).

Within the latter group of cases, some courts distinguish among the rules governing different types of insurance provisions. They note, for example, that “exclusions from coverage are to be narrowly and strictly construed because they are contrary to the fundamental protective purpose of an insurance policy.” Estate of Gleason v. Central United Life Ins. Co., 379 Mont. 219 (2015).

On the other hand, as this blog has previously reported, courts that otherwise apply the notice-prejudice rule recognize an exception for claims-made or claims-made-and-reported policies. In these cases, the courts have found that the notice requirement is not merely an element of the insured’s duty to cooperate, or an exclusion to coverage, but, rather, a term that “defines the scope of coverage” itself.

Thus, to excuse late notice in violation of such a requirement would re-write a fundamental term of the insurance contract.

Craft v. Philadelphia Indemn. Ins. Co., 343 P.3d 951 (Colo. 2015). See also Anderson v. Aul, 862 N.W.2d 304 (Wis. 2014); Brenegan v. Fireman’s Fund Ins. Co., No. B254760 (Cal. Ct. App. April 21, 2015).

Why Not Do Both?

As the name suggests, the notice-prejudice rule was formulated in cases in which the insured sought coverage for a claim after failing to give timely notice. But as it gained traction, the rule came to be applied in many other circumstances—including cases in which the insured sought coverage for a third-party claim that the insured had settled unilaterally.

In many of those cases, the insured’s actions violated an express contractual prohibition: either a term stating that the insured may not “settle” a claim without the insurer’s consent, or a more general ban against “voluntary payments.” To date, more than two dozen cases (many, but by no means all, involving uninsured/underinsured motorist coverage) have held that insurers may not enforce those provisions in the absence of “prejudice.” E.g., Mid-Continent Cas. Co. v. BFH Mining, Ltd., No. H-14-0849 (S.D. Tex. Sept. 3, 2015) (applying Texas law); Progressive Direct Ins. Co. v. Jungkans, 972 N.E.2d (807) (Ill. App. Ct. 2012); Beal v. Allstate Ins. Co., 989 A.2d 733 (Me. 2010); State Farm Mut. Auto. Ins. Co. v. Fennema, 137 N.M. 275 (2005).

Those courts that decline to apply the notice-prejudice rule to no-voluntary-payments or consent-to-settle provisions have generally based their decisions on a mirror image of the argument about “reasonable expectations”:

[No-voluntary-payment provisions] are designed to ensure that responsible insurers that promptly accept a defense tendered by their insureds thereby gain control over the defense and settlement of the claim.

Jamestown Builders, Inc. v. General Star Indemn. Co., 77 Cal.App.4th 341 (1999).

These courts have found, in other words, that the purpose of policy terms prohibiting unilateral settlement is sufficiently clear and important to warrant enforcement in a way which furthers that purpose. In a similar vein, in the UIM context, courts have declined to apply the notice-prejudice rule, on the ground note that an insured’s unauthorized agreement to release claims against the tortfeasor “destroys the insurance company’s right to subrogation.” Craig v. Larson, No. 311467 (Mich. Ct. App. Oct. 17, 2013).

On the other side of the ledger, when, in Lennar Corp. v. Markel Am. Ins. Co., 413 S.W.3d 750 (Tex. 2013), the Supreme Court of Texas found that the notice-prejudice rule should be applied to a prohibition against settlement that appeared in a policy’s Insuring Agreement, it based its ruling on a finding that an Insuring Agreement isn’t all that important—or, at least that it “is no more central to the policy than [the no-voluntary-payments clause].”

The Stresscon Case

Stresscon Corporation designs, fabricates, and erects structural and architectural precast concrete structures in Colorado and the Rocky Mountain region. In 2007, one of Stresscon’s subcontractors caused a fatal accident while operating a crane on Fort Carson Army Base near Colorado Springs. Construction delays resulted, and the project’s general contractor looked to Stresscon for the cost of those delays.

Stresscon notified Travelers, its liability insurer, about the claim, and Travelers issued a reservation of rights. On December 31, 2008, Stresscon settled with the general contractor, even though the contractor had neither filed a lawsuit nor demanded arbitration. Stresscon executed that settlement without consulting its insurer. In March 2009—at a time when it still had not given notice of the settlement—Stresscon brought a bad faith action against Travelers and other insurers.

