Illusory Coverage - A Continuing Thorn in the Side of Policyholders

Illusory Coverage – A Continuing Thorn in the Side of Policyholders

By David A. Gauntlett*

Courts differ on the fact circumstances that trigger application of the “illusory coverage” doctrine. These methods can be categorized into three (3) distinct approaches.  The first approach considers whether there is sufficient uncertainty about the application of the policy language as written so that a policyholder cannot define which potential claims against the policyholder fall within the scope of coverage. Other courts adopt a second view requiring definitive proof that there is no circumstance that would possibly give rise to coverage under the policy. The third and narrowest construction requires the policyholder to establish the precise portion of the insurance policy premium attributable to non-existent coverage.

First, Elimination of Coverage Without Notice

The majority of forums, including California, follow the first approach. An insurer must utilize exclusionary language that is “clear and unambiguous.”[1] Other cases are in accord with this view.[2] An insurer must “conspicuously notify [the insured] of a reduction in coverage.”[3] Moreover, “When reasonably practical contracts are to be interpreted in a manner that makes them reasonable and capable of being carried into effect[4],” Entertainers may purchase illusory coverage where advertising injury coverage in their CGL policy contains a “Field of Entertainment Limitation Endorsement”. This form of exclusion, however, did not reach alleged trademark infringing use of the trademark name[5]. Insurers that redefine policy terms, typically in an endorsement, allows the insurer to deny coverage for what was expressly covered in another section of the policy. This practice leaves policyholders paying a premium without any way of determining the extent of their coverage, much less receive any notice of a specific reduction in coverage.

In Classic, the court held that the wage and hour sublimit “endorsement” was unenforceable due to several instances that result in a lack of notice to the insured.[6] These include, among other things, the body of the policy did not contain the relevant exclusions or refer to the endorsement, the endorsement and notifications were attached to the end of the policy but the insurer provided no specific notice beyond those attached, nor did the insurer include the endorsement as part of the quote for renewal.[7]

In DVO, an endorsement containing a breach of contract exclusion provided expansive limitations due to its “based upon or arising out of” language. The court held that the complete overlap between claims of professional malpractice and breach of contract rendered the professional liability coverage in the E&O policy illusory.[8]

Second, Self-Contradictory Policy Provisions

Second, insurers that provide coverage for a particular type of loss but also explicitly exclude this loss in the same policy renders it “illusory coverage.”[9] A policyholder left with no potential basis for coverage also arises where the policy language in one section contradicts itself elsewhere, rendering coverage impossible.[10]

In Princeton, the insurer redefined “personal and advertising injury” coverage to include only offenses (a)-(c) of the full panoply of (a)-(g). As all “advertising injury” covered was set forth in (d)-(g), it effectively eliminated all “advertising injury” coverage by a sleight of hand redefinition endorsement without any contemporaneous notice to the policyholder that it had eliminated coverage for offenses (d)-(g). This endorsement modified “personal and advertising” coverage without any reduction in premium. The endorsement did not create ambiguity between differing perspectives or remove particular activities, it eviscerated all advertising injury it purports to cover.

As Princeton has explained, “insurance coverage is illusory when policy provisions, limitations or exclusions completely contradict the insuring provisions.” This heightened standard requires the policyholder to have no possible way of establishing coverage and receiving a return on their premium payments.[11] No reasonable policyholder would agree to pay premiums yet receive no coverage it paid for in return. “The doctrine applies when exclusions in effect allow the insurer to receive premiums when realistically it is not incurring any risk of liability.” [12]

Third, Premium Payments for Policy Provisions That Offer No Coverage

To date, only courts applying Minnesota law have adopted the most restrictive construction. They assert that to establish there is no coverage for a portion of the policy, the policyholder must show the policy premium paid differentiated between parts of the premium that are attributable to specific portions of coverage. The policyholder must be able to establish that “part of the premium is specifically allocated to a particular type or period of coverage and that coverage turns out to be functionally nonexistent.”[13] The doctrine applies only in the case where there was no value for the premium paid as it relates to that particular portion of coverage, rendering it illusory[14]. The policyholder, however, must establish both allocation of the premium and the policy language renders coverage non-existent.

If no “advertising injury” coverage is available due to a superseding definition of “personal and advertising injury” coverage in an endorsement but no distinct portion of the premium charged is clearly attributable to the coverage for “advertising injury”, the effective elimination of that coverage by an endorsement would not render the policy’s “advertising injury” coverage illusory.

Conclusion

Not all states have addressed the “illusory coverage” doctrine. Those that have utilize disparate approaches which flow from distinct public policy concerns. The first view emphasizes meeting the policyholder’s reasonable expectations of the scope of coverage based on the policy language in place. The second, combats insurers’ improper use of endorsements that redefine coverage without contemporaneously explaining what was eliminated by the redefinition. The third, avoids expansive coverage by limiting policy benefits to those that appertain to the precise premium paid for each discrete coverage component of the policy.  

