Law and Insurance

Federal Court Parses "Your Work" Exclusions in Favor of Insured Contractor

Mid-Continent Casualty Co. v. JHP Development, Inc., No. 05-50796 (5th Cir. January 28, 2009) see JHP Decision

This decision marks another skirmish in the continuing battle that insurance companies wage against covering liability for faulty construction.  After the Texas Supreme Court allowed coverage through the front door in Lamar Homes by holding that defective workmanship can constitute a covered "occurrence" causing "property damage" (see my discussion at Texas High Court Allows CGL Coverage of Construction Defects), the fight has shifted to the "business risk" exclusions behind the back door.

"Business risk" exclusions eliminate coverage for damage to the insured's work or products.  JHP was a building contractor hired to build 5 condominiums, one of which was to serve as a model unit.  (JHP appears to have been the general contractor for the project but also performed some of the work itself.)  JHP failed to properly water-seal the exterior of the building allowing water to penetrate the interior structures through walls and ceilings.  The construction fell into two phases: first, basic construction and finish of the model condo; second, finish of each of the other units once they were sold and the new owners had selected a desired finish.  Water damage to interior drywalls, stud framing, electrical wiring, and wood flooring allegedly occured after phase one was completed but before final completion of the project.

Owner sued JHP for $438,466.77 in repairs, and JHP's liability insurer, after timely notice, refused to defend or indemnify.  JHP apparently allowed entry of a default judgment for the amount demanded and then sued its insurer for coverage.  By the time the insurance lawsuit reached the 5th Circuit Court of Appeals, the Lamar Homes decision had forced the insurer to abandon its argument that faulty workmanship was not an "occurrence" that caused "property damage."  Instead, it relied on two business risk exclusions: referred to as j(5) and j(6) in the standard CGL policy.

J(5) excludes damage to "that particular part of real property on which [JHP] or any contractors or subcontractors working directly or indirectly on [JHP's] behalf are performing operations, if the 'property damage' arises out of those operations." 

J(6) excludes property damage to "that particular part of any property that must be restored, repaired or replaced because '[JHP's] work' was incorrectly performed on it." 

J(5) applies only if JHP or its subs "are performing operations"; i.e., during performance of construction operations.  The insurer argued that the exclusion applies at any time before the project is completed, and 4 units remained unfinished.  JHP disagreed and argued that it was not performing operations when the damage occurred because phase 1 was over, and phase 2 had not yet begun.  The court agreed with JHP and found that "[t]he prolonged, open-ended, and complete suspension of construction activities pending purchase of the condominium units does not fall within the ordinary meaning of 'performing operations'."  J(5) does not exclude coverage.

Application of j(6) turned on the meaning of the phrase, "that particular part" of JHP's work.  Mid-Continent argued that the whole project was JHP's work, including the particular part that had to be repaired or replaced.  JHP parsed the language differently.  The particular parts that had to be repaired (the interior dry walls, etc.) were not damaged because of JHP's work on the interior, but rather because of JHP's alleged failure to properly water-seal the exterior.  In other words, j(6) would exclude only damage to the part of the work that was performed improperly, the exterior (or, more precisely, the sealant on the exterior). 

The court again agreed with JHP but only after considering other decisions that appeared to side with Mid-Continent.  An earlier version of the exclusion before the 1980's targeted the insured's work in a broader sense (excluding damage to the named insured's work "or any portion thereof"), and courts construing the broader language had applied the exclusion to all parts of the named insured's work, not just the parts that were defectively built.  So the court distinguished these earlier cases and held that exclusion j(6) also did not apply.  Accordingly, Mid-Continent wrongly refused to defend and indemnify.

