This is one of a series of articles under the by line “Butler on Bad Faith” originally published in Mealey’s Litigation Report: Insurance Bad Faith, Vol. 15, #10, p. 25 (September 19, 2001). © Copyright Butler 2001.
Coverage determinations regarding the nature of policy duties that liability insurers owe to additional insureds may create bad faith exposure for the unwary insurer. Bad faith liability frequently arises when an insurer fails to recognize the scope of defense and indemnification obligations it owes to an additional insured. Issues also arise when additional insureds compete with named insureds for limited policy proceeds which cannot adequately protect the interests of both. This article highlights the source of the dilemma – the scope of the coverage afforded to an additional insured – and provides illustrations of bad faith exposure in the wake of claims asserted against additional insureds.
Liability insurers’ failure to recognize that additional insureds have many, if not all, of the same rights to coverage as the named insured lies at the heart of this problem. For many years, carriers argued that their policies limited the scope of additional insured coverage, so that the policy only required an insurer to respond if a claimant asserted a theory of vicarious liability against the additional insured’s liability or if a claimant asserted that the additional insured was not otherwise actively negligent.
Few liability policies, however, contain additional insured language expressly limited to vicarious liability or active negligence. ISO additional insured endorsements typically provide coverage for the additional insured’s liability “arising out of” the named insured’s work, without reference to the character of the additional insured’s conduct giving rise to its liability; i.e., active or passive negligence. Virtually all additional insured endorsements use some version of this language to describe the coverage conferred upon the additional insureds.
While a few courts have limited the availability of coverage under the endorsement to those situations where the additional insured’s liability is purely vicarious,(1) courts following the emerging trend have rejected insurers arguments that the language of such endorsement covers only passive negligence An emerging majority of courts have. The emerging majority of courts broadly construe such language, equating the phrase “arising out of” to causally connected with.(2) These courts have broadly construed policy language providing both defense and indemnity rights to additional insureds.
McIntosh v. Scottsdale Ins. Co., 992 F.2d 251 (10th Cir. 1993), illustrates how the majority of courts determine the scope of additional insured coverage. In McIntosh, an attendee at a city-sponsored street dance was injured when he attempted to take a short cut to restroom facilities at the dance. The dance’s sponsor had a liability policy Scottsdale that named the city of Wichita as an additional insured. The injured party sued the city, and the city tendered its defense to Scottsdale. After Scottsdale denied coverage and refused to extend a defense, the City went to trial against the plaintiffs. The City stipulated that it was 100% liable, and the jury awarded $74,571.15 in damages.
The plaintiffs then filed a garnishment action against Scottsdale, arguing that Scottsdale was liable for the judgment because plaintiff’s injuries arose out of the festival and that the policy covered the city, even for its own negligence. Scottsdale contended the additional insured endorsement provided coverage for the City for its vicarious liability only.
The McIntosh court concluded that the policy phrase “arising out of” “clearly relates to causation” and that the facts presented demonstrated the requisite causal connection that established coverage for the City under the additional insured endorsement. Id. at 255. The court also noted that, if Scottsdale had wanted to limit the coverage available pursuant to the additional insured endorsement to only the vicarious liability of the additional insured, “language clearly embodying that intention was available.” Id.
Carriers’ efforts to limit the scope of additional insured coverage by arguing that a particular activity was not part of the “work” of the subcontractor have similarly met with little success. For example, in Shell Oil Co. v. AC&S, Inc., 649 N.E.2d 946 (Ill. App. Ct. 1995), the court addressed whether the following facts demonstrated liability “arising out of” the work of the named insured. The named insured’s employee perform some insulation work at the additional insured’s facility as part of his employment for named insured. While walking back to the named insured’s construction trailer, the named insured’s employee tripped over a pipe and sustained injuries. The employee then filed a workers’ compensation claim against the named insured and a complaint against the additional insured landowner.
