Applying Michigan law, the Sixth Circuit held that when an insurer breaches its duty to defend, it is not automatically subject to damages in excess of policy limits. Rather, under general principles of contract interpretation, “damages beyond the value of the contract” are appropriate only if they “arise naturally from the breach or [ ] were in contemplation of the parties at the time the contract was made.” Stryker Corp. v. XL Ins. America, 681 F.3d 806 (6th Cir. June 5, 2012). In so ruling, the court abrogated prior Sixth Circuit precedent which held that any losses resulting from a breach of the duty to defend were consequential losses and thus would not count towards the limits of liability.

The insurance dispute arose out of litigation against Pfizer and Stryker stemming from the implantation of expired artificial knees. In prior coverage litigation, XL was found liable under an umbrella policy for losses on direct claims against Stryker (the named policyholder) as well as claims against Pfizer for which Stryker was liable pursuant to an asset purchase agreement. The Sixth Circuit affirmed the finding of liability against XL, but remanded the issue of consequential damages to the district court with instructions to “consider what portion, if any, of the total liability for [previous] judgments beyond the $15 million [policy limit] represents consequential damages as defined under Michigan contract law.”  

The Sixth Circuit issued several other noteworthy rulings relating to damages in excess of policy limits.

Priority of Claims: The court rejected Stryker’s argument that XL was obligated to pay direct claims against Stryker prior to making a settlement payment to Pfizer. The court held that because XL entered into a settlement with Pfizer before it was held liable for direct claims against Stryker, Pfizer settlement payments would count against the policy limits. As the court noted, courts in other jurisdictions have similarly held that an insurer may pay claims in any order it chooses.  

Defense vs. Indemnification Costs Towards Policy Limits: The court held that Pfizer’s defense costs in the underlying tort actions did not count towards XL’s policy limits. Because the policy language defined “Insured” in such a manner that encompassed Pfizer, Pfizer’s defense costs were in addition to policy limits. In so ruling, the court distinguished cases in which the term “Insured” did not include third-party beneficiaries and/or additional insureds. However, the court reached a different conclusion with respect to costs associated with Pfizer’s indemnification action against Stryker. Those costs stemmed directly from liability assumed by Stryker under the asset agreement with Pfizer and were thus part of the general grant of coverage and therefore subject to the limits of liability.