News - October 2005

• Carrier Recovers Defense Costs for Non-Covered Claims
• Vacancy Exclusion Applies to Building During Renovation
• Late Notice Excused Under "Claims Made and Reported" Policy
• Knowledge of Broker Who Becomes Agent Can Defeat Rescission

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Carrier Recovers Defense Costs for Non-Covered Claims

The California Supreme Court has ruled that when a CGL insurer properly reserves its rights to recoup defense costs from its insured, the insurer can obtain full reimbursement of those defense costs if the insurer ultimately establishes that the policy never afforded a potential for coverage at the time of tender. (Scottsdale Insurance Company v. MV Transportation (2005) 36 Cal.4th 643)

Facts

A third-party competitor sued MV Transportation for breach of contract, unlawful business practices and misappropriation of trade secrets. MV tendered its defense to Scottsdale, MV's general liability insurer. Scottsdale asserted it did not believe its defense obligation was triggered based on the facts alleged in the underlying action. However, Scottsdale agreed to defend MV under a reservation of rights, including the right to seek reimbursement of defense costs for causes of action not potentially covered. MV and its competitor ultimately settled the underlying case.

In a separate action for declaratory relief, Scottsdale filed a motion for a determination that it never had a duty to defend and that it was entitled to reimbursement of all defense costs it advanced. The trial court denied Scottsdale's motion.

While the Court of Appeal reversed the trial court and found that Scottsdale did not have a duty to defend, the Court of Appeal nonetheless concluded that Scottsdale's defense duty was only extinguished prospectively and that Scottsdale was not entitled to reimbursement of defense costs from the insured. Scottsdale then sought review in the California Supreme Court.

Holding

The Supreme Court reversed, in part, the Court of Appeal's decision. The Supreme Court affirmed the determination that Scottsdale never had a duty to defend, and separately held that Scottsdale was entitled to reimbursement of all defense costs it had advanced to MV.

The Supreme Court reasoned that, because there was never a potential for coverage at the time of tender, a duty to defend "never arose." Because Scottsdale properly reserved its right to seek reimbursement of defense costs from its insured, and because Scottsdale established that there was never a potential for coverage with respect to any of the claims asserted in the underlying action, the Supreme Court concluded that Scottsdale was entitled to reimbursement of all defense costs.

Comment

This case provides important clarification of a CGL insurer's Buss rights. While the Buss case analyzed an insurer's defense costs reimbursement rights in a "mixed" action (i.e. an action involving potentially covered and non-covered claims), the MV Transportation caselogically extends an insurer's Buss rights to an action in which there was no potential for coverage for any of the claims at the time of tender.

Consequently, when an insurer is faced with a tender of defense involving unsettled case law concerning the policy's potential coverage, the insurer is not forced to deny a defense outright and risk a bad faith suit by the insured. Instead, the insurer can "in an abundance of caution, afford the insured a defense under reservation of rights," with the understanding that the insurer can recoup all defense costs advanced if the insurer later establishes, as a matter of law, that its duty to defend never arose.

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Vacancy Exclusion Applies to Building During Renovation

The California Court of Appeal has ruled that a building under renovation is not "under construction," and that damage that occurs while the building is vacant does not fall within an exception to a vacancy exclusion. (TRB Investments, Inc. v. Fireman's Fund Insurance Company (2005) 130 Cal.App.4th 1594)

Facts

TRB Investments, Inc. purchased a tenant-occupied commercial building, and insured the building through Fireman's Fund. Upon termination of the lease, the tenant vacated the building.

Several months after the initial tenant vacated the building, TRB entered into a lease with a new tenant. The new lease agreement provided that, before the new tenant moved into to the building, TRB would make various renovations. TRB hired a general contractor, who began the renovations.

Over a period of two weeks, subcontractors worked on the building's electrical system and air conditioning system. During a weekend, when no work was underway, a water heater failed, causing extensive water damage to the building.

The policy contained an exclusion that eliminated coverage for certain kinds of damage (including water damage) if the building had been "vacant" for more than 60 days prior to the loss. The policy defined a building as "vacant" if it did not contain enough business personal property to conduct customary operations. It was undisputed that, at the time of the loss, the building did not contain enough business personal property to conduct customary operations.

However, the exclusion also contained an exception that provided that a building "under construction" was not vacant. TRB asserted the building was "under construction" because of the renovations and that, therefore, the exception to the exclusion applied. Fireman's Fund disagreed, and denied TRB's claim. TRB sued Fireman's Fund, but Fireman's Fund prevailed in the trial court and in the California Court of Appeal.

Holding

The Court of Appeal held that a building undergoing renovation is not "under construction" within the meaning of the exception to the exclusion. The Court held that the term "under construction" applies to construction of a new structure, not to renovation of an existing structure.

According to the Court of Appeal, the purpose of the vacancy exclusion is to prevent vandalism and to ensure prompt discovery of other types of damage. The Court reasoned that buildings that are under construction usually have workers present on almost a daily basis, which deters vandalism and allows for relatively quick discovery of other types of damage.

The test, according to the Court of Appeal, is whether the building is complete enough so that its intended occupants can occupy it. The Court concluded a building under renovation is one that presently can be occupied, but nonetheless requires some repairs and improvements in order to meet the needs of the intended occupant.

