INSURANCE LITIGATION: INCLUDING BAD FAITH AND EXTRA CONTRACTUAL DAMAGES

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1 INSURANCE LITIGATION: INCLUDING BAD FAITH AND EXTRA CONTRACTUAL DAMAGES Presenter: MARK L. KINCAID Kincaid & Horton, L.L.P. 114 West 7th Street, Suite 1100 Austin, Texas / / fax Co-Authors: SUZETTE E. SELDEN Kincaid & Horton, L.L.P. 114 West 7th Street, Suite 1100 Austin, Texas / / fax ZACH WOLFE Fleckman & McGlynn, P.L.L.C. Bank of America Center 515 Congress Avenue, Suite 1800 Austin, Texas State Bar of Texas 32 nd ANNUAL ADVANCED CIVIL TRIAL COURSE July 29-31, 2009 San Antonio CHAPTER 29

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3 MARK L. KINCAID KINCAID & HORTON, L.L.P. 114 West 7th Street, Suite 1000 Austin, Texas / / fax Mark Kincaid is a partner in Kincaid & Horton, L.L.P. He graduated from the University of Texas with B.B.A. and J.D. degrees with honors. He is board-certified in Civil Trial Law, Consumer & Commercial Law, and Civil Appellate Law by the Texas Board of Legal Specialization. Mr. Kincaid represents consumers and businesses in insurance litigation, deceptive trade practice litigation, and business disputes. Mr. Kincaid teaches Insurance Litigation as an Adjunct Professor at the University of Texas School of Law. In 1994, Mr. Kincaid was appointed by Governor Ann Richards to head the Office of Public Insurance Counsel, a state agency that advocated for insurance consumers, where he served before returning to private practice. Mr. Kincaid is a former member and past chair of the State Bar of Texas Consumer Law Council. He is chair of the State Bar Pattern Jury Charge committee on Business, Consumer, Insurance, and Employment. Mark Kincaid was managing editor of Texas Consumer Law Reporter from , and he has directed numerous programs on consumer and insurance law and has authored and presented many articles on these subjects. He is co-author of the Texas Practice Guide: Insurance Litigation (West 2009). Mark s colleagues have given him an AV rating in the Martindale-Hubbell Law Directory, and designated him a Super Lawyer in the 2003 through 2009 surveys of Texas lawyers published by Law & Politics Media and the publishers of Texas Monthly magazine.

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5 SUZETTE E. SELDEN KINCAID & HORTON, L.L.P. 114 West 7th Street, Ste Austin, Texas / / fax Suzette Selden is an associate at Kincaid & Horton, L.L.P. She graduated magna cum laude from Brigham Young University with a B.A. degree and cum laude from the University of Houston Law Center with a J.D. degree. She was a visiting student at the University of Texas School of Law during her third year of law school. Mrs. Selden represents consumers and businesses in insurance litigation, deceptive trade practice litigation, and business disputes. Suzette Selden served as legal editorial assistant at Jones McClure Publishing the publisher of the O Connor s litigation manuals, where she worked on O Connor s Texas Causes of Action and several other legal manuals. Additionally, she was head notes and comments editor of the Houston Journal of International Law from Before attending law school, Mrs. Selden worked as a television news producer for an ABC affiliate station in Washington state and interned for the Dateline NBC news magazine program in New York City.

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7 Zach Wolfe Fleckman & McGlynn, PLLC 515 Congress Avenue, Suite 1800 Austin, Texas Phone: Fax: Zach Wolfe is a member of the law firm Fleckman & McGlynn, PLLC. He has over 11 years of experience in a wide variety of business litigation matters, including trials, arbitrations, and appeals. His extensive experience in commercial litigation includes insurance coverage, securities fraud, embezzlement, partnership disputes, intellectual property, trade secrets, commercial lease disputes, and business torts. He received his undergraduate degree magna cum laude from Harvard in 1994 and graduated from the University of Texas School of Law with honors in He has written a number of articles on insurance litigation topics.

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9 TABLE OF CONTENTS 1. The Plaintiff is considering filing suit The Defendant sent the pleadings from the Plaintiff s suit to the Insurer The Plaintiff has decided on a strategy of trying to plead into coverage The Defendant sent the pleadings from the Plaintiff s suit to the Insurer, The Defendant sent the pleadings from the Plaintiff s suit to the Insurer, The insurer agreed to defend and has been paying for a defense lawyer, Suit has been filed, and the Plaintiff s ability to collect will depend on the existence of insurance coverage A lawyer selected by the Defendant has been defending the lawsuit for months Two Plaintiffs sue the Defendant The Insurer hired a lawyer to defend, but the Insurer keeps messing with the defense The defense lawyer hired by the insurer is doing a great job of defending An Insurer that has been defending a Defendant under a reservation of rights letter settles the claim The Plaintiff feels her case is strong and well-developed, so she is ready to make a settlement demand The Defendant is very worried about liability and the toll the ongoing suit is taking Choice of Law Principles Choice of Law Cases The Plaintiff has a very large damage claim, After the Plaintiff filed suit, The Plaintiff just got a huge verdict against the Defendant Power Point: Insurance Issues for Trial Lawyers i

