It’s a Fine Line: Interpreting Status-Based Exclusions

Insurance companies and their adjusting staff are well aware of basic policy interpretive rules. When determining whether the insurance company has a duty to defend a tendered complaint, the rules are stacked against the insurance company, and in favor of coverage. As an example, in most jurisdictions, insurance companies have a duty to defend their insured when the underlying tendered complaint discloses a “potential” or “possibility” for liability within the policy’s coverage.

Insurance companies and their adjusters are not immune from making “hair-splitting” mistakes. A case in point is Metropolitan Property and Cas. Ins. Co. v. McCarthy, 754 F.3d 47 (1st Cir. 2014). In McCarthy, the insurance company brought a declaratory judgment action to establish that it did not have a duty to defend its insured from claims that the insured’s ward had sexually and physically abused a younger boy. The insurer argued that the insurance policy’s abuse exclusion was applicable under the facts presented in the underlying complaint and, therefore, there was no duty to defend. The insurance company based its argument on the language in the abuse exclusion which stated, in relevant part: “We do not cover bodily injury caused by or resulting from the actual, alleged or threatened sexual molestation or contact, corporal punishment, physical abuse, mental abuse or emotional abuse of a person …”.

If that was the only language in the abuse exclusion, the insurer might have had a reasonable argument for not defending its insured. Unfortunately for the insurance company, the adjuster did not read the entirety of the exclusion. The first sentence relied upon by the insurance company appeared to exclude any type of abuse inflicted by any person. However, while the first sentence of the exclusion was written in general terms, the second sentence of the exclusion was significant. The second sentence of the exclusion qualified the first sentence by stating: “This exclusion applies whether the bodily injury is inflicted by you or directed by you or another person to inflict sexual molestation or contact, corporal punishment, physical abuse, mental abuse or emotional abuse upon a person.” Thus, the second sentence of the exclusion was reasonably read by the Court to preclude coverage only for abuse inflicted or directed by an insured rather than by any individual.

Under the facts of the case, the adult named insured was not the perpetrator of any abuse. The underlying complaint established that the alleged abuser was a minor ward of the adult named insured, but the complaint did not state that the ward resided with the adult named insured. Rather, the allegations in the underlying complaint permitted an inference that the ward, like the victim, stayed only temporarily, though repeatedly, at the adult named insured’s home. Thus, there was an inference that the ward was not a resident in the insured household and, therefore, may have been a non-insured whose conduct would be outside the abuse exclusion. The fact that the perpetrator might not be an insured individual under the homeowner policy meant the exclusion might not apply. Because the complaint allowed inferences that the adult named insured’s ward was not a resident of her household, and that the complaint alleged that the ward inflicted physical, non-sexual abuse on the younger boy, the homeowner policy would cover the resulting harm. Accordingly, the insurer had a duty to defend the underlying action.

The McCarthy case demonstrates that even mainstream insurance companies, utilizing experienced and trained adjusters can make mistakes when they split the hairs of an insurance policy exclusion focusing upon one sentence of the exclusion while ignoring a qualifying sentence of the exclusion. When interpreting an insurance policy “all parts and clauses of [the] insurance policy must be considered together that it may be seen if and how far one clause is explained, modified, limited or controlled by the others.” Jipson v. Liberty Mutual Fire Ins. Co., 942 A.2d 1213, 1216 (Me. 2008).

The McCarthy case is a reminder to all claim professionals that by segregating the language of policy exclusions—by splitting hairs in the wording—can lead to serious mistakes which can expose the insurance company to bad faith liability. Lesson learned?