LET THE PUNISHMENT FIT THE CRIME
By: Finley Harckham Footnote1
Hundreds of millions of dollars of insurance coverage is forfeited every year because policyholders and brokers have a natural reluctance to give notice of claims and occurrences to insurance companies. Understandably, risk managers often wait until the extent of a loss or potential liability becomes clear to give notice. However, under the laws of many states, policyholders who fail to give immediate notice may find that all coverage has been forfeited, even if the insurance company has suffered no detriment as a result of the delay. Forfeiture of insurance coverage is a massive and disproportionate penalty for what may be a relatively harmless breach by the policyholder. Our culture and our laws frown on forfeitures. Late notice forfeiture rules are out of date and out of touch.
Over the years, courts have denied coverage due to late notice even when the delay was as little as seven days, and are sometimes unpersuaded by the most reasonable excuses of policyholders. The impact of the late notice forfeiture rule was recently illustrated in striking fashion by a court in Michigan. Footnote2 In that case, a policyholder with the advice and consent of its broker waited approximately two years to give notice of a spill of hazardous material. The policyholder waited because it believed the cleanup expenses would be minimal. When the problem compounded, the policyholder and the broker decided to give notice to the insurance company which denied coverage without even attempting an investigation. The policyholder sued the insurance company for coverage, and the court held that coverage was forfeited solely on the basis of late notice. The policyholder was left with an uninsured loss approaching $1 million.
No sound reason exists for automatically punishing policyholders who give late notice with a total forfeiture of insurance coverage. Under general principles of contract interpretation, the measure of damages caused by late notice would be limited to the loss to the insurance company, and the burden would be on the insurer to prove the extent of that loss. If the illogic of forfeiting insurance coverage merely because of late notice was applied in all contract cases, the homeowner whose final mortgage payment was late would forfeit all of the payments made and the house as well! Moreover, the usual legal rules of insurance policy construction require that policy provisions be interpreted to promote coverage. The heavy-handed late notice rule imposed in some states is an exception to the coverage promoting rule. Forfeiture of all rights hardly promotes coverage. Even outside the field of insurance the law frowns upon forfeitures--it is a penalty far out of proportion to the "crime."
Late Notice Standards
Standard form liability insurance policies, as well
as property insurance and other policies, contain provisions
that require policyholders to give notice of occurrences,
claims and suits. A standard notice of occurrence provision
found in general liability policies states that the
policyholder must notify the insurance company "as soon
as practicable of an occurrence or an offense that may result
in a claim."
Footnote3 A standard notice of claim or suit provision
found in general liability policies states that the insurance
company must be notified "immediately" if "a
claim is made or suit is brought against any insured."
Footnote4
The notice provisions and other standard form policy language were drafted by insurance industry trade associations in order to permit uniform interpretation of the basic policy terms. As the Travelers Indemnity Company stated:
Because of the way the insurance industry operates, most of the relevant policy language is found in standardized insurance forms, drafted by insurance associations or bureaus, and used industry wide. Footnote5
In spite of this fact, the courts are sharply divided over how the standard notice provisions should be construed. As a result, in different states a variety of distinct late notice rules are currently applied to identical insurance policy provisions.
The old anti-policyholder, pro-insurance company rule, which is still followed in some states, requires strict compliance with the notice provisions as a prerequisite to coverage. Under this rule, a policyholder who fails to do so automatically forfeits coverage for the particular loss or claim. A court will not even consider whether or not the delay caused any harm to the insurer. This rule was intended to effectuate the claimed purpose underlying the notice provision: providing the insurance company with notice before the trail of evidence grows cold. However, even if late notice has no effect upon the insurance company's investigation, coverage is forfeited.
