The Uneasy Relationship Between Liability Policies and ADR Clauses

The Uneasy Relationship Between Liability Policies and ADR Clauses | Risk & Insurance ADR clauses are meant to help when disputes arise among parties in construction and real-estate projects. Yet these good intentions could cost them their liability insurance proceeds--unless they know how to carefully draft and invoke the clauses.

By THOMAS B. ALLEMAN, a shareholder in the Insurance and Environmental Practice Groups at Winstead PC

Many real estate and construction contracts now include detailed alternative dispute resolution clauses that stipulate that the parties will attempt to resolve their differences, short of litigation, by submission of the dispute to mediation, arbitration or both.

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The impetus for such clauses is the perception that these ADR procedures will lower litigation costs and speed resolution of disputes. The hasty invocation of ADR clauses, however, may result in loss of available liability insurance proceeds through the insurer's invocation of two significant but overlooked requirements in virtually every insurance policy. They are:

1. The provisions stating that the insurer will pay on behalf of the insured only those sums that the insured is legally obligated to pay as damages and that the insurer has no obligation to reimburse the insured for voluntary settlements it makes without the insurer's consent.

2. The clause requiring the insured to give prompt notice to the insurer of all claims and demands.

THE GOOD SAMARITAN GETS NO INSURANCE

The first pair of provisions implements the overarching principle in a standard liability policy that the insurer is allowed to control the defense and determine when to settle within policy limits. The two provisions also express an even more basic idea:

"The parties to the insurance contract at the time the contract was made could not have reasonably intended it to cover the voluntary agreements of the insured to pay for damage it was not otherwise legally obligated to pay," as stated by the Nebraska Supreme Court in its 2003 decision in City of Scottsbluff v. Employers Mut. Ins. Co.

In other words, the otherwise commendable instinct to "make things right" may have the unintended consequence of costing the Good Samaritan its insurance coverage.

NOTICE

As for clause No. 2 mentioned above--the notice provision--virtually all liability policies contain provisions requiring the insured to give its insurer prompt notice of any claim or suit, as well as the opportunity to assume control of the defense of the claim.

Policies also contain provisions that relieve the insurer of the obligation to reimburse its insured for any defense costs, attorney's fees or settlement sums made before the insurer has been given notice of the claim by its insured.

Recent Texas Supreme Court cases, including National Union Fire Ins. Co. of Pittsburgh, Pa. v. Crocker, make it clear that it--like the courts in virtually every other state--does not view these provisions as boilerplate

Courts will enforce these clauses as written and allow insurers to avoid policy obligations where they have been prejudiced by noncompliance.

WHERE ADR COMES IN

How can this happen in the ADR setting? Even with pledges of confidentiality, statements or admissions that bear upon liability or damages (e.g., an agreement to make repairs) may well be considered prejudicial by the insurer, leaving the insured without coverage for what may turn out to be a substantial claim.

The insurer may also be in a position to deny a claim for attorney's fees or investigative expenses incurred in diagnosing the problem because they were not reported on time.

The idea of early notice is that it gives the insurer the right to conduct an investigation and control the defense, both of which are necessary to allow the insurer to make best use of the policy limits. The requirement that the insured give prompt notice should not be taken lightly.

In any dispute then, particularly those involving a construction or latent structural defect, thoughtful consideration should be given as to how to invoke an ADR clause.

Care should be taken to ensure that any demand to use the ADR process is worded so as to be a claim under the allegedly liable party's coverage, and that any party allegedly liable for the loss has put its insurers on notice of the dispute and obtained from those insurers a decision as to whether the insurer will participate.

Prospectively, ADR clauses should be drafted so as to require notification of liability insurers by affected parties as a condition of the use of the process. There will undoubtedly be disputes that are so small or easily resolved that this level of formality is not necessary, but careful attention should be paid in advance to any situation that may involve a substantial insurance claim.

Consultation with counsel and careful handling may avoid the loss of liability insurance proceeds later on.

January 8, 2009

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