The Insured has the Duty to Prove Coverage for Defense

Insured Obligated to Prove Exception to an Exclusion

In Zurich American Insurance Company v. Ironshore Specialty Insurance Company, 137 Nev.Adv.Op. 66, No. 81428, Supreme Court of Nevada, En Banc (October 28, 2021) the Supreme Court was asked to answer inquiries from the Ninth Circuit because two federal district courts issued conflicting decisions regarding whether, in Nevada, the insured or the insurer has the burden of proving that an exception to an exclusion of coverage provision applies. The Ninth Circuit certified the following questions to the Supreme Court of Nevada:

1 Whether, under Nevada law, the burden of proving the applicability of an exception to an exclusion of coverage in an insurance policy falls on the insurer or the insured?

2.  Whichever party bears such a burden, may it rely on evidence extrinsic to the complaint to carry its burden, and if so, is it limited to extrinsic evidence available at the time the insured tendered the defense of the lawsuit to the insurer?

FACTS

Throughout the 2000s, thousands of homes in Nevada were built by subcontractors under the direction of several development companies. During that period, these subcontractors were insured by appellants Zurich American Insurance Company and American Guarantee and Liability Insurance Company (collectively, Zurich). After the work on the homes was completed, the subcontractors switched insurers, obtaining insurance from respondent Ironshore Specialty Insurance Company (Ironshore). Ironshore’s policy insured the subcontractors against damages attributed to bodily injury or property damage that occurred during the new policy period. The policy provides that if the insured becomes legally obligated to pay damages because of bodily injury or property damage that qualifies under the policy, Ironshore will pay those sums. It further provides that Ironshore will have the right and duty to defend the insured if the suit seeks damages to which the policy applies. The policy applies only if the bodily injury or property damage is caused by an occurrence within the coverage territory and applicable policy period.

The Ironshore policy contains a “Continuous or Progressive Injury or Damage Exclusion” that modifies the insurance coverage provided under the policy. The exclusion provides that the policy does not apply to any existing bodily injury or property damage, except for “sudden and accidental” property damage:

This insurance does not apply to any “bodily injury” or “property damage” . . . which first existed, or is alleged to have first existed, prior to the inception of this policy. “Property damage” from “your work[, ]” … or the work of any additional insured, performed prior to policy inception will be deemed to have first existed prior to the policy inception, unless such “property damage” is sudden and accidental and takes place within the policy period.

Between 2010 and 2013, homeowners who had purchased homes within these development projects brought 14 construction defect lawsuits against the developers in Nevada state court, alleging the properties were damaged from construction defects.  Zurich settled claims against the subcontractors and then, in Nevada Zurich I, sued Ironshore in federal court seeking contribution and indemnification for the defense and settlement costs, as well as a declaration that Ironshore had owed a duty to defend the subcontractors against the underlying lawsuits. [Assurance Co. of Am. v. Ironshore Specialty Ins. Co. (Nevada Zurich I, No. 2:15-cv-00460-JAD-PAL, 2017 WL 3666298, at *1 (D. Nev. Aug. 24, 2017).] Ironshore moved for summary judgment, arguing that it had no duty to defend because there was no potential for coverage under the terms of the policy.

The federal district court granted summary judgment in favor of Ironshore. The court rejected the argument that the “sudden and accidental” exception to the exclusion of the coverage applied, reasoning that none of the complaints in the underlying lawsuits alleged that the damage occurred suddenly, and that without any evidence to support such an allegation, Zurich failed to carry its burden. In issuing this holding, the court implicitly concluded that the insured has the burden of establishing that an exception to an exclusion applies. The court also assumed that Zurich could have introduced extrinsic evidence to satisfy its burden, but it did not directly address the question.

Around the same time, another federal district court, in Assurance Co. of America v. Ironshore Specialty Insurance Co. (Nevada Zurich II, No. 2:13-cv-2191-GMN-CWH, 2015 WL 4579983 (D. Nev. July 29, 2015), reached a different conclusion in a substantially identical case. The judge in that case concluded that Ironshore owed a duty to defend because the underlying complaints “did not specify when the alleged property damage occurred and did not contain sufficient allegations from which to conclude that the damage was not sudden and accidental.”

The Nevada Zurich II court concluded that Ironshore failed to satisfy its burden of proving that the exception to the exclusion did not apply, implicitly concluding that the insurer had the burden of proving the nonapplicability of the exception to the exclusion. The Nevada Zurich II court also assumed that extrinsic evidence was admissible but did not address the issue directly.

DISCUSSION

In Nevada, insurance policies are treated like other contracts, and thus, legal principles applicable to contracts generally are applicable to insurance policies. When reading a provision of an insurance policy, the court’s interpretation must include reference to the entire policy, which will be read as a whole in order to give reasonable and harmonious meaning to the entire policy. Under an insurance policy, the insurer owes two contractual duties to the insured: the duty to defend and the duty to indemnify. Only the duty to defend is at issue.

