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How the courts are dealing with exclusion clauses in liability policies

R. Lee Akazaki on January 19, 2011

Heaven forbid, but your client will, one day, be sued. What advice can you give now about the scope of coverage? In these days of All-Risk liability insurance, there are only two certainties: All-Risk does not insure all risks; and exclusions are the main method of defining the scope of coverage.

R. Lee Akazaki, C.S., is a partner with Gilbertson Davis Emerson LLP

It does not help that the judicial interpretation of liability insurance coverage exclusions consists of generalities that courts often fail to apply with systematic consistency. Despite the mysteries of this area, the following is a practical approach to help your client understand how the judiciary actually interprets liability insurance exclusions.

Facts for Interpretation
The coverage exercise should always start with the applicable facts. The judge dealing with the litigation of a coverage dispute will start with the facts, then the insurance contract. So should you when you are discussing the scope of exclusions with the policyholder. In what circumstances could a dispute arise? What are the policyholder’s business activities that may be caught by an exclusion? While no one enjoys the contemplation of a lawsuit down the road, modern risk management requires asking these questions. The duty to defend and the duty to indemnify are the two essential functions of liability insurance. These duties will determine the nature and source of the facts that start your inquiry.

Duty to Defend: The provisions providing for duty to defend are essentially a form of legal services insurance. Quite often, this is the most valuable part of a liability policy, especially where the lawsuit’s merits are dubious or the amount claimed may be inflated. The facts are those stated in the statement of claim or other statement defining the litigated dispute. The courts afford the widest latitude to the reading of these allegations and to the terms of possibility of coverage under the policy. If and when the policyholder is sued and reports the claim to you for notification of the insurer, the “actual” facts (as known to the policyholder) do not matter.

Duty to Indemnify — Judgments: The facts are those determined by the court or other tribunal after evidence is presented at the trial or other substantive hearing. If these facts come within coverage, the insurer is obliged to pay out, subject to limits. The factual outcome will only be fixed at trial.

Duty to Indemnify — Settlements: What “facts” apply where a coverage dispute involving liability insurance survives the settlement of a lawsuit? Unlike the determination of fact available to a trial judge after a judgment or verdict has been made in the underlying suit, settlements are made on contingent facts, in that the insured defendant will most likely continue to deny the facts giving rise to liability. The key to this puzzle is the position of the parties after the defence obligation is assessed by the insurer.

Ordinarily, a coverage dispute arising from a settlement will come about after an insurer has declined coverage and is not defending. The insured will settle the claim and seek indemnity from the insurer. (Where an insurer has agreed to defend, either outright or under some reservation of rights, it is almost invariably the insurer who will settle the action. This is a function of provisions in most liability policies prohibiting insureds from accepting fault or settling claims without the consent of the insurer, the consequence of such conduct being the voiding of liability insurance coverage.)

An appreciation of the case law reveals two general statements:

1. Where the insurer did not defend but is found to have denied coverage wrongly, the insurer will be held liable for any reasonable settlement entered into by the insured. The court will not require the insured to prove liability to the plaintiff in situations where the insured defended on the basis that the plaintiff’s claim had no merit.

2. Where the insurer defended and reserved rights to deny coverage, the court will look to the evidence available to the parties at the time of settlement. The standard appears to be the facts reasonably informing the settlement, i.e. the decision to pay.

Insurance as Contract
The conventional starting point for interpretation of coverage under an insurance policy is not to employ any fancy legal rules, but rather to apply the general law of contract. The insurance must give effect to the intention of the parties by reading the words they have used. If there is no ambiguity, no special rules of construction are required. The rules of construction are like the presumptions used in organized sport to resolve the limits of human ability to adjudicate–e.g., “the tie goes to the runner.” If there is no tie, then the runner is safe or out. No special rule is required. To continue the sporting analogy, a close play does not justify the invocation of a rule. Rather, only where the umpire or referee cannot tell which play occurred first is any rule required. It is the same for insurance policy exclusions.

Resolution of Ambiguities
Genuine ambiguities do arise from time to time, often in manuscript insurance forms. How, then, does the law treat a true ambiguity? The insured has the onus of proving the loss came within the terms of an insured risk. The insurer bears the onus of proving it came within the terms of an exclusion clause. This dichotomy is simply an application of the general burden of proof, that the party advancing a proposition relating to a contract bears the burden. It is not a special rule applicable to insurance policies only.

There is no one-size-fits-all answer to the consideration of liability insurance exclusions, there is no real substitute for careful analysis of the facts.

If there is a true ambiguity, the best approach is to follow this order of determining whether the exclusion applies to the facts:

(1) the desirability of giving effect to the reasonable expectations of the parties

(2) the principle that coverage provisions should be construed broadly and exclusion clauses narrowly; and

(3) as a last resort, the famous contra proferentem rule, that an ambiguity in the document will be construed against the party who drafted it.

In the case of most liability policies, such as home, automobile, and standardized commercial general liability, there is a strong judicial impetus to resolve ambiguities in favour of insureds, even in cases where the ambiguities can be overcome through careful reading. In some cases, the exclusion clause simply does not make much sense without straining to read it the way one might expect the insurer to define the risk. If an insurance policy exclusion is difficult to read, chances are it will not be enforced. From a public policy perspective, this judicial rule is highly problematic, since the written document is proof that an exclusion was within the contemplation of the parties. While it is clever for courts to say their role is not to rewrite policy provisions, that is precisely what they do when effectively writing the exclusion out of the policy wording for ambiguity.

Concurrent Causes Giving Rise to a Claim
The rules for exclusions will be further complicated when there are two or more concurrent causes giving rise to a plaintiff’s damage or injury. The conventional wisdom used to be that the court should consider the “dominant” cause of an accident. If that cause triggered an exclusion, there would be no coverage. This proposition was held to have no application in the law of Canada, in a Supreme Court decision called Derksen v. 539938 Ontario Ltd. There, a projectile flew off the back of a vehicle in highway traffic into the window of an oncoming school bus, killing a child and seriously injuring three others. The Supreme Court concluded that the general liability policy covered the portion of the loss attributable to non-auto-related negligence. From a general insurer’s perspective, it clearly did not want to underwrite the risk of accidents taking place on Her Majesty’s highways. However, the court in Derksen found a way to put the risk on the general insurer.

Conclusion: Why Exclusions Matter
While there is no one-size-fits-all answer to the consideration of liability insurance exclusions, there is no real substitute for careful analysis of the facts as they apply to insurance policy wordings. The advice you give at the stage of processing the application is going to be an exercise in crystal-ball gazing. Nevertheless, in a world where managing client expectations is critical to avoiding surprises when accidents or lawsuits do happen, it is best to have an understanding of the way the legal process treats the operation of liability policy exclusions. As I tell the lawyers I teach, if you leap to conclusions, take the time to make sure they’re the right ones.

R. Lee Akazaki, C.S., is a partner with Gilbertson Davis Emerson LLP, and president of the Ontario Bar Association, 2010-11. The content of this paper is for professional education purposes only and not intended to provide a legal opinion.