Duty to Defend and Duty to Indemnify

This practice note addresses the two major duties that an insurer commits to providing under an insurance policy— the duty to defend and the duty to indemnify.

Insurers draft special contracts, called insurance policies, providing certain coverages to insureds and certain duties by insurers in the event of a covered loss. Covered loss will be defined in each type of policy and will vary based on the type of policy sold to an insured. The two major duties that an insurer finds itself obligated to an insured for are the duty to defend and the duty to indemnify. The duty to defend is a term that describes an insurer’s obligation to provide an insured with a defense to claims made under an insurance policy. The duty to indemnify describes an insurer’s obligation to pay a claim for loss or damage against an insured.

For additional insight into these concepts, see Duty to Defend and Duty to Indemnify Checklist; Insurer Duty-to- Defend Standard State Law Survey.

Basics of an Insurance Policy

The duty to defend and the duty to indemnify are primarily found in liability policies—those with third-party coverage implications. The basic rule of insurance policies is that, in exchange for payment of premium, the insured is entitled to compensation for those losses covered by the insurance policy during the insurance policy period. The first step in making the determination of coverage is to review the insurance policy and determine if the occurrence falls within the scope of coverage.

For guidance on what the Restatement of the Law of Liability Insurance provides with respect to the duty to defend and the duty to indemnify, see New Appleman on Insurance Law Library Edition § 16A.02.

The Insuring Clause

The analysis of potential coverage must begin with the insuring clause (also known as the insuring agreement). There may be some variances in the standard language that an insurer uses, but most policy language is common and a large percentage of commercial liability policies and personal lines insurance policies are from the Insurance Services Office (ISO) or American Association of Insurance Services (AAIS). ISO and AAIS are services that provide standard forms and rules for the industry. Both ISO and AAIS are reputable, well-established organizations that provide various coverage forms to their subscribers.

Typical Commercial General Liability (CGL) language for the insuring agreement is along the following lines:

The Company will pay on behalf of the insured all sums which the insured shall become legally obligated to pay as damages because of bodily injury or property damage to which this insurance applies caused by an Duty to Defend and Duty to Indemnify

occurrence and the Company shall have the right and duty to defend any suit against the insured seeking damages on account of such bodily injury or property damage . . . .

Numerous terms in the above clause are defined elsewhere in the policy, including bodily injury and property damage and suit, as well as occurrence.

Law students attending their first day of my insurance law class often hear: : “You must pay very close attention to what the insuring agreement is and what it is not. What the front page giveth with a short insuring agreement, the next section, ‘Exclusions,’ taketh away.” Students quickly learn that for every policy they are analyzing they must closely read bodily injury and property damage definitions, because that is the starting point.

Duty Triggers

The insuring agreement spells out that the insurer’s two duties are a duty to indemnify and a duty to defend. These duties are triggered if an occurrence leads to an insured making a claim for “bodily injury” or “property damage” that happens during the policy period. While both duties are related to each other, you must understand that each of the duties is separate and each is governed by different standards. Generally, liability policies provide insureds with coverage for tort types of actions. However, at least one jurisdiction had broadly read language in the insuring agreement that reads “legally obligated to pay damages” to apply to contract damages in addition to tort damages. Vandenberg v. Superior Court, 21 Cal. 4th 815, 838 (Cal. 1999).

For additional insight on initiating coverage and triggering the duty to defend, see New Appleman on Insurance Law Library Edition §§ 16.03, 17.01.

Burden of Proof

When it comes to establishing an insurer obligation for coverage, the insured must establish that the claim it has made falls within the scope of the policy’s coverage. Once the insured has established coverage, the burden is on the insurer to show that an exclusion applies or there otherwise is not coverage. If the insurer finds that an exclusion applies or there otherwise is not coverage, then the insured must show that there are applicable exceptions to the exclusion.

The Duty to Defend

Of the two duties of an insurer, the duty to defend is a much broader duty. The duty to defend is also litigated more often. The language from the sample CGL provision above states that the duty to defend is where “the Company shall have the right and duty to defend any suit against the insured seeking damages on account of such bodily injury or property damage . . .” The duty to defend is not only a duty, but a right of the insurer. The language imposes a duty to defend the insured against any suit that seeks damages that may be covered by the policy. An insurer’s obligation to defend is determined by comparing the allegations of the underlying complaint against the coverage afforded under the policy. If even a single claim potentially falls within coverage, the insurer generally must defend the entire action, even if the underlying lawsuit or claim is groundless, false, or fraudulent.

