Few areas of the law are as underappreciated as insurance coverage law. However, in today's climate, it is practically impossible to be involved in litigation and not be confronted with insurance coverage issues from time to time. While the reality certainly is that litigation is expensive, almost every client has liability insurance to provide coverage for litigation expenses in certain types of lawsuits. Therefore, a basic understanding of how liability insurance works is of critical importance, to clients as well as their in-house and outside counsel. With a full appreciation of the lack of glamour inherent in insurance coverage law, this article will outline the most important insurance coverage issues that everyone involved in the litigation process should know.

Initially, it is useful to clarify the types of insurance coverage. Broadly, insurance is divided into two types: first party and third party. First-party policies provide coverage for losses incurred directly by the policyholder. Examples of first-party policies are health insurance, life insurance and fire insurance.

Third-party insurance is a wholly different animal. The classic third-party policy is a liability policy which covers the policyholder for claims brought against it on grounds that it is liable to a third-party. These policies generally provide funding for defense expenses as well as settlements or judgments. For instance, if a lawsuit arises from a car accident, liability insurance will pay to defend the defendant driver as well as fund the resulting settlement or judgment. Examples of third-party policies are Comprehensive (sometimes "Commercial") General Liability policies (aka CGL policies); directors and officers liability policies (aka D&O policies) and errors and omissions policies (aka E&O policies).

This article focuses on liability insurance and addresses the common situation in which the client is having trouble obtaining a commitment from its liability insurer to pay defense expenses in a current lawsuit. At this early stage of litigation, a client or lawyer without an understanding of insurance coverage law is at a severe disadvantage, because some of the most important principles of coverage law run contrary to common sense. Insurers are well aware of this and often deny claims improperly, gambling that the policyholder will use its common sense, rather than the law and decide to drop its claim. If you take nothing else away from this article, take this: never assume that the insurer's argument against coverage is legally sound, no matter how sensible it may appear.

With that preamble, the following "rules" provide some basic knowledge that could prove invaluable if or more likely when, issues of liability coverage arise in litigation.

1. If an Insurer Denies Its Defense Obligation, Do Not Accept It Without Fully Investigating

Insurers and their coverage counsel are very adept at writing convincing denial letters which sound logical and appear to make sense. Never take the statements in these letters at face value. The reality is that insurers know that a well-crafted denial letter will often cause a policyholder to drop its claim rather than fight for coverage. Before even considering the validity of an insurer's position, it is absolutely critical that you obtain a complete copy of all potentially relevant liability policies, including all endorsements and amendments to those policies. Gather all relevant documents (e.g., correspondence with the insurer, application, complaint, discovery responses and deposition transcripts). Check the language the insurer is relying on to deny coverage. Sometimes the insurer will paraphrase policy language to its advantage. More often, insurers simply omit policy language which would provide coverage, while spending pages citing inapplicable provisions. Finally, check the insurer's recitation of the facts and its characterization of the claims. Often the insurer manipulates the facts to support its position. Even if the facts are correct and the policy language is properly quoted, do not stop your analysis — coverage may nonetheless be available, as the remaining points will illustrate.

2. Even if the Specific Causes of Action Are Not Covered, Look at the Factual Allegations. An Insurer Must Provide Coverage if the Facts Support Potentially Covered Claims

Whether a complaint triggers coverage under a liability policy does not depend on the specific causes of action pled in the complaint, but rather on whether the facts pled could support a covered claim. Waller v. Truck Ins. Exchange, Inc., 11 Cal.4th 1, 19 (1995). For instance, a complaint might contain solely causes of action for intentional wrongdoing. As it is black-letter law that insurance may not cover intentional wrongdoing, the insurer will likely deny coverage on that basis. However, if the claims for intentional wrongdoing assert facts which would support negligence claims as well, this denial would be improper. Because the facts support a covered claim, the insurer would still have a duty to defend and indemnify despite the language chosen by the plaintiff's counsel in drafting the complaint.

Similarly, business disputes often involve complaints which only assert breach of contract claims. Liability insurance generally does not apply to pure breach of contract claims and the insurer may well deny coverage on that ground. However, contract disputes often contain facts which trigger coverage for other claims not based in contract. For instance, claims for defamation, invasion of privacy, infringement of copyright and misappropriation of trademark or likeness are usually covered claims under the advertising and personal injury coverages in a liability policy. Alternatively, such claims may be covered under directors and officers liability or errors and omissions policies. Before accepting an insurer's position that a contract dispute does not trigger coverage, analyze the facts to see if they support other covered claims.

3. Late Notice Is Only a Valid Reason to Deny Coverage if the Insurer Can Prove Actual Prejudice from the Late Notice

Upon receiving notice of a lawsuit, the client should tender the claim to its insurers. It is good practice for outside counsel to confirm with the client that the claim has been tendered.

If the claim is tendered late, the insurer may deny coverage based on the policyholder's providing late notice. Policies often contain seemingly iron-clad notice provisions, which on their face purport to bar coverage. However, this is a situation where the law overrides the specific language of the policy. In general, an insurer may only properly deny coverage based on late notice if the insurer can show actual, substantial prejudice from the delay in notice. See Shell Oil Co. v. Winterthur Swiss Ins. Co., 12 Cal.App.4th 715 (1993).

