California Supreme Court’s Crawford Decision Changes the Face of Defense Payments and Potential for Erosion of Policy Limits

August 1, 2008

California’s Supreme Court recently threw the business community, and their insurers, a curve-ball. In particular, the court determined that the indemnity provisions of a contract obligated the indemnitor to begin paying the defense costs of the indemnitee at the outset of a lawsuit, prior to the time that it could be determined whether or not there would be liability on the indemnitee because of the negligence of the indemniter.

Assume that X (indemnitor) and Y (indemnitee)enter into a contract, for the lease of a building, for the sale of a product, to provide a service or for some other business purpose. X agrees to indemnify Y if Y is liable to a third party for damages, caused to some degree by the negligence of X. (Yes, each contract is unique and its terms are unique, so each contract needs to be reviewed and evaluated on its own merits.)  A lawsuit is filed against Y, seeking damages because of injury. Y thinks that the injury is attributable to the negligence of X and that X should defend/indemnify Y for any damages that Y incurs in connection with the lawsuit. Y tenders its defense of the lawsuit to X. 

X may or may not have insurance applicable to the loss. X may not also be sued in the lawsuit. Neither is pertinent to the analysis.

If the Crawford decision applies to the X /Y contract, then at this point, X will need to pay to defend Y in the lawsuit. If X is self-insured, then that expense will come out of X’s corporate coffers.  If X has insurance applicable to the loss, then X will turn to its insurer and ask that the insurer pay Y’s legal fees.

At that point, X’s insurer will need to look at the insurance contract entered into between X and the insurer, to determine what the policy says about coverage for liability that X has assumed under an “insured contract” (the X/Y contract may or may not be an “insured contract” as defined by the policy). If the X/Y contract is an “insured contract” within the meaning of the insurer’s policy, and there are no other coverage defenses, then X’s insurer will be obligated to indemnify X for the attorney fees/costs that X must pay to Y under the indemnity provision of the X/Y contract. (Stated another way, X’s insurer will need to pay Y’s defense fees/costs.) 

Because these payments are paid under the policy’s coverage provisions, they are indemnity payments made on behalf of X and they apply to reduce the policy’s available liability limits. (i.e. If X has a $1 million policy limit and $200,000 in attorney fees/costs are paid out for Y’s defense expense, then X now has only $800,000 liability limits remaining.)  The same is true for settlement payments made on behalf of Y.
So what should X do when it gets the demand from Y?  At the very least, X should:

1.    Review the X/Y contract to see if there is an applicable indemnity provision (the services of an attorney may be needed);

2.    Review its CGL policy (or other applicable policy) to see if it might have coverage for Y’s claims;

3.    Regardless of what X might think to be the answer to #2, tender the matter to all of X’s insurance carrier(s) and cooperate with the insurer’s investigation;

4.    If X has no applicable insurance coverage, it will need to investigate the loss and secure pertinent information regarding the loss or lawsuit, eg. get copies of demands, pleadings, loss information, etc.;

5.    Ultimately, respond to the tender. Whether X agrees to defend or not, in its response to Y, X needs to reserve its rights under the terms and conditions of the X/Y contract as to whether or not the contract is applicable to the loss and whether X has any obligations to Y under the contract. 
6.    Undertake to defend, or not, with or without your insurer.

What should X’s insurer do when it gets the tender from X?  At the very least, the insurer should:

    1.  Open a claim file and undertake to investigate the matter and evaluate it for coverage;

    2.  Evaluate the matter under both the “insured contract” exception to exclusion b of the CG0001 form (or its counterpart) and the “supplementary payment” provisions of the policy;

    3.  If the X/Y contract is an “insured contract” and the policy is otherwise applicable to the loss, agree to indemnify X for what X owes to Y under the X/Y contract, with or without reservation of rights (again, depending on the coverage analysis), working out an appropriate payment arrangement. Payments of Y’s expense fees/costs and any settlement funding will be paid as indemnity payments inside of the policy’s limits. 

    4.  If the X/Y contract is not an “insured contract”, then there is likely no coverage for X for what X might owe to Y as indemnity and no obligation to indemnify X for Y’s attorney fee payments. Again, however, each policy is unique and must be evaluated on its own merits and per its own terms and conditions. 

    5.  Whether or not the X/Y contract is an “insured contract”, if the loss otherwise falls within the scope of coverage available to X if X is directly sued in the matter, take a look at the policy’s “supplementary payment” provisions to determine if those requirements for defending Y could be satisfied, so that the attorney defending X could also defend Y. “Supplementary payments” are generally outside of limits.

   6.  Make a decision, properly advise the insured and proceed to handle the matter accordingly.

    7.  If agreeing to defend, consider other insurers who may need to participate in the defense of Y, including Y’s direct insurer, its “additional insured” insurers, and any other business entities that may have their own indemnity obligations for the claims at issue.

The end result?

•    If X has insurance, it will likely ask its insurer step into the defense at the outset rather than at the end of the matter;

•    If X has no insurance, it needs to consider how it plans to defend the matter.

•    For X’s primary insurers, you will be in essentially the same position as Y’s AI carriers, but your limits will generally be depleted by your payments (whereas an AI carrier’s payments would not deplete limits if defense is outside of limits). You will need to work out allocations with other responsible parties and you may find your policies exhausting earlier (so may need to give earlier notice to excess carriers and/or reinsurers).

•    For X’s excess insurers, you may find that the primary policy is exhausted earlier than it would have been had the primary insurer not had to indemnify X for Y’s defense fees/costs. You need to keep a closer eye on monitoring losses and factor in the effect of payments of Y’s defense fees/costs.

•    For reinsurers – the payments for Y’s attorney fees/costs will be indemnity on behalf of X and covered damages, with the impact of that turning on the terms of the applicable reinsurance treaties.

•    If you are Y, you want a strong indemnity provisions without exceptions that might mean that X doesn’t have to pay until after determination of negligence. You also want to have Additional Insured status under X’s policy, so that defense fees/costs don’t reduce limits available under X’s policy to pay whatever judgment or settlement must be paid. If not an AI, then the net effect of X’s policy for your purposes is that it is a burning limits policy, eaten up by payment of your attorney fees. This asset needs to be managed carefully during litigation and defense expense should not be allowed to eat up otherwise available policy limits that could be used to pay the claimant.

•    If you are X, you will want to try to modify the wording of future contracts to avoid this situation in the future, or insure against it.

•    Once a defense has been assumed, there are approaches that can be taken to ensure that the attorney fees paid are reasonable, that they are related to the work of the insured and other such things. The same kind of audits, motions and arguments that are often taken by insurers with respect to independent counsel (CA Civil Code section 2860) and “Buss rights” can be applied to what are now being called “Crawford fees”.