Cover exclusions are a key risk management tool for transactional liability insurers. But they can also be traps for the unwary. In the event of a claims dispute, the insurer will likely have the burden of proving that an exclusion applies and a judge or arbitrator may (depending on the circumstances) be instructed to interpret the exclusion based solely on its terms, without external evidence of what the underwriter meant. Therefore, disclaimers must be drafted carefully with potential disputes over their meaning in mind.
This article provides guidance for transactional insurers drafting coverage exclusions based on our extensive practice of consulting on insured transactions and claims management for our clients.
The legal landscape
While a full discussion of the law surrounding exclusions is beyond the scope of this article, let\’s first highlight several legal issues that can arise in the context of a coverage dispute. Each of these issues informs the editorial staff of the exclusions.
First, an established principle on the burden of proof: the policyholder typically bears the burden of \”establishing[ing] coverage in the first instance\”, while the insurer has the burden of \”proving that an exclusion applies\”.[1] Jurisprudence in the context of transactional liability is limited, but in coverage disputes in this area, policyholders generally urge the general principle to apply.
A second problem is As exclusions will be interpreted. In our experience, policyholders frequently cite case law which they believe imposes a strict standard on insurers seeking to invoke an exclusion. This includes cases saying, for example, that the exclusion must contain \”clear and unambiguous language\”; be \”tuned to strict and narrow construction\”; and be subject to \”no other reasonable interpretation\”.[2]
In this respect, at least one case suggests that courts may be inclined to reflexively apply such rules from other contexts to representation and warranty (RWI) insurance policies. In WPP Group USA, Inc. v. RB/TDM Investors, LLC, the court rejected a dismissal motion from a RWI insurer who had invoked an exclusion that excluded the portion of loss related to certain indemnities in the underlying purchase agreement. And the court observed, inter alia, that “[a]ambiguities in exclusions must be interpreted strictly and are normally resolved in favor of the insured,” citing a New York Court of Appeals case involving a homeowner\’s insurance policy.[3]
Exclusions should be written with this case law in mind, but subject to the law governing a particular insurance policy, insurers have answers to arguments such as the one in WPP extension. Insurers might argue that these rules of interpretation have emerged from a very different context – to address standard policies drafted by insurers and accepted by policyholders with limited bargaining power – and should not apply to transactional liability insurance, which often involves bespoke policies negotiated. by sophisticated parties, typically with the assistance of a lawyer.
Insurers can find support in case law that caters to “sophisticated” policyholders.[4] For example, in a recent case outside the RWI context, the policyholder was a sophisticated party who had negotiated the terms of the policy with the assistance of an outside law firm and a large and experienced insurance broker.[5] When the insurer relied on an exclusion to deny coverage, the First Circuit (interpreting Puerto Rico law) refused to apply to the exclusion a rule that required construction in favor of the policyholder. The court observed that the logic of public order typically requires the construction in favor of the insured: “to protect[ing] a weaker side when there is disparity at the negotiating table” – was not present in this case.[6]
Furthermore, some courts have suggested that, regardless of context, these interpretive presumptions simply reflect a specific application of contra proferentemthe rule according to which an ambiguous provision must be interpreted against its drafter.[7] From that perspective, such presumptions should not apply until After it is considered extrinsic evidence, and only if the insurer has drafted the provision in question. This view, however, is not always accepted.[8]
Drafting RWI coverage exclusions that work
Consequently, insurers must be prepared for courts or arbitrators to interpret vague or ambiguous exclusions in favor of policyholders. Underwriters should draft disclaimers as clearly as possible to minimize the risk of a judge or arbitrator misinterpreting the extent of the disclaimer. To this end, insurers should consider the following:
- Choose exclusions tailored to your subscription process: Given the tight timeline of a typical underwriting, insurers should create specific exclusions for issues that arise in the insured transaction. In some cases, this means incorporating exclusions that address specific issues relating to the company (or its industry) that would otherwise be covered by the policy (for example, excluding Medicare or Medicaid fraud claims for a health care provider). In other cases, it may mean adopting exclusions in areas where underwriters have not been able to exercise sufficient care and need to minimize risk.
- Ensure that the policy executed matches the intent of the subscriber and usual best practices: Since a third party, such as a judge or arbitrator, could interpret the exclusion after the fact, it is imperative that insurers draft the disposition carefully to ensure that the language matches the underwriter\’s intention. Among other best practices, editors should use clear, simple, and unambiguous language; ensure that definitions are clearly defined and used consistently; and pay close attention to the use of words that can potentially create ambiguity, such as \”and\”, \”or\”, \”each\”, \”each\”, and \”any\”. For example, an exclusion referring to \”A or B\” can be used in the sense \”inclusive\”, meaning \”A or B, or both” or in the exclusive sense, meaning “A or B, but not both”, depending on the context.[9] To avoid any ambiguity, an editor could instead indicate precisely which of these two potential interpretations is intended.
- Beware of \”illusory\” cover arguments.: Policyholders sometimes argue that an exclusion should be ignored (or interpreted narrowly) because its application would make the coverage afforded by a policy \”illusory\”. For example, by denying insurer RWI\’s dismissal application, the WPP extension judge noted that, even if the insurer\’s interpretation of the exclusion was correct, “coverage may not be precluded because [the insurer’s] the interpretation apparently makes the cover [for certain breaches] illusory.\”[10]
In general, cover is “illusory” only when it “eliminates[s] all or most of the coverage.”[11] However, underwriters should be aware of the potential for such arguments while ensuring that the exclusion is broad enough to address the anticipated risk.
- Don\’t assume that the courts will consider non-contractual documents: In general, courts attempt to interpret insurance policies by focusing on the contract terms themselves (along with aids such as established industry custom), and rely on evidence outside the four corners of the agreement (if at all) only when the provisions of the policy are ambiguous.[12] Underwriters should therefore seek to reflect their intent directly and clearly within the language of the disqualification itself and not assume that the court will consider other evidence (such as an email to a broker) regarding its meaning.
- It provides that the Insured has participated in the drafting of the PolicyWhere applicable, the parties should stipulate in the policy that the policyholder actually participated in drafting the policy, or even a particular clause, and that the policy is not to be construed against either party. While insurers can still bear the burden of demonstrating that an exclusion applies, this can prevent ambiguities from being played against them.
- Discuss with external counsel and claims professionals: In-house claims professionals and outside counsel can also be a helpful resource, especially as they may have faced similar issues in a previous litigation.
- Change the scope of coverage: Exclusions aren\’t the only way to limit your coverage. Rather than drafting an exclusion, an insurer can instead change or narrow some other provisions, such as the definition of a breach. As noted above, the policyholder typically has the burden of proving that a claim or loss falls within the scope of a policy\’s insurance contract. Note, however, that some courts have held that location and placement do not necessarily control, so a court may impose the burden of proof on an insurer even where a provision is not strictly labeled an exclusion.[13]
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