The insurer bears a duty to defend its insured whenever it ascertains facts which give rise to the potential of liability under the policy. Conversely, there is no duty to defend where there is no potential for coverage. If there is any doubt about whether the duty to defend arises, this doubt must be resolved in favor of the insured. However, the duty to defend is not absolute. A potential for coverage only exists when there is arguable or possible coverage.

Courts in many jurisdictions have concluded that the insured bears the burden of proving the sudden and accidental exception to an exclusion of coverage. The trend clearly appears to place the burden on insureds to prove that an exception to an exclusion applies to restore coverage. Some courts do not agree.

Nevada law provides that an insurance policy should be read according to general contract principles. Furthermore, Nevada law requires that the insured establish coverage under an insurance policy, whether claiming a duty to indemnify or a duty to defend. The majority approach is in accordance with basic tenets of evidence law in Nevada. The party that carries the burden of production must establish a prima facie case. The burden of persuasion rests with one party throughout the case and determines which party must produce sufficient evidence to convince a judge that a fact has been established. In Nevada, the burdens of production and persuasion rest with the insured, who has the initial burden of proving that the claim falls within policy coverage.

The duty to defend arises when there is a potential for coverage, whereas the duty to indemnify arises when the insured’s activity and the resulting damage actually fall within the policy’s coverage.

The Insured May Use Extrinsic Facts Available To The Insurer At The Time Of Tender To Prove The Insurer Had A Duty To Defend

An insurer bears a duty to defend its insured whenever it ascertains facts which give rise to the potential of liability under the policy. Thus, under Nevada law, an insured may present such extrinsic facts to the insurer, and rely upon them, in order to argue that the insurer owes a duty to defend as within an exception to an exclusion.

Neighboring California has held that “[a]n insurer’s duty to defend must be analyzed and determined on the basis of any potential liability arising from facts available to the insurer from the complaint or other sources available to it at the time of the tender of defense.” Waller v. Truck Ins. Exch., Inc., 900 P.2d 619, 632 (Cal. 1995) (quoting CNA Cas. of Cal. v. Seaboard Sur. Co., 222 Cal.Rptr. 276, 278-79 (Ct. App. 1986)). Since the duty to defend must be determined at the outset of litigation based upon the complaint and any other facts available to the insurer, the Nevada Supreme Court held that the insured may use extrinsic facts that were available to the insurer at the time it tendered its defense to prove there was a potential for coverage under the policy and, therefore, a duty to defend.

The certified questions were, therefore, answered as follows:

1.  the burden of proving the exception to an exclusion is on the insured, not the insurer; and

2.  in fulfilling its burden to prove the exception to an exclusion applies, the insured may utilize any extrinsic facts that were available to the insurer at the time the insured tendered defense to the insurer.

ZALMA OPINION

Accepting the rule followed by the majority of the courts in the U.S. and basic common sense, the Nevada Supreme Court applied the basic rule of law that it is the insured who is obligated to prove that coverage applies and can use extrinsic evidence to establish the coverage. So, in this who’s on first routine, the insured is on first to prove that an exception to an exclusion applies and if it succeeds the burden shifts to the insurer to prove the opposite.

Lender Must TreatMortgagee with Utmost Good Faith

When a mortgaged residence is  damaged by a storm and the homeowners’ property or flood insurer pays benefits for the storm damages, how should the mortgage company determine whether to use those insurance funds to pay down the delinquent mortgage principal and interest, or, alternatively, use the funds to repair the property, as provided by the loan agreement? In Wilmington Savings Fund Society, FSB, d/b/a Christiana Trust, not individually but as trustee for Pretium Mortgage Acquisition Trust, Plaintiff-Respondent v. Patricia E. Daw and Richard C. Daw, and TD Bank, N.A., and State Of New Jersey, No. A-0829-19, Superior Court of New Jersey, Appellate Division (October 22, 2021) the court established a duty of good faith and fair dealing between a lender and mortgagee with regard to the proceeds of an insurance claims.

When the loan agreement states the lender may choose to apply the funds to the outstanding debt if either repairs are “economically infeasible” or if such expenditures would impair the lender’s security interest, the lender has an obligation to the borrower to make that decision promptly and in good faith?

FACTS

The lender’s assignee held the storm insurance proceeds for over three years before ultimately applying them to the homeowners’ outstanding debt. During that lengthy interval, an estimated sum of $40,000 in mortgage interest accrued. Negotiations to modify the terms of the loan failed when the assignee demanded that two thirds of the insurance funds be applied to the debt upfront as a condition of the loan modification, which the homeowners contend would have left them with insufficient funds to complete all the repairs and disqualify them for a state grant that they had conditionally received.

ANALYSIS

Once the lender is provided with adequate information to determine how the insurance funds should be used-such as the estimated costs of repairs and market values-the lender is obligated to clearly advise the borrower within a reasonable period of time as to whether the requested use of insurance monies for repairs is economically infeasible or will impair its security in the property. The time to notify the borrower of the disposition may be extended if the parties mutually undertake good-faith negotiations to modify the loan terms. If the lender unreasonably delays making a decision to approve the proposed use of the insurance funds for repairs, the court has the equitable power to abate the mortgage interest that has accumulated in the meantime. Additionally, the lender must place the insurance funds in an interest-bearing, segregated account until the proper use of those funds is resolved.

