Laura Foggan, left, partner and Rachael Padgett, right, associate with Crowell & Moring.

Critics of the restatement of the law, liability insurance (RLLI) published by the American Law Institute (ALI) this June point out that its provisions often deviate from established state rules. Focusing on the issues of misrepresentation in procurement, reservations of rights, notice conditions and settlement credits, this article highlights four key differences between the RLLI's provisions and established Pennsylvania liability insurance law. These examples show both that the RLLI conflicts with settled Pennsylvania insurance law, and that the RLLI overrides important Pennsylvania public policy considerations.

Sections 7, 8 and 9: Misrepresentation

Section 7 of the RLLI lays out the test under which an insurer may rescind an insurance policy or deny a claim based on a misrepresentation made by a policyholder in its insurance application. To meet the RLLI test, the insurer must show that the misrepresentation is both material under Section 8, and that it "reasonably" relied on the misrepresentation "under the circumstances" under Section 9. The RLLI provides that a misrepresentation is "material" if "but for the misrepresentation, a reasonable insurer in the insurer's position would not have issued the policy or would have issued the policy only under substantially different terms." The RLLI's proposed tests under Sections 7, 8 and 9 combine to impose an objective "reasonableness" standard and unprecedented burden on insurers seeking to rescind insurance contracts when policyholders have made material misrepresentations in procuring insurance coverage.

Unlike the RLLI, Pennsylvania law follows the rule, adopted by many courts around the country, of "actual" subjective reliance. Under Pennsylvania law, an insurer may void a policy if it shows that it actually relied on an insured's false statement about something material to the risk. See Tudor Insurance v. Township of Stowe, 697 A.2d 1010, 1016 (Pa. Super. Ct. 1997) (to establish insurance fraud to void a policy, the insurer must "prove that the subject matter of the false statement was material to the risk assumed by the insurer; in other words, that the insurer relied to its detriment on the false statement in issuing the insurance policy"). See also Mount Airy Insurance v. Thomas E. Angst & Associates, P.C., 954 F. Supp. 1040, 1046 (E.D. Pa. 1997) (professional liability insurer satisfied every element of a claim for rescission of an insurance policy due to misrepresentations in the application for insurance, including that "Mount Airy relied on the statements in issuing the policy").

Pennsylvania law has never imposed the added barrier to rescission proposed by the RLLI of asking if a reasonable insurer would have relied on the insured's false statement. Under Pennsylvania law, if the insurer issuing the policy actually relied on a material misrepresentation, an insured cannot escape the consequences of making a false statement by contending that a reasonable insurer would not have relied on its misrepresentation.

Pennsylvania's actual reliance test allows insurers to accurately assess risks and calculate premiums based on representations made in insurance applications. If an insurer actually relied on a false statement and would not have issued the policy or would have issued the policy with increased premiums had it been aware of the misrepresented fact, it should have a right to rescind a policy. Every insurer has its own underwriting standards. Judging an underwriting determination by what a hypothetical, objectively reasonable insurer would have done, as the RLLI proposes, would undercut the market differences between specific underwriting standards applied by individual insurers. Additionally, the RLLI rule would lead to extensive and unnecessary discovery and expert battles to determine what underwriting decision a hypothetical reasonable insurer would have made under the circumstances.

Moreover, requiring an insurer to assess whether reliance on an insured's statements in an application is "objectively reasonable" would impose an increased burden of time and effort for an insurer to look behind the insured's representations in evaluating applications, which also carries with it increased costs. Many courts therefore recognize that a test of actual reliance, as opposed to a retrospective test of whether an insurer's reliance was objectively reasonable, is important to the insurance system. Thus, there are strong policy reasons behind the actual reliance test in Pennsylvania insurance law.

 Section 15: Reserving the Right to Contest Coverage

For an insurer to effectively reserve its rights to contest coverage, the restatement provides that an insurer must provide "timely notice to the insured of any ground for contesting coverage of which it knows or should know," see Section 15(1). Section 15(3) further imposes the burden on insurers reserving their rights to do so with "a written explanation of the ground, including the specific insurance policy terms and facts upon which the potential ground for contesting coverage is based, in language that is understandable by a reasonable person in the position of the insured." Significantly, unlike many states, the restatement does not require that an untimely reservation of rights cause prejudice to the insured for an insurer to lose the right to deny coverage.

Under Pennsylvania law, however, an insurer is not estopped from asserting coverage defenses not included in a reservation of rights letter, unless the insured has been actually prejudiced thereby. See, e.g., Nationwide Mutual Insurance v. Nixon, 682 A.2d 1310, 1314 (Pa. Super. Ct. 1996) (insured's assertion that insurer waived its right to rely on a coverage defense that it failed to specify in its reservation of rights letters, was "devoid of merit," because the insured was not prejudiced).

Pennsylvania courts have traditionally viewed the consequence of an insurer's failure to timely reserve its rights as a question of estoppel, as in Continental Insurance  v. Kovach, (W.D. Pa. Aug. 14, 2007) (applying Pennsylvania law) (noting that under Pennsylvania law, "an insurer may protect its rights under a policy by a timely reservation of rights which fairly informs the insured of the insurer's position," but that an estoppel will only apply "when there is actual prejudice, such as when an insurer's failure to assert all possible defenses in a reservation of rights letter causes an insured to act to his detriment in reliance thereon.") Prejudice is not presumed. See Rock-Epstein v. Allstate Insurance, (E.D. Pa. Sept. 29, 2008) (applying Pennsylvania law) ("Absent a showing of prejudice to the insured, the failure to raise all possible defenses in a denial of coverage letter is not a waiver … courts apply an estoppel only when there is actual prejudice…").

