A policyholder pays many thousands of dollars in premiums for pollution liablity insurance, only to have a court nullify all coverage on the ground that the insurer didn’t receive timely notice. How can that be?

These facts are, perhaps, not going to present themselves again in many cases, but they do show the lengths to which some insurance companies will go to avoid coverage obligations for which they readily accepted many thousands of dollars in up-front premiums. The great misfortune is that these insurers occasionally convince a court that they shouldn’t have to pay. Here is what happened.

A group of homeowners’ associations and a real estate company sued the City of San Diego over hydrogen sulfide contamination that the plaintiffs alleged had leaked from pipes within the City’s sewer system. The City and other members of the California Association of Counties had purchased pollution liability insurance from Indian Harbor Insurance Company in the amount of $10 million per occurrence and $50 million in the aggregate. The San Diego policies had self-insured retentions of $500,000. Indian Harbor filed a lawsuit against San Diego in the federal district court for the Southern District of New York, seeking a declaration that it did not have to provide coverage for the claims. (Get a copy of the opinion here.)

The Indian Harbor policy contained notice language that will be familiar to all lawyers who do insurance work. It required the City to provide notice to Indian Harbor of “every demand, notice, summons, order or other process received by the insured or the insured’s representative as soon as practicable.” The policy also contained a choice-of-law provision that required the application of New York law to any dispute about coverage. The policies were delivered to the City in California, not in New York.

San Diego provided notice of the first of a trio of lawsuits alleging the gas leaks over 2 years after the suit was filed, but before it had exhausted the $500,000 SIR. As many readers may know, New York was for many years notorious (and very nearly unique among all states) for providing that an insurer could successfully deny coverage on the basis of late notice without showing that the delay in providing notice had resulted in prejudice. That all changed in January 2009, when the New York implemented a statute that abrogated the no-prejudice rule. It provided that a carrier must establish prejudice before it can bar coverage on the grounds of late notice. The rule applied to policies “issued and delivered in New York on or after January 17 2009.”

The reason for requiring prejudice is well-grounded in basic and universal contract law. The breach of a contract is only actionable if the breach is material. Since the purpose of insurance is not only to spread the risks of harm among a great many policyholders but also — in recompense for the payment of premiums up front and in advance of performance — to provide such coverage as will fully meet the reasonable expectations of the insured, a breach of a notice provision cannot possibly be material unless it results in some harm to the insurer’s interests. For example, if the carrier loses a defense to the underlying claim that it might otherwise have had but for the delay in notice, then the late notice can fairly be said to have been prejudicial.

In addition, for purposes of insurance law, a notice provision is a term in the nature of an exclusion. It offers the carrier a way to get out of providing coverage that would otherwise apply and for which it has already been paid. For this reason, notice provisions are typically construed narrowly in favor of finding coverage. Nullification of coverage is the harshest penalty a court can apply to a policyholder. It stands to reason that courts should be loathe to do so unless substantial justice clearly requires it.

When viewed in this light, the New York no-prejudice rule was not merely an anomaly, it was something of an outrage that, fortunately, the legislature saw fit to correct. Accordingly, one would think that policyholders would be entitled to the benefit of the doubt and that courts would — and should — be inclined to apply the New York prejudice statute liberally.

In the case of the City of San Diego, it was not to be. The Court sided with Indian Harbor in concluding not only that 31 months of delay constituted late notice (not at all an unreasonable conclusion) but that San Diego was not entitled to the benefit of the New York prejudice rule: “The question of whether to abolish the common-law no-prejudice rule is therefore a pure matter of public policy for the Legislature and courts of New York to decide,” according to the opinion. “Until this occurs, the [new] notice-prejudice rule sweeps no more broadly than the terms of the statutory provision itself, which is limited to policies issued or delivered in New York after Jan. 17, 2009.” 

Two facts jump out of this holding. First, the Indian Harbor policies at issue were delivered “after Jan. 17, 2009.” Second, the policies were delivered in California (which requires a showing of prejudice to bar coverage for late notice), not in New York. Presumably, if the legislature intended the non-retroactivity of the statutory limitation to apply to any policies under New York law, it knew how to write a statute to effect that intent. Instead, it provided that the limitation of retroactivity should apply only to policies “issued and delivered in New York.” 

The court viewed the prejudice analysis entirely from the insurance company’s perspective. “Even before a self-insured retention has been exhausted, the carrier’s interests that are protected by a prompt notice requirement — including interest in investigating the claim, establishing reserves, and exercising early control over the claim — are fully implicated,” it said. These interests exist, certainly, but why even mention them if the real reason for negating coverage is simply that the prospective provisions of the new statute do not apply? And, having considered these interests, why not consider, as well, the other side of the prejudice coin: the prejudice to the insured in the complete denial of benefits for which it contracted and paid dearly? Why not question whether the interests of the insurer in investigating, setting reserves, and the like, were material? If the investigation can be reconstructed, reserves can be set at any time, and the insurer has not lost a defense to the underlying action, doesn’t the balance of harm suffered by each side fall heavily in favor of the insured?

In fact, if the policyholder really is “self-insured” — that is, providing its own defense and indemnity — for the first $500,000, is it really fair to say that the insurer has an interest in investigating, setting a reserve, or controlling the defense until the case actually does implicate the carrier’s coverage? Carriers that provide excess and umbrella coverage, as well as those that provide coverage that sits atop a significant SIR, routinely respond to notice from their policyholders with letters claiming that the notice is too early and that they plan to do nothing until the policyholder exhausts the underlying limits. Heads, I win; tails, you lose.

Finally, does it really comport with the intent of the legislature, to say nothing of the reasonable expectations of a California insured, to apply the old and grossly unfair no-prejudice rule to policies that were issued and delivered in a state other than New York and on a date after January 17, 2009? 

It is right and just that the old no-prejudice rule in New York is now a relic. Good riddance to it. The shame is that it should ever have been resurrected, with a reach extending clear across the country, to apply to the policies in the Indian Harbor v. San Diego case.