CHAPTER 3 CONSTRUCTION OF INSURANCE CONTRACTS

• Jurisdiction: United States

A. Rules of Insurance Contract Interpretation

Insurance policies are contracts. The courts of California, as well as U.S. federal courts applying California law, have established rules of construction of insurance contracts that are not the same as those applied to other contracts.

To understand insurance, insurance policies, and insurance claims, the lawyer, adjuster, insurer, and insured must understand how all insurance contracts are interpreted by the courts. Rules of insurance contract interpretation have developed over the last 300 years and are applied by courts with the intent to fulfill the desires of all parties to the contract.

The construction of insurance contracts should be governed by the same rules of construction applicable to all contracts.¹ Sometimes that happens but more often than not insurance contracts are interpreted more loosely to provide coverage—whether intended or not—to an insured who incurred a loss. The courts claim that when they construe an insurance contract, its terms are given their "ordinary and generally accepted meaning"² and that the primary goal of the court "is to give effect to the written expression of the party's intent."³

The U.S. Supreme Court, which must be followed by all California state or federal courts, in a concurring opinion by Justice Breyer, stated:

Under ordinary principles of contract law, one would construe the contract in terms of the parties' intent, as revealed by language and circumstance. See The Binghamton Bridge, 3 Wall. 51, 74 (1866) ("All contracts are to be construed to accomplish the intention of the parties"); Restatement (Second) of Contracts Section(s) 202(1) (1979) ("Words and other conduct are interpreted in the light of all the circumstances, and if the principal purpose of the parties is ascertainable it is given great weight"). ⁴

However, regardless of the learned opinions of justices of the Supreme Court, the following rules govern the construction of contracts of insurance, which do not necessarily apply to contracts like contracts of sale of real property or leases of equipment:

• "If the terms of a promise are in any respect ambiguous or uncertain, it must be interpreted in the sense in which the promisor believed at the time of making it, that the promisee understood it." ⁵

• If the language of a policy or contract is subject to two or more reasonable interpretations, it is ambiguous.

• "Where an ambiguity involves an exclusionary provision of an insurance policy, ‘[courts] must adopt the construction urged by the insured as long as the construction is not unreasonable, even if the construction urged by the insurer appears to be more reasonable or a more accurate reflection of the parties' intent.'" ⁶

As one court said:

In reaching the conclusion [that a policy exclusion was ambiguous, and the policy, therefore, provided coverage], a court should follow the settled rule that any ambiguity or uncertainty in an insurance policy is to be resolved against the insurer, and that if semantically permissible, the contract will be given such construction as will fairly achieve its object of providing indemnity for the loss to which the insurance relates. ⁷

This rule deals with the maxim that a contract should be construed against its drafter, and is sometimes referred to as the "contra preferendum" rule. Provisions excluding coverage are also strictly construed against the insurer.

Some rules applied to insurance contract interpretation include:

• Ambiguities in insurance applications will usually be construed against the insurer to avoid denial of coverage because of alleged misrepresentations. For example, it was held that policy wording is usually construed in favor of the insured and against the insurer if any ambiguity exists in the contract wording. ⁸

• The opposite is also true: if the language of the policy was drafted by the insured or his or her broker, ambiguous language is construed against the insured. When the language of an insurance contract is reasonably susceptible to two constructions, it should be construed in favor of the insured unless the insured is responsible for the ambiguity. ⁹

• On the other hand, where the language of a contract is clear and unambiguous, it must be interpreted solely by reference to the four corners of that document. ¹⁰

• When a policy is interpreted, the provisions of an endorsement control the interpretation over the body or declarations of a policy when the two are in conflict.

