Ordinarily, when a liability policy has a self-insured retention ("SIR"), the insurer's duty to defend does not attach until the SIR is exhausted.1 But, in American Safety Casualty Insurance Co. v. City of Waukegan,2 the US Seventh Circuit Court of Appeals (in an opinion by Judge Easterbrook) held that, absent clear policy language deferring the duty to defend, the duty attached immediately. Moreover, on a point applicable only in Illinois and not discussed further here, in the absence of a declaratory judgment action or other effort to resolve trigger disputes among the insurers, the failure to defend was vexatious and subjected the insurer to an award of attorneys' fees for the coverage litigation.
Insurers whose primary policies have SIR's should review them to make sure the language on accrual of the duty to defend is clear. Where attachment of the duty to defend becomes an issue in litigation, they should take care to call all relevant policy language to the court's attention and to explain facts about insurance market use of SIR's that the Seventh Circuit misunderstood. And, even if the duty to defend has not attached, a prudent insurer should determine whether there are other coverage issues promptly after notice of the suit.
The Case
Substantively, American Safety was a case about trigger of coverage for a malicious prosecution action (when the improper conduct leading to a wrongful conviction occurred or when the defendant was exonerated). The Seventh Circuit held the latter.3
That left the question of the SIR's effect on the policy's duty to defend. The duty to defend language was: "We shall have the right and duty to select counsel and defend any claims seeking damages to which Part II applies. Our right and duty to defend ends when we have used up the applicable limit of insurance in the payment of judgments or settlements." 4
The self-insured retention condition provided:
"Self Insured Retention" means: that sum or sums indicated in the Declarations or Schedule of "Self Insured Retentions" which the "Insured" shall pay: (a) For settlement or satisfaction of claims, "Suits" of judgments, after making deductions for all salvages and recoveries; plus (b) "Allocated Claims Expenses" . . . . The "Self Insured Retention" shall be paid by the "Insured" prior to any obligation on the part of this Company. This "Self Insured Retention" shall be funded by an "annual Aggregate Loss Fund" administrated by a "Third Party Administrator."5
The district court held that "exhaustion of Waukegan's self insured retention was not a precondition to the duty to defend and [did] not excuse American Safety from its duty to defend."6 It reasoned that the language was ambiguous as to whether the SIR affected the duty to defend.7 It also awarded attorneys' fees as a statutory penalty for vexatious delay in providing benefits.8
The Seventh Circuit affirmed on both the structural holding and the vexatious delay penalty. Describing the SIR as a "deductible," it reasoned that the duty to defend language in the policy set an endpoint on the duty to defend but no deferred starting point. Moreover, it saw little logic in requiring exhaustion of the deductible before the duty to defend arose. That would obstruct the insured's ability to obtain a defense if it lacked funds to obtain counsel and would entail switching lawyers when the SIR was exhausted, causing unwarranted delay and extra expense.9 Indeed, the Seventh Circuit thought that requiring the insured to defend undermined both parties contractual purposes in agreeing to a right and duty to defend, because the insured would not get a defense without paying in advance and the insurer would not get control of the litigation.10
Analysis
The Seventh Circuit Misunderstood the Insurance Market and Seemingly Failed To Appreciate the Full Implications of the Policy Language
The Seventh Circuit treated the terms "deductible" and "self-insured retention" as interchangeable, when the insurance industry regards them as significantly different:
A policyholder with an SIR generally assumes the responsibility for handling claims, reporting to the insurer only those claims that it considers likely to exceed the amount of its retained limit. On the other hand, under liability policies with a deductible, all claims are reported to the insurer for handling; the insurer will provide for the defense of its insured and, subject to policy limits, the insurer will pay on behalf of the insured the amount of any judgment or settlement of a covered claim, billing the insured for the amount of the deductible.11
Of course, the Seventh Circuit had no reason to know of that difference in meaning unless someone told it. One possibility is that the Seventh Circuit went beyond the arguments presented to it and analyzed the issue in light of what it thought made sense, without recognizing that its analysis failed to take account of some relevant information that had not been necessary to the parties' arguments.
Despite the fact that the Seventh Circuit did not understand this difference in meaning, one can be fairly confident that the City did. Standard primary liability policies do not contain either deductibles or self-insured retentions. Policies with self-insured retentions are generally purchased by policyholders with the assistance of brokers (and, sometimes, risk managers). Policyholders usually do not want SIR's unless they are comfortable with their ability to manage claims and wish to avoid the cost of having the insurer do that for them (unless the claim cannot be handled within the SIR). Insurers typically will not agree to write a policy with an SIR unless they are confident that the policyholder is able to manage claims in a way that will adequately protect against the obligation to make excessive payments when a claim does exceed the SIR. The Seventh Circuit was wrong to treat the SIR as if it were something imposed on the City: the City could easily have purchased a policy without an SIR had it not specifically desired an SIR.
