May an insurance policy include an exclusion that essentially eviscerates the fundamental nature of the coverage it provides?  A federal court in Texas says, “No.”

Disputes often arise between policyholders and insurers under liability insurance policies about whether a policyholder was aware at the time it purchased insurance coverage of facts and circumstances that reasonably placed the policyholder on notice of the reasonable likelihood of a subsequent claim.  Conceptually, it makes sense that a policyholder should not be entitled to run out to the insurance market to purchase indemnification for wrongful actions that it already has committed and that it knows are likely to subject it to subsequent claims for liability.  At times, however, insurers have gone overboard in attempting to protect themselves from “known” losses by imposing upon policyholders expansive disclosure requirements in application forms as well as inserting similarly broad exclusionary language in standard insurance liability coverage forms regarding an insured’s “prior knowledge” at the time of the policy’s inception.

A recent Texas decision demonstrates that, while insurers are well within their rights to prevent indemnifying policyholders for known liability exposure at the time of contracting, courts may elect not to enforce broadly drafted prior knowledge exclusions as written if such a result would interfere with the fundamental nature of the coverage provided.  InOneBeacon Insurance Co. v. T. Wade Welch & Associates, 2014 WL 28673701 (S.D. Tex. June 24, 2014) (get a copy here), at issue was a law firm’s claim under its professional liability policy seeking indemnification for its potential responsibility stemming from malpractice allegations.  OneBeacon disclaimed coverage by invoking the policy’s prior knowledge exclusion on the grounds that Welch was aware of some of the alleged wrongful acts that subsequently resulted in the malpractice claim prior to the policy’s December 2007 to December 2008 coverage period.

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At times, insurers have gone overboard in attempting to protect themselves from “known” losses.

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The prior knowledge exclusion broadly encompassed “any claim arising out of a wrongful act occurring prior to the policy period if, prior to the effective date of the [policy] . . . [the insured] had a reasonable basis to believe that [it] had committed a wrongful act, violated a disciplinary rule, or engaged in professional misconduct.”  The policy defined a “wrongful act” as “any actual or alleged act, error, omission or breach of duty arising out of the rendering or the failure to render professional legal services.”  As written, this exclusion broadly encompasses claims based on any wrongful act committed by a policyholder prior to the policy’s effective date so long as the policyholder believed (or reasonably should have believed) that it had acted wrongfully, regardless of whether it reasonably could have or should have believed that the act ultimately would result in a claim against it that would trigger the policy’s liability coverage.  Pursuant to this language, OneBeacon took the position that, because the discovery dispute in the underlying action that ultimately led to the malpractice claim was ongoing at the time the policy was issued, Welch had “a reasonable basis to believe that it had committed a wrongful act” at the time it purchased its malpractice coverage because he was aware, or reasonably should have been aware, that he had mishandled aspects of the discovery process in the underlying action (regardless of whether he reasonably could have or should have believed that this conduct would ultimately lead to his client bringing a malpractice claim against him).

Analyzing the plain meaning of the exclusionary language as written, the court concluded that the prior knowledge exclusion was sufficiently broad to encompass Welch’s current coverage claim because the malpractice action was based on Welch’s mishandling of a discovery dispute that occurred in part prior to the policy’s December 2007 inception date and because Welch was well aware that some of his conduct had been substandard (regardless of whether he was aware at the time that the conduct would result in an order of “death penalty sanctions” in the underlying action that would lead to a subsequent malpractice claim against him). Notwithstanding the plain meaning of the exclusionary language, however, the court concluded that interpreting the prior knowledge exclusion strictly as written would be inconsistent with the policy’s January 1995 retroactive coverage date, which operated to provide coverage for liability “caused by a wrongful act which takes places before or during the [December 2007 to December 2008] policy period and after the [January 1995] retroactive date.”  As the court astutely observed:

[I]f one were to interpret the prior knowledge provision in accordance with its plain language, the retroactive coverage would be illusory because no ‘wrongful act’ that the attorney was aware of, but did not think would result in a claim, would be covered.  These claims also would not be covered by a prior insurer, since the Welch Firm was only required under the application to report known claims, suits, or incidents, acts, or omissions ‘that may in the future give rise to a claim or suit’ to its former insurer.  Thus, the insurer’s construction creates an unintended gap in coverage.

The court ultimately held that, when properly interpreted in the context of the coverage provided and the circumstances present at the time the parties formed the contract, the prior knowledge exclusion “applies only to a claim arising out of a wrongful act if the insured could reasonably foresee it would result in a claim” rather than applying the more broadly written “reasonable basis to believe that [it] had committed a wrongful act” language.

Put simply, the Southern District of Texas federal district court got it right.  While insurers certainly are entitled to protect themselves from indemnifying likely claims known by policyholders as of the policy’s effective date, they should not be permitted to draft such exclusionary language in a manner that effectively eviscerates a significant portion of the expected coverage for which policyholders pay significant premiums.  When faced with a claim denial based on broad prior knowledge exclusionary language similar to the provision at issue in OneBeacon, policyholders accordingly should always keep in mind that under no circumstances should even the most unambiguous exclusionary language be enforced as written if it would operate to render illusory or otherwise frustrate the fundamental nature of the coverage provided.