Finally, Mid-Continent objected to the default judgment.  The 1996 Gandy case had ruled that insurers who wrongly failed to defend are bound only by judgments following a fully adversarial trial.  Default judgments are entered when the defendant fails to answer the complaint or appear for trial.  Not so, said the appellate court, pointing to the Texas Supreme Court's recent decision in Evanston Ins. Co. v. ATOFINA Petrochemicals, Inc., 256 S.W.3d 660 (Tex. 2008, see Evanston Decision ), which limited Gandy to "sweetheart deals" in which the insured defendant conspires to help the plaintiff obtain a monster judgment and then assigns its insurance claims to the plaintiff.  JHP did not do that, said the court.  Therefore, the result is governed by a pre-Gandy case, Employers Cas. Co. v. Block, 744 S.W.2d 940 (Tex. 1988), holding that an insurer who refuses to defend an insured when it has a duty to do so is bound by the amount of the judgment against the insured.

National Insurance Agents Association Fearful of Drift Toward Federal Regulation

In an open letter to President Obama, the Independent Agents & Brokers of America (the "Big I") gingerly nudged the President to leave in place state regulation of the insurance industry even as it pledged to work with the Administration on reforming the financial services industry.  See Big I Urges President.   The Big I has long opposed steps to federalize insurance regulation, which some in the insurance industry would welcome.  The open letter may have been prompted by alarm last week at signs that Congress may be warming up to federal regulation of the insurance industry.

Seven lawmakers urged Treasury Secretary Designate Timothy Geithner to support federal oversight of insurance companies, and Mr. Geithner's remarks at his confirmation hearing last Friday could be taken to imply that the Administration might consider federalizing insurance as part of the larger reform of financial institutions.  See Lawmakers Press Geithner on US Insurance Oversight.   

The example of AIG's meltdown is often used to support federal reform of the insurance market, but, as Big I's open letter states, the part of AIG that imploded was the company's financial services arm.  AIG's insurance units were largely unaffected and remained adequately captialized.  This, argues Big I, shows that state regulation of insurance companies works. 

Prerhaps, but the drum beat for federal reform seems to be getting stonger and quicker.

Policy Covering "Any Subsidiary Corporation" Does Not Cover LLC's

American Electric Power Co. v. Affiliated Insurance Co., No. 07-31061 (5th Cir. January 21, 2009), see American Electric Decision

 One of the quickest ways a company can lose coverage for its subsidiaries is to fail to make sure that the definition of "Insured" includes all the types of legal entities used to form the subsidiaries.  In this case, the policy in question covered the named insured "and any subsidiary corporation now existing or hereafter created or acquired." [My emphasis].  However, like many businesses in this modern age, the parent company formed a number of subsidiaries as "limited liability companies" or "LLC's," which are not corporations.  No coverage for the non-corporation subs.

The policy issued to American Electric Power Co. (AEC) covered employee theft (but this issue concerns every type of insurance on the market).  AEC acquired a company, CWS, and added it and its subsidiaries to AEC's insurance program.  Two subsidiaries of CWS were LLC's, one of which was found to have an employee theft problem.  Usually, AEC's insurance would not cover a new acquisition for pre-acquisition losses, but the Affiliated policy contained a "prior loss" clause that covered earlier losses if those losses would have been covered under an earlier policy.  A Chubb policy would have covered the losses (if discovered and reported at the time), but Affiliated denied coverage because the definition of "Insured," quoted above, would not have covered an LLC subsidiary.

AEC protested that ample evidence showed that CWS intended to cover all of its subsidiaries, including LLC's.  However, the court found the term "corporation" to be unambiguous and refused to consider "parol evidence," i.e., evidence outside of the policy itself.  AEC argued that "LLC" really means  "limited liability corporation," but the court pointed out that the legal distinctions between an LLC and a corporation are significant.  There are reasons that companies take advantage of the different types of business forms, and courts will not ignore the legal distinctions to obtain a favorable result for an insured in an insurance dispute. 

Finally, AEC asked the court to "reform" the policy to reflect CWS's original intent to cover all of its subsidiaries.  Obtaining reformation is usually an uphill battle because the court is asked to rewrite an unambiguous contract, which courts avoid in all but the most glaring cases.  In this case, reformation is even more difficult because Affiliated was not a party to the Chubb contract.  It is one thing to reform a contract when both parties to the contract are before the court; Affiliated can't speak for Chubb, so the remedy is out of the question.  The court upheld Affiliated's denial of coverage.

