Insurers May Face Excess Liability Without Bad Faith

In December 2018, the Nevada Supreme Court answered a certified question from the United States District Court for the District of Nevada and held that the consequential damages for which an insurer may be liable when it breaches the duty to defend are not constrained by the insurance policy’s limit of liability.

The Underlying Claim

In Century Surety Co. v. Andrew (Nev. Case No. 73756), the insurer of a mobile auto detailing business refused to defend a suit against the insured and one of its employees arising out of an accident involving one of the detailing company’s vehicles. The insurer’s position was that the driver was not acting in the course and scope of his employment at the time of the accident. The insured detailing company and its employee defaulted in the lawsuit and notified the insurer of the default; the insurer maintained its position that there was no coverage.

Subsequently, the insureds entered into a settlement with the claimant where they agreed to entry of a default judgment against them and an assignment of their rights against the insurer, in exchange for the claimant’s covenant not to execute any judgment against them. The claimant then sought entry of a default judgment for $18,050,183. After a hearing, the trial court entered a default judgment that included various factual findings (deemed admitted due to the default), including that the driver’s negligence caused the claimant’s injuries, the driver was acting in the course and scope of his employment at the time of the accident, and therefore, the insured employer also was liable.

The Coverage Litigation

Following entry of the requested default judgment, the claimant sued the insurer (as assignee of the insureds), and asserted claims for breach of contract, bad faith, and unfair claims practices. The coverage action was removed to federal court. There, the district court held that the insurer breached its duty to defend because the complaint alleged potentially covered claims, but that the insurer was not bound by the default judgment entered against the insured. See Andrews v. Century Sur. Co., 134 F. Supp. 3d 1249, 1253 (D. Nev. 2015). The district court also ruled that the measure of damages for breaching the duty to defend included the insureds’ reasonable defense costs in the underlying action, and “the damages reasonably foreseeable at the time of the contract, capped at [the policy’s] $1 million [limit],” because the insurer had not acted in bad faith. See id. at 1254. However, upon reconsideration, the district court held that “Nevada law allows for recovery of all reasonably foreseeable consequential damages for a breach of contract, regardless of the good or bad faith of the breaching party. There is no special rule for insurers that caps their liability at the policy limits for a breach of the duty to defend.” Id. at 1259.

The Nevada Supreme Court Holds That Policy Limits Have No Bearing on Damages Recoverable by an Insured for Breach of the Duty to Defend

The District Court subsequently certified the following question to the Nevada Supreme Court:

Whether, under Nevada law, the liability of an insurer that has breached its duty to defend, but has not acted in bad faith, is capped at the policy limit plus any costs incurred by the insured in mounting a defense, or is the insurer liable for all losses consequential to the insurer's breach?

See 134 Nev. Adv. Op. 100 at p. 2 (Dec. 13, 2018).

The Nevada Supreme Court began its consideration of the certified question by observing that “‘[t]he duty to defend is a valuable service paid for by the insured and one of the principal benefits of the liability insurance policy.’” Id. at p. 7 (quoting Woo v. Fireman’s Fund Ins. Co., 164 P.3d 454, 459-60 (Wash. 2007)). The court then discussed case law from other jurisdictions, including those of the majority view – that the policy limit caps an insurer’s liability for breach of the duty to defend in the absence of bad faith – and the minority view, that the policy limit does not so operate.

The Nevada Supreme Court concluded that “the minority view is the better approach[,]” because interpreting the duty to defend to be “limited to and coextensive with the duty to indemnify would be essentially meaningless.” Id. at p. 11. Instead, the court held that while the policy limits restrict the amount an insurer would have to pay in response to its duty to indemnify, “‘they do not restrict the damages recoverable by the insured for a breach of contract by the insurer.‘” Id. (quoting Comunale v. Traders & Gen. Ins. Co., 328 P.2d 198, 201 (Cal. 1958)). Accordingly, the court further held:

[E]ven in the absence of bad faith, the insurer may be liable for a judgment that exceeds its policy limits if the judgment is consequential to the insurer’s breach.