• As said in Insurance Co. of N. Am. v. Electronic Purification Co., 67 Cal. 2d 679, 689, 63 Cal. Rptr. 382, 433 (1967), "the insurance company gave the insured coverage in relatively simple language easily understood by the common man in the marketplace, but ‘attempted to take away a portion of this same coverage in paragraphs and language which even a lawyer, be he from Philadelphia or Bungy, would find difficult to comprehend.'" ¹¹

• These rules are all subject to the limitation that:

[A] court cannot and should not do violence to the plain terms of a contract by artificially creating ambiguity where none exists. In situations in which reasonable interpretation favors the insurer, and any other would be strained and tenuous, no compulsion exists to torture or twist the language of the contract. An insurance company has the right to limit the coverage of a policy issued by it and when it has done so, the plain language of the limitation must be respected. ¹²

Basically, the construction of an insurance contract should always be controlled by the statement that "the courts will not indulge in a forced construction of an insurance policy so as to fasten a liability on the insurance company which it has not assumed."¹³

This is a rule usually honored more in the breach than in the following, and often forces litigants to the courts of appeal to obtain the benefit of the rule. Since interpretation of an insurance contract is a question of law, fully reviewable on appeal, it is often necessary to take a case to court to gain an effective interpretation of the contract of insurance.¹⁴

The California Supreme Court, faced with what appeared to be a clear and unambiguous policy exclusion, held in AIU Ins. Co. v. Superior Court, 51 Cal. 3d 807, 799 P.2d 1253, 274 Cal. Rptr. 820 (1990), that under comprehensive general liability (CGL), insurance policies issued by insurers to FMC Corporation (FMC) obligated the insurers to provide coverage to FMC for cleanup and other "response" costs incurred pursuant to the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) (42 U.S.C. § 9601 et seq.) and related state and federal environmental laws.

The California Supreme Court, applying statutory rules of contract interpretation, concluded that

the mutual intention of the parties at the time the contract was formed governed interpretation. (Civ. Code § 1636.) Such intent is to be inferred, if possible, solely from the written provisions of the contract. The "clear and explicit" meaning of these provisions, interpreted in their "ordinary and popular sense," unless "used by the parties in a technical sense or a special meaning is given to them by usage" (id., § 1644), controls judicial interpretation. (Id., § 1638.) Thus, if the meaning a layperson would ascribe to contract language is not ambiguous, the court must apply that meaning.

If there is ambiguity, however, it is resolved by interpreting the ambiguous provisions in the sense the promisor (i.e., the insurer) believed the promisee understood them at the time of formation. (Civ. Code, § 1649.) If application of this rule does not eliminate the ambiguity, ambiguous language is construed against the party who caused the uncertainty to exist. (Id., § 1654.)

FMC unquestionably possessed both legal sophistication and substantial bargaining power. For this reason, the insurers contended, the court should neither construe the policy language at issue in this case in the broad sense understood by laypersons (as opposed to a narrower technical sense) nor resolve ambiguities in favor of coverage. There is some force to these arguments, particularly in light of the fact that FMC itself operates a subsidiary that drafts CGL policies identical to those at issue in this case.

Since the CGL policies at issue in the case covered sums which FMC became "legally obligated" to pay as "damages" (or "ultimate net loss") incurred because of "property damage," the supreme court agreed that while a layperson might reasonably define "damages" in broad terms, it would be unlikely one would do so in the context of the coverage provision at issue. To the extent that the policy language was ambiguous in light of the way environmental statutes authorized relief, the goal of the court remained to protect the objectively reasonable expectations of the insured.

Even if government response costs are incurred largely to prevent damage previously confined to the insured's property from spreading to government or third-party property (i.e., the costs are "mitigative" in character), reimbursement of such costs constitutes "damages" in ordinary terms. A contrary result would fail to fulfill the reasonable expectations of the parties.

The supreme court concluded that it would exalt form over substance to interpret CGL policies to cover one remedy but not the other. Given the practical similarity of remedies available under the environmental statutes at issue here, [the court concluded] that a reasonable insured would expect both remedies to fall within coverage as "damages." The court agreed that remedial and mitigative costs—incurred to pay for measures taken in advance of any release of hazardous waste—are not incurred "because of property damage" until such damage has occurred. Whether on the waste site itself or elsewhere, there could be no coverage under CGL policies.

Although the costs of compliance with injunctions ordering FMC to

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