A "principled" approach to coverage? The American Law Institute and its Principles of the Law of Liability Insurance.

• Author: Aylward, Michael F.

THIS Spring, the American Law Institute ("ALI") will meet in Washington, D.C., to consider the latest sections of a far-reaching project entitled Principles of the Law of Liability Insurance. Although the Principles project has been in the works for nearly four years and addresses issues of profound importance to the insurance industry, policyholders, and insurance practitioners regarding the interpretation and scope of liability insurance, many insurance claims professionals, policyholders, and outside counsel know little of it.

The idea for this project appears to have begun with a suggestion by Professor Kenneth Abraham, an active and influential member of ALI's Council. The ALI's Council approved the proposal for the Principles project in May 2010. Professors Thomas Baker of the University of Pennsylvania Law School and Kyle Logue of the University of Michigan Law School were appointed as the Reporters, and a team of 36 lawyers chosen from the judiciary, academia, industry (on both the insurer and policyholder sides), and active law-firm practitioners were invited to serve as the Principles project's Advisors. The group of Advisors is fixed. As with other ALI Restatement and Principles projects, the effort also includes a large "Members Consultative Group" that also has offered comments and advice as the project has progressed. Any member of the ALI can participate in the Members Consultative Group ("MCG"). The Advisors and Members Consultative Group include representatives of insurers and policyholders.

The ALI creates its Restatement and Principles projects through a dialectic, involving input from Advisors and Members Consultative Group members and discussions in the ALI Council and yearly meetings of the ALI general membership, a process that takes place over (often many) years. The objective is to produce a product of broad usefulness and applicability that reflects a consensus from constituencies representing different perspectives on the subject matter in question.

Unlike the more familiar ALI Restatements, which seek to summarize principles of the law where there is a general consensus, a Principles project seeks to declare what the ALI, through its deliberative process, thinks the law ought to be. As one of the Reporters has said, a Principles project seeks to set forth "best practices."

In 2005, the ALI published a Handbook setting out four types of projects: Restatements, Legislative Recommendations, Principles, and Studies. It discussed both Restatements and Principles. Restatements were "clear formulations of common law and its statutory elements or variations," reflecting the law as it presently stands or as it might plausibly be stated by a court. Then there was the Principles category. This had not previously been used in ALI terminology, and had clearly been created in connection with the Corporate Governance project and its ramifications. Principles, the Handbook announced, "may be addressed to courts, legislatures, or governmental agencies. They assume the stance of expressing the law as it should be, which may or may not reflect the law as it is." (1)

The Reporters for the Principles project observed in the Memorandum introducing Tentative Draft No. 1 that:

Although this is a Principles project rather than a Restatement, we support many existing rules. We have attempted to provide clear articulations of and to set forth the primary justifications for those rules. In a few Sections, our statement of a rule is a bit more direct than that of the courts in at least some jurisdictions, but in each of those instances we believe that the rule we propose describes what courts actually do in a substantial number of jurisdictions. In a number of instances, however, we propose adjustments to existing rules that we believe are superior. That, of course, is the point of a Principles project. (2) At the ALI's May 2013 meeting, some members raised the issue of whether the Law of Liability Insurance project should be transformed into a Restatement. As the original proposal to create this project evidently generated much discussion about whether the project should result in Principles or a Restatement, many knowledgeable about the project believe that this issue has been resolved, however, and is unlikely to be revisited.

The approach of the Reporters has been to state existing state law with an eye towards principles that encourage economic efficiency and fairness to both insurers and policyholders and serve the interests of the public, including individual consumers and small businesses. Discussions at the Advisors' and Members' meetings, ALI Council, and ALI general membership meetings have focused in part on the effect that these rules will have on ordinary consumers. The Reporters have also stated that a key objective is trying to reduce the amount of litigation between policyholders and insurers.