The additional insured tendered the defense of the employees claim to the named insured and its insurer, National Union. National Union failed to respond to the additional insured’s tender of defense. The additional insured then filed suit against National Union, seeking a determination that National Union owed the additional insured a defense and coverage for the employee’s lawsuit.
National Union argued that it was not obligated to defend or indemnify the additional insured landowner because the contract between the named and additional insureds specifically limited coverage to work performed by the named insured and that the pipe the employee tripped over had nothing to do with the work being performed by the named insured. The court rejected this assertion, adopting the reasoning found in its earlier decision in Maryland Casualty Co. v. Chicago and North Western Transp. Co., 466 N.E.2d 1091, 1094 (Ill. App. Ct. 1984), finding that “the phrase ‘arising out of’ is both broad and vague, and must be liberally construed in favor of the insured; accordingly, ‘but for’ causation, not necessarily proximate causation, satisfies this language.”
Applying the “but for” analysis to the facts at hand, the court determined that the additional insured had coverage under the named insured’s policy because the employees injuries arose from the named insured’s operations on the additional insured’s premises. The injured employee was at the additional insured’s facility pursuant to the subcontract between the named insured and additional insured, in furtherance of his employment with the named insured. His injuries allegedly occurred when he tripped over a pipe transversing a gravel walkway he was using to return to the named insured’s work trailer, located on the additional insured’s premises. The employee testified that he used this particular walkway because he did insulation work in that vicinity for his employer, the named insured. Holding that the injuries would not have occurred “but for” the employee’s employment by the named insured and the named insured’s presence on additional insured’s premises, the court concluded that the underlying complaint alleged facts that fall within or potentially within policy coverage obligating National Union to defend the additional insured in the underlying lawsuit.
When assessing a complaint against their additional insured, carriers may experience difficulty establishing that allegations do not implicate the work performed by the named insured. Prudent insurers will defend the additional insured subject to a reservation of rights. The failure to defend an additional insured can create exposure to bad faith damages as illustrated in Campbell v. Superior Court, 44 Cal. App. 4th 1308 (Cal. Ct. App. 1996).
In Campbell, a homeowner made claims against the general contractor/additional insured (Campbell) and subcontractor/named insured (Acralight) for the subcontractor’s installation of allegedly leaking skylights. The homeowner demanded settlement from Farmers Insurance Company in the amount of $350,000 for the claims against Campbell and $50,0000 for the claims against Acralight.
Campbell tendered the defense and indemnity of the suit to Farmers. Farmers agreed to defend Acralight. However, Farmers refused to defend Campbell, claiming its policy only provided coverage for Campbell for Campbell’s liability arising out of the actions of Acralight and that Farmers’ investigation of the case revealed that Acralight was not negligent in designing, fabricating or installing its work.
Because its own insurer was insolvent, Campbell retained personal counsel to defend the homeowner’s suit. Campbell ultimately settled with the homeowner. Campbell then filed an action against Farmers, alleging both breach of contract and breach of the implied covenant of good faith and fair dealing.
Farmers asserted that its failure to defend could only support a claim for breach of contract. Although the trial court granted Farmer’s motion to dismiss on this ground, the Court of Appeal reversed. The court concluded that any breach of the insurance contract, including failing to defend an insured, could support a bad faith claim if the insurer’s conduct was unreasonable. Id. at 1319.
The court acknowledged that no California court had previously found that refusal to defend, in and of itself, would support a tort claim for breach of the covenant of good faith and fair dealing. Writing from what it described as a “clean slate,” the court examined long-standing California authority and determined that an unreasonable refusal to defend could support a claim for tort damages. Id. at 1319.
