In the following guest post, Francis Kean and John McCarrick take a look at the state of play with respect to D&O insurance policy exclusions in light of the current market conditions, as well as the different approach to policy exclusions under U.S. and U.K. law. Francis is a Partner, Financial Lines, at McGill and Partners. John is a partner in the White & Williams law firm. I would like to thank Francis and John for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is Francis and John’s guest post.
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- Introduction
After more than a decade of a competitive (i.e., soft) market characterized by ample underwriting capacity and heavy competition among D&O insurers in chasing D&O business, over the past year, D&O underwriters and brokers have been forced to conduct business under a markedly different set of underwriting conditions. A so-called “hard” market, characterized by decreasing competition for underwriting risks, substantial increases in premiums and tightening terms and conditions, has come into existence.
The shift in market conditions has created a parallel shift in negotiating leverage; brokers are now finding it more difficult to insist on the broad scope of coverage terms available during the soft market and are spending more time and energy assembling sufficient underwriting capacity to maintain expiring tower limits. D&O underwriters are operating under tightening internal management control over corporate underwriting appetite for risks and minimum premium pricing expectations.
Since much has been said by other commentators about the adequacy of premiums, retentions, sub-limits and the like, we thought it would be helpful to offer the benefit of our joint experience in the U.S. and U.K. to help brokers and underwriters engage in thoughtful dialogue about coverage limitations; particularly in the area of exclusions. In our view, a shared understanding of the nuances of exclusionary wording can lead to more creative ways of approaching coverage limitations and negotiating successful coverage outcomes.
A. Different Types of Exclusion
At the outset, it’s useful to keep in mind that exclusions in liability policies — of which D&O is one sub-category — tend to fall into one of three broad categories:
- Conduct exclusions: Typically, this type of exclusion is directed at wrongful conduct or misfeasance suggesting intentionally bad conduct. Perhaps the best example is the exclusion in respect of dishonest acts. Another typical one is in respect of the gaining of profit to which the insured was not legally entitled. Sometimes these exclusions stray into the territory of specifying criminal or fraudulent behaviour. Generally, the benefit of the doubt is given to the insured in the sense that insureds are presumed innocent of charges of dishonest or criminal activity (and therefore entitled to defense costs coverage) unless and until either a final court adjudication is made against them, or they admit that the relevant conduct occurred.
- “Other insurance” exclusions: Here, the purpose of the exclusion is to remove from the scope of cover specific types of risks expected to covered by other common classes of insurance. In other words, the exclusion is aimed at more precisely delineating the specific sub-category of insurance in question. So, for example, the “bodily injury/property damage” exclusion in a D&O policy is intended to align with the insuring agreement of a general liability policy. Similarly, the “ERISA” exclusion is intended to match up with the insuring grant of a fiduciary liability policy. Some, but not all, D&O policies contain a professional liability exclusion to make it clear that the policy is intended to provide D&O – and not errors & omissions (i.e., professional services) coverage, and the policyholder would be expected to purchase professional liability coverage separately. Disputes often arise when brokers and underwriters are negotiating the language of “other insurance” exclusions being added by endorsement, especially where there is doubt about whether the drafted language creates a gap between different kinds of coverage, or unintentionally creates the potential for overlapping coverage between two different types of policies.
- Specific matter exclusions: This category of exclusions is almost always in the form of an endorsement to the policy (one notable exception is a continuity exclusion in the specimen wording where the operative date is identified on the declarations page of the policy). This category of exclusions seeks to address a particular feature of a risk, which the underwriter specifically intends to limit, restrict or exclude from coverage. An example, in the context of a privately-held company, might be an exclusion in respect of claims by shareholders with a specified percentage ownership stake in the company. In a publicly-traded company, by contrast, D&O underwriters may wish to limit the scope for prospectus liability cover to avoid picking up coverage for subsequent public offerings of the company’s stock. Also falling within this sub category are exclusions for specific pending litigations or disputes involving the policyholder, which the underwriter wants to avoid covering if it migrates into a subsequent D&O claim.
B. How are Exclusions Interpreted?
Another useful reference point for thinking about how exclusions legally operate relates to the way in which courts approach exclusions in the context of a coverage dispute. For this portion of the discussion, we will, where necessary, separate the U.S. legal approach from the U.K. legal approach but in fact the similarities are greater than the differences.
- The U.S. Legal Approach
Questions of insurance coverage interpretation are decided as a matter of state – and not federal – law. Although coverage disputes can end up in federal court for different reasons, even federal courts will look to the state law that applies to interpretation of the insurance contract when deciding insurance coverage issues.
