Make Whole Doctrine and Deductibles

he insurer that had provided errors and omissions (E&O) insurance filed a diversity action against the insurance broker, as its insured, seeking declaratory judgment that it was entitled to funds held in escrow from a settlement from insurers that had provided builders risk coverage and an inland marine (IM) policy for a contractor. The broker counterclaimed for declaratory judgment that it was entitled to recover its deductible from the escrow funds. This case is Fireman's Fund Ins. Co. v. TD Banknorth Ins. Agency, 644 F.3d 166 (2011).

Haynes Construction Company began work on a housing development and retained TD Banknorth as its agent to arrange insurance coverage. TD procured a builders risk policy from Peerless Insurance Company and an IM policy from Hartford Insurance Company. In 2006, a fire destroyed a house being built on a lot in the development. Peerless denied coverage because the lot was not listed in the builders risk policy—an error of omission by TD Banknorth. Haynes thereupon claimed against TD for its negligent omission of the lot.

To protect against the risk of such negligence, TD Banknorth had purchased an E&O policy with Fireman's Fund. TD forwarded the claim to Fireman's Fund and the insurer settled with Haynes for $354,000. Of that amount, TD contributed $150,000 (its deductible) and the insurer contributed the rest. TD Banknorth and Fireman's Fund then subrogated against Peerless and Hartford. In the ensuing settlement, Peerless paid $88,000 and Hartford paid $120,000 in exchange for complete releases; these amounts were placed in an escrow account. In March 2008, Fireman's Fund commenced this action against TD Banknorth seeking a declaration that it was entitled to all of the escrow funds. TD counterclaimed for a declaration that, under Connecticut's make whole doctrine, it was entitled to recover its $150,000 deductible from the escrow funds.

The United States District Court ruled in favor of the insurer. This appeal followed.

The United States Court of Appeals, Second Circuit, said that the appeal turned on a single question of law: is TD Banknorth entitled to recoup the $150,000 deductible by virtue of Connecticut's make whole doctrine?

The Circuit Court found that in Connecticut, insurance companies have an equitable right of subrogation at common law, and this equitable right is subject to the make whole doctrine, which provides that the insurer may enforce its subrogation rights only after the insured has been fully compensated for all of its loss. Thus, when insurance coverage compensates a policyholder for less than the full loss, the insurer must first use any recovery from a third party to compensate the policyholder for the remainder of its loss before keeping anything for itself.

Now, the court continued, if parties desire to contract around the make whole doctrine, they must state expressly that the doctrine is not to apply. The subrogation clause in the E&O policy was found to be boilerplate, and the court said that such a clause does not displace the make whole doctrine; displacement requires wording that speaks specifically to the priority of recovery. The court concluded that the clause in the E&O policy did not abrogate the make whole doctrine. Furthermore, the court went on, even if the clause in this case did abrogate the state's make whole doctrine, such abrogation would not apply to the $150,000 deductible. By its own express terms, the E&O clause concerns only the sums that the insurer pays on behalf of its insured and the deductible paid by TD does not fit this description.

The insurer argued that the make whole doctrine does not apply to deductibles. The Circuit Court noted that there are strong arguments on both sides of this issue.

The insured's claim to the funds is based on the make whole doctrine meaning exactly what it says—if it intends to make the policyholder truly whole, it would apply to deductibles just as it does to non-deductible losses. The insured argued that even if the policyholder is made whole for a loss in excess of all coverage, the insured still remains out of pocket to the extent of the deductible. Making the policyholder truly whole so that the policyholder suffers no net loss to the benefit of the insurer would therefore require compensating him for the deductible as well.

On the other hand, the insurer countered that the equitable principle that underlies the make whole doctrine is that a loss should be borne according to the allocation of risk in the insurance contract. The insurer said that the risk of the deductible is specifically allocated to the insured and it would therefore disservice the equitable principle behind the make whole doctrine to apply the doctrine to deductibles. Fireman's Fund also argued that including deductibles in the make whole doctrine impairs the usefulness of deductibles in general and creates an unhealthy incentive. By allocating the first portion of a loss to the policyholder, the deductible encourages the policyholder to take adequate precautions to avoid the loss in the first place, and this idea is potentially weakened if the insured believes that the deductible may be reimbursed by the insurer.

