A recent opinion by a New Jersey appeals court holds that liability insurance policies that require payment of defense costs “outside the limits” of liability do not, in fact, require payment of defense costs outside the limits of liability.  Has the New Jersey Appellate Division destroyed the duty to defend?

Most standard liability insurance policies — including, very likely, your homeowner’s and your auto liability policies — expressly require the insurer to defend any suit against the insured without applying the costs of the defense to erode the limits of liability.  If the insured has a policy with $100,000 limits of liability, those limits apply solely to the payment of any settlement or judgment against the insured.  They do not apply to the costs of defending the suit.  If it costs the carrier $200,000, or even $2,000,000 to defend a claim against the insured under that $100,000 policy, the carrier must pay those defense costs until the suit is settled or resolved by a judgment.  The carrier’s defense obligations stop only after it pays the $100,000 limits in settlements or judgments.

It is universally understood by all policyholders, by all insurance companies, by courts, and by essentially every other authority on insurance that this is how the duty to defend works.  It is entirely possible for a carrier to be exposed to the payment of defense costs that, in the aggregate, exceed the limits of liability in the policy.  That is the bargain the parties made when the policy was issued.  The insurance industry has been making a great deal of money since at least 1946, when the Comprehensive General Liability insurance policy came into existence, on the basis of this bargain.  The CGL policy puts the insurer in charge of defending covered lawsuits and paying for the costs of defense.  Insurers accomplish this task more efficiently and far more cheaply than the insured is likely to be able to accomplish it.  This is because carriers have a stable of “panel counsel” to call upon to defend their insureds.  These are, typically, experienced trial lawyers who are willing to work for the insurance company for greatly reduced hourly rates in exchange, usually, for the prospect of a steady book of work from the insurer.

On September 30, 2014, the New Jersey Appellate Division eliminated the duty of an insured’s carriers to pay for defense costs outside of policy limits, even though the policies in question expressly stated that defense would not erode the limits.  The case is IMO Industries v. Transamerica, et al. , Docket No. A-6240-10T1 (Sept. 30, 2014) (Get a copyhere).

It would appear on reading the holding of this case that CGL coverage has now been stood on its head.  How could that have happened?

IMO was a very complex coverage case that involved dozens of insurance companies insuring nearly $2 billion worth of liabilities, with policies dating back to the 1930s.  IMO was a defendant in approximately 75,000 underlying asbestos personal injury claims for which it sought defense and indemnity coverage from its liability carriers.  It had reached interim agreements with its primary carriers (the carriers that provided the first of several layers of insurance coverage) under which IMO and the insurers shared indemnity payments to settle the underlying personal injury claims and under which several of the carriers shared among themselves the payment of 100% of IMO’s defense costs.  The parties complied with these interim agreements until the carriers began to take the position that their policy limits had been exhausted by the payment of defense and indemnity costs.

The “lead” insurer of the group of carriers was Transamerica Insurance Group, or TIG, which had been paying defense costs associated with the underlying personal injury cases for a number of years under a policy that provided that defense costs were “outside the limits” of liability in the policies.  The TIG policies had limits of liability of $1 million and the policies provided that TIG’s coverage obligations would come to an end only after it had made indemnity “payments” totaling $1 million.  Until that time, it had an obligation to defend IMO without respect to the amount of the defense costs.  Since the underlying personal injury claims were being settled for small payments, some of them for as little as a few thousand dollars, the TIG policies would not be exhausted by these payments for many years.  TIG’s defense payments, on the other hand, significantly exceeded $1 million.

According to the New Jersey court, the main issue on the appeal was “whether TIG must cover defense costs for an endless or indefinite time until it has actually paid the indemnification limits of its policies, or whether those policies were exhausted and TIG has no further obligations to IMO.”  Those of us who have been practicing in the insurance arena for many years could not have fathomed, before reading that sentence in the opinion, that the answer to such a question could ever be the subject of any serious dispute.  Of course TIG had to continue to pay defense costs until its policy limits were exhausted.  How could it possibly be otherwise?  If an outside-the-limits defense obligation were not enforced, then a central reason for paying premiums for such coverage in the first place would be utterly destroyed.  Remarkably, though, the IMO court held that TIG’s defense-cost payments would be added to the indemnity payments it had made to determine if the policies had been exhausted.  It then held that, since defense and indemnity payments totaled more than the limits, TIG had overpaid and IMO must pay TIG back.  It would appear at first blush on reading the holding of this case that CGL coverage has now been stood on its head.  How could that have happened?

It appears to have happened, at least in part, because of that age-old cliché that hard cases make bad law.  This case really was quite unusual.  It will be the rare case in which an insurer would be required to pay 15 or 20 times its policy limits in defense costs before exhaustion of policy limits by indemnity payments.  It would seem that it simply didn’t sit right with the trial judge and the Appellate Division that a carrier could be required to continue defending an insured indefinitely.  It also appears from references in the Appellate Division’s opinion that the trial judge believed, incorrectly, that no insured could reasonably expect to received more from its carrier in defense costs than the policy limits.  Of course, that is precisely what the policy (which is drafted, after all, by the insurance industry) says can happen; it is the basis upon which the insured pays up-front premiums for the coverage; and it is major selling point of the CGL policy that the insurance industry has been marketing since 1946.  It is, in short, absolutely within the reasonable expectations of an insured that the carrier will perform its defense obligations exactly as the carrier has promised in writing that it would do.