As in all civil legal disputes, there is a threshold issue as to which party bears the burden of proving or disproving the legal issue. When it comes to insurance coverage interpretation, the policyholder bears the initial burden of providing that the matter for which coverage is being sought satisfies each and every element of the applicable insurance agreement. In the context of a D&O claim, the various elements look something like this:
[Insurer agrees to cover] + [Loss resulting from] + [a Claim] + [made against an Insured] + [during the Policy Period] + [for a Wrongful Act]
But as is evident from the example above, almost every element of the initial burden also involves a defined term in the policy, and yes, the policyholder has the initial burden of establishing that each definitional element has been met too. That is often a challenging task because definitions can be complex, and subject to limitations and carve-backs.
The good news for policyholders is that once the initial burden of demonstrating that all of the elements of the insuring agreement (and applicable definitions) has been met, the burden then shifts to the insurer to demonstrate that one or more policy provisions apply to fully or partially limit coverage.
A few points to keep in mind: first, not all exclusions are located in the exclusions section of the policy. Some are listed by endorsement and others are contained within definitions (for example, the broad definition of “Loss” often contains numerous carve-backs which courts generally view as akin to exclusions such that the insurer has the burden of establishing their applicability.) Other limitations to coverage can be found in portions of the policy that identify the policyholder’s duties in the event of a claim, such as providing timely notice, obtaining the insurer’s consent before agreeing to a settlement or incurring defense costs, or cooperating with the insurer throughout the life of the claim. The insurer has the burden of establishing that the policyholder has not met any of these conditions, which if shown to have been breached by the policyholder, may void coverage for the entire claim.
- The UK Legal Approach
The starting point for construing contracts of all kinds under English law is well settled and was succinctly expressed by Lord Neuberger in Arnold v Britton [2015] UKSC 36; [2015] AC 1619, at paragraph 15 where he said:
“When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to “what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean”…and it does so by focussing on the meaning of the relevant words, … in their documentary, factual and commercial context.”
On the question of who has the burden of proof with respect to particular aspects of a contract of insurance, the position is very similar to that in the US. In other words, the burden rests on the policyholder to demonstrate that the facts and circumstances underlying the insurance claim come within the framework of the relevant insuring clauses. Having achieved this, the burden shifts to the insurer to demonstrate that any limitations or exclusions to cover apply to restrict or deny cover.
Just as with US D&O wordings, policies governed by English law can also be unnecessarily complex making the task of identifying where the burden sits more difficult. For example, it is not unusual to find a lengthy definition of the key term “Loss” setting out not simply what is included within that term but also what is specifically not included. In the final analysis what matters is the court’s judgment as to what a reasonable person would have understood the relevant language in the contract to mean.
- What Happens When There is Ambiguity or Controversy as to the Meaning of Exclusions?
Given the obvious significance of exclusionary language to the outcome of an insurance claim, it is perhaps unsurprising that there is often disagreement between the policyholder and the insurer about the how the relevant language should be interpreted. In this context there are perhaps more distinct differences of approach between the UK and the US legal systems.
The UK Approach
In recent years, the English courts have drawn a distinction between exclusions contained in insuring contracts and those to be found in other types of contract. Dealing with other types of contract first, one well known rule of construction is known by its Latin maxim: “Contra Proferentem.” The literal translation of the Latin maxim is “against the offeror.” The idea behind it is that where any contract clause is considered to be ambiguous it should be interpreted against the interests of the party that created, introduced or requested that the clause be included. So, in the context of exclusionary language relied on by one party in respect of its liability for negligence or liability in contract, the effect of the contra proferentem rule can be to narrow its ambit.
By contrast, exclusionary language in an insurance contract serves a different purpose under English law. As the Court explained the position in a 2017 judgment in a professional indemnity case of Crowden v QBE : “ position in respect of insurance contracts is wholly distinguishable in that an exclusion clause in an insurance policy is not designed to exclude, restrict or limit a primary liability on the part of the insurer; instead, it is intended to define the risk which the insurer is prepared to accept by way of the insurance contract. Further, the exclusion clause in an insurance policy does not ordinarily operate to deprive the insured of rights which existed prior to or but for the cover afforded by the Policy.”
The significance of this distinction is that the question as to who has assumed responsibility for the drafting of the relevant language in an insurance contract assumes less significance and once again is subjected to the primary rule of construction relating to what a reasonable person would have understood the relevant provision to mean (see above).
The US Approach
Under most US states’ common law, there is no reason for a court to look beyond the plain meaning of an exclusion unless the court first finds that the exclusion is ambiguous in its intended meaning. Once that finding has been reached, the contra proferentem rule is often applied if the exclusion is located in the main body (i.e., the so-called “specimen” wording) of the policy that the insurer intends to apply to all policyholders – as distinguished from policy endorsements, which are typically tailored to the unique features of a particular risk and generally the subject of negotiation between the insurer and the policyholder with the assistance of a broker, if one is involved.
