The 'Sophisticated Insured' Defense

First-Party Cases

Strict Application of the Sophisticated Insured Defense

In Baxter International, Inc. v. American Guarantee and Liability Insurance Co., 861 N.E. 2d 263 (Ill. App. Ct. 2006), the insured, a global medical products manufacturer, sought coverage after a hurricane damaged its Puerto Rico facilities. The insurer, American Guarantee and Liability Insurance Co., indemnified Baxter in the amount of $30.7 million, which included the fair market value of Baxter's damaged finished goods inventory. American maintained that the $15 million lost profit component of its payment for lost inventory should reduce the amount it owed for Baxter's loss during the period of business interruption. Baxter disagreed. The trial court granted summary judgment for Baxter. Id. at 266.

On appeal, the court found the provisions that related to the calculation of losses under the policy to be ambiguous. Id. at 269. Because of Baxter's sophistication and substantial bargaining power, the court declined to apply the contra proferentem doctrine. The court explained: 'The anti-drafter rule is intended to aid the party with less bargaining power during the drafting process and is not appropriate where the parties are equally sophisticated.' Id. (emphasis added). Because the parties were on equal footing, the court relied on general principles of contract interpretation and held that American's indemnification payment for lost profits should reduce Baxter's business interruption claim. Id. at 271.

Another case in which the insured's sophistication was a dispositive
factor was Michael Foods, Inc. v. Allianz Insurance Co., No. 02-CV-3504 (JMR/FLN), 2003 U.S. Dist. LEXIS 7037 (D. Minn. Apr. 21, 2003). The insured, Michael Foods, had purchased all-risk insurance to protect its poultry operation. After two of its hen barns collapsed following a snowstorm, Michael Foods immediately notified the insurer, Allianz. Approximately six months later, Allianz denied coverage, citing faulty construction as the reason for the collapse. Michael Foods filed suit in August 2002, 18 months after the barn collapsed. Allianz moved for summary judgment, arguing that Michael Foods failed to comply with a policy provision that required it to bring suit within 12 months of discovery of the occurrence that gave rise to the claim.

It was clear that Michael Foods filed its lawsuit outside the unambiguous one-year limitations period. The key question was whether that period was reasonable. The court found Michael Foods to be a 'highly sophisticated company' that retained the assistance of an insurance broker and ”knew and understood the language of the policy.” Id. at *7-8 (emphasis added) (citation omitted). Thus, the court concluded that Michael Foods could have asked Allianz to waive the one-year limitations period or it could have filed suit as a 'prophylactic' measure after Allianz denied coverage. Id. at *8. Considering 'the sophistication of the plaintiff and its insurance broker,' the court held, 'there is no basis to find the one year clause unreasonable.' Id.

In Baxter, as in Michael Foods, the court equated commercial sophistication with equal bargaining power. By contrast, in the following cases, the courts accepted the sophisticated insured defense only when the insureds actually participated in the policy negotiation or drafting process.

Analysis of the Insured's
Actual Participation in Policy Drafting

In American Home Assurance Co. v. Merck & Co., Inc., 386 F.Supp. 2d 501 (S.D.N.Y. 2005), the insurer denied coverage to pharmaceutical manufacturer, Merck & Co., Inc., for losses that resulted from damage to Merck's products while in transit. The parties cross-moved for summary judgment, with the dispute centering primarily on the interpretation of the policy's Control of Damaged Goods clause. Id. at 505-06. The court denied in part both parties' motions for summary judgment.

The court noted that contra proferentem 'does not apply where, as here, 'large corporations, advised by counsel and having equal bargaining power, are the parties to a negotiated policy[,]' … and where Merck itself may have supplied some of the critical language in the [p]olicy.' Id. at 512 (emphasis added). It did not explain how mere participation in the negotiation process guaranteed the insured equal bargaining power and equal influence over the policy's language. The same is also true of the following cases.

In Eastern Associated Coal Corp. v. Aetna Casualty & Surety Co., 632 F.2d 1068 (3d Cir. 1980), a jury awarded the insured coal company more than $4.7 million under a business interruption policy for losses incurred after an underground fire forced the closing of a mine. The insured was forced to divert coal from other mines and purchase high-priced coal on the open market to satisfy its obligations under a supply contract. Aetna argued on appeal that the insured was not entitled to business interruption coverage for expenses incurred in fulfilling the supply contract.