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*David A. Gauntlett is a principal of Gauntlett & Associates. For more information, visit Gauntlett & Associates at www.gauntlettlaw.com.  

[1] Smith v. Allstate Ins. Co., 241 Va. 477, 480 (1991) (“[I]t is incumbent upon the insurer to employ exclusionary language that is clear and unambiguous.”)

[2] Cothran v. State Farm Mut. Auto. Ins. Co., 421 S.C. 562, 571 (Ct. App. 2017) (“South Carolina courts refuse to enforce insurance policy exclusions that render the coverage ‘virtually meaningless.’”); Alliance Mut. Ins. Co. v. Dove's Welding, 214 N.C. App. 481, 488 (2011) (“[T]o adopt the plaintiff's very broad reading of the exclusion clause would result in the exclusion clause swallowing up the whole of the commercial liability policy, and render any coverage contained therein illusory.”)

[3] Allstate Ins. Co. v. Fibus, 855 F.2d 660, 663 (9th Cir. (Cal.) 1988) (Before renewal, Allstate issued an eight-page document that listed the replacement provisions with no highlighted text indicating changes)

[4] Manzarek v. St. Paul Fire & Marine Ins. Co., 519 F.3d 1025, 1032-33 (9th Cir. (Cal.) 2008)

[5] Vivid Video, Inc. v. North Am. Specialty Ins. Co., 1999 U.S. District LEXIS 15322, *12 (C.D. Cal June 29, 1999). (“[It] excludes coverage for injuries which may arise from the substantive content of its entertainment activities.”) see also, Edwin F. McPherson (2015). Entertainers Beware – You May Have Less Insurance Coverage Than You Think, 45 Sw.L.Rev 33, p. 5

[6] Classic Distrib. & Bev. Grp., Inc. v. Travelers Cas. & Sur. Co. of Am., No. CV 11-07075 GAF (RZx), 2012 U.S. Dist. LEXIS 129545 (C.D. Cal. Aug. 29, 2012) (The court determined that the policy, absent the endorsement, covered only defense expenses incurred in connection with California Insurance Code § 226 claims, and that Travelers had no duty to pay "loss" associated with those claims.)

[7] David A. Gauntlett (2014). Insurance Coverage for Wage and Hour Claims Under a Variety of Insurance Policies. ABA Insurance Litigation Committee, p. 23.

[8] Crum & Forster Specialty Ins. Co. v. DVO, Inc., 939 F.3d 852, 857 (7th Cir. (Wis.) 2019) (Endorsement that excluded any loss “based upon or arising out of” a breach of contract is extremely broad, rendering the professional liability coverage illusory.)

[9] Cherrington v. Erie Ins. Prop. & Cas. Co., 231 W. Va. 470, 490 (2013) (“To apply this exclusion to preclude coverage for the damages occasioned by the very same work that the policy expressly covers would render such coverage illusory and would be contrary to the policy's stated intention to provide indemnity for this specific loss.”)

[10] Princeton Express & Surplus Ins. Co. v. DM Ventures USA LLC, 209 F. Supp. 3d 1252, 1258 (S.D. Fla. 2016) (An endorsement containing a Field of Entertainment Exclusion excludes “advertising injury” from “personal and advertising injury” coverage.)

[11] Ellifson v. W. Bend Mut. Ins. Co., 312 Wis. 2d 664, 672 (Ct. App. 2008) (Coverage is not illusory when there are circumstances which the insurer will pay for, such as the conduct of a permissive user of the vehicle.)

[12] Taylor v. Sec. Nat’l Ins. Co., 2018 U.S. Dist. LEXIS 37863, *11 (D.S.C. Mar. 8, 2018) quoting Colorado Intergovernmental Risk Sharing v. Northfield Ins. Co., 207 P.3d 839, 843 (Colo. App. 2008).

[13] Jostens, Inc. v. Northfield Ins. Co., 527 N.W.2d 116, 119 (Minn. Ct. App. 1995) (Umbrella policy with enumerated discrimination exclusions is not illusory because it provided a wide variety of coverage and the insured could not show part of the premium was allocated to coverage that is excluded.)

[14] Midwest Family Mut. Ins. Co. v Cummings, No. A10-1537, 2011 Minn. App. Unpub. LEXIS 508, *23 (May 23, 2011) (“The additional premium increase[d] the amount… compensated for a single occurrence …[E]ach premium amount purchased a specific liability coverage; consequently… the doctrine of illusory coverage does not apply.”)