Splitting the file in liability insurance.

• Author: Richmond, Douglas R.

LIABILITY INSURERS owe their insureds contractual duties of defense and indemnity. Both duties are linked to coverage, but they are different in key respects. The duty to indemnify exists as soon as the contract is formed, but the duty is conditional; the insurer's duty to pay proceeds is not due and owing until the insured's liability is established. (1) The duty to defend is not similarly conditioned; it exists as soon as a claim potentially within coverage is made, regardless of whether the law would impose liability in the circumstances. (2) The fact that an insurer's duty to defend arises at the outset of litigation while its duty to indemnify is determined at the conclusion of the litigation means that an insurer may have to defend an action in which there will be no duty to indemnify the insured. (3) In such cases, insurers typically defend insureds under a reservation of rights.

An insurer's defense under reservation of rights sometimes concerns insureds and courts because of potential conflicts of interest that can arise. (4) There are essentially three issues: (1) whether the insurer may defend the case in such a way as to defeat coverage; (2) whether the insurer may mount less than a full defense if it believes it will be able to later deny coverage or that any ultimate loss will not be covered; or (3) whether the insurer will gain access to the insured's confidential or privileged information which it can then use to its advantage in coverage litigation. (5) To guard against these possibilities and to dispel later allegations of bad faith, liability insurers sometimes "split the file" in a case defended under reservation of rights. In such cases, the insurer establishes one file for the investigation and defense of the loss and a second file for the investigation and resolution of coverage issues, and assigns a different claims professional to each. (6)

But insurers do not always split files, and their failure to do so occasionally gives rise to bad faith and estoppel allegations, among other claimed wrongs. Policyholders' lawyers insist that insurers that do not split claim files in appropriate cases breach their duties to their insureds, violate industry custom and practice, and violate state unfair claims settlement practices acts. (7) They base these arguments on years of case law holding that insurers cannot employ the same defense counsel representing the insured to develop coverage defenses, or use information wrongfully obtained by a defense lawyer to deny coverage. (8) There is, however, a material difference between an insurer inducing a defense lawyer to violate her duties to her client or exploiting confidential information supplied by a careless or unprincipled defense lawyer to deny coverage and an insurer making a single adjuster responsible for evaluating both liability and coverage. The former types of conduct may well expose the insurer to bad faith liability or strip it of coverage defenses; the latter arrangement, standing alone, should not. The fact that a single claims professional is responsible for both liability and coverage issues in a given case does not compel the conclusion that the insurer will be tempted to shortchange the insured's defense. Courts' focus when evaluating insurer-insured conflicts in this context therefore must be on the insurer's allegedly improper collection or use of information to the insured's detriment, not on the insurer's internal organization. (9) Although insurance companies may opt to split files in appropriate cases, they have no duty to do so. (10) An insurer's failure to split a file, without more, will not support bad faith allegations or similar claims. (11)

This article explains why insurers do not have a duty to split files in cases in which coverage is disputed. Part I begins that analysis with a survey of the limited case law on the subject. Part II goes beyond the cases in explaining why insurers have no duty to split files. Part II also recognizes that although insurers clearly have no duty to split files, that fact alone does not necessarily end the inquiry. Rather, the next question is whether insurers arguably should split files in appropriate cases to preempt potential bad faith or estoppel arguments or further the insured's defense. Part II identifies several possible reasons for splitting files that insurers may wish to consider and briefly identifies some logistical considerations when splitting files. Of course, the fact that an insurance company opts not to split a file in a particular case evidences nothing other than a legitimate exercise of business judgment.

1. Reviewing the Case Law

   No reported case has recognized a duty on an insurer's part to split a file and several courts have expressly rejected calls for such a duty. A few courts have discussed insurers' use of information developed in an insured's defense to advance their coverage positions, or insurers' decisions to split files or their methods for doing so, but have always stopped far short of endorsing a duty to split a file.

   1. Cases Rejecting a Duty to Split a File

      State Farm Fire & Casualty Co. v. Superior Court (12) is one of the first reported cases to address file-splitting. State Farm was a bad faith case. In the underlying action, State Farm defended its insureds, the Durants, under a reservation of rights. State Farm also filed a declaratory judgment action alleging that it had no duty to defend or indemnify the Durants under their homeowners policy. State Farm provided the Durants with independent counsel--Cumis counsel, in California parlance--and retained a separate law firm to prosecute the declaratory judgment action. (13) A single State Farm adjuster, Ted Krempa, managed both cases. Krempa was the company's sole point of contact with the Durants' independent counsel, Dwight Worden, and also communicated with the law firm serving as coverage counsel. Krempa thus "served in a dual capacity, assisting and communicating with counsel defending [the] Durants in the liability case, and at the same time communicating with and assisting the State Farm counsel asserting lack of coverage in the declaratory relief action." (14) Krempa maintained only one file. (15)

      In the bad faith case, the Durants sought production of all documents in Krempa's file. Their theory was that an adjuster handling the defense of a liability action is the agent of the insured and any independent counsel, and that an insured and its lawyer are thus entitled to see everything in the adjuster's file. The Durants argued that since Krempa was their agent, any communication he had with coverage counsel waived any attorney-client privilege that might otherwise have attached, just as if he had communicated directly with the Durants. (16) The trial court agreed with the Durants and State Farm petitioned the California Court of Appeal for a writ of prohibition.

      The State Farm court began its analysis by observing that Cumis required "complete independence of counsel" in cases raising a conflict of interest. (17) As the court saw matters, the Durants were asking it to add a layer of separation to this mandate and require "that not only the counsel involved in the cases but the adjusters assigned to each case (the 'liability' case as distinguished from the 'coverage' case) be separate--that the files on each case be separate and apart--and indeed ... that a veritable wall be erected between the insurance company's administration of the two cases." (18) The court declined to adopt this approach.

      The court recognized that an adjuster serves as the insured's agent in the defense of a liability action and that as a result, communications with the adjuster are protected by the attorney-client privilege. The adjuster is most easily understood to be the insured's agent in cases in which coverage is clear. (19) That does not mean, however, that the adjuster is the insured's agent for all purposes or in all instances. An adjuster is also the insurer's agent. Where coverage is at issue, the adjuster's loyalties are "divided" and an insured cannot reasonably expect the adjuster to be concerned with only its interests. (20) The independent counsel regime was created to remedy this problem. Indeed, the court continued, the presence of independent counsel adequately protects insureds' interests in case such as this one. (21) The court concluded that for economic reasons "it would be unwise to impose yet another layer of administration" on liability insurers. (22)

      The court noted that this was not a case in which an adjuster took advantage of misplaced or mistaken confidences. Worden understood State Farm's potential adversity; it was his responsibility as independent counsel to prevent improvident revelations to Krempa and, through Krempa, to State Farm. (23) Nor was there...