If an insurance company owes a duty to defend, the dispute should be decided promptly, on the pleadings. Any delay undermines the duty to defend. The scope of the duty to defend should be adjudicated on the pleadings as quickly as possible to give policyholders the true value of their policies and the benefit of their contracts.

The value and purpose of the duty to defend

The duty to defend is one of the most valuable components of an insurance policy. Like it or not, American society is litigious. Companies cannot prevent lawsuits through good conduct, laudable intentions, or strong compliance programs.  Refuting liability and damages is expensive even if the core facts are undisputed or the case is frivolous.

For a single company or individual, the frequency and size of litigation generally is unpredictable, making budgeting for defense costs a difficult task.  In any single year, the risk of litigation is low, but when a claim does come in, defense costs can be significant.  This litigation landscape is a problem for legal departments trying to budget or reserve for litigation costs.

The duty to defend addresses this problem using the principles of risk transfer and risk pooling.

  • Risk transfer: the risk and costs of defending litigation is transferred to the insurance company in exchange for a premium payment.
  • Risk pooling: the insurance company takes the collective risks of litigation against all policyholders in a pool large enough that aggregate defense costs can be statistically analyzed and predicted on an annual basis.

This way no one has to assess the risk that any individual company is sued or anticipate those defense costs. Policyholders can include insurance premium costs in their legal budgets, and shift covered defense costs onto the insurer. The insurance company underwriters can evaluate the aggregate defense spend at a gross systemic level and charge premiums to cover those costs (with a healthy profit margin).

The insurer’s obligation to defend

However, without intervention, this system creates an incentive for insurers to disavow the duty to defend if the anticipated defense costs are greater that the anticipated costs to dispute coverage. In order to prevent this, state law often rebalances the financial incentives using a type of carrot and stick approach:

  • Carrot: Courts construe the duty to defend broadly and in favor of policyholders wherever possible. The law requires insurers to defend if there is any “potential for coverage.” Insurers must establish that there is “no possible factual or legal basis” of coverage before denying a defense. If the policy language is unclear, or there is some interpretation of the complaint that falls within coverage, an insurer must
  • Stick: If an insurer wrongly refuses to defend, it faces significant liability to their policyholders, not limited by the policy limits. Although the specific damages available can vary based on the outcome of the underlying action, insurers that deny a defense incorrectly face consequential, tort, and punitive damages, and may have to fully indemnify a later judgment or settlement, even if it exceeds the policy limits.

Extended litigation of coverage disputes further injures policyholders

When an insurer refuses to provide a defense, the policyholder generally must hire lawyers to sue its insurer to compel a defense. These coverage disputes burden the policyholder with the costs of two litigations: the defense fees for the underlying claim and the cost of litigating with the insurer.

In these coverage disputes, delay and extended litigation hurts policyholders who need to pay defense costs as they accrue, not years later. Policyholders have no say in whether the insurer disputes coverage and can be forced into unexpected litigation. Few legal departments budget for litigation against their own insurer, expecting ordinary litigation costs to be covered by their insurer. In contrast, insurers are well-funded and have experienced coverage attorneys on retainer, ready to defend even the most spurious coverage defense.

Requiring policyholders to conduct discovery before evaluating defense duty can frustrate its purpose

Adding to policyholders’ woes is that many trial judges are wary of deciding cases on the pleadings. Most trial judges are understandably used to overseeing factual disputes, which are better resolved by trial on fully vetted factual record. But this is not warranted in duty to defend cases, since insurance policy interpretation is a question of law presented by indisputable facts established in the pleadings.

Since the duty to defend is so broad and should be decided solely by comparing the policy to the complaint in the underlying litigation, Courts should decide such disputes on motion, without discovery or trial. It makes no sense to burden policyholders with unnecessary discovery and expert costs if there is a potential for coverage for the underlying complaint.

Resolving these disputes on the pleadings

Most jurisdictions allow courts to adjudicate these kinds of substantive issues on the pleadings.  For example, Rule 12(c) of the Federal Rules of Civil Procedure allows a court to award the policyholder a judgment on the pleadings in exactly these types of circumstances. The duty to defend is well suited for a judgment on the pleadings because the insurer’s duty to defend arises from the pleadings already made in the underlying case – not from any evidence collected in the coverage dispute. This is why courts and policyholders should try to resolve the duty to defend on these early motions.

If an insurer can request a decision on coverage through an early motion to dismiss, as they frequently do, the policyholder deserves that same right using a motion for judgment on the pleadings. Similarly, courts should not hesitate in making an affirmative finding of the duty to defend when denying an insurer’s motion to dismiss. A finding that the insurer did not meet its burden to show no possibility of coverage is fundamentally the same as an affirmative finding that there was a potential for coverage, and a breach of the duty to defend. By deciding the duty to defend early, courts can give teeth to the duty to defend and provide policyholders with the benefit of their bargain.