Although the court found no ambiguity in the policy language, it indicated that, even if it had, it would not have applied the contra proferentem doctrine because of the insured's sophistication and its role in negotiating the policy. Id. at 1075-77. The court said, 'the principle that ambiguities in policies should be strictly construed against the insurer does not control the situation where large corporations, advised by counsel and having equal bargaining power, are the parties to a negotiated policy.' Id. at 1075 (emphasis added). The court observed that it was the insured's broker who selected the policy forms, prepared the policies, and sent them to the insurer for execution. Id. Because Pennsylvania law required the court to resolve ambiguities against the policy drafter, the court could not construe the language against Aetna, and determined that the insured's increased costs to fulfill the supply contract were not covered.

Similarly, in the following case, the court also rejected the contra proferentem doctrine after finding that the insured had actually drafted the relevant policy language.

In Newport Associates Development Co. v. Travelers Indemnity Company of Illinois, 162 F.3d 789 (3d Cir. 1998), the appellate court affirmed the district court's grant of summary judgment to the insurer, holding that an insurance policy covering a marina did not cover damage to a breakwater caused by a storm. The appellate court's decision turned on a provision in the insurance policy that covered '[s]lips ' and other integral parts collectively called 'slips. … ” Id. at 792. The insured argued that the phrase 'other integral parts' encompassed the breakwater. Travelers countered that the provision only applied to slips and their attached parts. The appellate court agreed with the district court that the policy was unambiguous and failed to cover the breakwater. Id. at 792-93. Nonetheless, the court went on to consider contra proferentem, rejecting Newport's contention that the policy should be construed against Travelers. It noted that the marina management company, which had the same corporate parent as the insured, had an independent broker procure the insurance policy for the marina. Id. at 791, 794. The broker met with a Newport employee to discuss the scope of coverage, drafted a policy with input from the Newport employee, and submitted it to Travelers. The Travelers policy incorporated verbatim the language recommended by the broker.

'[T]he crucial fact,' according to the court, was that Travelers 'did not unilaterally impose the policy on Newport.' Id. at 794. It continued, ”[t]he dispositive question is not whether the insured is a sophisticated corporate entity, but rather whether the insurance contract is negotiated, jointly drafted or drafted by the insured. In such instances, we conclude that the doctrine of contra proferentem should not be invoked to inure to the benefit of the insured.” Id. (emphasis added). Because the policy here was either drafted by the insured or could be considered to have been jointly drafted by the insured and insurer, the court found the insured could not rely on contra proferentem.

It should be noted that even if the sophisticated insured defense is accepted by the court based on the insured's actual contribution to the language of the policy, the insured may still prevail. See Fountain Powerboat Industries, Inc. v. Reliance Insurance Co., 119 F.Supp. 2d 552 (E.D.N.C. 2000) (concluding that both parties shared equal bargaining power during the negotiation process and that there was no reason to construe ambiguous terms against Reliance, but still finding in favor of insured).

Rejection of the Sophisticated Insured Defense

On the other end of the spectrum, courts have disregarded the sophisticated insured defense and applied the contra proferentem doctrine even when the insured was a large, sophisticated corporation that contributed to the policy language.

In Northwest Airlines, Inc. v. Globe Indemnity Co., 225 N.W. 2d 831 (Minn. 1975), the insured sought recovery under a blanket crime policy for losses it sustained when a plane was hijacked. The lower court determined that Northwest was entitled to recover under the policy because it found that there had been a wrongful abstraction of money from Northwest's premises. The Minnesota Supreme Court affirmed, finding the policy to be ambiguous and rejecting the insurer's argument that the contra proferentem rule was inapplicable because 'the policy at issue was the result of arm's-length negotiations between defendant and a sophisticated insured which was represented by its own insurance experts.' Id. at 837, n.2. The court noted that the specific provisions at issue were taken verbatim from a printed form supplied by the insurer. Id. at 837, n.2.

The Northwest Airlines case demonstrated a court's reluctance to discard the contra proferentem doctrine at the first sign of a commercially sophisticated insured. Instead, the court focused on the origin of the policy language at issue. The court in the next case took the same approach.