Many states have modified the old anti-policyholder rule somewhat by allowing coverage if policyholders can demonstrate that they acted reasonably in failing to give timely notice and that late notice did not prejudice the insurance company. Even this less arbitrary rule can result in the forfeiture of coverage where the insurer was not harmed, because it places upon the policyholder the considerable burden of proving a negative proposition: that the insurance company was not prejudiced by late notice. Indeed, in the context of environmental coverage claims, some courts have found prejudice merely upon a showing that, after the time notice should have been given, events transpired which could, conceivably, have prejudiced the insurance company in an investigation of a claim. Coverage was forfeited in those cases even though the insurance companies routinely deny coverage for environmental claims, and do not investigate unless sued by their policyholders for coverage.
In recent years, courts in a number of states have recognized the severity of the anti-policyholder rules and adopted a less draconian approach. These courts have held that coverage is not forfeited unless the insurance company can demonstrate that it was prejudiced by late notice. This rule gives weight to the overriding purpose of insurance--to insure. For convenience, this rule can be referred to as the pro-policyholder rule. However, even this rule allows the insurance company to bring about the forfeiture of coverage if it can prove it was prejudiced by late notice. Thus, the pro-policyholder rule can still result in disproportionate punishment of the policyholder--forfeiture of all coverage and premiums--even when the insurance company was damaged to a far lesser extent.
Forum Shopping
The application of different notice rules has led to two major problems. Most importantly, policyholders are unfairly losing the benefits of the insurance coverage they paid for and upon which they relied. Second, the courts' inconsistent interpretations of the standard form notice provisions result in wasteful litigation. Often it is impossible to know which notice rule will be applied in any given instance. That determination can be made only by a court applying a sometimes complex legal analysis. Factors typically considered by the courts include the site of the loss; the location of negotiation, signing, delivery and performance of the insurance policy; and the residences of the policyholder and insurance company.
The ruling that a court might make on the issue of which late notice rule to apply is often unpredictable in situations where the policyholder and insurance company have strong ties to states with different late notice rules. Insurance companies may take advantage of these conflicting rules and deny coverage on grounds of late notice. The insurance company can then wait to see if the policyholder is willing to incur the expense of commencing a lawsuit to resolve the question or sue the policyholder under favorable state law.
Thus, conflicting state laws lead to "forum shopping," where each of the contesting parties attempts to get the case tried in court in a state with rules favoring its position. The value of insurance is greatly diminished when policyholders must endure the time and expense of litigation to determine the meaning of standard policy provisions. For example, it has been reported that Shell Oil Co. was forced to spend in excess of $25 million in its environmental insurance coverage action. Very few policyholders could or would spend that much, so the mere threat of litigation by the insurance company against its policyholder can effectively nullify insurance.
One Form, One View
If liability insurance coverage is to function as it was intended, a single notice rule should be adopted nation-wide. As a number of insurance industry organizations recently argued to the California Supreme Court, all standard form provisions must be uniformly interpreted for insurance to function properly. Moreover, as a matter of contract interpretation and common sense, standard form notice provisions should always be given the same meaning.
To address these problems, the courts should uniformly apply a new late notice rule grounded in contract law, public policy and fundamental fairness. Under this rule, an insurance company should be required to demonstrate it was prejudiced by late notice in order to defeat coverage. Even then, coverage should only be reduced by the amount the insurance company has been damaged. For example, if an insurance company can show that its investigation expenses were increased by the policyholder's late notice, the increased investigation expenses would be an example of actual damages. If an insurance company can show that it would have successfully defended the claim against the policyholder, then the amounts paid to settle or pay the claim against the policyholder would be actual damages. Let the punishment fit the crime!
Most courts recognize that they should seek to uphold the fundamental purpose of insurance--to give certainty and protection to the policyholder in the form of coverage. That primary goal will often be defeated under existing late notice rules, in some instances regardless of whether the insurance company was prejudiced by late notice. As the Hartford Accident and Indemnity Company correctly notes, "[a]n insurance policy is not to be construed as a game of cat and mouse, in which the insurer (or reinsurer) can avoid liability if he succeeds in catching his insured in a technical breach." Footnote6 The proposed new rule promotes coverage, while recognizing that insurance companies should not suffer to the extent of their actual prejudice from late notice.