Unlike Pennsylvania's measured approach, the RLLI rule is a "gotcha" for insurers. The insured receives a windfall and an insurer that did not timely reserve all coverage rights cannot later assert a defense, even where the insured has not relied to its detriment on the insurer's mistake. The underlying policy behind estoppel is to prevent injustice to a party who has detrimentally relied on an insurer's actions; to estop an insurer from denying coverage when there has been no detrimental reliance contravenes this purpose.

Section 35: Notice and Reporting Conditions

The RLLI requires that an insurer may not deny coverage due to an insured's failure to satisfy a notice–of-claim provision in a liability insurance policy unless the insurer shows that it was prejudiced. The RLLI's "notice-prejudice" rule, moreover, extends to notice-of-claim provisions in both occurrence and claims-made liability policies. Section 35, comment d ("A claims-made policy that contains only the traditional notice condition, and not the claim-reporting condition in the insuring agreement, is not a claims-made-and-reported policy and, thus, only the ordinary notice-prejudice rule would apply …").

While Pennsylvania has adopted the notice-prejudice rule for occurrence-based liabilities policies, it does not require an insurer to show that it was prejudiced by an insured's untimely notice under a claims-made policy, see ACE American Insurance v. Underwriters at Lloyds, 939 A.2d 935, 940-41 (Pa. Super. Ct. 2007) (finding that "Pennsylvania has not extended the … notice-prejudice rule beyond that context of occurrence liability policies"), Commonwealth v. Wilson, 601 Pa. 96 (Pa. 2009). The two notice requirements in most claims-made policies require that notice of a claim must be provided to the insurer promptly or as soon as practicable, and notice or reporting of the claim must be made during the policy period for the loss to be treated as falling within the time period covered by the policy. Together, the dual notice provisions in claims-made policies are critical to the insurance arrangement and provide value to insurers and policyholders.

In this regard, Pennsylvania recognizes that claims-made policies differ fundamentally from occurrence policies. Notice provisions are central features in claims-made policies, and insurance law rules should not interfere with the heart of the parties' agreement. Moreover, claims-made policies increase the availability of insurance because they facilitate an insurer's ability to accurately predict and underwrite risks. That ability depends on the policies' notice provisions. In fact, courts and commentators have observed that undermining notice provisions would impair the willingness of insurers to offer claims-made policies, to the detriment of insurers, policyholders and tort victims. See, e.g., Jeffrey P. Griffin, "The Inapplicability of the Notice-Prejudice Rule to Pure Claims-Made Insurance Policies," 42 Conn. L. Rev. 235, 270 (2009) (arguing that "application of the notice-prejudice rule to pure claims-made policies harm both the insurer and insured"). Because the insurance system depends on predictability, courts and commentators have also stated that imposing a prejudice requirement on the notice provisions of claims-made policies would harm the market for insurance. See Griffin, 42 Conn. L. Rev. at 266. Thus, Pennsylvania's rule refusing to read a prejudice requirement into any aspect of the dual claims-made notice provisions is well-grounded, as well as settled state law.

Section 43: The Effect of Partial Settlements

Section 43 of the RLLI provides that a nonsettling insurer's liability is reduced by another responsible insurer's settlement with the insured only "by the amount paid for those losses by any insurers that settled with and were released by the insured." In other words, the RLLI follows the "pro tanto" approach to settlement credits given to a non-settling insurer.

By contrast, Pennsylvania follows the pro rata settlement-credit rule, under which the nonsettling insurer receives credit equal to the settling insurer's apportioned share of liability. This is reflected by a U.S. Court of Appeals for the Third Circuit decision reducing an insurer's liability by the amount of a settling insurer's pro rata share of the loss. See Koppers v. Aetna Casualty & Surety, 98 F.3d 1440, 1452 (3d Cir. 1996) (stating that Pennsylvania would apply a pro rata settlement credit where an insured was sued for environmental contamination, many insurance policies were triggered, and the insured had settled with some primary and excess carriers). The Koppers court explained that its decision was consistent with the Pennsylvania Supreme Court's decision in J.H. France Refractories v. Allstate Insurance, 626 A.2d 502, 510 (Pa. 1993) (applying pro rata time on the risk allocation among all triggered insurers for an indivisible loss) and Gould v. Continental Casualty, 585 A.2d 16 (Pa. Super. Ct. 1991), which held that where two insurers cover the same loss, and one insurer settles, the other insurer is entitled to reduce its liability by the apportioned share of the settling insurer. The RLLI's pro tanto settlement-credit rule is thus flatly inconsistent with Pennsylvania law.

The pro-rata settlement credit rule ensures that an insurer pays its fair share of a loss, no more and no less. It avoids the risk of a policyholder colluding to set up a targeted insurer for more than its share of the loss. The pro rata rule is favored over the pro tanto rule for other reasons as well. For instance, the pro tanto approach also may create uncertainty in calculating how much to "set off," because settlements seldom break down into a clear allocation between payments made for each particular claim.

Conclusion

These four examples highlight important Pennsylvania insurance law principles that contradict the rules found in the RLLI. Each of these illustrations shows that the RLLI conflicts with Pennsylvania's established state law, as well as the clear public policy principles that underlie Pennsylvania's rules. Simply put, the RLLI does not reliably match the policy choices made by Pennsylvania or the state's longstanding insurance law rules.

Laura Foggan is a partner in Crowell & Moring's Washington, D.C. office, and chair of the firm's insurance/reinsurance group. Contact her at [email protected].

Rachael Padgett is an associate in the firm's Washington, D.C. office. She is a member of the firm's insurance/reinsurance and mass tort, products and consumer litigation groups. Contact her at [email protected].