In General Mills, Inc. v. Gold Medal Insurance Co., 622 N.W. 2d 147 (Minn. Ct. App. 2001), a captive insurer appealed a summary judgment ruling that found coverage for losses suffered by the insured food manufacturer after its grain stock was sprayed with an unapproved pesticide.

Before the contamination incident, General Mills had established Gold Medal, a wholly owned subsidiary, as its captive insurer. American Risk Management, an independent company, handled Gold Medal's essential services. Although 'General Mills had considerable bargaining power with respect to the terms of the various policies,' Id. at 150, American Risk Management drafted the language of the policies issued by Gold Medal to General Mills.

The appeals court emphasized that '[r]elatively equal bargaining power does not preclude application of the doctrine of contra proferentem,' and went on to affirm a number of the district court's holdings, including a holding that a contamination exclusion in the all-risk policy was ambiguous and that the insurer had not met its burden of proving that the exclusion applied. Id. at 152-53. Thus, even though General Mills demonstrated its sophistication by establishing a captive insurer, it could still benefit from the contra proferentem doctrine since it was not the drafter of the policy.

In the final case, the insured actually participated, in a limited way, in drafting the insurance policy. However, the court held that the insured's participation was not sufficient to warrant abrogation of the contra proferentem doctrine.

In In Re Environmental Insurance Declaratory Judgment Actions, No. UNN-L-08573-89 (N.J. Super. Ct. Law Div. May 11, 1992), Order and transcript reprinted in 6-27 Mealey's Litig. Rep. Ins. 6 (May 19, 1992), the insurers refused to cover damage to buildings and land owned by the insured, Westinghouse Electric Corporation, under Westinghouse's first-party property policies, so Westinghouse filed suit. The insurers argued that Westinghouse, with the help of its broker, had drafted the relevant language. The court noted that, '[a]lthough plaintiff may have indeed selected insurance coverage from a 'menu,' the items to choose from were standard fare in the industry. There is nothing unique about the wordings in the policy. The first-party policies here may hardly be defined as 'manuscript.” Transcript at 127. Therefore, the court concluded that the contra proferentem doctrine still applied. The case (which also involved issues under third-party policies) shows that an insured's mere participation in the policy drafting process within parameters set by the insurer does not necessarily mean that the insured has exerted the kind of influence over the policy language that would make contra proferentem inapplicable.

Conclusion

As is evidenced above, some courts have been receptive to the sophisticated insured defense in the first-party insurance context. A few have embraced the defense, but have not established a clear metric by which to judge the insured's sophistication. Furthermore, the assumption of these courts that commercial sophistication is the equivalent of equal bargaining power and expertise in insurance is simply not the case for many commercially sophisticated insureds. Insurers typically draft the insurance policy and have superior knowledge of the insurance industry, which allows them to frame policy language to limit the coverage provided to insureds.

For large commercially sophisticated insureds, having a 'risk management department,' even one with several employees, is no equal of any reasonably sized insurer. The risk manager has to procure coverage and administer claims under workers compensation, property, auto, directors' and officers' liability, and general liability policies. The insurer has a separate underwriting department and a separate claim department for each line of coverage. Thus, during the underwriting process, the insured is always represented by a jack-of-all-trades, who is matched up against a specialist. No matter how commercially sophisticated the insured and no matter how much the insured has participated in negotiations concerning the policy language, if the insurer is the party with the most influence over the policy language, as is usually the case, the rationale for applying the contra proferentem doctrine remains sound.

A majority of courts consider the contra proferentem doctrine to be a pillar of insurance law. The doctrine requires ambiguous terms in an insurance policy to be construed against the insurer and in favor of coverage for the insured. A prominent rationale behind the doctrine is that insurance policies are usually standard-form contracts drafted entirely by insurers.

In certain cases, insurers have asserted two reasons for setting aside the contra proferentem doctrine: 1) the insured is a large, 'sophisticated' corporate entity which should not benefit from ambiguity in the policy when it had the bargaining power and/or expertise to modify the language; and 2) the insured actually participated in negotiating or drafting the policy and, therefore, should not benefit from ambiguity, when it is just as responsible as the insurer for any ambiguity that exists.