Stresscon’s policy contained a term stating:

No insured will, except at that insured’s own cost, voluntarily make a payment, assume any obligation, or incur any expense, other than for first aid, without our consent.

In the trial court, the insurer attempted to rely on that provision at every stage of the proceedings—moving unsuccessfully for summary judgment, for a directed verdict and for judgment n.o.v. Each time, the court ruled that this no-voluntary-payments clause was subject to Colorado’s notice-prejudice rule, which was adopted by the Colorado Supreme Court in Friedland v. Travelers Indemnity Co., 105 P.3d 639 (Colo. 2005). Although the plaintiff in Friedland had settled an underlying claim without the insurer’s consent, the court focused in that case on the late notice aspect of the insurer’s defense. Applying the notice-prejudice rule to the policy’s notice and cooperation provisions, the Supreme Court held that the unilateral settlement created a presumption of prejudice, which the insured could try to rebut on remand.

The trial court found that the same rule applied to Stresscon’s claims, and the court of appeals affirmed.

It’s Definitive

In reversing all of those rulings, the Supreme Court distinguished Friedland, because, in that case,

[w]e did not … extend our … notice-prejudice rule to no-voluntary-payments or consent-to-settle provisions … . Quite the contrary, we took pains to note that in the insurer’s motion for summary judgment in Friedland, it had expressly raised the no-voluntary-payments provision … as a bar to recover, and we expressly declined to address that issue … .

The court also reasoned that public policy supported enforcing no-voluntary-payments clauses according to their terms, because such enforcement “can hardly be characterized as ‘reap[ing] a windfall.’”

To the extent that an insurer unreasonably delays or denies payment of a claim, its insured is provided specific statutory remedies, including specific penalties, costs, and fees.

Finally, the court found that the case was governed by Craft, supra—the case in which the same court had declined to extend the notice-prejudice rule to claims-made-and-reported policies. According to the majority, the reason Craft applied is that a no-voluntary-payments clause is just as fundamental to defining the scope of insurance coverage as a provision that limits coverage to claims that are reported during the policy period:

Much like the notice of claim provision in Craft, the contract clause at issue in this case, far from amounting to a mere technicality imposed upon an insured in an adhesion contract, was a fundamental term defining the limits or extent of coverage. This so called ‘no voluntary payments’ clause clearly excluded from coverage any payments voluntary made or obligations voluntarily assumed by the insured without consent … .

Stresscon, therefore, is the antithesis of Lennar Corp., supra., which reasoned that an Insuring Agreement is “no more central to the policy than [a no-voluntary-payments clause].” And it was precisely this aspect of the Stresscon opinion which the dissent attacked. The dissent read the court’s previous decisions to hold that the notice-prejudice rule applies

where a provision of an insurance contract does not fundamentally define the scope of coverage, but instead protects the insurer’s opportunity to investigate and defend or settle claims … .

The three dissenting justices denied that a no-voluntary-payments clause could be “fundamental” in this way:

[T]he no-voluntary-payments provision … serves the same interests as the prompt notice provision we addressed in Friedland. … [It] is intended to prevent an insured from unilaterally settling a claim and thereby depriving an insurer of its choice to defend or settle in the first instance. …. Unlike the date-certain notice requirement in the claims-made policy in Craft, a standard no-voluntary payments provision is not a ‘fundamental term of the insurance contract’ because it does not define the policy’s temporal-boundaries nor does it define the scope of the policy’s coverage.

Now What?

In the law of insurance, all contract terms are not created equal. Take exclusions, for example:

[A]ll exclusions are to be narrowly interpreted and all questions resolved in favor of the insured; exceptions and exclusions are to be strictly construed so as to render the insurance effective.

Eberle v. Nationwide Mutual Insurance Co., NO. 2013–CA–000898–MR (Ky. Ct. App. May 6, 2016).

In Stresscon, a slim majority of Colorado’s Supreme Court held that no-voluntary-payments clauses are not subject to those restrictions—and, in fact, that they are entitled to the highest degree of deference that a term in an insurance policy can receive. It remains to be seen whether this view will catch on. If it does, it could become a valuable tool in combating imprudent and collusive settlements.