The Known Loss Doctrine and Liability Insurance
Insurance coverage is premised on the concept of fortuity – a loss that occurs by chance or accident. When an insurance company issues a policy, it insures against a risk of possible loss, not a certainty. Insurance carriers do not intend to provide coverage for a loss that has already occurred, is in progress, or is substantially certain to occur. Yet, situations will arise where policyholders attempt to obtain insurance coverage for a loss that has already occurred. A classic example is the homeowner who calls his agent to obtain flood insurance while water from a burst pipe rises on the floor around his ankles. In response, courts have developed a common-law rule most often referred to as the “known loss” doctrine, which provides that there is no coverage for a loss that has already occurred at the time the insured applied for the policy. While this might appear to be a straightforward principle – surely one cannot purchase insurance for a loss that has already occurred ˗ courts have not reached consistent results when applying the rule, particularly in the context of third party liability claims. While insurers can avoid these problems by either (1) excluding coverage for known losses in the insuring agreement or (2) requesting information regarding known losses during the application process, it is not always practical to request this information across all lines of business. Thus, courts should continue to recognize the known loss rule and refuse to allow insurance coverage for a loss that has already occurred.
While first party policies provide coverage for a particular occurrence, liability policies provide insurance for the risk that the insured will be found liable for the occurrence. With a first party claim, there will rarely be any uncertainty about whether there has been a loss, even if the full extent of the loss is not yet known. However, there may still be uncertainty about whether a particular event will give rise to liability claims or if the insured will be found liable. For that reason, some courts have refused to apply the known loss rule to third party liability claims. Yet, other courts have found that there is no valid reason for distinguishing between two types of policies with regard to the rule, which is based on the public policy that (1) insurance covers risks, not certainties, and (2) insureds should not benefit when they wrongly withhold material information from insurers in order to obtain insurance.
When courts have recognized the known loss rule, they have not always applied it consistently in the context of third party liability claims. Some courts have concluded that the known loss doctrine will bar coverage only when the legal liability of the insured is a certainty. Other courts have held that the rule applies if the insured knows that it is “substantially probable” that the insured will be liable for the damage.
While it would seem clear that the known loss rule would apply to situations where an actual lawsuit has been filed prior to the inception of the policy, courts have not always agreed. For example, in Bartholomew v. Appalachian Ins. Co., the lawsuit for which the insured sought coverage had already been filed prior to the inception date of the insurance policy at issue; thus, the risk of “loss” to the insured was a “virtual certainty” by the time insurance was purchased. When the insurer subsequently sought to void coverage, the First Circuit applied the known loss rule and held that the policy did not provide coverage for the claims against the insured. On the other hand, in Stonehenge Engrg. Corp. v. Employers Ins. Of Wausau, the Fourth Circuit held that the filing of a lawsuit is insufficient to trigger application of the known loss rule unless the insured knows, before obtaining coverage, that entry of a judgment against it in the underlying lawsuit was “substantially certain” to occur.
The known loss rule may also come into play when an insured seeks to obtain coverage with a retroactive date. In a Wisconsin case, Am. Family Mut. Ins. Co. v. Bateman, the insured contacted her agent to obtain insurance coverage for her daughter’s car five days after it had been involved in an accident, requesting that coverage be issued retroactive to one day prior to the accident. Because it was certain that a claim would be made, the court held “there was simply no risk to insure with respect to that accident.”
Courts have also disagreed as to what level of knowledge is required on the part of the insured.
A number of courts have required actual knowledge of the loss. Other courts have required something less than actual knowledge, and have required only a “reason to know,” or “evidence of probable loss,” or considered whether a “reasonable prudent” insured would know that the loss is highly likely to occur.
Because the known loss doctrine turns on what the insured knows, or should know, questions arise as to whether courts should apply an objective or subjective standard in evaluating the insured’s knowledge. For example, the insured may claim that he was aware of a loss, but was not aware that he could potentially be held liable. Under a subjective standard, courts will give deference to the insured’s subjective belief that he bore no liability for the loss and, thus, had no duty to disclose the loss to his insurer. Under an objective standard, the court will examine whether the insured’s justification for not reporting the loss is reasonable.
Following the Supreme Court of California’s decision in Montrose Chem. Corp. of Calif. v. Admiral Ins. Co., the standard commercial general liability policy was revised to exclude from coverage bodily injury or property damage that occurs “in whole or in part” before the policy begins, if known to the insured. There are few reported cases interpreting the exclusion, which has also been referred to as the “Montrose Endorsement,” but courts have required insurers to establish a close connection between the injury or damage known by the insured prior to the policy period and the injury or damage for which coverage is being sought. Although the known claim exclusion would appear to make the known loss doctrine irrelevant in some situations, the exclusion is not included in all liability policies.
Some courts have refused to apply the known loss doctrine based on the policy exclusion for an “expected or intended” injury, concluding that there is no need to adopt a new rule because the element of fortuity is sufficiently addressed by existing policy provisions. However, the exclusion focuses on whether the loss was accidental, while the “known loss” rule focuses on whether the insured knew of the loss at the time the policy was issued.
In some instances, policy provisions regarding misrepresentation or concealment of a loss, as well as similar state insurance statutes, may apply to a situation where the insured fails to disclose a known loss when applying for insurance coverage. While there is some overlap, coverage will only be void if the insured has a duty to disclose certain information, typically in response to affirmative questions asked during the application process. The known loss doctrine focuses on the insured’s knowledge of a loss prior to the policy inception date, and not whether the insured failed to disclose information that it was required to disclose during the application process. The rule should apply even if the insurer did not ask about known losses during the application process.
Some courts have held that the insurer may not use the known loss doctrine to defeat coverage if it also knew of the loss prior to the policy’s inception date. For example, claims may be disclosed through loss runs provided during the policy application or renewal process. Because the insurer had knowledge of the loss, yet agreed to issue coverage anyway, the insurer should not be permitted to assert a known loss defense if the insured later seeks coverage for a claim that was disclosed.
In addition to requesting loss runs, many applications ask the insured to disclose claims or potential claims. However, these questions are not always asked during the application process, particularly with personal lines policies where the underwriting is minimal. Because fortuity is central to insurance, the known loss doctrine allows the insurer to argue that it should not be required to provide insurance for an accident or claim that has already occurred – even though it may not have specifically addressed known losses in the policy or requested such information during the application process. And while it may not be practical to require disclosure of known losses across all lines of business, a request for retroactive coverage should always serve as a red flag. Before issuing a policy with a retroactive date, the insurer should inquire about known losses.