The determination of when an insurer pays defense costs turns on whether the E&O policy is an indemnity or a liability policy
The hypothetical
HealthPayPlus (HPP) designs custom record management systems for large hospital systems. HPP developed a system for Research Hospitals of America (RHA) that HPP promised would revolutionize RHA's provision of healthcare services and the processing of payments for those services. Despite months of testing, the HPP system crashed just weeks after it went live. RHA filed suit against HPP alleging breach of contract, negligence, and misrepresentation.
HPP has a professional services errors and omissions (E&O) insurance policy that requires its insurer to pay loss. Defense costs are included within the definition of loss. The critical issue for HPP will be the timing of when its insurer must pay defense costs. Must the insurer pay defense costs as the litigation progresses, or only reimburse defense costs HPP has paid after the litigation is concluded and after judgment has been entered against HPP?
Indemnity v. liability
This determination turns on whether the E&O policy is an indemnity or a liability policy. The 3rd Circuit in Little v. MGIC Indem. Corp. described the distinction between indemnity and liability policies as follows:
[U]nder an indemnity policy the insurer is obligated only to reimburse the insured for covered loss that the insured himself has already paid. Under a liability policy, by contrast, the insurer's obligation to pay arises as soon as the insured incurs liability for the loss; the insured need not pay the loss first.
Given the substantial defense costs HPP will face to defend the RHA litigation, whether its E&O policy is a liability policy will be critical to its bottom line.
"Legally obligated to pay"
As with any insurance coverage issue, the analysis begins with the language of the policy. HPP's E&O policy defines "loss" to include "Defense costs . . . that an Insured is legally obligated to pay." The phrase "legally obligated to pay" requires an insurer to pay an insured's defense costs when those costs are incurred.
Courts have recognized that policies with an immediate payment obligation are liability policies. In Fed. Savs. and Loan Ins. Corp. v. Burdette, thecourt concluded a policy was a liability rather than indemnity policy because "losses are to be paid . . . when there is a legal obligation to pay, rather than after the [insured has] actually paid out under a determination of liability." In Combs II v. Int'l Ins. Co., the 6th Circuit ruled that a liability policy requires the insurer "to pay these costs when the insureds are legally obligated to pay them, i.e., when the costs are incurred, and not . . . when the lawsuit is finally disposed of and [the insurer] has determined that the claims were covered."
"Shall reimburse"
In contrast to the liability language above, an indemnity policy would only require the insurer to reimburse defense costs that HPP expended if, and when, the litigation was resolved and HPP was found liable. For example, in Vitkus v. Beatrice Co., the insurer had no duty to pay defense costs incurred by the insured until the underlying litigation was resolved because the policy stated that insurers "shall reimburse costs, charges and expenses only upon the final disposition of any claim." Similarly, in Save Mart Supermarkets v. Underwriters at Lloyd's London, the policy at issue provided: "[w]hen it has been determined that Underwriters are liable under this Insurance, Underwriters shall thereafter promptly reimburse the Assured for all payments." Based on this language, the court held the insurer only had "an obligation to pay defense costs as a portion of ultimate net loss only if and when there is a determination that the underlying action is covered under the Policy."
Conclusion
Liability policies protect insureds from the financial harm they would experience if the insurer did not pay the cost of defense. Courts have explained that "to hold otherwise would not provide insureds with protection from financial harm that insurance policies are presumed to give." For HPP, or any insured, facing staggering defense costs, it is critical that its E&O policies are liability not indemnity policies. The issues discussed here may also be applicable to many directors and officers insurance policies.
This article first appeared in Inside Counsel.
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