It is not unusual for a policyholder, denied coverage, to argue that it never had a chance as the policy is illusory.  This usually happens when the claim at issue involves a risk that is fundamental to the insured’s business.  As the insured sees it, if the policy does not provide coverage for something at the heart of why the insured needs the policy, that it provides no coverage at all.  Hence, it is illusory.  These arguments are routinely rejected by courts on the basis that, while the policy may not provide coverage for an important risk, it provides coverage for other potential hazards.  So, since it provides some coverage, it is not illusory.

However, two appeals courts, in the past six weeks, have concluded that policies were illusory.

First up was Crum & Forster Specialty Ins. Co. v. DVO, Inc., No. 18-2571 (7th Cir. Sept. 23, 2019).  At issue was coverage for DVO, which had entered into a contract with WTE, to design and build an anaerobic digester for WTE.  Don’t know what that is?  Silly you.  It is used to generate electricity, from cow manure, which would then be sold to the electric power utility.  “WTE sued DVO for breach of contract, alleging that DVO failed to fulfill its design duties, responsibilities, and obligations under the contract in that it did not properly design substantial portions of the structural, mechanical, and operational systems of the anaerobic digester, resulting in substantial damages to WTE. It sought over $2 million in damages and fees.”  The case made it trial.  The court found in favor of WTE and ordered DVO to pay over $65,000 in damages and $198,000 in attorney’s fees. 

The issue before the court was the availability of coverage, for DVO, under a professional liability policy issued by Crum & Forster.  All agreed that the insuring agreement – the wrongful act and professional services requirements -- had been satisfied.  

The dispute was over the applicability of the breach of contract exclusion:

This Policy does not apply to “damages”, “defense expenses”, “cleanup costs”, or any loss, cost or expense, or any “claim” or “suit”:

Based upon or arising out of:

a. breach of contract, whether express or oral, nor any “claim” for breach of an implied in law or an implied in fact contracts [sic], regardless of whether “bodily injury”, “property damage”, “personal and advertising injury” or a “wrongful act” is alleged.

All agreed that the exclusion applied on its face.  But was it so broad as to make the policy illusory?  This was the issue before the Seventh Circuit.  If so, the court’s task is to reform the policy to meet the insured’s reasonable expectations.

The trial court said that the policy was not illusory since, despite the contract exclusion, the policy still provided coverage for other risks: “[A]lthough coverage for professional malpractice would effectively fall within that exclusion as to claims alleged by the party to the contract, third parties could still bring tort claims against DVO that would not fall within the exclusion and would trigger the duty to defend in the E&O provision of the policy. The district court reasoned that as a contractor, designer, engineer and builder, DVO has a duty to use reasonable care in carrying out its contractual obligation so as to avoid injury or damage to the person or property of third parties, even though they have no contractual relationship with DVO.”

But the Seventh Circuit saw it much differently, given that the contract exclusion was broad enough to include even any third-party claims: “[T]hat analysis [the district court’s] cannot support the court’s conclusion. If more narrow language was used, the district court’s determination that third-party liability would still be covered might have merit. But the language in the exclusion at issue here is extremely broad. It includes claims ‘based upon or arising out of’ the contract, thus including a class of claims more expansive than those based upon the contract. Wisconsin courts have made clear that the ‘arising out of’ language is broadly construed.”

The court held that, based on the breach of contract exclusion, the C&F policy was illusory and the remedy is as follows: “[W]hen a policy’s purported coverage is illusory, the policy may be reformed to meet an insured’s reasonable expectation of coverage.  Therefore, the focus now is not on the hypothetical third-party actions, but on the reasonable expectation of coverage of the insured in securing the policy. There is, after all, no reason to believe that DVO in purchasing Errors and Omissions coverage to provide insurance against professional malpractice claims had a reasonable expectation that it was obtaining insurance only for claims of professional malpractice brought by third parties.”

The trial court’s task was to reform it: “But we need not determine precisely what reformation is appropriate here. DVO did not file a cross-motion for summary judgment. The district court on remand may consider DVO’s reasonable expectations in securing the coverage, and can reform the contract so as to give effect to that expectation. The focus, however, must be on that reasonable expectation, which was upended by the breach of contract exclusion that rendered it illusory. The availability of third-party claims is irrelevant unless it is determined to be a part of DVO’s reasonable expectation of coverage.”

Illusory Coverage Case 2

Then last week the Arizona Court of Appeals issued its decision in Starr Surplus Lines Ins. Co. v. Star Roofing, No. 18-0641 (Oct. 31, 2019).  At issue was coverage for Star Roofing, which had performed roofing work on a commercial building in Tempe.  Maria Delarosa, an employee of a tenant in the building, suffered a fracture of her right forearm and other bodily injury when she allegedly fell and passed out in the building’s parking lot.  Delarosa alleged that her injuries were the result of being overcome by breathing the fumes released from Star Roofing’s work. 

Starr Surplus defended Star Roofing under a reservation of rights, asserting the pollution exclusion as a basis to deny coverage.  Starr Surplus filed a coverage action, seeking a determination that the pollution exclusion barred coverage.

The trial court found in favor of Star Roofing, concluding that the pollution exclusion was limited to “traditional environmental pollution.”  The appeals court decision is really long and has oodles of issues.  Importantly here, the court agreed that the claim at issue did not involve traditional environmental pollution.   

But then the court went further and addressed illusory coverage, given the nature of Starr Roofing’s operations: “Further, the transaction as a whole--the insuring of a roofing business--calls into question the advisability of a broader application of the pollution exclusion than would arise in ‘traditional environmental pollution-related claims.’  In the present case, Starr Surplus’ own underwriting activities made it fully aware of Star Roofing’s work, and the risk inherent in the installation of a roof was contemplated by the Starr Policy. This was the very risk complained about in the Delarosa action, and the scope of interpretation requested by Starr Surplus would result in illusory coverage for the ordinary commercial business activities of the insured, a result not contemplated by either party to the insurance contract.”

Needless to say, these decisions open a wider door to what is considered illusory coverage.