An insurer ignores its duty to defend at great peril. Should an insurer wrongly deny an insured defense obligation, the consequences may be breach of the covenant of good faith and fair dealing. Furthermore, a general rule that has developed from case law in the various states is that if an insurer wrongfully refuses to defend its insured, it is liable on the judgment. See Gray v. Zurich Ins. Co., 65 Cal. 2d 263 (Cal. 1966). Insurers must carefully review the four corners of the complaint and determine if the allegations contained in the complaint bring potential coverage under the policy in question.

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Insurers should also keep in mind that courts in many jurisdictions review the unequal bargaining positions of the insured and insurers. Ambiguities from the unequal bargaining positions are held against the insurer, which drafted the policy. The courts often also try to determine the reasonable expectations of the insured.

Practitioners should also be aware that, while the general rule is that the insurer must consider the four corners of the complaint to determine defense obligations (see below for Texas and its unique eight corners rule), some jurisdictions have addressed the question of whether an insurer might have a duty to defend in cases where the pleadings do not allege a covered occurrence but the insurer has actual knowledge of facts that would support a position that the lawsuit involves such an occurrence. For example, in Fitzpatrick v. American Honda Motor Co., 78 N.Y.2d 61 (N.Y. 1991), the highest court of New York answered that question in the affirmative, finding that “the insurer cannot use a third party’s pleadings as a shield to avoid its contractual duty to defend its insured.” Because the insurer drafted the policy and because of its stronger bargaining power and leverage, all doubts about the duty to defend generally are found in favor of the duty.

The practitioner must review the applicable jurisprudence on the use of extrinsic evidence beyond the complaint. At least 14 states permit extrinsic evidence to be used only to establish coverage, 7 states permit extrinsic evidence to be used to establish or negate coverage, and 17 jurisdictions prohibit extrinsic evidence. The other jurisdictions either have special rules for extrinsic evidence admissibility or the issue is unclear.

The Definition of Suit

One issue that courts in California and other jurisdictions have struggled with is what constitutes a suit. The issue has been especially difficult in environmental matters, where often the dispute is in the administrative realm instead of the traditional court system. Courts have not uniformly developed a consistent approach to whether such administrative actions fall within the definition of suit and thereby trigger the duty to defend. Practitioners faced with this question should review the applicable jurisdiction’s body of law to determine how that jurisdiction has addressed this question.

Importance of the Duty to Defend

In most CGL policies, the defense costs do not erode the policy limits. Thus, the duty to defend can be a very valuable source of support for an insured. Defense costs in a large suit, especially in product liability or environmental matters, can be extremely expensive and such lawsuits can also last for many years. This valuable benefit is one of the reasons that the duty to defend is so often litigated. However, as with everything in insurance, there are exceptions to this general rule. The practitioner handling a claim for the insured must examine the policy to determine if it is a defense within limits or “self-liquidating” policy. If it is such a policy, then the defense costs (which can be enormous) will erode policy limits.

In addition, various jurisdictions have ruled that an insurer is not entitled to be reimbursed for the cost of defense absent an express provision in the insurance policy. Research has indicated that not many liability policies contain such express language permitting an insurer to recover out-of-pocket defense costs.

Texas and Duty to Defend

In Texas, the duty to defend is based on the eight corners or complaint allegation rule—to determine the duty to defend, which is broader than the duty to indemnify, one can only consider the language of the insurance policy and the language of the complaint. (For a discussion of the process that Texas uses, see “Eight Corners and True Facts” discussing factual things that can be reviewed, but how Texas courts look narrowly on extrinsic evidence).

The Duty to Indemnify

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The duty to defend and duty to indemnify are related, but separate duties. An insurer could have a duty to defend even if it is ultimately determined that the insured has no liability under the insurance policy it has defended.

The duty to indemnify comes at the end of the lawsuit when liability is established, unlike the duty to defend which is determined when the suit is filed and goes on during the pendency of the suit.

The duty to indemnify is much narrower than the duty to defend. A review of the facts developed during the suit must be examined to determine if they fall within the indemnification obligations of the insuring agreement. The typical CGL policy provides that the “Company will pay on behalf of the insured all sums which the insured shall become legally obligated to pay as damages because of bodily injury or property damage to which this insurance applies caused by an occurrence.”

The courts have struggled with whether administrative fines and penalties qualify as “damages” under the CGL policy language. This duty to indemnify is triggered by an insured—by settlement, or judgment, or verdict—being obligated to pay damages.

Settlement of Claim

Most policies include language that requires the insured to obtain the consent of the insurer to settle claims. If the insured agrees to settle with a claimant without obtaining the insurer’s consent, the insured risks losing any potential insurance coverage for that claim. The right of consent to settlement is a strong one held by insurers. If the insurer has denied defense to the insured or has denied coverage to the insured, then such consent is waived by the insurer.