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11 INSURANCE LITIGATION, INCLUDING BAD FAITH AND EXTRA CONTRACTUAL DAMAGES Mark L. Kincaid, * Suzette E. Selden,¹ & Zach Wolfe As every experienced trial lawyer knows, and as new lawyers soon find out, insurance issues can substantially impact, and even dominate, trials from before suit is filed, up to when (and whether) the judgment is paid. The problem is that trial lawyers like to think about trials, not insurance. So what happens when insurance issues intrude? What do you do? What do you need to know? What should you be thinking about? These are the questions this paper will address. The hope is that you will get enough information to become conversant with the important insurance issues you are likely to encounter. For more experienced lawyers, this will be more of a review; for the less experienced, more of a heads-up. You won t learn enough insurance law to be in danger of becoming an insurance nerd. The examples will follow the normal sequence of a trial from pre-suit to post-verdict. 1. The Plaintiff is considering filing suit. There may be claims against several parties, and the facts may justify alleging intentional and accidental conduct. What should the Plaintiff think about insurance coverage? One of the first insurance issues the Plaintiff s lawyer will confront is whether to plead into coverage, although the very idea is something of a * Mark L. Kincaid is a partner with Kincaid & Horton, L.L.P. in Austin. He graduated with honors from the University of Texas Law School and teaches Texas Insurance Litigation there as an adjunct professor. He is board-certified in Consumer Law, Civil Trial Law, and Civil Appellate Law. He is co-author of West s Texas Practice Guide on Insurance Litigation, and has written and spoken frequently on insurance and consumer issues. ¹ Suzette E. Selden is an associate with Kincaid & Horton, L.L.P. She graduated with honors from Brigham Young University with a B.A. (2002), and the University of Houston Law Center (2006). Zach Wolfe is a partner with Fleckman & McGlynn, P.L.L.C. in Austin. He has diverse experience in a variety of business litigation matters, including representation of businesses in disputes with their insurers. He graduated with honors from the University of Texas School of Law in 1997, where he learned most of what he knows about insurance law from Mark Kincaid s Insurance Litigation course. misnomer. All a plaintiff can do is plead the case in a manner that gives rise to the insurer s duty to defend its insured. But that doesn t mean the insurer has to pay the claim. The duty to pay depends on the proof at trial, and proof on coverage issues (in a subsequent trial) that were not decided in the underlying suit. a. Why plead into coverage? It seems counterintuitive that a plaintiff would intentionally plead in a way that provoked an insurer to fund the opposition. Nevertheless, there are significant reasons why this is precisely what the plaintiff wants to do. The most obvious reason to plead into coverage is to try to prove a claim that is covered so the insurer will have to pay it. This rationale exists when the defendant does not have the resources to pay. In a thorough paper on the subject, Professor Ellen Pryor identifies several other reasons why a plaintiff might plead into coverage: If an insurer finds itself obligated to defend, the insurer may take into account defense costs, even of a non-covered claim, which may give the claim settlement value. (1) If a claim is covered, the insurer has a duty to settle and may be liable for an excess judgment if it breaches that duty. An insurer defending a potentially covered claim may determine that the risk of failing to settle is too high, so the insurer may be willing to pay. (2) The insurer could erroneously fail to defend, which in some jurisdictions (but not Texas) will estop the insurer from contesting its duty to pay. (3) In some jurisdictions, if the insurer wrongfully denies a defense, it may be liable for extracontractual damages, which may give the claim value. (4) If the insurer defends, but does not properly reserve its right later to contest coverage, the insurer may have waived coverage defenses and be required to pay the claim. Ellen S. Pryor, The Stories We Tell: Intentional Harm & The Quest For Insurance Funding, 75 Tex. L. Rev. 1721, 1734 (1997). b. Why not? There may be valid reasons not to plead into coverage, if the facts support a claim that is not necessarily covered. For example, if the defendant has sufficient resources to pay the resulting judgment, requiring the defendant to defend a claim that is not covered by insurance may create economic incentives to settle. Aside from economic considerations, a plaintiff may want to avoid triggering coverage, as a matter of 1

12 principle. For example, a victim of abuse may want to sue the abuser for intentional conduct, seeking vindication and to punish the wrongdoer. Other strategic factors may favor not pleading into coverage. If the plaintiff wants quick injunctive relief, then triggering a defense by an insurer may hamper the process, without providing any benefit. See Beth D. Bradley, Pleading Traps & Tricks: Pleading In & Out of Coverage, in State Bar of Texas Insurance Law Section, Insurance, Litigation and You: The Impact of Insurance In Litigation, tab 3, p. 11 (2004). Unnecessarily pleading multiple years, or invoking multiple lines of coverage, may simply complicate negotiations because of issues between and among the various insurers. Id. 2. The Defendant sent the pleadings from the Plaintiff s suit to the Insurer, asking it to defend and pay if necessary. The suit alleges various claims. Some appear to be covered; some may not be. Is the Defendant entitled to a defense? Under Texas law, the Defendant would be entitled to a defense as long as at least one of the claims is covered. If the petition potentially states any covered claim, the insurer must defend the entire suit. The courts reason that the insurance contract obligates the insurer to defend its insured, not to provide a partial defense. See St. Paul Ins. Co. v. Tex. Dept. of Transp., 999 S.W.2d 881, 884 (Tex. App. Austin 1999, pet. denied); Landmark Chevrolet Corp. v. Universal Underwriters Ins. Co., 121 S.W.3d 886, 890 (Tex. App. Houston [1st Dist.] 2003, no pet.); Rhodes v. Chicago Ins. Co., 719 F.2d 116, 119 (5th Cir. 1983). This is also an important principle for the Plaintiff to recognize when attempting to plead into coverage (see section 3 below). This is just one of the many rules governing the insurance company s duty to defend. Under Texas law, the following general principles will determine whether the Defendant will be entitled to a defense from its insurer: The duty to pay and the duty to defend are distinct, separate duties. King v. Dallas Fire Ins. Co., 85 S.W.3d 185, 187 (Tex. 2002); Trinity Universal Ins. Co. v. Cowan, 945 S.W.2d 819, (Tex. 1997). An insurer s duty to defend is determined solely by the allegations in the pleadings and the language of the insurance policy. This is the eight-corners or complaint allegation rule. Lamar Homes, Inc. v. Mid-Continent Cas. Co., No , 2007 WL , at *8 (Tex. Aug. 31, 2007); King, 85 S.W.3d at 187; Trinity, 945 S.W.2d at 821; National Union Fire Ins. Co. v. Merchants Fast Motor Lines, Inc., 939 S.W.2d 139, 141 (Tex. 1997). The allegations of the complaint should be considered in light of the policy provisions, without reference to the truth or falsity of the allegations, and without reference to what the parties know or believe the true facts to be. Guideone Elite Ins. Co. v. Fielder Road Baptist Church, 197 S.W.3d 305, 308 (Tex. 2006); Argonaut Southwest Ins. Co. v. Maupin, 500 S.W.2d 633, 635 (Tex. 1973); Colony Ins. Co. v. H.R.K., Inc., 728 S.W.2d 848, 850 (Tex. App. Dallas 1987, no writ); Gulf Chem. & Metallurgical Corp. v. Associated Metals & Minerals Corp., 1 F.3d 365, 369 (5th Cir. 1993). A court resolves all doubts regarding the duty to defend in favor of finding the duty. King, 85 S.W.3d at 187; Merchants, 939 S.W.2d at 141; Heyden Newport Chem. Corp. v. Southern Gen. Ins. Co., 387 S.W.2d 22, 26 (Tex. 1965). Where the complaint does not state facts sufficient to clearly bring the case within or without the coverage, the general rule is that the insurer is obligated to defend if there is, potentially, a case under the complaint within the coverage of the policy. Stated differently, in case of doubt as to whether or not the allegations of a complaint against the insured state a cause of action within the coverage of a liability policy sufficient to compel the insurer to defend the action, such doubt will be resolved in the insured s favor. Heyden Newport v. Southern Gen., 387 S.W.2d at 26 (quoted in Nat l Union v. Merchants, 939 S.W.2d at 141). A court must focus on the factual allegations rather than the legal theories asserted. Lamar Homes, 2007 WL , at *10; Farmers Texas County Mut. Ins. Co. v. Griffin, 955 S.W.2d 81, 82 (Tex. 1997); Nat l Union v. Merchants, 939 S.W.2d at 141. If the petition does not allege facts within the scope of coverage, an insurer is not legally required to defend a suit against its insured. King, 85 S.W.3d at 187; Trinity, 945 S.W.2d at 821. A court will not look outside the pleadings or imagine factual scenarios that might trigger coverage. National Union v. Merchants, 939 S.W.2d at The Plaintiff has decided on a strategy of trying to plead into coverage. How should the Plaintiff plead the case? If the Plaintiff decides to try to plead into coverage, the following strategies should be considered. 2

