While California courts addressed a number of important questions of insurance law in 1997, the California Supreme Court focused on one issue more than all others: allocation. Must a liability insurer pay for the entire defense of a case that is only partially covered, or may some of the costs be allocated to the insured?

To say that the answer to that question is clear, however, may be stretching things. During the summer, the California Supreme Court held an insurance company could demand reimbursement for the cost of defending uncovered claims.

But then, just before the ball dropped in Times Square, the Supreme Court on Dec. 29 dropped its own bomb in an environmental coverage case. The high court reversed that portion of an intermediate appellate court's decision requiring a company that chose not to buy insurance for some of the years that pollution had occurred to share pro rata in the defense costs of a lawsuit resulting from that pollution.

However, the Court did not disallow apportionment altogether - relying on its earlier decision, it allowed insurers in some circumstances to seek reimbursement for the costs of defending those parts of a claim that were not even potentially covered under the policy.

Among the issues still on the Supreme Court's docket as 1998 begins is another environmental coverage question: whether an insurer's duty to defend is triggered by a government agency's administrative order that the insured may be responsible for cleaning up contaminated property. Different divisions of the same Court of Appeals went different ways on that question last year, and the California Supreme Court has taken both cases up on review.

Finally, California Courts of Appeal decided in 1997 that some insurance company records are open to discovery by insureds suing over allegations that their claims were improperly handled, although one of these two decisions is not yet final.

Allocation of defense costs

A liability insurer's duty to pay for the defense of a lawsuit is very broad in California. A duty to defend is owed whenever the claims in a complaint are even potentially covered. But this broad duty may leave insurers with the bill for the entire defense of an action, even when most of the claims, and most of the damages sought by the claimant against the insured, have no potential for coverage under the policy.

In Buss v. Superior Court (Transamerica Ins. Co.), 16 Cal.4th 35 (July 24, 1997), the California Supreme Court held that insurers in such cases may seek reimbursement from the insured for the cost of defending claims that have no potential for coverage. The key words here are "reimbursement" and "no potential."

Buss began as a commercial dispute, in which 26 of the 27 causes of action alleged were claims such as breach of contract and economic torts which were not covered by the policy issued by Transamerica. The 23rd cause of action was for defamation, a potentially covered claim under the facts of the case.

Transamerica paid for the defense of the entire case, and then demanded that the insured reimburse it for the costs of defending the claims that were not even potentially covered. The Supreme Court agreed that Transamerica could make such a demand.

The Court held that when an insurer defends an insured under a reservation of rights, it may later seek reimbursement of costs attributable solely to claims that held no potential for coverage. According to the Court, when an insured buys an insurance policy, it buys peace of mind that the insurer will defend it against potentially covered claims. It does not buy, and the insurer does not agree to provide, a defense against claims that hold no potential for coverage.

The Court also said that an insurer must defend an entire action even if only one claim is potentially covered, since a meaningful defense must be immediate and complete. But when all is said and done, the insurer may have given the insured more than he bargained for, and may be entitled to get something back. It is up to the insurer to prove, by a preponderance of the evidence, which costs were attributable to the uncovered claims.

The principles set forth in Buss were examined - and expanded - by the Court again a few months later, but in a different context. In Aerojet-General Corp. v. Transport Indemnity Co., 97 Daily Journal D.A.R. 15551 (December 29, 1997), an aerospace manufacturer was sued for environmental damage caused by more than 30 years of releasing hazardous substances at its plant. During some of that time, the manufacturer had obtained conventional liability insurance from various companies, which included insurance for defense. For about eight years, however, the company had obtained "fronting" policies from one particular insurer that did not include coverage for defense costs.

The Court of Appeals ruled that fairness required the manufacturer to pay its share of the defense costs, to be determined by dividing all the years of damage by the number of years the manufacturer had self-insured its defense costs.