Insurers have invoked this 'sophisticated insured' defense frequently in the third-party insurance context, with mixed results. Compare , e.g. , Eagle Leasing Corp. v. Hartford Fire Insurance Co. , 540 F.2d 1257, 1261 (5th Cir. 1976), with CPS Chemical Co., Inc. v. Continental Insurance Co. , 536 A.2d 311, 318 (N.J. Super. Ct. App. Div. 1988). The defense has been less common in the first-party context, although there is no particular reason to believe that courts would treat the sophisticated insured defense differently in this context. The first-party cases discussed below show that insurers have invoked the sophisticated insured defense in first-party cases not only to persuade the court to set aside the contra proferentem doctrine, but also to convince the court to construe notice and suit-limitation provisions strictly against the insured.

First-Party Cases

Strict Application of the Sophisticated Insured Defense

In Baxter International, Inc. v. American Guarantee and Liability Insurance Co. , 861 N.E. 2d 263 (Ill. App. Ct. 2006), the insured, a global medical products manufacturer, sought coverage after a hurricane damaged its Puerto Rico facilities. The insurer, American Guarantee and Liability Insurance Co., indemnified Baxter in the amount of $30.7 million, which included the fair market value of Baxter's damaged finished goods inventory. American maintained that the $15 million lost profit component of its payment for lost inventory should reduce the amount it owed for Baxter's loss during the period of business interruption. Baxter disagreed. The trial court granted summary judgment for Baxter. Id. at 266.

On appeal, the court found the provisions that related to the calculation of losses under the policy to be ambiguous. Id. at 269. Because of Baxter's sophistication and substantial bargaining power, the court declined to apply the contra proferentem doctrine. The court explained: 'The anti-drafter rule is intended to aid the party with less bargaining power during the drafting process and is not appropriate where the parties are equally sophisticated.' Id. (emphasis added). Because the parties were on equal footing, the court relied on general principles of contract interpretation and held that American's indemnification payment for lost profits should reduce Baxter's business interruption claim. Id. at 271.

Another case in which the insured's sophistication was a dispositive
factor was Michael Foods, Inc. v. Allianz Insurance Co., No. 02-CV-3504 (JMR/FLN), 2003 U.S. Dist. LEXIS 7037 (D. Minn. Apr. 21, 2003). The insured, Michael Foods, had purchased all-risk insurance to protect its poultry operation. After two of its hen barns collapsed following a snowstorm, Michael Foods immediately notified the insurer, Allianz. Approximately six months later, Allianz denied coverage, citing faulty construction as the reason for the collapse. Michael Foods filed suit in August 2002, 18 months after the barn collapsed. Allianz moved for summary judgment, arguing that Michael Foods failed to comply with a policy provision that required it to bring suit within 12 months of discovery of the occurrence that gave rise to the claim.

It was clear that Michael Foods filed its lawsuit outside the unambiguous one-year limitations period. The key question was whether that period was reasonable. The court found Michael Foods to be a 'highly sophisticated company' that retained the assistance of an insurance broker and ”knew and understood the language of the policy.” Id. at *7-8 (emphasis added) (citation omitted). Thus, the court concluded that Michael Foods could have asked Allianz to waive the one-year limitations period or it could have filed suit as a 'prophylactic' measure after Allianz denied coverage. Id. at *8. Considering 'the sophistication of the plaintiff and its insurance broker,' the court held, 'there is no basis to find the one year clause unreasonable.' Id.

In Baxter, as in Michael Foods, the court equated commercial sophistication with equal bargaining power. By contrast, in the following cases, the courts accepted the sophisticated insured defense only when the insureds actually participated in the policy negotiation or drafting process.

Analysis of the Insured's
Actual Participation in Policy Drafting

In American Home Assurance Co. v. Merck & Co., Inc. , 386 F.Supp. 2d 501 (S.D.N.Y. 2005), the insurer denied coverage to pharmaceutical manufacturer, Merck & Co., Inc., for losses that resulted from damage to Merck's products while in transit. The parties cross-moved for summary judgment, with the dispute centering primarily on the interpretation of the policy's Control of Damaged Goods clause. Id. at 505-06. The court denied in part both parties' motions for summary judgment.