This "notice-prejudice" rule applies regardless of how the notice provision is worded. Even if notice is described as a "condition precedent" to coverage, it does not apply to bar coverage. Hanover Ins. Co. v. Carroll, 241 Cal.App.2d 558, 565 (1966). Moreover, notice may not be asserted as a basis for denial of coverage if the insurer also asserts any other grounds for denial. CNA Casualty of California v. Seaboard Surety Co., 176 Cal.App.3d 598, 617 (1986).

Courts that have applied the "notice-prejudice" rule have rarely found in favor of the insurer and generally have made it nearly impossible for an insurer to deny on this basis. For instance, it is not enough to allege that late notice impacted the insurer's ability to investigate the claim or effect early settlement. Northwestern Title Security Co. v. Flack, 6 Cal.App.3d 134 (1970). Only serious, significant actual prejudice against the insurer will support a denial based on late notice.

4. If the Insurer Has a Duty to Defend Any Claim in a Lawsuit, It Must Defend All the Claims

Even if an insurer accepts its defense and indemnity obligation, it remains important to evaluate just what the insurer has agreed to do to satisfy that obligation. It is unfortunately common for insurers to accept the duty to defend and then, inappropriately, seek to limit that duty. The most common argument insurers use to try to limit their defense obligation is to point to uncovered claims in the complaint and seek to only pay a pro-rata share of the defense based on the number or size of covered versus uncovered claims. Although it may appear sensible at first blush that an insurer should only be obliged to defend potentially covered claims, the law reaches the opposite conclusion. Even if some or even most of the claims asserted in a complaint are not potentially covered, the insured is entitled to an immediate defense to the entire complaint as long as at least one claim is potentially covered. Presley Homes, Inc. v. American States Ins. Co., 90 Cal.App.4th 571, 575 (2001); Buss v. Superior Court, 16 Cal.4th 35, 48 – 49 (1997). The Buss case is a perfect example of this principle. In that case, the court found that the Lakers owner was entitled to a full defense to a complaint containing 27 causes of action, of which only one was found to be potentially covered.

Similarly, insurers will sometimes attempt to limit their defense obligation by arguing that because multiple insurance policies owe a duty of defense (for example, in a continuing loss pollution case), each insurer is only responsible for its pro-rata share of the defense. While it is possible for multiple insurers on a single case to work out apportionment of defense fees among themselves, the fact is that each insurer owes the policyholder a 100 percent defense to the entire claim. Courts have held that when an insurer pays the policyholder only a pro-rata share of defense, it is the functional equivalent of a wrongful denial. Haskel, Inc. v. Superior Court, 33 Cal.App.4th 963, 976 fn 9 (1995); State of California v. Pacific Indemnity Co., 63 Cal.App.4th 1535, 1545-1548 (1998).

There is a dark cloud underneath the silver lining that this case law provides. Although the courts have created this 100 percent defense obligation as a prophylactic measure to protect policyholders, courts do recognize that the insurance policies should not have to pay for uncovered claims. Therefore, at the conclusion of a case, an insurer may seek reimbursement from its policyholder for any defense expenses "that can be allocated solely to the claims that are not even potentially covered." Buss, 16 Cal.4th at 52. Needless to say, this is a difficult burden; only rarely have insurers sought such reimbursement. Nevertheless, the client and counsel must be aware of the possibility of such a reimbursement action at the end of the case.

5. Even if There Is No Potential Coverage, the Insurer May Still Be Liable

On occasion, an insurer will accept a defense obligation and later determine that it never should have accepted the defense because the complaint did not contain any potentially covered claims. This is a rare occurrence, but does happen. In such a situation, the insurer may demand reimbursement of amounts paid, refuse to pay previously promised fees and expenses and/or simply cut off payments. Even if the insurer is correct and there never was a potential for coverage, all may not be lost. Under principles of waiver and estoppel, the insurer may still owe a duty to the policyholder. This is particularly true if the insurer's basis for withdrawing the defense is a fact which was known or should have been known by the insurer at the time it accepted defense.

The argument is that, unlike the insurer, the policyholder is not in the insurance business. The policyholder can take the position that it reasonably believed the insurer had fully investigated the facts at the time it accepted the defense obligation. While insurers usually reserve their right to withdraw from defense, they are only allowed to do so based on additional allegations or facts discovered later in the litigation. If the fact was known or should have been known to the insurer at the time it accepted defense, the insurer's recent discovery of the fact is tantamount to an admission of grossly negligent claims handling by the insurer. Therefore, when an insurer accepts defense without reserving its right to assert a known potential coverage defense, the insurer is precluded from later denying coverage on that basis. See Miller v. Elite Ins. Co., 100 Cal.App.3d 739, 755 (1980). Moreover, if the policyholder reasonably relied on the insurer's acceptance of defense and suffered damages as a result of that reliance, the insurer is estopped from denying coverage. See Insurance Co. of the West v. Haralambos Beverage Co., 195 Cal.App.3d 1308, 1321 (1987). 

The conclusion to be drawn from these five basic rules is that it is unwise to give up on insurance coverage without a thorough analysis of the insurer's position. More often than not, an insurer's initial denial of coverage is not the last word on the subject. The rules presented above should assist in cutting through the more common misconceptions regarding coverage and allow you to respond to insurers' arguments. However, not everyone can be — or wants to be — an insurance coverage guru. Do not hesitate to contact White & Case should you be faced with a recalcitrant insurer either refusing to defend or delaying in providing a coverage response. Sometimes, a single letter from a lawyer armed with an understanding of coverage law is enough to transform a denial of coverage into an agreement to fully fund the policyholder's defense.