Insurance & Reinsurance - USA

Introduction
Duty-to-Defend Policies v Indemnity Policies
Office of General Counsel’s Opinion Letter
Comment

Introduction

The New York Insurance Department has long prided itself on being an activist state regulator for insurance business underwritten in the world’s financial capital. In a surprise development, the insurance department has waded into an area thought not to be an area of controversy or dispute – defence arrangements under directors' and officers' liability (D&O) policies. It remains to be seen whether this first effort by the insurance department to regulate more closely D&O insurance contracts is indicative of further regulatory actions to come.

The department recently refused to approve a D&O policy form that obligates policyholders to arrange and direct their own defence. The legal basis for this refusal was the subject of an opinion letter from the department’s Office of General Counsel issued in October 2008. In light of the department’s previous approval of such policy forms, this can only be seen as a fundamental change of regulatory policy affecting New York licensed D&O insurers that underwrite public company D&O insurance. Contrary to the views of some commentators, however, the department has not taken a new position on the separate issue of whether D&O policies may contain a defence costs within policy limits provision.

Public company D&O policyholders have long viewed their right to select their own choice of defence counsel and to direct their own defence as a non-negotiable coverage feature. Under the department’s current position, policy forms submitted for approval must state that the defence of D&O claims is to be provided by D&O insurers (although policy forms providing policyholders with a limited ability to associate in their own defence may be approved). It remains to be seen whether the department’s new position will face fiercer opposition from D&O insurers that would potentially face expanded defence obligations or from D&O policyholders that would potentially face a materially shrunken role in their own defence of D&O claims.

Policy wording
In order to obtain approval of new D&O policy wordings, D&O insurers must draft D&O policies with the following new features: (i) the new D&O wording must affirm that the insurer owes a ‘duty-to-defend’ claims to which the policy applies; and (ii) the new D&O wording may not contain provisions allocating coverage for defence costs between covered and uncovered loss.

Affected policies
Although both primary and excess admitted D&O policies subject to future approval by the New York Insurance Department must reflect that the coverage provided is duty-to-defend in nature and both will bear the added loss costs attendant to this new coverage requirement, the additional obligations will affect the primary D&O insurer most immediately.

Defence costs coverage obligation
Presumably, because the department did not expressly address this issue, defence costs within or inside limits provisions are still permitted, so this coverage feature is not affected by the department’s recent change in position.

Existing policies
Existing policies previously issued to insureds on approved forms should not be affected by the Office of General Counsel opinion, which does not have the force of law or regulation. Likewise the issuance of new, non-duty-to-defend policies on forms previously approved by the department should not be affected by the Office of General Counsel opinion. However, it is likely that the department will seek to adopt, by regulation, a prohibition on the future sale of non-duty-to-defend D&O policies in New York.

Right to challenge
First, an affected party (either a policyholder or a D&O insurer) may file an Article 78 proceeding in New York court seeking to compel the department to approve non-duty-to-defend D&O policy forms on the grounds that the argument presented in the Office of General Counsel opinion letter is a flawed interpretation of the law. Alternatively, a group of affected parties may initiate lobbying efforts to push through legislation specifically granting insurers the right to underwrite non-duty-to-defend D&O policies.

Short-term obligations
Licensed D&O insurers seeking approval of previously unapproved D&O policy forms in New York will need to ensure that those policy forms explicitly recognize that the D&O insurer owes a duty to defend reported claims.

Duty-to-Defend Policies v Indemnity Policies

The phrase 'duty-to-defend' is a term of art in the insurance industry with roots in the common law. In general terms, the duty to defend refers to an insurer’s duty to hire and compensate defence counsel and any other necessary professionals when an insured party is named in a lawsuit (or other proceeding) for which coverage is available. D&O policies underwritten for public companies originally were underwritten as ‘indemnity’ policies that imposed no kind of contemporaneous defence or defence funding obligation on the D&O insurer. Instead they required D&O insurers to include defence costs when tallying up their overall obligation to pay ‘loss’ after a covered claim had been fully resolved. This arrangement worked reasonably well when D&O insurers were providing reimbursement coverage to policyholder corporations (ie, reimbursing the corporation for its advancement/indemnification payments to or on behalf of its directors or officers), because solvent corporate policyholders could afford to wait until the end of a D&O claim before seeking reimbursement of their D&O payments from the insurer. However, when the corporate policyholder was insolvent or otherwise unable to provide advancement or indemnification (eg, in connection with a shareholder derivative lawsuit, where indemnification may be prohibited), the at-risk insureds were the directors and officers themselves – and the concept of waiting until the end of the lawsuit to recover their payments and defence costs was decidedly unattractive.