Comment

This is the first case in which a California appellate court has issued a reported decision interpreting the meaning of the term "under construction" in an exception to a vacancy exclusion. There is a split in authority among other appellate courts around the contrary, with some finding that a building undergoing renovation is a building "under construction," and some finding a building undergoing renovation is not a building "under construction."

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Late Notice Excused Under "Claims Made and Reported" Policy

The California Court of Appeal has held that, to avoid an inequitable forfeiture, a lawyer was excused from his failure to report a claim to his professionally liability insurer within the policy period, despite the fact the conditions of the policy provided coverage only for "claims made and reported" during the policy period. (Root v. American Equity Specialty Ins. Co. (2005) 130 Cal.App.4th 926)

Facts

American Equity issued a professional liability policy to Attorney Walter Root. The policy provided coverage for "claims made and reported" to American Equity from February 28, 1998 to February 28, 1999. The policy required Root to report a claim within the policy period as a condition precedent for coverage.

On February 25, 1999 (three days before the expiration of the policy), a reporter called Root and asked him to comment on a malpractice suit filed by Root's former client. Root thought the call was a prank, since he had obtained a $2.75 million settlement for the client.

Root went on a short vacation and returned on March 2, 2005. At that time, he read a news article about the malpractice suit and realized the call a few days earlier was not a prank. Root immediately notified American Equity about the suit. However, American Equity refused to defend the suit because Root had failed, by two days, to report the claim within the policy period.

Holding

Under Civil Code section 3275 and under common law, a court may excuse compliance with a condition of coverage when enforcement of that condition results in an inequitable forfeiture. The Court of Appeal held that the reporting requirement of the American Equity policy operates as a forfeiture because it removes from coverage a claim that otherwise would be covered, based solely on an action the insured does not take.

The Court concluded enforcement of the reporting requirement was inequitable under these facts because: (1) Root missed the reporting deadline by only two days; (2) he had a short amount of time (less than 2 business days before expiration of the policy) to investigate the basis of the reporter's phone call; (3) he reported the claim to American Equity the same day he read about it in a legal journal; and (4) American Equity gave Root no opportunity to purchase an extended "tail" period to report late-in-the-policy claims. The Court did not base its decision on the "notice prejudice" rule that is applicable to "occurrence-based" liability policies.

Comment

This case is significant because it essentially allows for the possibility that an insured can circumvent a "claims made and reported" clause by offering a reasonable excuse for failure to comply with the clause. Of course, the issue of whether the insured's failure to comply with the condition will result in an inequitable forfeiture often will involve a question of fact that a court will have to decide on a case-by case-basis.

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Knowledge of Broker Who Becomes Agent Can Defeat Rescission

The California Supreme Court has ruled that knowledge of a broker (who later becomes an agent for an insurer) can be imputed to the insurer if that knowledge is present in the mind of the agent while acting for the insurer, and that such knowledge can defeat a rescission claim. (O'Riordan v. Federal Kemper Life Assurance (2005) 36 Cal.4th 281)

Facts

Patrick and Amy O'Riordan consulted Robert Hoyme, an independent insurance broker, to obtain life insurance policies. During meetings with Hoyme, the O'Riordans filled out application forms for Federal Kemper Life Assurance policies at the preferred nonsmoker rate.

On the application, Kemper inquired whether the applicant had "smoked cigarettes in the past 36 months?" Amy told Hoyme she had quit smoking five years ago but stated she "might have had a couple of cigarettes in the last couple of years." Hoyme indicated "that's not really what they're looking for," and marked the "no" response.

Prior to the O'Riordans' applications, Hoyme had not sold insurance for Kemper. After filling out the O'Riordans' applications, Hoyme submitted a request to be appointed as Kemper's agent to Cenco Insurance Marketing, a general agent for Kemper with authority to recruit agents. Cenco thereafter approved Hoyme's request to be appointed a Kemper agent.

When Amy died from breast cancer nearly two years later, Patrick made a claim for benefits under the Kemper policy. Kemper did an investigation and found that, less than a year before Amy applied for the policy, Amy had asked her physician for, and received, a nicotine patch. Kemper denied the claim and rescinded the policy based on Amy's alleged material misrepresentation that she had not smoked in the 36 months prior to the application. Patrick sued Hoyme, Cenco and Kemper.

The trial court granted Kemper's motion for summary judgment and the Court of Appeal affirmed.

Holding

The California Supreme Court reversed, holding there was a material issue of fact as to whether Amy had concealed her smoking in the application because the question in the application could be construed as an inquiry regarding "habitual" use (as Hoyme allegedly had interpreted the question).

The Supreme Court further held that a broker who later becomes an agent has a duty to disclose to the insurer any material information regarding the application, and that knowledge an agent acquires before the commencement of an agency relationship can be imputed to an insurer if that knowledge can reasonably be said to be present in the mind of the agent while acting for the insurer.

Comment

This case illustrates that an insurer who seeks to rescind a policy must carefully examine the application to determine whether the application can be deemed to be ambiguous.

This case also illustrates the sometimes hazy nature of the duties owed by a person who is both a broker and an agent. The case further demonstrates that knowledge that a broker acquires before the establishment agency relationship sometimes can be imputed to the insurer.

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