Fifth Circuit Predicts Texas Law Will Validate Wasting Limit Policies

Liability insurance policies typically have two main components: defense and indemnity. North American Specialty Ins. Co. v. Royal Surplus Lines Ins. Co., 541 F.3d 552, 559 (5th Cir. 2008). Most liability policies that are issued provide for defense costs to be paid in addition to the policy limits. However, some policies are issued as “eroding policies” in which the insurer’s payments to defense counsel to defend the liability suit count against the policy limits. The Fifth Circuit Court of Appeals recently analyzed an insurance policy, under Texas law, which contained an endorsement transforming the policy from a policy in which defense costs were outside the limits to a policy with “eroding limits.”

In Amerisure Mut. Ins. Co. v. Arch Specialty Ins. Co., 784 F.3d 270 (5th Cir. 2015). The insurance policy in question was converted from a defense outside of limits policy to an eroding policy by way of endorsement. The question before the Court was whether defense costs and attorney’s fees were “expenses” under the policy and thus costs incurred by the primary insurer for defending the insured thereby reducing the liability limits that were available.

Amerisure issued a Texas commercial liability package policy to Admiral Glass & Mirror Co. (Admiral). Under the terms of the policy, the policy provided coverage in excess of any other coverage afforded by a controlled insurance program policy. Arch issued an owner controlled insurance program (OCIP) policy to Endeavor Highrise, LP (Endeavor) as well as its contractors and subcontractors. Admiral was a subcontractor insured under the OCIP policy. The OCIP policy had a combined BI/PD limit of $2M per occurrence and a general aggregate limit for the same amount. The policy had a completed operations aggregate limit of $2M.

The OCIP policy contained a supplemental payments provision which provided that Arch would pay “[a]ll expenses we incur” in connection with any covered claim and that “[t]hese payments will not reduce the limits of insurance.” However, the OCIP policy had an endorsement (Endorsement 16) which expressly deleted and replaced the foregoing statement with “[supplemental payments] will reduce the limits of insurance.” The OCIP policy further provided that Arch’s duty to defend ended “when we have used up the applicable limit of insurance in the payment of judgments or settlements.”

Prior to this claim, the record indicated that Arch had settled three claims under the OCIP policy: (1) a wrongful death action which was settled for $1.555M plus attorney’s fees and defense costs of $159,543.16; (2) a property damage toilet leak claim which was settled for $60,000 plus attorney’s fees and defense costs of $62,620.18; and (3) a fire sprinkler leak claim which was settled for $880,000 plus attorney’s fees and defense costs of $31,671.87. Combined total of the settlements was $2.495M. The combined attorney’s fees and costs incurred totaled $253,835.21.

Endeavor sued Admiral and others for faulty work. Amerisure tendered the lawsuit to Arch as the primary insurer. Amerisure incurred $23,879.27 in defense fees prior to Arch accepting the tender. Then, in April 2012, Arch withdrew from the defense of the Endeavor lawsuit asserting that attorney’s fees, defense costs, and settlements of $2M from defending Admiral and other subcontractor defendants exhausted Arch’s policy limits. At that point, Amerisure took over the defense and incurred an additional $114,957.14 in defense fees and costs before ultimately settling the claims against Admiral. At that point, Arch had paid $1.555M plus defense costs of $159,543.15 under the general coverage limit of the OCIP. Arch paid settlements totaling $1,472,032.61 plus defense costs of $527,967.36 under the products-completed operations coverage of the OCIP policy.

Arch was sued by Amerisure in Texas state court for breach of contract. Amerisure argued that Arch had wrongfully refused to defend and indemnify Admiral. The case was removed to federal court. Amerisure then filed a motion for partial summary judgment seeking a declaration that Arch had not exhausted its policy because defense costs did not erode the policy limits or, in the alternative, that Arch had a continuing duty to defend after the policy was exhausted. Arch filed a cross-motion for partial summary judgment.

The district court held that Arch did not breach its duty to indemnify but that it did breach its duty to defend Admiral. Arch appealed.

On appeal, Amerisure argued that the term “expenses” set forth in the supplemental payments provisions of the Arch policy did not include attorney’s fees and other costs of defense. In the alternative, Amerisure argued that even if “expenses” included defense costs the effect of the statement “all of the terms and conditions of this policy remain unchanged which was set forth in Endorsement 16 when read in conjunction with the language in the policy that the duty to defend expired when “we have used up the [policy limits] in the payment of judgments or settlements” meant that the policy limits were eroded only by payment of “judgments or settlements,” and not defense costs. Arch took the position that the term “expenses” included defense costs and that the endorsement controlled over any contrary language in the policy so that the endorsement converted the policy into an eroding limits policy. The Fifth Circuit Court of Appeals agreed with Arch.

The Fifth Circuit Court of Appeals found that giving the term “expense” its ordinary meaning would include situations where the insurer paid costs of defense, including attorney’s fees. The Court then addressed the question of whether the “supplementary payments” provision of the policy eroded the limits. The Court of Appeals rejected the District court’s finding that the proper construction of the endorsement and the main policy in essence created two policy limits: one for the indemnity obligation, which was satisfied by payment of settlements, judgments, and “supplementary payments” including defense costs, and one for the defense obligation, which was satisfied only by payment of settlements and judgments. The Court of Appeals found that the District court’s construction read the endorsement out of the policy because there could never be an end to the duty to defend unless the insurer paid the policy limits in indemnity payments. Applying standard rules of construction, the Court held that the policy was not ambiguous and that Arch’s construction was the only reasonable construction of the policy.

Next, the Court of Appeals addressed Amerisure’s argument that the policy limits were not exhausted because Arch had included within its calculations the payment for the toilet leak claim and the fire sprinkler claim which were wrongfully paid. Amerisure argued that those claims were not covered under the products completed coverage because the apartment building had not yet reached the stage of completion. The Court concluded “that it is unnecessary to plumb these depths because, even assuming arguendo that there is a cause of action for ‘wrongful exhaustion,’ the district court correctly held it does not apply here. We conclude that the reasons given by the district court in this regard are clear, and we need not address this argument further.” The District court summarily found that the erosion language in the policy was unambiguous and was, therefore, unenforceable. The policy in question stated, in relevant part:

4. The limits of any applicable Royal primary policy are eroded by “Supplementary Payments,” which include fees and costs incurred in the defense of the Nursing Home Defendants, prejudgment interest, and post-judgment interest.