13 a. Plead other theories Parties seeking to plead into coverage have an incentive to allege alternate theories, even though some theories may be excluded. For example, in St. Paul Ins. Co. v. Texas Department of Transportation, the plaintiffs allegation that the insured was negligent in its supervision of highway construction was sufficient to trigger the insurer s duty to defend, even though the plaintiffs allegations of gross negligence and intentional torts would be excluded by the intentional injury exclusion. 999 S.W.2d at 887. In Westchester Fire Ins. Co. v. Gulf Coast Rod, Reel & Gun Club, 64 S.W.3d 609 (Tex. App. Houston [1st Dist.] 2001, no pet.), the insureds were covered for claims that they intentionally dredged a waterway, where the resulting damage was not expected or intended. In Northfield Ins. Co. v. Loving Home Care, Inc., 363 F.3d 523, (5th Cir. 2004), the court found a duty to defend based on pleadings that the defendant acted negligently, even though extrinsic evidence showed the injuries to the child were intentional. The plaintiffs had amended the petition to remove all allegations relating to the intentional nature of the behavior. Id. Repleading to recharacterize conduct as negligent instead of intentional will not work in cases where the conduct is inherently intentional. For example, sexual molestation of a minor is inherently intentional, no matter how it is pleaded. See, e.g., Maayeh v. Trinity Lloyds Ins. Co., 850 S.W.2d 193, (Tex. App. Dallas 1992, no pet.). Even if the intentional act exclusion does not apply, sexual assault is not an occurrence within the scope of coverage because it is not accidental. See State Farm Fire & Cas. Co. v. Brooks, 483 F. Supp. 2d 695, 702 (E.D. Tex. 1998). Similarly, pleading that the defendant was drunk will not make an intentional assault unintentional. Id. at ; see also Wessinger v. Fire Ins. Exch., 949 S.W.2d 834, 840 (Tex. App. Dallas 1997, no pet.). b. Plead broadly and generally The general rule is that if the pleadings are too vague or general, the court may find they lack sufficient facts to state a claim potentially within coverage, and the court will not read facts into the pleadings. See, e.g., Trinity Universal Ins. Co. v. Cowan, 945 S.W.2d at 825. On the other hand, clarity in pleadings may not be helpful when trying to plead into coverage. As noted above, courts generally hold that uncertainties are resolved in favor of finding a duty to defend. In Burlington Ins. Co. v. Texas Krishnas, Inc., 143 S.W.3d 226 (Tex. App. Eastland 2004, no pet.), the court found a duty to defend where several different theories were alleged against several different parties all arising out of abuse. Characterizing the pleadings as vague, broadly worded, and containing a mishmash of legal theories and factual allegations, the court noted that that the pleadings might well be the result of very careful, as opposed to very careless, pleading practice. 143 S.W.3d at 232. c. Plead other insureds or actors Another strategy for pleading into coverage is to consider whether the facts support liability for more than one person on more than one theory. For example, in King v. Dallas Fire Ins. Co., 85 S.W.3d 185, 186 (Tex. 2002), the insurer had a duty to defend an insured employer against claims that it negligently hired, trained, and supervised an employee who committed an intentional assault, even though the assault itself was not a covered occurrence. See also Burlington Ins. Co. v. Texas Krishnas, Inc., 143 S.W.3d 226, (Tex. App. Eastland 2004, no pet.) (insurer had duty to defend allegations of negligently hiring, training, and supervising individuals who committed abuse); State Farm Gen. Ins. Co. v. White, 955 S.W.2d 474, 477 (Tex. App. Austin 1997, no pet.) (insurer had duty to defend bystanders sued for negligently failing to report intentional abuse by another). Thus, even where one actor commits an intentional tort, there may be legitimate grounds to allege that another actor was negligent, and the negligence claim is more likely to be covered. Alleging that an individual acted as the agent for a defendant can also help plead into coverage. In Heyden Newport, the plaintiffs alleged that Pickering was an agent for the insured, Newport Industries, at the time of the collision. The court held this allegation sufficient to invoke the duty to defend, regardless of the defendant s extrinsic allegation that Pickering was not its agent at the time. 387 S.W.2d at 26. d. Plead again The duty to defend is determined based on the most recent pleading. See Fielder Road Baptist Church v. Guide One Elite Ins. Co., 139 S.W.3d 384, 390 (Tex. App. Fort Worth 2004, no pet.), aff d, 197 S.W.3d 305 (Tex. 2006); Royal Ins. Co. v. Hartford Underwriters Ins. Co., 391 F.3d 639, 644 (5th Cir. 2004). If an initial pleading does not trigger coverage, the party trying to plead into coverage should consider an appropriate amendment that will invoke the duty. e. Plead different dates Several cases find a duty to defend where the petition alleges conduct occurring during the period of the insurer s coverage, even though extrinsic evidence shows the conduct did not occur during the policy period. In Guideone Elite Ins. Co. v. Fielder Road Baptist Church, the plaintiffs alleged the church s 3