The high court rejected mathematical apportionment of defense costs to the insured during periods of self-insurance, citing a 1997 Court of Appeals decision in County of San Bernardino v. Pacific Indem. Co., 56 Cal.App.4th 666 (July 8, 1997), review denied Oct. 1, 1997. Nevertheless, the Court allowed insurers to seek apportionment in another way. Citing the principles it had established in Buss, the Court said that allocation of defense costs to the insured was appropriate for parts of claims that were not even potentially covered under the policy.

Is an administrative order a suit?

Two Courts of Appeal opinions reached opposite conclusions in 1997 about the effect of an administrative order or notice advising an entity that it is a responsible party for cleaning up a contaminated site. If such an order or notice constitutes a suit, it may trigger a duty to defend under a standard CGL policy. The Supreme Court has already granted review in both of these cases.

In Foster-Gardner Inc. v. National Union Fire Insurance Co. of Pittsburgh, Pa., 56 Cal.App.4th 204 (1997), review granted October 15, 1997. Division Two of the Second District Court of Appeals held that an administrative order constituted a suit under a standard CGL policy, thus triggering the insurer's duty to defend even though no lawsuit in a court of law had been filed. The Foster-Gardner court adopted the functional equivalent approach to this issue, explaining that treating an administrative order as a lawsuit reflects the modern realities of our legal system, including the use of alternative dispute resolution and administrative proceedings, in lieu of court actions.

A couple of months later, however, another Division of the same court of Appeals held that an administrative notice does not constitute a "suit" under a standard CGL policy, and therefore does not trigger the insurer's duty to defend.

In Fireman's Fund Ins. Co. v. Superior Court (Vickers Inc.), 57 Cal.App.4th 1252 (Sept. 24, 1997), review granted Dec. 23, 1997, the court applied "plain meaning" rules of policy interpretation and thus distinguished between suits and claims. Although a claim can be broadly defined and may ultimately ripen into a suit, the court said these two things are not the same - a suit unambiguously means a lawsuit in a court of law.

Discovery of information

California courts produced two significant decisions for insurers in the discovery arena in 1997. One dealt with discovery of information about "other insureds," and the other concerned the discoverability of the insurer's claims manuals.

The more recent of these cases, Pfizer Inc. v. Aetna Casualty & Surety Co., 59 Cal.App.4th 840 (October 29, 1997), petition for review filed Dec. 10, 1997, held that several insurers had to answer interrogatories calling for information about how they handled other, similar claims. Such discovery is usually opposed - and frequently denied by courts - on the dual grounds that it is both burdensome to the insurer and violates the privacy rights of the other insureds.

The court in Pfizer allowed the discovery under the particular facts of this case. As for the burdensomeness objection, the court placed a lot of stock (apparently without any support in the record) in the ability of the insurance company's computer systems to identify the files that would help it respond to the discovery requests.

Considering that the court' s decision apparently applied to several layers of insurers spanning several years, it seems doubtful that the court' s assumption about the sophistication of each insurer's computer system was accurate.

As for the insured's privacy rights, which are defined by statute in California, the court said that the other insureds were likely to be corporations that would have diminished privacy interests in their insurance files.

In another discovery case, Glenfed Development Corp. v. Superior Court (Nat. Union Fire Ins. Co. of Pittsburgh, Pa.), 53 Cal.App.4th 1113 (March 27, 1997), the Court of Appeals answered a question of first impression in California by holding that an insurance company's claims manuals may be discoverable in a "bad faith" action.

Looking ahead

Along with the question of whether an administrative order or notice may trigger a defense obligation, California courts have several other major issues on their dockets.

The Supreme Court is reviewing two cases concerning whether the consequential damages awarded for an insurer's "bad faith" can encompass punitive damages awarded against the insured in underlying litigation despite the settled rule that punitive damages are not insurable in California as a matter of public policy. See Kransco v. American Empire Surplus Lines Ins. Co., 63 Cal.Rptr.2d 532, review granted Aug. 20, 1997; and PPG Industries Inc. v. Transamerica Insurance Co., 49 Cal.App.4th 1120, review granted Dec. 18, 1996.

The year ahead may very well prove to be as eventful for insurers and insureds alike in California as the year that just passed.