It appears to have happened, at least in part, because of that age-old cliché that hard cases make bad law.

Not for nothing: there is also a substantial body of case law — which IMO and amicus curiae (friend of the court) parties cited to the court — that recognizes precisely what the trial judge held could not be within the parties’ expectations; that insureds actively seek liability coverage with defense costs outside the limits and that such coverage may far exceed the carrier’s indemnity obligations.

Nevertheless, the circumstances in this case were undoubtedly an extreme instance of defense costs exceeding policy limits.  And the case was decided in the context of an allocation scheme that the New Jersey Supreme Court first fashioned in 1993 (in a case called Owens-Illinois v. United Ins. Co.) and has been refining ever since.  In cases such as this one, where multiple policy periods and layers of coverage are triggered by claims that the policyholders products or actions have caused harm for many years, the New Jersey courts allocate coverage among the triggered insurance policies on a pro-rata basis, in accordance with the years on the risk times the limits of the policies.  The New Jersey Supreme Court has fashioned this scheme as a way to ameliorate the difficulties inherent in resolving monster cases such as IMO, which usually involve incredibly complex insurance programs spanning decades of coverage for liabilities arising out of thousands of underlying suits against the insured.  The Court has even said that the language of the policies must sometimes yield to the interest of efficiency and predictability in resolving allocation problems in this complex coverage area.

It was, in fact, prior cases in which the New Jersey Supreme Court refused to enforce a policy provision that was contrary to the Owens-Illinois allocation model that provided theIMO court with the rationale it sought to ignore the defense obligations contained in TIG’s policies.  “As we have stated, policy terms and traditional principles applicable to ordinary coverage litigation must bend insofar as they conflict with application of the Owens-Illinoisframework.”  The IMO court found just such a conflict in the fact that TIG had paid 15 to 20 times its policy limits in defense costs to IMO, with no real end in sight.

The IMO decision also illustrates how important it can be to frame a case with language that grabs a court’s attention.  TIG called the obligation to defend outside policy limits the “running spigot theory” of defense costs.  That visually and emotionally evocative characterization appears to have struck a chord with both the trial judge and the Appellate Division, as it was referenced repeatedly in the IMO opinion.  Of course, it is absolutely accurate to observe that a “running spigot” is precisely what the insurance industry intended to market and sell to policyholders when it drafted the defense obligation into the CGL policy.  But there is something about the running spigot of defense payments that simply  seems somehow unfair.

Perhaps the most important take-away from the IMO decision is that it is most unlikely to apply to the average policyholder’s homeowners or auto policies.  Here’s what the court said about the statements the trial judge, Judge Donald Coburn, said about the defense obligation in IMO’s policies:

We recognize that some of Judge Coburn’s statements in his oral decision of May 24, 2011, if applied to other types of liability coverage, may deviate from the expectations of insureds who purchase “outside the limits” policies and pay premiums to cover all their litigation expenses. But Judge Coburn was not addressing a typical insurance claim for a single occurrence and a single insurance policy. He was deciding how the allocation model established in Owens-Illinois and Carter-Wallace should apply to long-tail claims, with many primary and excess policies covering years of loss, some of which did not have defined limits of coverage for defense costs. As Judge Coburn stated in his decision, “exhaustion may mean one thing in one context [and] it may mean another thing in another context.”

As if this statement were not a sufficiently clear signal from the court that the decision to deprive IMO of its outside-the-limits defense coverage would apply to IMO only, the Appellate Division also said the following:

To allay some of the fears expressed by amicus curiae, the exhaustion decision in this case is closely tied to its facts. We reach no general conclusion that an insurer’s obligations to cover defense costs and other litigation expenses through an “outside the limits” policy is limited by the maximum amount of indemnification coverage provided in that policy.

The problem with “designer” decisions such as this one, which fashion a remedy that is supposed to apply only to the parties directly before the court, is that they often create mischief.  First, one never knows for sure if a court in some future case might not find the facts and circumstances sufficiently similar to the facts in IMO to deprive yet another policyholder of the defense obligations it purchased with its premium dollars.  Second, this kind of decision-making by an appellate court is contrary to the principals of stare decisis on which our entire system of common law is supposed to be based.  Appellate courts are supposed decide cases in such a way that the rules they fashion apply in a universal way, so that future litigants have a measure of predictability in the commerce with their fellow men.

When a court has to couch its decisions in language that, at the very least, suggests that the ruling of the case should, perhaps, not apply to anyone else, it does violence to the principle of stare decisis.  In fact, there is a certain irony in the way the IMO decision was resolved; the court, on the one hand, ostensibly refused to hold the carrier to the full measure of its coverage obligation on the ground that doing so was the only way to be faithful to the principles of efficiency and predictability that are the foundations of theOwens-Illinois framework.  On the other hand, by suggesting — without coming out and saying so expressly — that the rule it applies here might not apply to other carriers and insureds, it has sown some serious potential uncertainty about whether future trial courts are expected to enforce the duty to defend as agreed by the parties.

The only way to eliminate this uncertainty now would be for IMO to seek appellate review and for the New Jersey Supreme Court to grant it.