14 youth pastor was employed from 1992 to 1994 and committed sexual abuse during that time. 197 S.W.3d at 308. The insurer s policy was effective from 1993 to Id. The Texas Supreme Court held that the court of appeals properly refused to consider extrinsic evidence that the youth pastor left employment with the church in 1992, before the insurance policy took effect, because that was extrinsic evidence that would contradict the facts alleged in the petition. Id. at 307, 311; see also Gulf Chemical, 1 F.3d at The Defendant sent the pleadings from the Plaintiff s suit to the Insurer, asking it to defend and pay if necessary. The pleadings state a claim within coverage and entitle the Defendant to a defense. If the Insurer wrongfully delays or denies a defense, what can the Defendant do? Under the recent Texas Supreme Court case Lamar Homes, Inc. v. Mid-Continent Casualty Co., one option a Defendant has is to sue the Insurer under the Prompt Payment of Claims statute. 242 S.W.3d 1, at *16-17 (Tex. 2007). The prompt payment statute, formerly codified as article of the Texas Insurance Code and now recodifed as sections , provides for additional damages when an insurer wrongfully refuses to pay or delays payment of a claim. Specifically, if an insurer fails to promptly respond to or pay a claim as required, the prompt payment statute makes the insurer liable to the insured for both the amount of the claim and interest on the amount of the claim at the rate of eighteen percent a year as damages, together with reasonable attorney s fees. Tex. Ins. Code (a). This remedy is now available to a defendant when its insurer wrongfully refuses to defend a case. For example, in Lamar Homes, the insured, a construction builder, sold a new home that developed problems due to defects in the foundation. 242 S.W.3d, at *5. The buyers sued the builder, which forwarded the lawsuit to its insurance company seeking a defense and indemnification under a commercial general liability (CGL) insurance policy. The insurer denied coverage and refused to defend. Consequently, the builder sought a declaration of its rights under the CGL policy and sought recovery under the prompt payment statute. Upon finding that the claims asserted against the builder were covered by the CGL policy and that the insurer had breached its duty to defend, the Texas Supreme Court held that the prompt payment statute applied and that the builder was entitled to the costs of its defense as well as eighteen percent interest and attorney s fees. Id., at *19. The prompt payment statute requires that the insurer follow certain procedures and meet certain deadlines in responding to and paying claims. To trigger the insurer s duties, the defendant must supply the insurer with certain information. First, the defendant must submit a written notice of claim. Tex. Ins. Code (4), After receiving the notice, the insurer has fifteen days to acknowledge receipt, commence its investigation, and request from the claimant all items, statements and forms that the insurer reasonably believes, at that time, will be required from the claimant. Id But the statutory deadlines for accepting and paying the claim will not begin to run until the insurer receive[s] all items, statements, and forms required by the insurer to secure final proof of loss. Id , According to Lamar Homes, in a duty to defend situation, the statutory deadlines will not begin to run until the defendant provides the insurer with statements or invoices for legal services: [t]hese statements or invoices are the last piece of information needed to put a value on the insured s loss. 242 S.W.3d, at *19. Therefore, a defendant must be sure to submit his bills for legal services to the insurer in order to trigger his rights under the prompt payment statute. Id. 5. The Defendant sent the pleadings from the Plaintiff s suit to the Insurer, asking it to defend and pay if necessary. The Insurer sent back a letter citing many definitions and exclusions from the policy and explaining many reasons the Insurer asserts for never paying the claim. Nonetheless, the letter concludes with an offer to defend, and even pay for a lawyer to be chosen by the Insurer. The Defendant likes the idea of a free lawyer, but is leery of one chosen by the Insurer, especially considering the letter took pains to list all those reasons the Insurer has for never paying the claim. What should the Defendant do? The insurer has sent what is known as a reservation of rights letter that is, it is agreeing to provide a defense, but is reserving the right to later deny payment of the claim. When an insurer decides to defend under a reservation of rights, the insured has the right to reject this qualified defense and hire his own defense lawyer. The insurer must pay for this lawyer. Britt v. Cambridge Mutual Fire Ins. Co., 717 S.W.2d 476, 481 (Tex. App. San Antonio 1986, writ ref d n.r.e.); Rhodes v. Chicago Ins. Co., 719 F.2d 116, (5th Cir. 1983). When presented with a qualified defense, the insured can choose to accept the qualified defense, knowing the insurer may pay for the defense but later deny coverage. Alternatively, the insured can reject the qualified defense and insist that the insurer tender an unqualified defense that is agreed to provide coverage to pay the claim, in addition to 4