By promoting coverage and not forfeiture, the proposed rule advances the social goals of insurance. Courts have long recognized that the shifting and pooling of risk accomplished by insurance benefits not only the policyholder, but the larger society as well. Footnote7 Recognizing those goals, the Attorney General of New York, a state that still follows the old anti-policyholder late notice rule, recently argued to a New York court that New York state should adopt a more policyholder-oriented rule.
Under general rules of contract law, the party alleging a breach of contract must demonstrate that it suffered some damage as a result of the breach. The proposed rule is consistent with the principle that the burden of proving damage should rest with the party alleging a breach. An insurance company should be compensated for its actual damages flowing from late notice--it should not be entitled to declare the entire coverage forfeited.
Also, the proposed rule is consistent with the fact that standard form notice provisions in liability insurance policies are typically non-negotiable terms that must be accepted by the policyholder if it wants to purchase coverage. Such one-sided adhesion provisions should be interpreted in the light most favorable to the non-drafter under rules of contract interpretation.
Unfortunately, no mechanism exists for persuading the courts to adopt a single, correct approach to the late notice problem. Although courts in several states have slowly abandoned the anti-policyholder rules, the adoption of a uniform, correct approach, if it is to happen at all, will probably take decades. A Maryland court, advocating the uniform interpretation of standard insurance policy provisions, stated that the structure of the state and federal court systems "make[s] the achievement of such uniformity an illusion."
Thus, for the foreseeable future, policyholders will continue to face the possible forfeiture of coverage when they give late notice. Risk managers must overcome their reluctance to give immediate notice in situations where they think a problem is not sufficiently serious. At a later date, when the full extent of the problem is known, insurance coverage may have been forfeited. For the same reason, notice should be given to umbrella and excess insurers even though it may seem likely that upper levels of coverage will never be reached. The fact that a policyholder's reluctance to give late notice is understandable does not impress aggressive insurance company lawyers who are more interested in winning lawsuits against policyholders than in promoting business relations and fulfilling the public policy goals of insurance.
Giving notice may seem like a bitter sip of medicine. Take it now because notice is not like fine wine; it does not get better with age.
Finley Harckham is a partner in the New York office of Anderson Kill Olick & Oshinsky, P.C., a law firm that regularly represents policyholders in insurance coverage disputes. This article is a revised version of two articles by the author and others. Anderson, Harckham and Lewis, THE LATE NOTICE PROBLEM, Risk Management, Nov. 1992; Tesoriero, Harckham and Roland, The Draconian Late Notice Forfeiture Rule, Insurance Litigation, April, 1993.
Steelcase, Inc. v. American Motorists Ins. Co., No. G87-553 CA1 (W.D. Mich. 1989), aff'd without op., 907 F.2d 151 (6th Cir. 1990).
Miller, S. & Lefebvre, P., Miller's Standard Insurance Policies Annotated, Vol. 1, p. 454-607 (1988).
Id.
Travelers' Reply Memorandum In Support of Coordination at 7, Armstrong Cork Co. v. Aetna Casualty & Sur. Co., No. 31536 (Cal. Super. Ct.) (filed Jan. 2, 1981).
Brief of Plaintiff-Appellee at 41, Hartford Accident & Indem. Co. v. Calvert Ins. Co., 826 F.2d 1055 (3d Cir. 1987) (No. 86-5898) (filed Mar. 17, 1987).
See Caminetti v. Superior Court, 16 Cal. 2d 838, 842, 108 F.2d 911 (1940), cert. denied, 313 U.S. 579 (1941) (insurance is a "business particularly charged with a public interest"). Carpenter v. Pacific Mut. Life Ins. Co., 10 Cal. 2d 307, 329, 74 P.2d 761 (1937), aff'd, Neblett v. Carpenter, 305 U.S. 297 (1938).
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