To address this issue, D&O insurers modified their policy wordings to provide that for purposes of so-called ‘side A’ claims (where no corporate advancement or indemnification was available), the D&O insurers would advance defence costs, while still maintaining a strict indemnity obligation for reimbursement of ‘side B’ indemnification payments. Over time, D&O insurers dropped the ‘indemnity-only’ requirement for side B claims too and D&O insurance policies generally obligated the D&O insurers to advance covered defence costs for all D&O claims – whether covered by side A or side B of the D&O policy.

Significantly, however, D&O insurers continued to treat the D&O coverage as ‘duty to reimburse’ (albeit contemporaneously) and did not transform the coverage into duty-to-defend coverage. This is a distinction with a difference, in that ‘duty-to-reimburse’ coverage was intended to allow D&O insurers to allocate between covered and non-covered claims for relief and between covered and non-covered parties – primarily to protect the D&O policy from dilution through payments for uncovered matters and uncovered parties.

The right of D&O insurers to seek an allocation between covered and uncovered claims for relief was first seriously limited in 1985 by the Maryland Supreme Court, which ruled that allocation of defence costs could not be undertaken if the defence of uncovered matters was ‘reasonably related’ to the defence of covered matters.(1)

In more recent cases courts have continued to make it difficult for insurers to withhold payment of defence costs prior to a judicial finding of no coverage.(2)

The court in Federal v Kozlowski stated:

"This court has recognized that under a director's and officer's liability policy calling for the reimbursement of defence expenses, as in Gon and Okada 'insurers are required to make contemporaneous interim advances of defence expenses where coverage is disputed, subject to recoupment in the event it is ultimately determined no coverage was afforded'."

The duty to pay “arises at the time the insured becomes ‘legally obligated to pay’”. The contemporaneous payment of defence costs is required because:

“the only reasonable interpretation of the loss clause in the directors and officers policy is that the insurer's obligation to pay accrues when the insured incurs the obligation, not after it has paid a judgment."

Thus, while Federal had to pay defence costs as they were incurred in the securities action and the criminal proceeding, its ultimate liability for such costs was with respect only to such liabilities as fell under the coverage provided. To the extent such liabilities were excluded from coverage by the personal profit exclusion, Federal was not required to pay for defence costs. Since this allocation could not be made at this juncture and the duty to defend was broader than the duty to indemnify, Federal had to pay all defence costs as incurred, subject to recoupment when Kozlowski's liabilities, if any, were determined.(3)

The Federal v Kozlowski Case identified another leverage issue important to D&O insurers: recoupment. Under non-duty-to-defend policies, a D&O insurer can reserve its right to seek recoupment of defence costs paid by the D&O insurer prior to a court finding of no coverage. Depending on the overall amount of defence costs previously advanced by the D&O insurer, the prospect of being required to repay those amounts could well impact on a D&O policyholder in deciding whether to settle with the D&O insurer and on what terms. Jurisdictions are divided on whether an insurer has a similar right of recoupment under a duty-to-defend arrangement.

Although the specific rights and duties of insurers under insurance policies vary according to specific policy language, the following are general conceptual differences between indemnity policies and duty-to-defend policies:

• In indemnity policies, the insured retains and manages defence counsel and controls the litigation (including settlement negotiations); in duty-to-defend policies, the insurer has each of these rights and duties. Notably, however, depending on the applicable policy language of both indemnity and duty-to-defend policies, the insurer or insured, respectively, may retain some say in the choice of counsel, management of counsel and control of the litigation.
• Duty-to-defend policies generally impose a duty on the insurer to defend a claim entirely if any portion or aspect of the claim is covered; case law interpreting indemnity policies generally upholds the rights of insurers to allocate between covered and uncovered aspects of claims.
• Duty-to-defend policies require insurers to bear – on a first dollar basis – the costs of litigation (deductibles are typically applied at the time of settlement); in indemnity policies, the insured must cover the initial costs of litigation until the self-insured retention is exhausted and then seek reimbursement from the insurer for amounts incurred in excess of the retention.
• Duty-to-defend policies require the insurer to pay for the defence of a claim until a court (or arbitrator) finds that the insurer owes no coverage obligation. At that point, in certain jurisdictions, the insurer’s only right is to discontinue paying defence costs.(4) In a ‘duty-to-advance’ situation, the insurer can reserve the right to later seek recoupment of previously advanced defence costs if it is later determined that the claim at issue is not covered.