15 providing a defense or the insured may seek his own counsel, at the insurer s expense. None of these answers will always be preferable. There are several factors that should be considered. If coverage is doubtful, a defense under a reservation of rights may be a good thing. Often an insurer will have to defend a claim based on the allegations in the petition, but the proof at trial may negate coverage. In that event, the insured loses nothing by accepting the qualified defense, because that is all he would be entitled to anyway. In addition to getting a free defense, the insured may receive other benefits. First, the defense may be effective to win the claim, so coverage does not matter. Second, the cost of defending the claim may create settlement value sufficient to get the claim resolved. Third, the circumstances of the case, or sometimes just the momentum of the litigation, may induce the insurer to tender some amount in settlement, based on its perception that there is a risk of coverage. On the negative side, when an insurer defends under a reservation of rights there is an inherent conflict. One of the key benefits of a good defense is often to position the case for a favorable settlement. It may be very undesirable to reach a critical juncture where the case could be settled only to have the insurer insist that it will not settle because there is no coverage. In that situation, the insured could benefit from a lawyer willing to aggressively argue coverage issues with the insurer. An independent lawyer may be more effective in making those arguments than a lawyer chosen by the insurer who may be reluctant to jeopardize other relations with the insurer. It may be in the insured s interest to insist that the insurer embrace coverage. Failing that, it may be in the insured s interest to have his own attorney, being paid by the insurer. Sometimes having an attorney chosen by the insured may create more uncertainty on a part of the insurer, which can create settlement pressure, if that is desired. There are reasons it might not be a good idea to insist that the insurer pay for an attorney selected by the insured. When the insurer chooses the lawyers, under certain circumstances the insurer may be to blame and held responsible for conduct of that lawyer. A mistake in the defense of the case might be attributable to the insurer and thus create a basis to collect from the insurer. On the other hand, if the insured chooses a lawyer, the insurer may have a more plausible argument that it did not control the conduct of the lawyer and cannot be blamed for any mistakes. Although the reasoning is questionable, one court held that the insured could be guilty of contributory negligence based on his selection of, and failure to replace, his chosen defense counsel who the court said was incapable of properly handling the civil case in the professional manner. State Farm Fire & Cas. Co. v. Gandy, 880 S.W.2d 129, 137 (Tex. App. Texarkana 1994). rev d on other grounds, 925 S.W.2d 696 (Tex. 1996). Another factor to consider is the attorney s fees. Insurance defense lawyers often agree to work for lower hourly rates, presumably in return for getting repeat business from the insurer. Hiring a person of similar experience in the free market may require higher hourly fees, and the insurer may balk at paying those fees. This creates the prospect of having to fight over the proper amount of fees at the very beginning of the case. Still another factor to consider is that in many cases insurance defense lawyers work under litigation guidelines imposed by insurers. These guidelines may limit what work is done by the lawyer and may dictate that certain tasks be performed by paralegals. A free market lawyer without an ongoing relationship with the insurer may be less likely to be influenced by such guidelines. 6. The insurer agreed to defend and has been paying for a defense lawyer. Unlike the preceding example, the insurer did not send a letter reserving a right later to deny coverage. Nevertheless, the insurer changes its mind and does try to raise a coverage defense. The general rule is that waiver and estoppel cannot be used to create insurance coverage. Texas Farmers Ins. Co. v. McGuire, 744 S.W.2d 601, 603 & n.1 (Tex. 1988). A significant exception to this rule until recently was the Wilkinson exception. In Farmers Texas County Mutual Ins. Co. v. Wilkinson the court recognized this general rule but held, However, it follows from these general principles that, if an insurer assumes the insured s defense without obtaining a reservation of rights or a nonwaiver agreement and with knowledge of the facts indicating non-coverage, all policy defenses, including those of non-coverage, are waived, or the insurer may be estopped from raising them. 601 S.W.2d 520, (Tex. App. Austin, 1980, writ ref d, n.r.e.). However, the Texas Supreme Court rejected the Wilkinson exception in Ulico Casualty Company v. Allied Pilots Association, 262 S.W.3d 773 (Tex. 2008). The court held that an insurer was not estopped to assert lack of coverage, and did not waive the argument that a claim made outside the coverage period was not covered. Ulico provided liability insurance to APA under a claims made policy. APA submitted a claim after the coverage period expired, but Ulico agreed to reimburse APA for defense costs. When the insurer later denied coverage and asserted it did not owe defense costs, APA asserted and obtained jury findings 5

16 that Ulico was estopped to deny coverage or had waived the argument that the claim was not covered. The supreme court reiterated the rule that the doctrines of waiver and estoppel cannot be used to expand coverage under a policy. See Washington Nat l Ins. Co. v. Craddock, 130 Tex. 251, 109 S.W.2d 165 (1937) (no waiver); Texas Farmers Ins. Co. v. McGuire, 774 S.W.2d 601 (Tex. 1988) (no estoppel). The court recognized that waiver and estoppel may operate to avoid a forfeiture such as by preventing the insurer from arguing late notice, but the doctrines could not be used to extend coverage to a risk that was not covered. The court disagreed with the holding in Wilkinson that an insurer that assumes the insured s defense without obtaining a reservation of rights and with knowledge of facts indicating noncoverage waives all policy defenses, including the defense of noncoverage, and is estopped from raising the defense. The court held that, for estoppel to prevent the assertion of a defense of noncoverage, there must be a showing of prejudice. The court specifically disagreed with Wilkinson s statement that non-coverage of a risk is the type of right an insurer can waive and thereby effect coverage for a risk that was not covered by the contract. The court also seemed to disagree with Wilkinson s assumption that defending without an effective reservation of rights necessarily created prejudice. The court contrasted the decision in Tilley where the insured suffered actual prejudice from the insurer asserting a coverage defense of late notice that was developed by the defense attorney hired by the insurer. See Employers Cas. Co. v. Tilley, 496 S.W.2d 552 (Tex. 1973). Because the court found no evidence that APA was prejudiced, and because it was undisputed that the claim was made outside the coverage period, the court reversed and rendered judgment that APA take nothing. The Fifth Circuit has restated the elements as requiring proof: (1) that the insurer had sufficient knowledge of the facts or circumstances indicating non-coverage but (2) assumed or continued to defend its insured without obtaining an effective reservation of rights or non-waiver agreement and, as a result, (3) the insured suffered some type of harm. Pennsylvania Nat l Mut. Cas. Ins. Co. v. Kitty Hawk Airways, Inc., 964 F.2d 478, 481 (5th Cir. 1992). The courts have held that for estoppel to prevent the assertion of a defense of non-coverage, there must be a showing of prejudice. Pacific Indem. Co. v. Acel Delivery Serv., Inc., 485 F.2d 1169, 1173, 1175 (5th Cir. 1973); State Farm Lloyds, Inc. v. Williams, 960 S.W.2d 781, 785 (Tex. App. Dallas, 1997, writ dism d by agreement); Kitty Hawk, 964 F.2d at 481 n. 11. The holding in Ulico does not allow for the previous Wilkinson assumption that defending without an effective reservation of rights necessarily creates prejudice. More will have to be shown to meet the prejudice element. 7. Suit has been filed, and the Plaintiff s ability to collect will depend on the existence of insurance coverage. What information should the Plaintiff get regarding coverage? What can the Plaintiff do about coverage issues at this point? In state court, the simplest way to obtain information about the Defendant s insurance coverage is to serve a standard Request for Disclosure. Rule 194.2(g) of the Texas Rules of Civil Procedure requires the Defendant to disclose any indemnity and insuring agreements described in Rule 192.3(f). Rule 192.3(f) provides: Except as otherwise provided by law, a party may obtain discovery of the existence and contents of any indemnity or insurance agreement under which any person may be liable to satisfy part or all of a judgment rendered in the action or to indemnify or reimburse for payments made to satisfy the judgment. Information concerning the indemnity or insurance agreement is not by reason of disclosure admissible in evidence at trial. Similarly, Rule 26(a)(1)(D) of the Federal Rules of Civil Procedure requires disclosure of any insurance agreement under which any person carrying on an insurance business may be liable to satisfy part or all of a judgment which may be entered in the action or to indemnify or reimburse for payments made to satisfy the judgment. Note that these rules do not say that discovery is limited to insurance policies that cover the alleged loss. The language may be liable, although somewhat vague, acknowledges the practical reality that whether a policy covers an alleged loss is often highly uncertain. Does this mean the Defendant must produce every insurance policy in its files? In In re Dana Corp., 138 S.W.3d 298, 301 (Tex. 2004), a toxic tort case involving multiple plaintiffs, the defendant argued that it should not be required to mass-produce insurance policies until each plaintiff established which of the company s products was allegedly at fault and for what time periods the exposure allegedly occurred. The supreme court refused to go that far, but it agreed that a threshold showing of applicability must be made before a party can be ordered to produce multiple 6