The court found that there is no statutory or precedential support for either position in Connecticut. Whether the make whole doctrine applies to deductibles is a matter of Connecticut law that is best settled by the Connecticut Supreme Court, said the Circuit Court, and so, the question was certified to that state's Supreme Court. The adjudication of this dispute was stayed until the court received guidance from the Connecticut Supreme Court.

Editor's Note: This case presents sound arguments on both sides of the question as to whether the make whole doctrine includes deductibles. The Circuit Court seemed to lean toward the position that the deductible paid by the insured should be included in the doctrine so that the insured is truly “made whole” after suffering a loss. However, that court sent the question to the Connecticut Supreme Court for a definitive answer.

The Connecticut Supreme Court ruled in 2013 that the make whole doctrine does not apply to insurance policy deductibles, and the Second Circuit ruled that TD Banknorth may not claim reimbursement for the deductible until Fireman's Fund has been repaid in full. Since the expenses incurred by the insurer exceeded the $208,000 of settlement funds being held in escrow, the insurer was entitled to the entire amount.

Latent Manifestation of Property Damage as an Accident

This action is based on an underlying state court action wherein Green, a construction business, contracted with the Lyon County Board of Education to construct a middle school which later developed cracks in the building's concrete. The Lyon County Board of Education filed a lawsuit against multiple parties, including Green. This case is Westfield Ins. Co. v. B.H. Green & Son, 2013 WL 5278243.

After Green finished construction on the school building, cracks developed in the concrete. Originally, this damage was alleged to be the result of a chemical reaction in the concrete known as an alkali carbonate reaction (ACR).This reaction is allegedly the result of certain impurities present in the concrete supplied to Green by Federal Materials Company. When the concrete was delivered to the construction site, Federal Materials satisfied all specifications supplied by the Board of Education's architect and passed all required testing.

When Green was sued, it sent the complaint to its insurer, Westfield Insurance Company. The insurer denied coverage and filed this action seeking a declaration that there was no coverage and so, no required defense.

The United States District Court for the Western District of Kentucky noted that the question came down to whether the alleged property damage from a latent manifestation of ACR was an accident, and thus, an occurrence within the terms of the policy. To be an accident, the court said, the concrete's failure must be a fortuitous event—an accident that occurred after the installation and not attributable to poor workmanship. The court also noted that in Kentucky, for an event to be an occurrence, the event has to be one that cannot be controlled by the insured because it beyond the power of any human being to bring to pass, or it is within the control of a third party. In determining whether an event is fortuitous, and thus, an accident, a court in Kentucky must consider the elements of intent and control; it asks not only whether the insured intended to build a faulty product, but also whether such building was a chance event beyond the control of the insured.

The court found that in this instance, there was no faulty performance that Green might have observed or controlled. Indeed, the concrete that Green used satisfied the specifications of the Board of Education's architect and all relevant inspectors. The insurer argued that Green should have expanded upon the owner's own specifications and that this failure to take additional steps to prevent ACR means that Green had control within the meaning of the policy's terms. However, the court said, neither the law nor the contract required such steps. Green lacked control over the design function and was under no obligation to act to the contrary.

Because the elements contributing to the concrete's impairment were thoroughly beyond Green's control, the resultant damage to the building was characterized by the court as a fortuitous event, an accident. Therefore, Westfield had a duty to provide a defense to the claims against its insured, Green.

