Where a party is sued, and that party seeks insurance coverage, questions of fact that apply to the underlying case will occasionally overlap with issues relevant to the existence of coverage. For example, whether the defendant insured acted intentionally may be a question in the underlying case and also a question in the coverage action. Where the insurer contests coverage and refuses or limits its involvement, the insured and injured party will often wish to resolve the underlying claim in a way that causes damages to fall solely on the insurance company's shoulders. Arizona courts have given the parties in the underlying case an enormous amount of leeway to do this by establishing the insured's liability through the use of “Damron” and “Morris” agreements.1 For example, if the parties agree that the insured was at fault in an accident, the insurer who has previously refused to defend (a Damron agreement) or defended under a reservation of rights (a Morris agreement) is stuck with that agreement and cannot later dispute its insured's fault (absent some very extraordinary circumstances such as fraud or collusion).

A tougher question is whether the insured and injured party can stipulate to facts that, in addition to establishing liability, also cut off the insurer's ability to disclaim coverage under the terms of the policy. Recently the Arizona Supreme Court weighed in on this issue, and said the answer, essentially, is no: The insurer can still contest coverage despite an agreement between the insured and injured party stipulating to facts that go to both the insured's liability and coverage.

The case is Quihuis v. State Farm Mut. Auto. Ins. Co., CV14-0093-CQ (Oct. 1, 2014). Carol Cox sold her Jeep to Norma Bojorquez, who gave it to her daughter, Iliana. Cox gave Bojorquez the only keys to the car, but did not transfer the title because Bojorquez was to make installment payments. Iliana got into an accident with Yolanda Quihuis. The Quihuises sued Iliana, and the Coxes for negligently entrusting the car to Iliana. The Coxes had a State Farm auto policy , but State Farm refused to defend the Coxes because they had transferred ownership of the Jeep to Bojorquez. The policy did not cover vehicles that the Coxes did not own. The Coxes and Bojorquezes entered into a “Damron agreement”: they agreed that the Coxes owned the vehicle, agreed to request a default judgment for damages against the Coxes that the Quihuises agreed not to execute upon, and the Coxes assigned their rights under the State Farm policy to the Quihuises. The Quihuises filed a declaratory judgment action in federal court against State Farm.

The district court issued summary judgment for State Farm, and the Quihuises appealed to the Ninth Circuit. The Circuit sent the question to the Arizona Supreme Court. Could State Farm litigate whether the Coxes owned the Jeep at the time of the accident? Or was that already determined by the stipulation and default judgment, and so State Farm was precluded from relitigating the issue?

The court applied the Restatement (Second) of Judgments § 58, which provides the following guidance:

  • When an insurance company has an obligation to defend and indemnify the insured, a judgment for the injured person has the following effects on the insurance company in a subsequent action:
    • he insurance company cannot dispute the existence and extent of the insured’s liability to the injured person; and
    •  the insurance company cannot re-litigate issues determined in the action against the insured person as to which there was no conflict of interest between the insurance company and insured.

The court also looked to a 2004 Arizona court of appeals decision,Associated Aviation Underwriters v. Wood, which held that the insurance company could litigate unresolved coverage issues related to the insured’s conduct, but could not re-litigate issues such as fault, causation or damages. Here, the issue was sticky: Ownership of the Jeep was the basis of Quihuises’ claim against the Coxes. However, ownership also determined whether the State Farm policy applied. Nevertheless, the Court found Wood did not conflict. State Farm was not trying to litigate the “existence or extent” of the Coxes’ liability; and so subparagraph (a) of the Restatement did not apply. The ownership issue was not actually litigated in the action between the Quihuises and the Coxes, and so subparagraph (b) of the Restatement did not apply either. Therefore, State Farm was not precluded from litigating whether the Coxes owned the Jeep when Iliana got into the accident.

The court’s decision is based on the peculiar facts of the case. If it had held otherwise, then it would allow the Coxes and Quihuises to stipulate to a fact—one that was contrary to the actual facts—and create coverage under the policy. It would mean State Farm would have been obligated to defend the Coxes, even though there was no coverage under the policy.

While Quihuis was an automobile case, its implications are broader. The issue could arise for example in negotiating a Damron or Morrisagreement stipulating that the negligent individual was the insured defendant’s employee when facts may show otherwise, and the policy only covers defendant and its employees. Insureds should be aware of the possibility that a fact issue that appears decided in a stipulated judgment may arise again in the coverage action – but only if it relates to coverage. Stipulated facts going solely to the merits of the case generally appear to remain safe from a collateral attack by the insurer.

The court also ended with a warning to insurance companies: when they refuse to defend, as State Farm did, they do so at their “peril”. If the court later finds coverage, the insurance company must pay the damages awarded by default judgment, up to the policy limits, unless it can prove the injured plaintiff and the insured defendant colluded or committed fraud. The insurance company also may be liable for contract damages for breaching its duty to defend, and bad faith tort claims. Therefore, “the prudent practice is for an insurer to defend its insured under a reservation of rights and expeditiously pursue a determination on coverage.” The upshot is while Quihuis protects an insurer’s right to dispute coverage, it should not embolden insurers to refuse to defend when they do so.