With such power of consent also comes a duty of the insurer to utilize such control and make decisions on behalf of the insured in good faith and with due regard for the interest of the insured. Mismanaging the power of consent can expose the insurer to the possibility of a finding of bad faith in the following ways: • Failure to advise the insured of settlement opportunities • Failure to advise the insured regarding probable outcomes of litigation –and– • Failure to settle when the insurer is provided a settlement demand that is not unreasonable

In some instances, the insurer who has failed to act reasonably and in good faith has been found to be liable for any excess judgment above the insured’s policy limits. Practitioners representing insurers should be attuned to these risks and advise their clients of such potential for unlimited liability.

The Reservation of Rights

How does an insurer protect itself from waiving its ability to consent to settlement or from a finding of bad faith in failing to defend? One tool used by insurers and that practitioners should understand is the reservation of rights letter. A reservation of rights letter is a hedge of sorts—the insurer agrees to defend the insured while reserving the right to disclaim coverage at a later date.

Insurers use the reservation of rights letter in a wide variety of situations, but the most common are when there are multiple counts and multiple allegations in the complaint, at least some of which do not fall within the scope of potential coverage, or where there is an applicable policy exclusion. Many other less common bases may also be used by an insurer when issuing its reservation of rights letter.

Insurers often use a reservation of rights letter because at the beginning, when the insured provides notice of a claim, the actual details and facts are not robust, but consist of various unsubstantiated allegations and, often, few or no confirmed facts. In reserving its rights to later deny coverage, the insurer is letting the insured know that the claim, in whole or in part, may not be covered under the policy, pending further investigation, and that coverage may subsequently be denied by the insurer.

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The reservation of rights protects an insurer's interests, while alerting the insured that resources may not be available for the defense or indemnity of the insured for the claim.

For additional information about the reservation of rights, see New Appleman on Insurance Law Library Edition § 16.03.

Steps for the Policyholder Practitioner

The practitioner who has a client with a potential claim should take several steps when informed by the client that a suit or claim has been submitted against the client. 1 Ask the client to provide you with all policies that might be responsive to the claim. There may be clashes of coverage, other insurance provisions to review, and potential theories that you can explore with your client, the insured. 2 Ask the client to provide you with relevant documentation of the claim, including pleadings and correspondence. 3 Review (1) and (2) to determine potential defense obligations. Discuss your assessment with the client. 4 Assist your client with notification to the relevant insurers of the potential claim. 5 Review any denials of coverage or reservation of rights letter provided by the insurer. 6 Assess with your client next steps and approaches based on what happens after the denial or reservation of rights letter is received. Consider filing a declaratory judgment action against the insurer or pushing back on the reservation of rights. 7 If a defense is provided, or if there is a denial of coverage or reservation of rights, consult with client about whether the defense counsel has any potential conflicts because of its unique triumvirate relationship—the defense counsel is retained by the insurer to defend the policyholder, and conflicts can arise because of this unique relationship. Some states have jurisprudence that dictates counsel may be retained by the insured in such conflict situations. 8 Consider settlement opportunities and consult with client to determine approach and strategy and whether to make a policy limits demand.

Steps for the Insurer Practitioner

The practitioner who has an insurer client that has been notified of a potential claim from an insured should take several steps when informed by the client that notice has been provided to the insurer. 1 Ask the insurer for the applicable policy that is relevant to the noticed claim. 2 Ask the insurer to provide the notice of claim and any relevant pleadings. 3 Review the relevant pleadings to determine if any of the allegations are potentially covered by the applicable insurance policy. 4 Review the insurance policy’s insuring agreement, conditions, and exclusions to determine what defenses to the duty to defend might exist. 5 After consulting with the insurer client, draft an appropriate response to the notice—accept the defense, defend under a reservation of rights, deny or disclaim coverage. 6 Based on the decision in the response to the notice, determine if appropriate to file a declaratory judgment action. 7 Monitor the lawsuit and developments to determine if facts have changed to warrant a subsequent denial of coverage, and to determine what, if any, indemnification obligations might exist.

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8 If an offer or demand to settle is submitted in the underlying lawsuit, consult with insurer about how to proceed, and advise the insurer of the potential risk it faces if it refuses the settlement and is later found to have not acted in the best interests of the insured.

For additional information about declaratory judgment actions that seek to determine whether the insurer owes a present duty to defend, see New Appleman on Insurance Law Library Edition § 7.05.