As this is not a Restatement, the Reporters for the Principles project have taken care to distinguish between what they view as "mandatory rules" that must be applied regardless of what an insurance contract says, and "default rules" that apply unless an insurance policy provides otherwise. As discussed below, the sections of the project produced thus far develop a concept that "default rules" may be waived by so-called "large commercial policyholders." Certain sections include a "bright line" definition of "large commercial policyholders," using as a general criterion businesses with assets exceeding $10 million in accordance with definitions employed by the SEC. This definition generated extensive discussion with many questioning the use in coverage disputes of this $10 million threshold and, assuming the use of such a criterion, the appropriate way to define it. Comments also questioned the assumption that the use of an insurance broker provides protection for policyholders, even commercial policyholders with at least $10 million in assets, given that liability insurance even for very large companies is sold on standardized policy forms, or using key terms that are standardized and that, for the most part, are not subject to revision or negotiation.

With regard to the concept of "mandatory rules," the Reporters' Memorandum states:

One important, cross-cutting innovation in Chapters 1 [on interpretative rules and waiver and estoppel] and 2 [on the duty to defend and pay defense costs] is to specify when a rule is a mandatory rule (meaning that the rule cannot be changed by contract) and when a rule is a default rule (meaning that the rule applies only if the liability insurance policy does not specify a different rule). A substantial number of the rules stated in Tentative Draft No. 1 are default rules for large commercial liability insurance policies. Most of those rules are mandatory for other liability insurance policies, however. In many cases, this innovation provides greater protection to consumers and small commercial policyholders than the prevailing common law of liability insurance, which generally grants insurers broad latitude in the drafting of insurance policies. (3) Like Restatements, the drafts of this Principles project include statements of "black-letter" rules followed by Comments, examples, and Reporters' Notes.

1. The Scope Of The Principles Project

   The Principles of the Law of Liability Insurance will ultimately contain four chapters. Chapter One addresses basic principles of insurance contract interpretation, the doctrines of waiver and estoppels, and the effect of misrepresentations made by policyholders during the application process. Chapter Two focuses on the obligation of a liability insurer to defend (or pay defense costs), as well as the duty to settle and cooperation issues. Still to come are Chapters Three and Four. Chapter Three will address the scope of insured risks and topics such as trigger, allocation, and issues related to high-profile exclusions and conditions, while Chapter Four will focus on advanced insurance contract issues like choice of law, remedies, bad faith, and enforceability.

   Chapter One was presented as a "discussion draft" at ALI's May 2012 Annual Meeting. Following further drafts and input from the Advisors and the Members Consultative Group, Chapter One and part of Chapter Two, presented as "Tentative Draft No. 1," were approved at ALI's Annual Meeting in May 2013. The ALI approved Sections 1 through 15 of Tentative Draft No. 1, which included Interpretation (Ch. 1, Topic 1); Waiver and Estoppel (Ch. 1, Topic 2); and Misrepresentation (Ch. 1, Topic 3 and subsequently voted to approve Sections 16-23.

   On September 3, 2013, the Reporters issued Council Draft No. 4 which contains new Sections 24-34 addressing the obligation of insurers to make reasonable settlement decisions (and the consequences of failing to do so) and whether insurers have a right to recoup defense cost or settlement payments. These materials will be reviewed and voted on by the Council in the spring of 2014. The Reporters state in the prologue to Council Draft No. 4 that "even more so than Chapter 1, Chapter 2 attempts to clarify and unify existing liability insurance law. Almost without exception, Chapter 2 states rules that already apply in many jurisdictions."

2. The Principles

   A. Chapter One: Basic Liability Insurance Contract Principles

   Chapter One consists of a definitional section and three topics: (1) Interpretation (in Sections 2-4); (2) Waiver and Estoppel (in Sections 5-6); and (3) Misrepresentations (in Section 7-11).

1. Section I: Definitions

   Certain definitions key to the Principles project are quoted below for context. Subsection 2 defines "commercial policyholder" as a "policyholder with a commercial liability insurance policy." (4) Subsection (4) defines a "large commercial policyholder" as:

   A commercial policyholder that, at the time the policy is issued, has assets equal to the threshold set forth in [section] 12(g)(1)(A) of the Securities Exchange...