Office of General Counsel’s Opinion Letter

Opinion letters issued by the Office of General Counsel are not legally binding. In addition, while the department’s opinion letter signals that the department will decline to approve non-duty-to-defend D&O policy forms going forward, this opinion letter in no way alters or modifies the contractual terms of insurance policies that have already been approved and issued to insureds.

On October 16 2008 the Office of General Counsel of the New York State Insurance Department issued an opinion letter that advised that “a D&O liability policy may not include a provision that places the duty to defend upon the insured, rather than the insurer”. This opinion letter was in response to an inquiry from an insurance company whose D&O policy filing was denied.

In the fairly lengthy discussion portion of the opinion letter, the department references three legal grounds for its decision: New York Insurance Law Section 1113, New York Insurance Law Section 3420 and Regulation 107. As set forth below, these legal grounds provide relatively weak support for the department’s conclusion. However, even if the department’s opinion letter lacks a strong legal basis, New York licensed insurers seeking approval for new D&O policy forms nevertheless must comply with the department’s position or risk that their forms will be denied approval.

New York Insurance Law Section 1113
The department first seeks to support its conclusion by referencing Section 1113(a)(13) of the New York Insurance Code, which defines ‘personal injury liability insurance’ (of which D&O liability is a type) as “insurance against legal liability of the insured and against loss, damage or expense incident to a claim of such liability”. The department states that pursuant to this statutory language, D&O insurance must “include coverage for legal defence costs associated with a covered claim”. Of course, this basic statement provides little or no support for the department’s position, because both non-duty-to-defend and duty-to-defend D&O policies provide coverage for “legal defence costs associated with a covered claim”. There appears to be no reason to conclude that Section 1113(a)(13) mandates that D&O policies place the duty to defend on insurers.

New York Insurance Law Section 3420
In further support of its decision, the department asserts that New York Insurance Law Section 3420 “evidences a New York public policy” of protecting “a potential liability policy claimant from being denied compensation under the policy due to failings of the insured”. In distinguishing between ‘policy claimant’ and ‘insureds’, the department likely is asserting that this public policy serves to protect insured parties other than the insured entity (ie, individual directors or officers). In short, the department appears concerned that under an indemnity policy, the actions of an insured entity can undermine another insured party’s ability to obtain insurance coverage for defence costs.

Regardless of whether the department accurately states the public policy underlying Section 3420, the department appears to be ignoring the fact that many policy provisions unrelated to the duty to defend create the possibility that the actions of the insured entity or a single insured party could undermine coverage for other insured parties (eg, provisions permitting the insurer to rescind a policy based on misrepresentations made in the policy application). In addition, the fact that the department can point only to an implied ‘public policy’ underlying Section 3420, rather than an explicit provision of the text of Section 3420, suggests that Section 3420 provides, at best, weak support for the department’s position.

Regulation 107
The department also references Regulation 107(5) in support of its position that a D&O insurance policy must place the duty to defend on the insurer. The department, in quoting Regulation 107, asserts that the duty to defend consists of “more than simply paying defence costs” and entails “providing a proper defence”. Notably, however, Regulation 107 regulates only whether a policy may place defence costs inside the limits of liability (ie, provide that defence costs reduce or exhaust the policy’s limits of liability), and does not regulate whether a policy must contain a duty to defend. It is therefore puzzling that the department relies upon this provision in asserting that insurance policies should contain a duty to defend.

In addition, the department cites Regulation 107 for the proposition that D&O policies may not “limit the availability of insurance coverage for legal defence costs”. The department appears concerned that indemnity policies “limit the availability for legal defence costs” because they:

• require insureds to take charge of the defence as a condition to coverage;
• require insureds to absorb the administrative costs of the litigation; and
• permit the insurer to allocate between covered and uncovered matters.

As explained above, Regulation 107 does not address the issue of whether D&O policy forms must contain a ‘duty to defend’. Similarly, Regulation 107 does not regulate whether D&O policy forms may contain allocation provisions. As such, the department appears to be interpreting Regulation 107 more broadly than is justified.

Defence costs within limits
The department’s opinion letter is a response to a specific question – whether a “D&O liability policy may include a provision that places the duty to defend upon the insured rather than the insurer”. It would appear that the opinion letter fails to address the issue of whether a D&O policy may contain a ‘defence costs within limits’ provision. Indeed, duty-to-defend provisions are separate and distinct from provisions that place defence costs ‘inside’ or ‘outside’ policy limits, and although certain duty-to-defend policies reserve those policies’ limits of liability solely for settlements or judgments, many policies place defence costs inside limits of liability. Such defence costs do erode or exhaust policy limits. Thus, the department’s position that it will not approve new non-duty-to-defend D&O policy forms does not in itself indicate that the department will not approve new defence costs within limits D&O policy forms.