The court noted that contra proferentem 'does not apply where, as here, 'large corporations, advised by counsel and having equal bargaining power, are the parties to a negotiated policy[,]' … and where Merck itself may have supplied some of the critical language in the [p]olicy.' Id. at 512 (emphasis added). It did not explain how mere participation in the negotiation process guaranteed the insured equal bargaining power and equal influence over the policy's language. The same is also true of the following cases.

In Eastern Associated Coal Corp. v. Aetna Casualty & Surety Co. , 632 F.2d 1068 (3d Cir. 1980), a jury awarded the insured coal company more than $4.7 million under a business interruption policy for losses incurred after an underground fire forced the closing of a mine. The insured was forced to divert coal from other mines and purchase high-priced coal on the open market to satisfy its obligations under a supply contract. Aetna argued on appeal that the insured was not entitled to business interruption coverage for expenses incurred in fulfilling the supply contract.

Although the court found no ambiguity in the policy language, it indicated that, even if it had, it would not have applied the contra proferentem doctrine because of the insured's sophistication and its role in negotiating the policy. Id. at 1075-77. The court said, 'the principle that ambiguities in policies should be strictly construed against the insurer does not control the situation where large corporations, advised by counsel and having equal bargaining power, are the parties to a negotiated policy.' Id. at 1075 (emphasis added). The court observed that it was the insured's broker who selected the policy forms, prepared the policies, and sent them to the insurer for execution. Id. Because Pennsylvania law required the court to resolve ambiguities against the policy drafter, the court could not construe the language against Aetna, and determined that the insured's increased costs to fulfill the supply contract were not covered.

Similarly, in the following case, the court also rejected the contra proferentem doctrine after finding that the insured had actually drafted the relevant policy language.

In Newport Associates Development Co. v. Travelers Indemnity Company of Illinois , 162 F.3d 789 (3d Cir. 1998), the appellate court affirmed the district court's grant of summary judgment to the insurer, holding that an insurance policy covering a marina did not cover damage to a breakwater caused by a storm. The appellate court's decision turned on a provision in the insurance policy that covered '[s]lips ' and other integral parts collectively called 'slips. … ” Id. at 792. The insured argued that the phrase 'other integral parts' encompassed the breakwater. Travelers countered that the provision only applied to slips and their attached parts. The appellate court agreed with the district court that the policy was unambiguous and failed to cover the breakwater. Id. at 792-93. Nonetheless, the court went on to consider contra proferentem, rejecting Newport's contention that the policy should be construed against Travelers. It noted that the marina management company, which had the same corporate parent as the insured, had an independent broker procure the insurance policy for the marina. Id. at 791, 794. The broker met with a Newport employee to discuss the scope of coverage, drafted a policy with input from the Newport employee, and submitted it to Travelers. The Travelers policy incorporated verbatim the language recommended by the broker.

'[T]he crucial fact,' according to the court, was that Travelers 'did not unilaterally impose the policy on Newport.' Id. at 794. It continued, ”[t]he dispositive question is not whether the insured is a sophisticated corporate entity, but rather whether the insurance contract is negotiated, jointly drafted or drafted by the insured. In such instances, we conclude that the doctrine of contra proferentem should not be invoked to inure to the benefit of the insured.” Id. (emphasis added). Because the policy here was either drafted by the insured or could be considered to have been jointly drafted by the insured and insurer, the court found the insured could not rely on contra proferentem.

It should be noted that even if the sophisticated insured defense is accepted by the court based on the insured's actual contribution to the language of the policy, the insured may still prevail. See Fountain Powerboat Industries, Inc. v. Reliance Insurance Co. , 119 F.Supp. 2d 552 (E.D.N.C. 2000) (concluding that both parties shared equal bargaining power during the negotiation process and that there was no reason to construe ambiguous terms against Reliance, but still finding in favor of insured).

Rejection of the Sophisticated Insured Defense

On the other end of the spectrum, courts have disregarded the sophisticated insured defense and applied the contra proferentem doctrine even when the insured was a large, sophisticated corporation that contributed to the policy language.

