CHAPTER § 5.02 Basic Insurance Concepts

• Jurisdiction: United States

§ 5.02 Basic Insurance Concepts

[1] Policy Interpretation

In approaching an insurance policy, the polestar of interpretation is the intention of the parties.⁵ It is the duty of a court, if possible, to ascertain and carry out that intention, applying principles of construction.⁶ In accordance with these rules of construction, it is important to look to the whole agreement to understand each part of an insurance policy. "[A]ll parts and clauses must be considered together so that it may be seen if and how one clause is explained, modified, limited or controlled by the others."⁷ For example, to aid parties in interpreting their language, all insurance policies contain definitional sections that define some terms of art or special words for policy purposes.⁸ Typically, such defined words are printed in boldface and often capitalized throughout the policy and will govern in both the body of the policy and in the endorsements.⁹

If the language of the entire policy reveals the parties' intent, it is unnecessary to examine extrinsic evidence.¹⁰ But if the intent cannot be determined from the policies, courts may resort to considering parol evidence.¹¹ Additionally, because some provisions of insurance policies are somewhat standardized, court decisions may have previously interpreted such disputed portions of the policy.

Applying these principles to evaluate an insurance policy as a whole, courts typically begin by establishing whether coverage for the claimed loss exists. If the court finds coverage, it may then examine the policy for any exclusion or limitation to that coverage. The Supreme Court of Wisconsin summed up the mechanics of how a court should approach its initial review of an insurance policy:

Judicial interpretation of a contract, including an insurance policy, seeks to determine and give effect to the intent of the contracting parties. Insurance policies are construed as they would be understood by a reasonable person in the position of the insured. However, we do not interpret insurance policies to provide coverage for risks that the insurer did not contemplate or underwrite and for which it has not received a premium.
Our procedure follows three steps. First, we examine the facts of the insured's claim to determine whether the policy's insuring agreement makes an initial grant of coverage. If it is clear that the policy was not intended to cover the claim asserted, the analysis ends there. If the claim triggers the initial grant of coverage in the insuring agreement, we next examine the various exclusions to see whether any of them preclude coverage of the present claim. Exclusions are narrowly or strictly construed against the insurer if their effect is uncertain. We analyze each exclusion separately; the inapplicability of one exclusion will not reinstate coverage where another exclusion has precluded it. Exclusions sometimes have exceptions; if a particular exclusion applies, we then look to see whether any exception to that exclusion reinstates coverage. An exception pertains only to the exclusion clause within which it appears; the applicability of an exception will not create coverage if the insuring agreement precludes it or if a separate exclusion applies.¹²

Notwithstanding the similarities between insurance policies and other types of commercial contracts, however, most courts apply special rules favoring coverage for the insured to the interpretation of insurance policies. First, where provisions of an insurance policy are ambiguous, "those ambiguities must be construed against the insurer . . . [and] liberally construed in favor of the insured."¹³ For a court to adopt a policyholder's construction, the policyholder must show only that its interpretation of the ambiguous policy language is not unreasonable.¹⁴ In fact, this is true "even if the construction urged by the insurer appears to be more reasonable or a more accurate reflection of the parties' intent."¹⁵

This rule applies with equal force to any exclusions or limitations contained in the policy.¹⁶ Because an insurance contract is meant to provide coverage, limitations and exclusions must be strictly construed.¹⁷ So before enforcing an exclusion, many courts must find that it is clearly intended to apply; otherwise, the court adopts a reasonable construction that is most favorable to the insured.¹⁸

In addition, most jurisdictions "uphold[] the insured's expectations as to the scope of coverage, provided that the expectations are objectively reasonable."¹⁹ "In practice, the rule is that the objectively reasonable expectations of applicants and intended beneficiaries regarding the terms of insurance contracts will be honored even though a painstaking study of the insurance provisions would have negated those expectations[.]"²⁰ Notably, some courts will give credence to the insured's reasonable expectations and find that coverage exists even when the policy is unambiguous.²¹

Finally, after an insured proves that a loss falls within the scope of the policy, the insurer bears the burden of proving that any policy exclusions or limitations apply.²² Similarly, the insurer must prove that any affirmative defenses would bar coverage.