The court highlighted the significance of the duty to defend, concluding that “it is undeniable that insurance is purchased to provide the peace of mind and security that comes from knowing that if the insured contingency arises, the insurer will defend against the claim.” The court noted that “[a]n anomalous situation would be created if, on the one hand, an insured can sue for the tort of breach of the implied covenant if the insurer accepts the defense and later refuses a reasonable settlement offer, but, on the other hand, an insured is denied tort recovery if the insurer simply refuses to defend.” In the former instance, the insured could recover emotional distress and punitive damages but in the latter situation, would be limited to recovery of only attorney fees and settlement costs expended by the insured. The court further observed that:
This dichotomy could have the effect of encouraging an insurer to stonewall the insured at the outset by simply refusing to defend because if it were later to be successfully sued by the insured because of that refusal, it (the insurer) would be in no worse position financially than if it had accepted the case, defended, and then settled. That is, an insurer considering the option of breaching an implied covenant would have a strong financial incentive to do so at the very outset by refusing to defend rather than risk the more expansive liability applicable to a breach of the implied covenant arising out of a later performance of its duties.
Id. at 1320.
The Campbell court also found that an additional policy concern supported allowing the case to proceed on the theory of breach of the implied covenant. If the insured’s recovery was limited in such a case to contract damages, insureds would be treated inequitably based upon their financial status. For insureds who can provide their own defense with minimal financial impact, contract damages might be sufficient. But for an insured whose assets are limited or non-existent, limiting damages to contract damages only may not fully compensate the insured for the losses it suffers.(3) Id.
The court rejected Farmers’ assertion that it should not be held liable for tort damages because Campbell was never exposed to damages in excess of its policy limits. The court stated that “Farmers’ request to not recognize a claim for breach of the implied covenant on this basis fails to acknowledge the big picture and ignores many pragmatic concerns.” Id. at 1321.
The court did state that there were limits to the liability that could be imposed for tortious breach of the implied covenant. “For one, breach of the implied covenant requires unreasonable conduct or an action taken without proper cause.” Id. If the insurer’s refusal to defend was reasonable, no liability could be imposed. The court also noted that an insurer could protect itself by defending under reservation of rights, agreeing to reimburse the insured for its defense costs if further litigation of the underlying action demonstrates that a defense is owed, or filing a declaratory judgment action to determine if it owes a defense. Id.
Another area of potential extra-contractual exposure occurs where named insureds and additional insureds have competing claims to be settled out of insufficient policy limits. Most insurance policies expressly recognize that an insurer is obliged to treat each insured as though separately and independently insured by the policy.(4) It is entirely possible for an insurer to be obligated to the additional insured in an instance where the named insured does not have coverage.(5)
When an insurer obligated to two or more insureds is faced with the prospect of settling a matter by exhausting remaining available policy limits, the question of whether such a settlement can be made in good faith without protecting all of the insureds can arise. A minority line of cases holds that an insurer can be liable for bad faith if it settles for policy limits on behalf of one insured and withdraws its defense of an additional insured.(6) This line of cases raises the question of how one goes about allocating policy proceeds proportionately between the insureds.
A minority of courts require that the policy proceeds should be allocated on behalf of each insured based upon the percentage of overall liability borne by each insured. See, e.g., Countryman v. Seymour R—11 School Dist., 823 S.W.2d 515 (Mo. Ct. App. 1992). Most jurisdictions, however, hold that not proportionately allocating policy proceeds is not bad faith in itself. See, e.g., Country Mut. Ins. Co. v. Anderson, 628 N.E.2d 499 (Ill. App. 1993). This topic is discussed in more detail at Mealey’s Litigation Report: Insurance Bad Faith, Vol. 13, #10, p. 21 (September 21, 1999) in the article entitled “Good Faith Settlement of Claims in Excess of Policy Limits Against Multiple Insureds.”
Liability carriers may misconstrue the scope of coverage for additional insureds. Failing to properly recognize and act upon the actual coverage afforded to an additional insured can crate bad faith exposure for carriers. Courts have begun to acknowledge that carriers cannot impose limitations to the coverage of an additional insured based upon distinguishing claims of passive negligence from claims of active negligence or upon the precise scope of the work to be performed by an additional insured. Failing to defend an additional insured under such circumstances can give rise to bad faith. Carriers should also exercise care in settling cases involving multiple additional insureds.