In Northwest Airlines, Inc. v. Globe Indemnity Co. , 225 N.W. 2d 831 (Minn. 1975), the insured sought recovery under a blanket crime policy for losses it sustained when a plane was hijacked. The lower court determined that Northwest was entitled to recover under the policy because it found that there had been a wrongful abstraction of money from Northwest's premises. The Minnesota Supreme Court affirmed, finding the policy to be ambiguous and rejecting the insurer's argument that the contra proferentem rule was inapplicable because 'the policy at issue was the result of arm's-length negotiations between defendant and a sophisticated insured which was represented by its own insurance experts.' Id. at 837, n.2. The court noted that the specific provisions at issue were taken verbatim from a printed form supplied by the insurer. Id. at 837, n.2.

The Northwest Airlines case demonstrated a court's reluctance to discard the contra proferentem doctrine at the first sign of a commercially sophisticated insured. Instead, the court focused on the origin of the policy language at issue. The court in the next case took the same approach.

In General Mills, Inc. v. Gold Medal Insurance Co. , 622 N.W. 2d 147 (Minn. Ct. App. 2001), a captive insurer appealed a summary judgment ruling that found coverage for losses suffered by the insured food manufacturer after its grain stock was sprayed with an unapproved pesticide.

Before the contamination incident, General Mills had established Gold Medal, a wholly owned subsidiary, as its captive insurer. American Risk Management, an independent company, handled Gold Medal's essential services. Although 'General Mills had considerable bargaining power with respect to the terms of the various policies,' Id. at 150, American Risk Management drafted the language of the policies issued by Gold Medal to General Mills.

The appeals court emphasized that '[r]elatively equal bargaining power does not preclude application of the doctrine of contra proferentem,' and went on to affirm a number of the district court's holdings, including a holding that a contamination exclusion in the all-risk policy was ambiguous and that the insurer had not met its burden of proving that the exclusion applied. Id. at 152-53. Thus, even though General Mills demonstrated its sophistication by establishing a captive insurer, it could still benefit from the contra proferentem doctrine since it was not the drafter of the policy.

In the final case, the insured actually participated, in a limited way, in drafting the insurance policy. However, the court held that the insured's participation was not sufficient to warrant abrogation of the contra proferentem doctrine.

In In Re Environmental Insurance Declaratory Judgment Actions, No. UNN-L-08573-89 (N.J. Super. Ct. Law Div. May 11, 1992), Order and transcript reprinted in 6-27 Mealey's Litig. Rep. Ins. 6 (May 19, 1992), the insurers refused to cover damage to buildings and land owned by the insured, Westinghouse Electric Corporation, under Westinghouse's first-party property policies, so Westinghouse filed suit. The insurers argued that Westinghouse, with the help of its broker, had drafted the relevant language. The court noted that, '[a]lthough plaintiff may have indeed selected insurance coverage from a 'menu,' the items to choose from were standard fare in the industry. There is nothing unique about the wordings in the policy. The first-party policies here may hardly be defined as 'manuscript.” Transcript at 127. Therefore, the court concluded that the contra proferentem doctrine still applied. The case (which also involved issues under third-party policies) shows that an insured's mere participation in the policy drafting process within parameters set by the insurer does not necessarily mean that the insured has exerted the kind of influence over the policy language that would make contra proferentem inapplicable.

Conclusion

As is evidenced above, some courts have been receptive to the sophisticated insured defense in the first-party insurance context. A few have embraced the defense, but have not established a clear metric by which to judge the insured's sophistication. Furthermore, the assumption of these courts that commercial sophistication is the equivalent of equal bargaining power and expertise in insurance is simply not the case for many commercially sophisticated insureds. Insurers typically draft the insurance policy and have superior knowledge of the insurance industry, which allows them to frame policy language to limit the coverage provided to insureds.

For large commercially sophisticated insureds, having a 'risk management department,' even one with several employees, is no equal of any reasonably sized insurer. The risk manager has to procure coverage and administer claims under workers compensation, property, auto, directors' and officers' liability, and general liability policies. The insurer has a separate underwriting department and a separate claim department for each line of coverage. Thus, during the underwriting process, the insured is always represented by a jack-of-all-trades, who is matched up against a specialist. No matter how commercially sophisticated the insured and no matter how much the insured has participated in negotiations concerning the policy language, if the insurer is the party with the most influence over the policy language, as is usually the case, the rationale for applying the contra proferentem doctrine remains sound.