[2] Duty to Defend and Indemnify

There are generally two distinct coverage obligations in most third-party liability insurance policies (which, as explained below, protect against liability the insured has to others): (1) a duty to defend the insured against claims, and (2) a duty to indemnify the insured for covered losses from those claims. An insurer's duty to defend can be more important than the insurer's duty to indemnify. The cost of the investigation and defense of a lawsuit can sometimes exceed the claim amount sought by the injured party. It is important to understand not only when an insurer must cover a loss, but also when an insurer must assume the defense of the claim.²³ If the underlying action falls within the scope of the risk covered by the policy, an insurance carrier may be obligated to defend and indemnify. Throughout the United States, "as a general rule, an insurer's duty to the insured is determined primarily by the pleadings in the underlying lawsuit" and comparing them with the policy's language.²⁴ A New Jersey court set forth the general rule regarding the duty to defend this way: "[T]he complaint should be laid alongside the policy and a determination made as to whether, if the allegations are sustained, the insurer will be required to pay the resulting judgment, and in reaching a conclusion, doubts should be resolved in favor of the insured."²⁵

This test is also called the "four-corners" (or sometimes "eight-corners") test.²⁶ "Like coverage generally, when determining an insurers duty to defend, the allegations in a complaint must be 'liberally construed' in favor of coverage."²⁷ If a complaint sets forth several theories of recovery, and only one is potentially covered, the insurer must defend the entire action.²⁸ In such situations, however, the insurer may be able to recoup defense costs, or deny advancement of defense costs, from the policyholder that were not related to defending the insured claim if the various claims can be readily apportioned.²⁹

Courts hold that the duty to defend generally attaches "regardless of how false or groundless those allegations might be."³⁰ If the allegation is one for which coverage exists, the insurance carrier must defend.

An insurer's duty to defend and duty to indemnify are distinct and separate duties.³¹ The duty to defend is broader than the duty to indemnify.³² An insurer's duty to defend is triggered whenever the allegations in a complaint, liberally construed, suggest a reasonable possibility of coverage, or when the insurer has actual knowledge of facts establishing the same.³³ An insurer may have a duty to defend claims falling within the policy even if it may not ultimately be obligated to indemnify the insured for a loss.³⁴

An insurer may be relieved of its duty to defend if it can establish, as a matter of law, that there is no possible factual or legal basis upon which it might eventually be obligated to indemnify its insured, or by proving that the allegations fall wholly within a policy exclusion.³⁵ Additionally, an insurer may be relieved of its duty to defend when the policy's limits are exhausted through payment of judgments and settlements.³⁶ Some courts have noted that an insurer cannot tender the policy limits to avoid the expense of investigation, settlement, and defense of the claim.³⁷ This is not a settled rule, however. Whether an insurer can so discharge its obligations varies from jurisdiction to jurisdiction, as the courts are split on the issue of whether the insurer may discharge its entire duty to defend by paying out the policy limit in settlement or by tendering the policy limit for application to settlements at the discretion of the policyholder.³⁸ Further, while many policies provide that the cost to defend is "outside" of the policy limits, some policies state that defense costs will erode or reduce the policy limits. In such circumstances, the insurer also may be relieved of its duty to defend when the solely the payment of defense costs exhausts the policy limits. This, again, depends upon the specific policy language and the laws of the applicable jurisdiction, which may limit the insurer's ability to abandon the defense of its insured.

[3] Distinction Between Occurrence-Based and Claims-Made Policies

The distinction between "occurrence" and "claims-made" policies is important in the pharmaceutical industry because many pharmaceutical lawsuits involve situations where the alleged side effects of a product do not manifest themselves until years after ingestion. Thus, whether a policy is "occurrence-based" or "claims-made" determines which policy potentially responds to a claim. Thus, coverage litigation often boils down to determining when the injury occurred for purposes of insurance coverage. This...