17 decades of insurance policies. Id. Insurance policies need not be produced until they are shown to be applicable to a potential judgment. Id. Thus, the Plaintiff should be prepared to take reasonable steps to limit the requested policies to those that may apply to a potential judgment, especially in cases implicating multiple policies and policy periods. Of course, the insurance-savvy Plaintiff will often want to obtain more than the insurance policy alone. For example, the Plaintiff may want to serve an interrogatory asking what position the insurer has taken on coverage, or serve a request for production asking for a copy of the insurer s reservation of rights letter and any similar correspondence. The reservation of rights letter provides especially valuable information. First, it will alert the Plaintiff to the coverage issues in dispute, allowing the Plaintiff to shape its pleadings and proof to try to maximize coverage (see the discussion of pleading into coverage in section 3 above). Second, the reservation of rights letter is important because if the insurer is defending without an effective reservation of rights, with knowledge of the facts indicating non-coverage, and there is a showing of prejudice, the insurer will be held to have waived any defense of non-coverage. See Ulico Cas. Co. v. Allied Pilots Ass n, 262 S.W.3d 773, 785 (Tex. 2008). It may also be important for the Plaintiff to know whether the limits of the Defendant s policy have been exhausted or diminished by other claims. The Plaintiff may want to depose a representative of a corporate Defendant with knowledge about the Defendant s insurance coverage. The Plaintiff may even want to investigate what extra-contractual claims the Defendant has against its insurer because these issues affect collectability and, hence, settlement value. Does Rule 192.3(f) authorize additional discovery concerning insurance coverage, beyond merely obtaining a copy of the applicable insurance policies? In Dana Corp., the Texas Supreme Court said no. 138 S.W.3d at The plaintiffs in that case sought to compel the defendant to produce a witness for deposition to testify regarding insurance policies. Id. Specifically, the plaintiffs wanted to find out what policies existed and whether their limits were exhausted or about to be exhausted. Id. The court acknowledged that the purpose of Rule 192.3(f) is to facilitate settlement discussions, but it refused to read the Rule broadly as authorizing discovery of more than the insurance agreement s existence and contents. Id. at However, the court left open the possibility that discovery of additional information concerning insurance coverage could be obtained under the general relevance standard for the scope of discovery stated in Rule 192.3(a). Id. at 304. That Rule provides, in general, that a party may obtain discovery regarding any non-privileged matter that is relevant to the subject matter of the pending action. Tex. R. Civ. P (a). Based on Rule 192.3(a), the court in Dana Corp. found that the trial court did not abuse its discretion in ordering the defendant to produce a witness for deposition on insurance coverage. However, the court hinted that the scope of that deposition might be limited to proving up the contents of the policies. Dana Corp., 138 S.W.3d at 304. The court provided little guidance to the parties concerning the proper scope of questioning, if any, concerning erosion of the insurance policy limits. Id. So how much discovery of additional insurance information does Rule 192.3(a) allow? The easy part of the answer is that the Plaintiff can obtain as much discovery as the Defendant is willing to provide. If the parties are engaged in serious settlement discussions, it may be in the Defendant s own interest to provide additional information about its insurance coverage. For example, if the Plaintiff has made a settlement demand that exceeds policy limits, the Defendant may want to give the Plaintiff information about the limits to encourage the Plaintiff to make a lower demand. On the other hand, if the Defendant will not cooperate and the issue must be presented to the trial court, the question will be whether the discovery is relevant to the subject matter of the pending action under Rule 192.3(a). 8. A lawyer selected by the Defendant has been defending the lawsuit for months. After taking discovery, filing and responding to various motions, and engaging in settlement discussions, the Defendant s lawyer learns for the first time that the Defendant has an insurance policy that might provide coverage for the Plaintiff s claims. What should the Defendant do? Typically, the insurance policy will require the insured to give prompt notice of a claim or suit to the insurer. However, the Defendant should not assume that coverage is lost when timely notice is not given. To preserve the Defendant s rights, defense counsel should immediately send written notice to the insurance company. See Sparks v. Aetna Life & Cas. Co., 554 S.W.2d 228, 230 (Tex. Civ. App. Dallas 1977, no writ) (oral notice was insufficient where policy required written notice). Next, the Defendant should avoid taking any action that might prejudice the insurer. Although the issue is unsettled, the insurance company may be required to prove that it was prejudiced by the failure to give timely notice. 7

