Insurance Law Alert: Duty to Reimburse Defense Costs under Claims-Made Errors and Omissions Insurance Limited to Potentially Covered Claims

In Health Net v. RLI Insurance (No. B224884, filed 5/22/12), Health Net was sued in class actions by New Jersey policyholders alleging that the health plan under-reimbursed for treatment by relying on an outdated and systemically flawed computer program. They alleged ERISA violations for nondisclosure, failure to provide full review, and breaches of fiduciary duties.

Health Net was also investigated by the New Jersey Department of Banking and Insurance, leading to a consent order and fines. However, it was subsequently learned that Health Net concealed the extent of its misconduct from the Department. Meanwhile, Health Net engaged in extensive discovery abuses in the class actions, leading the court to enter as a discovery sanction a finding that Health Net had knowingly and willfully used outdated data, that its corporate officials acted to hide its misconduct, and that Health Net made false claims in discovery. Health Net settled the lawsuits by paying $215 million.

Health Net then sued four insurers for failure to reimburse defense costs under claims-made errors and omissions insurance. The policies covered damages from claims made against the insured for any wrongful act, defined as “any actual or alleged breach of duty, breach of confidentiality, neglect, error, misstatement . . . committed solely in the conduct of the Insured’s Professional Services.”

The court held that most of the claims were not covered as constituting payment of policy benefits due and “[e]ven in the absence of an express exclusion, courts have held that a claim alleging breach of contract is not covered under a professional liability policy because there is no ‘wrongful act’ and no ‘loss’ since the insured is simply being required to pay an amount it agreed to pay.” However, the court ruled that there was a potential for coverage to the extent that the plaintiffs had been seeking damages beyond the policy benefits, including non-contract damages for breaching New Jersey regulations, non-contract damages for the failure to disclose, and related attorney’s fees.

Having concluded that there was a potential for coverage, the court went on to address the insurers’ duty to reimburse defense costs. Citing Buss v. Superior Court, the court noted that under general liability insurance the duty to defend operates prophylactically based on the potential for coverage, and obligates the insurer to defend the entirety of an action, subject to a right of reimbursement for costs incurred solely because of uncovered claims. According to the Health Net court, the underlying principles produce the opposite result for a claims-made defense-reimbursement policy:

“Importing this analysis into a policy with the duty to reimburse, rather than defend, and the procedural posture of the underlying action having been concluded by settlement, the insurer would have a duty to reimburse for defense costs incurred only in the defense of potentially-covered claims.”

The court also noted that the policies covered “claims,” and that “‘claim’ . . . is only the specified dishonest ‘acts, errors, or omissions’. . . . This supports the conclusion that ‘Claim’ does not mean ‘entire action,’ but is in fact limited to the relevant claims within the action.”

For the same reason, the court ruled that the policies’ dishonest acts exclusion would not apply to the entirety of the lawsuits. The exclusion stated that: “[t]his policy does not apply to any Claim: (a) arising out of or alleging any criminal, malicious, dishonest or fraudulent act, error or omission of any Insured; however, the Insurer shall defend Claims alleging fraud, dishonesty, malicious or criminal acts, errors or omissions up until a judgment, ruling at law, finding in fact, plea bargain or plea of no contest, at which point the Insurer shall be reimbursed for the expenses incurred in defending such Claims.”

The court stated that: “we read the exclusion to provide that, if there is a finding in fact of a dishonest act, there is no duty for the insurer to reimburse for any defense costs of the claim (either before or after the finding in fact) to the extent the claim arose out of the dishonest act.” “In this case, the dishonest act found by the federal court is HN’s¬†knowing and willful use of outdated data. While some of the claims . . . arose out of this misconduct, many others did not. . . . Thus, the dishonest act exclusion does not preclude coverage for the entirety of the potentially-covered claims.”

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May 25, 2012