The insurer then argued that even if the claims were a covered occurrence, there was no coverage because of the “your work” exclusion. Westfield argued that the supplier of the concrete, Federal Materials, was not a subcontractor for Green and so, the subcontractor exception in the exclusion did not apply. The district court found no Kentucky case law defining a subcontractor so it looked to other sources. The court decided that whether Federal Materials could be properly considered a subcontractor depends on whether it manufactured the concrete according to Green's specifications. For a material supplier that does not perform work at the site to be a subcontractor, the court said that the supplier must manufacture the material according to the specifications supplied by the general contractor, and its materials contract with the general contractor must explicitly incorporate terms from the master contract or otherwise explicitly indicate that the materials at issue are manufactured or supplied specifically for the master contract's project.

In this instance, Federal Materials mixed the concrete at its own facility, using its own equipment, and in accordance with the architects' project specifications. Federal Materials also delivered the concrete to the job site. Therefore, the court ruled, Federal Materials can be seen as a subcontractor and the subcontractor exception to the “your work” exclusion can be applied.

In conclusion, the court ruled that Green lacked control over the Board of Education, its architects, and the project specifications for the design of concrete mixes; the concrete mix satisfied all required inspection; and any defects were not immediately observable. Therefore, any damage is properly characterized as an accident and is thus an occurrence within the meaning of the liability policy. Accordingly, the insurer had a duty to defend and its motion for summary judgment was denied.

Editor's Note: The U.S. District Court had to answer the questions of whether the latent manifestation of damage to the concrete was an accident from the standpoint of the insured, and whether the supplier of concrete in this case was a subcontractor of the insured, thus triggering the subcontractor exception to the “damage to your work” exclusion. The court answered “yes” to both questions.

This decision is also helpful in that the court offers its opinion on the difference between a subcontractor and a material supplier, with its relevance to coverage under a general liability policy.

Choice of Law Provision

The insured filed a motion for summary judgment regarding controlling law as to her uninsured motorist (UM) and bad faith claims. This case is Coronel v. GEICO Ins. Agency, 2013 WL 3270574.

The matter is question arises from the hit-and-run accident that took place in 2007, which left the insured's fiancé dead. The fiancé was struck and killed in Arizona. The insurance on the car that the insured and the fiancé were driving was insured under a policy issued in New York; the policy contained a choice of law provision that stated the policy is to be interpreted pursuant to the laws of New York.

GEICO paid $100,000 under the policy for the wrongful death claim, but when the insured sought an additional amount on behalf of herself and her children for negligent infliction of emotional distress, GEICO denied coverage. The denial was based on the choice of law provision under New York law that prohibits such recovery. The insured commenced her action against GEICO seeking recovery for her and her children's' injuries as well as for GEICO's breach of good faith. She sought a ruling as to which state law applied, New York or Arizona.

The United States District Court for Arizona noted that Arizona courts follow the Restatement to determine which state's law applies. The Restatement states that a choice of law provision is enforceable if the particular issue is one in which the parties could have resolved by an explicit provision in their agreement. Moreover, the provision will be enforced unless either the chosen state has no substantial relationship to the transaction or parties, or the application of the chosen state's law would be contrary to the public policy of a state that has a greater interest in the matter.

In this instance, the court said that New York law governs the UM claim because the choice of law provision contained in the auto policy is valid. The provision is not unique, nor does it go against public policy. As for the bad faith claim, the court said that the choice of law provision was not valid. The court ruled that it is contrary to Arizona public policy to allow parties to contract to a provision that permits insurers to unfairly deal with its residents. The court then applied the Restatement contacts test and found that Arizona has the most significant ties to the claim. The accident that took the life of the insured's fiancé took place in Arizona, she lives in Arizona, and the claims were filed in Arizona. Thus, the court held that Arizona law governs the bad faith claim.

So, the UM claim was governed by New York law since the choice of law provision was valid and New York law prevented recovery by the insured in this instance. The bad faith claim was governed by Arizona law and that claim was allowed to continue.

Editor's Note: The insured received a partial summary judgment in that her bad faith claim was ruled not to be subject to New York law even though the auto policy was written in that state. The bad faith claim was governed by Arizona based on the significant contacts test. This case shows that a claim may or may not be subject to a choice of law provision and the parties to an insurance contract should be aware of this fact.