Superstorm Sandy and Its Aftermath

On October 29, 2012, Superstorm Sandy battered the Jersey Shore. As described by the Daws, the storm caused the ocean to break through the dunes near their Point Pleasant home and rush into the bay. The residence was flooded with over two feet of water, destroying much of the first floor and requiring it to be gutted. The disposition of the insurance proceeds was governed by several provisions within the mortgage. These provisions apparently are common or standard terms that have been discussed in other mortgage cases.

The Foreclosure Litigation and Other Events

As the loan remained in default, plaintiff filed a mortgage foreclosure complaint against the Daws in March 2016, which the Daws did not answer. Consequently, default judgment was entered against them in June 2016.

Despite the plaintiff’s filing of the foreclosure complaint, the Daws requested another loan modification to enable them to keep the house. Concurrently, the lender obtained in October 2016 a broker’s price opinion (“BPO”). The BPO stated that the house was “in average condition” and that “as-is,” in the next 90 to 120 days, the probable sale price of the house was $440,000, compared to $450, 000 if the proposed repairs were completed. The BPO estimated the “as-is” list price of the home was estimated as $459,900, compared to $469,900 if the property were repaired. The BPO stated it was “unknown” if the property needed emergency repairs, and only noted the property needed exterior repairs costing slightly over $6,000.

On March 3, 2017, the trial court issued an order granting in part and denying in part the Daws’ objection to the entry of final judgment. The court found the Daws had adequately identified a discrepancy in the amount due on the mortgage at time of foreclosure, because the $150,000 of insurance proceeds had not been deducted from the debt. Additionally, the judge noted that plaintiff had not approved the repairs, and therefore violated the contract by not carrying out either of the two specified options for the insurance proceeds.

Final Motion Practice

The Daws argued that plaintiff had unfairly held the $150,000 in insurance proceeds without a disposition of them for over three years. They calculated that if, hypothetically, plaintiff had promptly applied the insurance proceeds to the outstanding principal and interest when it received the funds in October 2015, the final balance due on the mortgage loan would have been about $40,000 less.

THE APPEAL

It is well settled that “an implied covenant of good faith and fair dealing” inheres in “every contract in New Jersey.” Sons of Thunder, Inc. v. Borden, Inc., 148 N.J. 396, 420 (1997); see also Restatement (Second) of Contracts § 205 (Am. Law Inst. 1981) (“Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”). The implied covenant signifies that “neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract.” Sons of Thunder, Inc., 148 N.J. at 420 (quoting Palisades Props., Inc. v. Brunetti, 44 N.J. 117, 130 (1965)).

These general principles sensibly extend to how a mortgage lender or its assignee exercises its control over insurance proceeds received after a borrower’s home has been damaged by a storm. The old adage, “Don’t throw good money after bad,” pertains. In some instances, it will be unreasonably expensive for certain repairs to be made with the insurance money, even if contrary to what the homeowner desires.

Lenders and their assignees must convey their decisions and reasons concerning the disposition of insurance proceeds to homeowners with clarity and consistency.

The insurance funds are viewed as substitute collateral and the mortgagee’s claim on them is sometimes described as an “equitable lien.” This means simply that the mortgagee is entitled to recover the funds to the extent necessary to compensate for the impairment of security that results from the loss or damage, with a maximum recovery equal to the balance owing on the mortgage debt. This result is required to avoid unfairness to the mortgagee through devaluation of the real estate as a consequence of the loss or damage. [Third Restatement § 4.7 cmt. a (1997)]

If repairs are objectively shown to be economically infeasible or would impair the lender’s security, then the insurance proceeds must be applied promptly to the mortgage balance, unless otherwise agreed upon by the parties.

It is appropriate for the insurance funds to be placed – if not applied to the mortgage debt – in an interest-bearing account until their disposition is finally determined. Such opportunity for the funds to grow, even at a modest interest rate, is preferable to the funds remaining dormant, because if the funds appreciate, that growth can be applied to either the resources available to finance repairs or to pay down the debt.

Rather than attempting on an incomplete record to apply the new standards the court announced in this opinion it elected to remand the issue of the disposition of the insurance funds to the trial court. Consistent with principles of fairness and reasonableness expressed in the Restatement (Third) of Property (Mortgages) (1997), the mortgage lender (or its assignee) in such situations owes the borrower an implied covenant of good faith and fair dealing in determining the disposition of the property or insurance funds.

ZALMA OPINION

People sometimes forget that the covenant of good faith and fair dealing applies to all contracts, not just insurance contracts. In this case the New Jersey court enshrined that duty on mortgage contracts with regard to the use of insurance proceeds held by the mortgagor instead of applying the funds to the repair or to reduce the mortgage debt. The mortgagor did neither and was chided by the court for holding money for too long without explaining the reasons to the mortgagee. There are no tort damages for the breach but there are contract damages that may be available to the mortgagee.