When I review a client's insurance program, definition of "Insured" is one of the first things I evaluate.  This is not always easy when the client is a master limited partnership with a corporate general partner that itself has subsidiaries in exotic organizational forms.  However, the effort is absolutely necessary, as this case shows.  The business types are precisely defined in the law, so it is usually easy for an insurer to show that an LLC is not a corporation.  Moreover, failure to qualify as an insured is a show stopper.  No degree of coverage is allowed. 

Risk Managers, check your policies.

Court Allows Jury To Decide If Pre-Existing Condition Exclusion Applies

Byung Kim and Yong Kim v. Time Insurance Co., No. 4:07-cv-4201 (S.D. Tex. December 22, 2008).

I do not usually comment on health insurance cases, but with the new administration's focus on reforming health care, this case shows why finding a way to avoid the challenges presented by the pre-existing-condition exclusion would save the courts a lot of hair-splitting as well as cover beneficiaries for necessary medical care.  Hair-splitting cases require some factual recitation, so hang on.

A pre-existing condition is defined in the Time policy as a sickness or injury and related complications (1) for which medical advice, diagnosis, care or treatment was sought or received, or (2) that produced symptoms that would cause an ordinarily prudent person to seek medical care, either within 12 months before the policy effective date.  The court had to decide whether Yong Kim's gastric pain, evident for months before the policy began, was caused by liver disease (a mix of cirrhosis, Hepatitis B, and resulting cancer) or diverticulitis.  If the pain and other symptoms were caused by liver disease, then Time did not have to pay for a liver transplant that all the physicians thought was necessary.

The plaintiff and her husband had not been insured for 10 years.  Their son prodded them, and they finally relented, purchasing a policy that took effect on July 17, 2007.   Mrs. Kim had not seen a doctor for anything for the previous 5 years, although for about 10 years she had suffered from constipation which she treated with over-the-counter remedies.  On July 20, 2007, her daughter took Mrs. Kim to a hospital for shortness of breath and sever intermittent abdominal pain that had first appeared around the beginning of July (wellbefore inception of the policy).  A CT scan led to a diagnosis of cirrhosis, colonic diverticulosis, and other conditions.  After transfer to another hospital, she was diagnosed with liver cancer, for which she needed a liver transplant.  She was also diagnosed with diverticulitis.

The insurance company's medical director reviewed the records and determined that Yong Kim's liver condition was a pre-existing condition not covered by the policy.  Asked to reconsider, Time had the records reviewed by another medical director, who reached the same conclusion.  The Kims rounded up a battery of their doctors who determined that the the pain was actually caused by the diverticulitis because her liver disease usually does not cause the kind of acute pain she reported.  Moreover, the liver disease was not a factor in causing diverticulitis.  The insurer consulted with other medical experts who concluded that liver disease caused the symptoms.  The insurer paid $390,616.91 for treatment of diverticulitis but continued to deny coverage for treatment of the liver disease, including the transplant.  Litigation ensued.

The court determined, "It is impossible to reconcile the competing expert opinions regarding the cause of Plaintiff Yong Kim's pre-coverage symptoms."  The court noted that none of the insurer's doctors reviewing the case had treated the patient, and Time had provided no evidence regarding their qualifications in diagnosing either liver disease or diverticulosis.  The court dutifully scrutinized and discussed prior case law (the details of which I will spare you), which indicated that any symptoms that would prompt a reasonably prudent person to seek medical advice or treatment before the policy effective date are enough to trigger the pre-existing-condition exclusion. 

Here, however, the court could find no reasonable basis for ruling out diverticulitis as the cause the pre-coverage symptoms.  Hence, "viewing the record in the light most favorable to Plaintiffs, a reasonably jury could find that Time incorrectly chose liver cancer, not diverticulitis, as Yong Kim's pre-existing condition."  Time's motion for summary judgment denied. 

However, the court dismissed bad faith claims against Time.  A jury might find that Time had made a mistake, but the facts do not allow a finding that Time had deliberately ignored evidence or otherwise conducted a bad-faith investigation.  The fault, Dear Brutus, is not in ourselves or our insurers but in our cumbersome health care insurance system.  An equitable way to get coverage for pre-existing conditions that does not invite beneficiaries to game the system by putting off the expense of insurance until after symptoms appear should help simplify health care coverage and unburden the courts. 