18 Several factors may come into play in determining whether the insurer is required to show that it was prejudiced by the delay in providing notice. a. Is the notice requirement a covenant, or a condition precedent? In Hernandez v. Gulf Group Lloyds, 875 S.W.2d 691 (Tex. 1994), the Texas Supreme Court held that an insured s violation of a settlement-without-consent exclusion does not negate coverage where the insurer fails to show actual prejudice. Id. at 693. The exclusion in Hernandez stated that coverage did not apply to bodily injury or property damage with respect to which the insured made any settlement without the insurance company s written consent. Id. at 692 n. 1. However, the court reasoned that insurance policies are contracts subject to rules applicable to contracts generally, including the principle that only a material breach by one party will excuse the other party from performing. Id. at When the insurer is not prejudiced by the insured s breach, the breach is not material, and coverage is not affected. Id. at 693. Does the prejudice requirement of Hernandez apply to an insured s failure to give timely notice of suit? In Hanson Production Co. v. Americas Insurance Co., 108 F.3d 627 (5th Cir. 1997), the Fifth Circuit said yes. The insurer in Hanson argued that the prejudice requirement is limited to those policies that are subject to a mandatory endorsement required by the State Board of Insurance (see below). The Fifth Circuit disagreed, stating that it believed the Texas Supreme Court would opt for a uniform rule of construction requiring the insurer to show prejudice. Id. at 630. Applying Hernandez, the court held that the insurer must show prejudice to avoid coverage based on insured s failure to provide prompt notice of a claim. The court reasoned that [t]he fundamental principle of contract law recognized in Hernandez that a material breach by one contracting party excuses performance by the other party, and an immaterial breach does not is equally applicable to notice cases. Id. at 631. The Fifth Circuit followed the same reasoning in Ridglea Estate Condominium Ass n v. Lexington Insurance Co., 415 F.3d 474, 480 (5th Cir. 2005), holding that the prejudice requirement applied to a property insurance policy. The court based its decision on the the method of the Texas Supreme Court s reasoning in Hernandez, and the general principle underlying that reasoning. Id. Coastal Refining is another case rejecting a narrow interpretation of Hernandez. In that case, the Houston Court of Appeals rejected the insurer s argument that the reasoning of Hernandez is limited to uninsured/underinsured motorist claims, stating that Hernandez was expressly decided on the fundamental principle of contract law that a material breach by one contracting party excuses performance by the other party, and an immaterial breach does not. Coastal Refining & Mktg., Inc. v. U.S. Fid. & Guar. Co., No CV, 2006 WL , at *5 (Tex. App. Houston [14th Dist.] May 30, 2006, no pet. h.) (not yet published). In contrast, the Dallas Court of Appeals has adopted a narrow interpretation of Hernandez, holding that the insurer is not required to prove prejudice where the policy states the notice requirement as a condition precedent to coverage. PAJ, Inc. v. Hanover Ins. Co., 170 S.W.3d 258, 261 (Tex. App. Dallas 2005, pet. granted); accord Prodigy Communications Corp. v. Agric. Excess & Surplus Ins. Co., 195 S.W.3d 764, (Tex. App. Dallas 2006, pet. filed) (applying PAJ). In PAJ, the court acknowledged Hernandez s principle that only a material breach excuses performance by the other party. Id. at 260. However, the court distinguished Hernandez as dealing with a mere contractual covenant, as opposed to a contractual condition. Id. at 263. Noting that the clause at issue in Hernandez was contained within a policy exclusion, the court stated, We see a significant difference between a policy condition (performance of which is necessary to trigger any obligation for coverage) and a policy exclusion (which operates only after the obligation for coverage is in place). Accordingly, the PAJ court declined to follow federal cases requiring the insurer to show prejudice. Id. The Texas Supreme Court granted a petition for review in PAJ but has not yet issued a decision. The court may use PAJ as an opportunity to clarify how far the reasoning of Hernandez reaches. b. Does the Texas Department of Insurance s mandatory endorsement apply? The Texas Department of Insurance requires general liability policies issued in Texas to include an endorsement stating that the insured s failure to comply with a notice requirement will not bar coverage for bodily injury or property damage unless the insurance company is prejudiced. Chiles v. Chubb Lloyds Ins. Co., 858 S.W.2d 633, 635 (Tex. App. Houston [1st Dist.] 1993, writ denied). If the policy is subject to this requirement, and if the claim is for bodily injury or property damage, the insurer will be required to show prejudice. Coastal Refining, 2006 WL , at *3. However, even if the policy is subject to this mandatory endorsement, the prejudice requirement may not apply if the claim is for personal injury or advertising injury rather than bodily injury or property damage. See PAJ, 170 S.W.3d at 263 (mandatory endorsement did not apply to advertising 8

19 injury coverage); Gemmy Indus. Corp. v. Alliance Gen. Ins. Co., 190 F. Supp. 2d 915, (N.D. Tex. 1998) (same), aff d 200 F.3d 816 (5th Cir. 1999), opinion at 1999 WL c. Claims-made or occurrence policy? Generally, an occurrence policy provides coverage for claims arising out of an occurrence that takes place during the policy period, while a claimsmade policy provides coverage for claims that are made during the policy period. In late notice situations, this distinction can affect whether the insurer is required to show prejudice. Several decisions have held that claims-made policies, unlike occurrence policies, are not subject to a prejudice requirement. Ridglea, 415 F.3d at 480 n.4; Fed. Ins. Co. v. CompUSA, Inc., 319 F.3d (5th Cir. 2003); Matador Petroleum Corp. v. St. Paul Surplus Lines Ins. Co., 174 F.3d 653, 658 (5th Cir. 1999). Compare St. Paul Guardian Ins. Co. v. Centrum G.S. Ltd., 383 F. Supp. 2d 891, (N.D. Tex. 2003) (prejudice requirement does apply to all occurrence-based policies regardless of the type of coverage at issue). The rationale is that coverage does not even arise under a claims-made policy until the claim is reported during the policy period. See, e.g., Hirsch v. Texas Lawyers Ins. Exch., 808 S.W.2d 561, 565 (Tex. App. El Paso 1991, writ denied) ( To require a showing of prejudice for late notice would defeat the purpose of claims-made policies, and in effect, change such a policy into an occurrence policy. ). A further distinction can be drawn between a claims-made policy, which requires that the claim be made during the policy period, and a claims-made and reported policy, which requires the claim to be made and reported to the insurer during the policy period. The insured might argue that the prejudice requirement should apply where the policy is merely claims-made but not where the policy is claims-made and reported. However, at least one court has rejected this argument. Chicago Ins. Co. v. Western World Ins. Co., 1998 WL 51363, at *3 (N.D. Tex. 1998) (not designated for publication). d. Dealing with unclear case law As illustrated by the case law discussed above, it is not entirely clear under Texas law whether an insurer must demonstrate prejudice before it can avoid its obligations under a policy where the insured breaches a prompt-notice provision or a consent-to-settle provision. Motiva Enterprises, LLC v. St. Paul Fire & Marine Ins. Co., 445 F.3d 381, 386 (5th Cir. 2006). What is clear is that the defendant who gives late notice of a claim or suit should do as much as it can to make a factual record that demonstrates a lack of prejudice to the insurer. Whether the insurer is prejudiced by lack of notice is generally a question of fact. Struna v. Concord Ins. Services, Inc., 11 S.W.3d 355, (Tex. App. Houston [1st Dist.] 2000, no pet.). The defendant should avoid entering into a settlement without the insurer s consent, trying the case without the insurance company s involvement, relinquishing rights the insurance company might want to preserve, etc. If prejudice is avoided, the defendant will at least preserve the ability to argue that the failure to give timely notice does not excuse the insurer from providing coverage. 9. Two Plaintiffs sue the Defendant. One Plaintiff s injuries are grievous; the other s less so. Either claim would exceed the policy limits. The Insurer pays the policy limits to settle the smaller claim, leaving Defendant exposed on the larger claim. What do the remaining Plaintiff and the Defendant do? Unfortunately for the Plaintiff and the remaining Defendant, the Defendant probably has no claim against the Insurer for violating its Stowers duty to accept a reasonable settlement offer within policy limits. Under Texas Farmers Insurance Co. v. Soriano, 881 S.W.2d 312, 315 (Tex. 1994), an insurer cannot be held liable for negligence where it enters into a reasonable settlement with one claimant, even where the settlement exhausts or diminishes the proceeds available to satisfy other more serious claims. Soriano offers a cautionary tale for Plaintiffs who wait too long to make a Stowers demand. In the underlying suit, two groups of Plaintiffs, the Medinas and the Lopezes, sued Soriano for wrongful death arising from a car accident. Soriano s policy limits were $20,000. Texas Farmers Insurance offered $20,000 to the Medinas, but the Medinas rejected this offer. Farmers later settled the Lopez claim for $5,000 and offered the remaining $15,000 to the Medinas. The Medinas rejected this offer, but later demanded $20,000. Id. at 313. Farmers would not pay $20,000, and the Medinas took their claims to trial, obtaining a judgment exceeding $172,000. Id. Soriano subsequently sued Farmers for negligence and obtained a judgment including over $520,000 in actual damages. Id. at 314. On appeal, Farmers argued that there was no evidence that it violated its Stowers duty by settling the Lopez claim for $5,000 and subsequently refusing to settle the Medina claims for $20,000. Soriano, on the other hand, argued the Lopez settlement was unreasonable when viewed in comparison to the more serious Medina claims. When faced with multiple claims with inadequate proceeds, Soriano argued, an insurer should weigh the seriousness of the claims and attempt to settle those 9