Moreover, although the department’s opinion letter references Regulation 107 for the proposition that liability policies may not “limit the availability of legal defence costs”, the department’s opinion letter also explicitly acknowledges that Regulation 107 contains certain exceptions, including an exception for D&O policies. Given that the department has not specifically addressed whether defence costs within limits provisions are proper, and given that it has not disavowed Regulation 107, insurers should assume that Regulation 107 remains in force and that defence costs within limits provisions that comply with Regulation 107 will be approved.

Insured’s control over the litigation
Although the department clearly states that new D&O insurance policy forms must place the duty to defend on the insurer, the department’s opinion letter also indicates that it may approve policy forms that grant control over selection of defence counsel and participation in the defence to the insured. The department’s letter states that it:

"conceivably would approve a policy filing under which the insured has an option to exercise some degree of control over or significant participation in the defence of a claim, provided that the insurer maintains the ultimate duty to defend.”

Comment

Unfortunately, the department’s position will create new obligations for D&O insurers that decide to write D&O policies placing the duty to defend on the insurer. Under duty-to-defend policies, insurers are liable for additional administrative costs in managing litigation (even to the extent that the department permits control over the litigation to be transferred to the insured). However, most importantly, whereas D&O insurance policies typically permit an insurer to allocate between covered and uncovered matters, under the common law applicable to duty-to-defend policies and the department’s clear edict in its opinion letter, insurers will now be responsible for defending 100% of a claim even where only a portion of that claim is covered. It is not yet known how these changes will affect premium pricing for D&O policies.

In addition, insurers that issue duty-to-defend D&O policies to public company insureds will face significant legal uncertainties as, for the first time, they will be subject to the body of law governing duty-to-defend policies. While D&O underwriters and claims handlers are familiar with the body of case law addressing defence costs issues arising in non-duty-to-defend D&O policies, they are unlikely to be as well versed in duty-to-defend case law. Equally importantly, given that there is little duty-to-defend case law in the D&O context, courts will be required to apply, by analogy, duty-to-defend case law precedent from other contexts (ie, environmental liability insurance) to potentially non-analogous D&O situations. As such, New York D&O insurers that issue duty-to-defend D&O policies to public companies will be charting new territory.

The department’s position on this issue is widely viewed as unfortunate and harmful to insurers and insureds alike. Although D&O insurers, brokers and policyholders are still absorbing and considering the department’s revised position, a few different possible responses can be foreseen. First, an affected party (either an insured or an insurer) may file an Article 78 proceeding in New York court seeking to compel the department to approve non-duty-to-defend D&O policy forms on the grounds that the argument presented in the Office of General Counsel opinion letter is a flawed interpretation of the law. In this regard, the department explicitly acknowledges, in its opinion letter, that there is no case law support for its position:

“No New York case has addressed the superintendent’s authority under the Insurance Law to require a D&O policy to place the duty to defend upon the insurer."

Further, as explained above, the department provides little or no support for its position in the New York insurance law or in the department’s regulations.

Second, a group of affected parties may initiate lobbying efforts to push through legislation specifically granting insurers the right to underwrite non-duty-to-defend D&O policies. However, in the meantime, it appears that licensed D&O insurers seeking approval of new D&O policy forms in New York will need to ensure that those policy forms place the duty to defend on the insurer. A murkier question is whether the department intends to take steps to try to preclude insurers from continuing to write D&O policies on previously approved policy forms that do not place the duty to defend on the insurer.

For further information on this topic please contact John F McCarrick, Neil R Pearson, Maurice Pesso or Peter de Boisblanc at Edwards Angell Palmer & Dodge by telephone (+1 212 308 4411) or by fax (+1 212 308 4844) or by email (jmccarrick@eapdlaw.com or npearson@eapdlaw.com or mpesso@eapdlaw.com or pdeboisblanc@eapdlaw). The Edwards Angell Palmer & Dodge InsureReinsure.com Blog can be accessed at www.insurereinsure.com.

Endnotes

(1) See Continental Cas Co v Bd of Educ of Charles County, 489 A2d 536 (Md 1985).

(2) See, for example, Federal Ins Co v Kozlowski, 18 AD3d 33, 792 NYS2d 397 (1st Department 2005).

(3) 18 AD2d at 42.

(4) At least one court in New York has addressed this issue. See Gotham Ins Co v GLNX, Inc, No 92 Civ 6415 (TPG) (SDNY 1993) (holding that an insurer with a duty to defend may recoup defence costs upon a finding of no coverage).

(5) 11 NYCRR Section 71, et seq, last amended in 1997.