Court Allows Jury To Decide If Pre-Existing Condition Exclusion Applies

Byung Kim and Yong Kim v. Time Insurance Co., No. 4:07-cv-4201 (S.D. Tex. December 22, 2008).

I do not usually comment on health insurance cases, but with the new administration's focus on reforming health care, this case shows why finding a way to avoid the challenges presented by the pre-existing-condition exclusion would save the courts a lot of hair-splitting as well as cover beneficiaries for necessary medical care.  Hair-splitting cases require some factual recitation, so hang on.

A pre-existing condition is defined in the Time policy as a sickness or injury and related complications (1) for which medical advice, diagnosis, care or treatment was sought or received, or (2) that produced symptoms that would cause an ordinarily prudent person to seek medical care, either within 12 months before the policy effective date.  The court had to decide whether Yong Kim's gastric pain, evident for months before the policy began, was caused by liver disease (a mix of cirrhosis, Hepatitis B, and resulting cancer) or diverticulitis.  If the pain and other symptoms were caused by liver disease, then Time did not have to pay for a liver transplant that all the physicians thought was necessary.

The plaintiff and her husband had not been insured for 10 years.  Their son prodded them, and they finally relented, purchasing a policy that took effect on July 17, 2007.   Mrs. Kim had not seen a doctor for anything for the previous 5 years, although for about 10 years she had suffered from constipation which she treated with over-the-counter remedies.  On July 20, 2007, her daughter took Mrs. Kim to a hospital for shortness of breath and sever intermittent abdominal pain that had first appeared around the beginning of July (wellbefore inception of the policy).  A CT scan led to a diagnosis of cirrhosis, colonic diverticulosis, and other conditions.  After transfer to another hospital, she was diagnosed with liver cancer, for which she needed a liver transplant.  She was also diagnosed with diverticulitis.

The insurance company's medical director reviewed the records and determined that Yong Kim's liver condition was a pre-existing condition not covered by the policy.  Asked to reconsider, Time had the records reviewed by another medical director, who reached the same conclusion.  The Kims rounded up a battery of their doctors who determined that the the pain was actually caused by the diverticulitis because her liver disease usually does not cause the kind of acute pain she reported.  Moreover, the liver disease was not a factor in causing diverticulitis.  The insurer consulted with other medical experts who concluded that liver disease caused the symptoms.  The insurer paid $390,616.91 for treatment of diverticulitis but continued to deny coverage for treatment of the liver disease, including the transplant.  Litigation ensued.

The court determined, "It is impossible to reconcile the competing expert opinions regarding the cause of Plaintiff Yong Kim's pre-coverage symptoms."  The court noted that none of the insurer's doctors reviewing the case had treated the patient, and Time had provided no evidence regarding their qualifications in diagnosing either liver disease or diverticulosis.  The court dutifully scrutinized and discussed prior case law (the details of which I will spare you), which indicated that any symptoms that would prompt a reasonably prudent person to seek medical advice or treatment before the policy effective date are enough to trigger the pre-existing-condition exclusion. 

Here, however, the court could find no reasonable basis for ruling out diverticulitis as the cause the pre-coverage symptoms.  Hence, "viewing the record in the light most favorable to Plaintiffs, a reasonably jury could find that Time incorrectly chose liver cancer, not diverticulitis, as Yong Kim's pre-existing condition."  Time's motion for summary judgment denied. 

However, the court dismissed bad faith claims against Time.  A jury might find that Time had made a mistake, but the facts do not allow a finding that Time had deliberately ignored evidence or otherwise conducted a bad-faith investigation.  The fault, Dear Brutus, is not in ourselves or our insurers but in our cumbersome health care insurance system.  An equitable way to get coverage for pre-existing conditions that does not invite beneficiaries to game the system by putting off the expense of insurance until after symptoms appear should help simplify health care coverage and unburden the courts.