However, even exclusionary endorsements can be construed against the insurer if the policyholder had no ability to negotiate the scope of the exclusionary endorsements or is otherwise relatively unsophisticated with respect to insurance coverage issues. For this reason, it is often difficult for a policyholder to persuade a court to apply the contra proferentem rule where the policyholder is a large, sophisticated entity with its own internal risk management or insurance department that regularly negotiates insurance contracts on the entity’s behalf, or is represented by an insurance broker in its dealings with its insurers. In these cases, the insurer will point to the relative sophistication of the policyholder or the involvement of an insurance broker in asking the court not to apply the contra proferentem rule in resolving an issue of insurance contract interpretation.
Given that there is no single federal US law that governs insurance contract interpretation, the standards to be used are those developed under each state’s common law. For this reason, the choice of a state law to be applied in construing the insurance contract is an important negotiating point in purchasing a D&O policy. Some states are viewed to be pro-policyholder with respect to insurance contract interpretation, and others are considered to be pro-insurer. Most states, though, are a mixed bag, depending on the kind of coverage dispute at issue.
For example, in the event a court finds an ambiguity in the wording of a particular exclusion, some states will then allow extrinsic evidence to be introduced by both the policyholder and the insurer supporting their respective arguments about what the parties intended. Some states will take into account the “reasonable expectations” of the policyholder, which effectively turns the analysis away from an objective assessment of the underwriting history of the exclusion at issue to a more subjective analysis focused on what the policyholder believed the exclusion meant when it purchased the policy – regardless of what the insurer can show it intended.
- Negotiating and Drafting Exclusions
As with all contractual language, the words used — and not used — count for everything! The received wisdom that an ill-placed comma or the unintended effect of employing brackets can transform the meaning and effect of an exclusion is perfectly true. Nevertheless there a few accepted norms or conventions when it comes to negotiating and drafting exclusions in D&O insurance contracts.
The introductory language It is often the case that the introductory words to an exclusion can have a very significant effect on the scope of cover excluded. At one end of the spectrum is wording which removes from cover any matter “based upon, arising from, relating to or in any way connected with” the excluded item has a significantly limiting impact. At the other end is language which narrowly excludes loss “for” a claim in respect of the excluded matter is far less onerous from the insured’s perspective. Sometimes, the clarity apparent at either end of the spectrum becomes blurred in the middle as parties seek to negotiate their respective corners.
Entire claim or portion of claim? Also relevant is the struggle for clarity around whether a claim tainted by an element of the excluded activity should be rejected as a whole or only in respect of that part caught by the exclusion. Limiting language either in the introduction or in the main body of the exclusion to the effect that only loss to the extent such loss is tainted by the exclusion should be caught by it is plainly helpful from the insureds’ perspective. The use by insurers of the term solely in the context of affirmative cover can have a similar exclusionary effect. So, for example, if cover is granted solely for wrongful acts committed by a director in his or her capacity as such, and that director is accused in a claim of acting in a dual capacity, the whole claim may arguably be excluded absent some language preserving coverage for a portion of the claim.
Does the exclusion apply to all loss? Separate from the question of whether the exclusion applies to the whole claim is the question as to whether it applies to all of the components of “loss” bundled together in the policy or only to certain of them. By far the most important distinction here is between loss in the form of damages, awards and settlements and loss in the form of defence costs and legal representation expenses. Sometimes insurers are willing to provide the latter whilst excluding the former. An example would be the insured v insured exclusion in the UK, which typically cover defence costs by expressly carving them back into the scope of cover. Another example might be in relation to the conduct exclusion where defence costs are advanced pending a final adjudication against the insured albeit in some policies this advancement may be subject to a “claw-back” or “recoupment” provision allowing the insurer to seek repayment of the defence costs it previously advanced on behalf of the insured once the exclusion is triggered.
- Conclusion
It would be trite to conclude that the scope for coverage disputes relating to the ambit of D&O exclusionary language is almost infinite, be it under US or English law. As D&O exposures continue to grow and expand, the importance of creating D&O policy language that precisely meets the shared coverage expectations of policyholders and D&O insurers is correspondingly heightened – and the exposure risk of getting the coverage wrong is substantial for all involved parties. For this reason, policyholders and D&O insurers quite properly are spending more time and resources carefully considering policy language and the applicable law under which that policy language will be interpreted. We endorse these efforts.
We hope we have succeeded in shining a light on some of the relevant obstacles and considerations. Perhaps the most important single piece of advice we can give is to have a clear and ideally common view at the outset as to the purpose of the exclusion. If both sides ask themselves honestly what the mischief is which the limitation on cover is seeking to address and then interrogate the agreed language by reference to a sample of relevant scenarios, the scope for ambiguity or controversy can perhaps be reduced if never entirely eradicated.