20 claims within policy limits that pose the greatest threat of liability for an excess judgment. Id. The Supreme Court rejected Soriano s argument, holding that when faced with a settlement demand arising out of multiple claims and inadequate proceeds, an insurer may enter into a reasonable settlement with one of the several claimants even though such settlement exhausts or diminishes the proceeds available to satisfy other claims. Id. at 315. The Court believed this approach promotes settlement and encourages claimants to make claims promptly. Id. The Supreme Court reasoned that Farmers could not be held liable for violating its Stowers duty because one of the elements of a Stowers claim is a settlement demand within policy limits. A demand above policy limits, no matter how reasonable, does not trigger the Stowers duty to settle. Id. at (citing Am. Physicians Ins. Exch. v. Garcia, 876 S.W.2d 842, (Tex. 1994)). Although the Medinas eventually made a $20,000 settlement offer, that offer did not come until after the policy limits had been reduced to $15,000 by the Lopez settlement. Therefore, there was no evidence of a settlement demand within policy limits. Id. at The Court also found that Farmers did not violate any duty to its insured by entering into the Lopez settlement and leaving less money available to settle the more serious Medina claims. The fact that the Medinas claims may be more serious is not evidence that the Lopez claim was unreasonable when viewed in comparison to the more serious Medina claims, the Court stated. To be unreasonable, the Court held, Soriano must show that a reasonably prudent insurer would not have settled the Lopez claim when considering solely the merits of the Lopez claim and the potential liability of its insured on the claim. Id. at 316. For trial lawyers, the key point from Soriano is that the Insurer is free to evaluate the reasonableness of each claim independently from the other. In a lawsuit with multiple Plaintiffs, each Plaintiff therefore has a powerful incentive to be the first to make a Stowers demand within the policy limits. This means that Plaintiffs must evaluate the settlement value of the case as early as possible. Of course, this may be difficult when the net worth of the Defendant is unknown. Notably, the Soriano opinion states that the Medinas rejected the Insurer s original $20,000 offer because they wished to investigate Soriano s personal assets. Soriano teaches trial lawyers that they may not have that luxury if they want to preserve a Stowers claim against the Insurer. What options, then, do the Plaintiff and the nonsettling Defendant have when the Insurer pays the policy limits to settle one claim, leaving the nonsettling Defendant exposed? In light of Soriano, the Plaintiff and the non-settling Defendant may want to consider choice-of-law principles as an escape hatch (see discussion of choice of law in section 12). Another state s law may recognize a broader duty of the insurer to act reasonably in settlement negotiations when faced with multiple claimants. 10. The Insurer hired a lawyer to defend, but the Insurer keeps messing with the defense. The Insurer won t pay the defense lawyer to do certain tasks, contending that they can be done by a paralegal. The Insurer won t pay for an expert the defense lawyer thinks is needed. The Insurer quibbles over venue choices and such. What should the defense lawyer do? What can the Defendant do? The defense lawyer owes her unqualified loyalty to the insured. Employer s Casualty Co. v. Tilley, 496 S.W.2d 552, 558 (1973). In State Farm Mut. Auto. Ins. Co. v. Traver, 980 S.W.2d 625 (Tex. 1998), the court extended that view and held that the attorney is the sole agent of the insured. The court also pointed out that ethical rules prohibit the attorney letting any outside influences impair the insured s defense. Id. at 628. Thus, the defense lawyer is an independent contractor. The court held that these factors prevent the insurer from exercising the control over the attorney that would lead to vicarious liability. Id. This just means that if the lawyer mishandles the case, the insurer cannot be held vicariously liable for the malpractice of the defense lawyer it has chosen. On the other hand, the insurer can be directly liable for its own conduct that limited the lawyer s decisions or caused the mishandling of the case. In Traver, the court remanded for consideration of any remaining claims based on the insurer s own misconduct. Id. at 629. If the insurer takes steps, or insists on a course adverse to the insured, the insurer may lose the right to control the defense, if there is a conflict of interests. The insurer may incur liability to the insured if it interferes with the lawyer s efforts on the client s behalf. In Northern County Mutual Insurance Co. v. Davalos, 140 S.W.3d 685, (Tex. 2004), the court held the insurer did not breach its duty to defend, because the conditions the insurer tried to impose did not create a sufficient conflict of interest. The insurer did not breach its duty to defend by conditioning its offer of a defense on the insured agreeing to waive his motion to transfer venue filed by attorneys who were already representing him. Id. The court recognized that under certain circumstances there will be a conflict of interests that prevents the insurer from conducting the defense; however, the court found this was not such a case. The 10