A city the size of Waukegan cannot be an amateur in handling claims generally, or law enforcement claims specifically. It may even be able to defend some claims using employee lawyers, instead of retaining outside counsel. So, it would make perfect sense for both parties to allow it to manage its own defense within the SIR, rather than paying a higher premium to have the insurer do so. Many claims probably can be defended completely without exceeding the SIR, meaning that (contrary to the Seventh Circuit's speculation) there would often be no reason to switch counsel. And, given the expectation that the City would select competent counsel, American Safety probably would be happy, in most cases, to continue with the same counsel, once the SIR had been exhausted.
The Seventh Circuit's misunderstanding of the insurance market should not have been significant if the policy language had clearly stated that the SIR applied to defense costs, as well as to indemnity. But, the Seventh Circuit may have failed to notice significant policy language pointing in that direction. The relevant language provided that:
"Self Insured Retention" means: that sum or sums indicated in the Declarations or Schedule of "Self Insured Retentions" which the "Insured" shall pay: (a) For settlement or satisfaction of claims, "Suits" of judgments, after making deductions for all salvages and recoveries; plus (b) "Allocated Claims Expenses" . . . . The "Self Insured Retention" shall be paid by the "Insured" prior to any obligation on the part of this Company. [Emphasis added.]
"Allocated Claims Expenses" was a defined term, and neither opinion tells us what the definition was. But the definition likely followed customary insurance industry usage, under which the most significant such expense is the expense of defending suits. If that were the definition, then the policy would clearly have contemplated (as is usual with SIR's) that the City would pay defense costs until the SIR was exhausted. That would mean that the duty to defend should not attach until the SIR was exhausted, contrary to the meaning adopted by the Seventh Circuit.
Such problems can be avoided in the future by more explicit policy language. Where cases arise under policies with less explicit language, special attention should be given to pointing out relevant (if sometimes obscure) provisions that are in the policy. It will often be useful and sometimes necessary to explain the insurance market features that the Seventh Circuit misunderstood.
A Prudent Insurer Whose Coverage is Subject to an SIR Should Identify Any Coverage Issues Regarding Claims Likely to Exceed the SIR
American Safety took the position that, upon receipt of a "precautionary notice" of a claim that had not yet exhausted the SIR, it need not "look at the policy to see if the provisions would apply."12 The Seventh Circuit appears to think otherwise, and its opinion will likely be used by insureds arguing that an insurer's silence should be treated as an affirmation of coverage. On the other hand, one basis for the Seventh Circuit's views would be its conclusion that a duty to defend arose at once, rather than being deferred until the SIR was exhausted. An immediate duty to defend would require a disclaimer or a reservation of rights to avoid coverage,13 so the court would have been correct in concluding that a prompt coverage position was required, if there were such a duty. On that view, the conclusion that American Safety had been required to analyze coverage would not apply in a case where the insurer had no other current obligation.
That view would be bolstered by significant authority that, where the insurer neither controls the defense nor has any other obligation to act on the insured's behalf, and absent a statute or regulation providing otherwise, an insurer need not reserve its rights or otherwise take a coverage position.14 Still, at a very minimum, the insurer must be ready to act promptly when it is called upon. That might happen at any time, should the insured receive a settlement demand in excess of the SIR and tender the remaining amount to the insurer, requesting it to respond to the demand.15 Moreover, where there is a possibility that some other insurer might be called upon, it is prudent to see that the other insurer is notified and fully informed before a decision must be made. Accordingly, coverage analysis should often be performed well before the insurer has any obligation to act, when there is a reasonable prospect that it may be called upon to do so.
If the coverage analysis indicates a problem, it is prudent to alert the insured (and, perhaps, other affected insurers) and see whether any problem can be resolved (or postponed by agreement). In light of the Seventh Circuit's opinion, failure to do so may even create enhanced liability exposure.
Footnotes
1 See William T. Barker & Ronald D. Kent, New ApplemanInsurance Bad Faith Litigation, Second Edition, §
2.09[3][a]. 2 Am. Safety Cas. Ins. Co. v. City of Waukegan,2012 WL 882504, 2012 U.S. App. LEXIS 5496 (7th Cir. Mar. 16, 2012) (IL law) ("Am. Safety II").
3 Am. Safety II, 2012 WL 882504, at __, 2012 U.S. App. LEXIS 5496, at *7-14.
4 Am. Safety I, 776 F. Supp. 2d at 683.
5 776 F. Supp. 2d at 685.
6 776 F. Supp. 2d at 699 (some capitalization omitted).
7 776 F. Supp. 2d at 699.
8 776 F. Supp. 2d at 704-05.
9 2012 WL 882504, at __, 2012 U.S. App. LEXIS 5496, at *17.
10 2012 WL 882504, at __, 2012 U.S. App. LEXIS 5496, at *17-18.
11 Barry R. Ostrager & Thomas R. Newman, Handbook on Insurance Coverage Disputes, § 13.13[a],
12 Am. Safety I, 776F. Supp. 2d at 690.
13 Jeffrey E. Thomas & Francis J. Mootz, III, The New Appleman on Insurance Law, Library Edition § 16.03[3][a].
14 Jeffrey E. Thomas & Francis J. Mootz, III, The New Appleman on Insurance Law, Library Edition § 16.03[3][f].
15 William T. Barker & Ronald D. Kent, New Appleman Insurance Bad Faith Litigation, Second Edition, § 2.09[3].
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