Id. at 13. However, the court cautioned that “an entire judgment is [not] automatically a consequence of an insurer’s breach of its duty to defend; rather, the insured is tasked with showing that the breach caused the excess judgment and ‘is obligated to take all reasonable means to protect himself and mitigate his damages.’” Id. (quoting Thomas v. W. World Ins. Co., 343 So. 2d 1298, 1303 (Fla. Dist. Ct. App. 1977)).

Insured’s Burdens to Prove Causation and Mitigate Damages Likely to Limit Impact of the Court’s Ruling

Most states recognize that where an insurer breaches its duty to defend, the insured is entitled to recover its defense costs as well as consequential damages naturally flowing from the insurer’s breach. Further, even where, as in Nevada, an insurer’s liability for breach of the duty to defend is not capped by its policy limits, the insured still bears the heavy burdens of: (1) proving that the insurer’s breach caused the alleged consequential damages; and (2) taking all reasonable measures to mitigate those damages. These burdens make it unlikely that carriers who have not acted in bad faith will routinely face potential liability for judgments in excess of their policy limits for breaching the duty to defend, particularly where the insured has the means to mount a vigorous defense on its own. Nevertheless, given that, at least in some states, an insurer’s liability for breach of the duty to defend will not necessarily be capped at its policy limits, insurers considering refusing to defend a claim would be wise to heed the court’s advice: “[T]he insurer refuses to defend at its own peril.” Id.

New Restatement of the Law, Liability Insurance May Require Insurers to Defend a Claim without the Possibility of Recoupment where Extrinsic Evidence Eliminates the Duty to Defend

Finally, although not the focus of the Nevada Supreme Court’s ruling, it is noteworthy that, in discussing the scope of an insurer’s duty to defend, the opinion cites the brand new Restatement of the Law, Liability Insurance (“RLLI”), § 13 cmt. c (Am. Law Inst., Proposed Final Draft No. 2, 2018). See id. at 7-8, n.4. While it does not appear to be an issue that was raised by the certified question, the court nevertheless took the opportunity “to clarify” that an insurer must determine whether it has a duty to defend based solely on the four corners of the complaint. See id. (citing United Nat’l Ins. Co. v. Frontier Ins. Co., Inc., 99 P.3d 1153, 1158 (Nev. 2004)). Citing the RLLI, the court further held that an insurer may rely upon extrinsic evidence to negate its duty to defend only where the insurer has defended under a reservation of rights and then brings an action either seeking to terminate that obligation or seeking a declaration after-the-fact that it had no such obligation. Id.

This provision of the RLLI is particularly troubling when considered in conjunction with Section 21, which provides:

Unless otherwise stated in the insurance policy or otherwise agreed to by the insured, an insurer may not seek recoupment of defense costs from the insured, even when it is subsequently determined that the insurer did not have a duty to defend or pay defense costs.

Restatement of the Law, Liability Insurance, § 21 (Am. Law Inst. Revised Proposed Final Draft No. 2, Sept. 7, 2018). Thus, under the newly approved RLLI, where a complaint on its face is potentially covered, but an insurer possesses extrinsic facts clearly demonstrating that there is no potential coverage, the insurer must not only defend the claim under a reservation of rights, but also may not be able to recoup its defense expenses upon a determination that it had no duty to defend. Such a potential outcome belies the Nevada Supreme Court’s apparent suggestion that the rule – precluding an insurer from relying upon extrinsic evidence to deny a duty to defend from the outset of a claim – is harmless because “the insurer can always agree to defend the insured . . . under a reservation of rights.” See 134 Nev. Adv. Op. 100 at 7-8, n.4.

While it does not appear that any court has simultaneously applied these two provisions of the new RLLI, they could require an insurer to defend a demonstrably uncovered claim and incur the added costs of a coverage action to obtain a judgment that it has no duty to defend (based upon the extrinsic evidence it could not rely upon to refuse to defend), all without the possibility of recouping its defense costs. Of course, insurers can avoid such an unfair result if they incorporate provisions into their policies giving them the right to seek recoupment of defense costs for uncovered claims.