The Consequences of an Insurance Company's Breach

Thus, a policyholder should not be required to show that the expenses it incurred to mitigate its loss after the insurance company breached the policy are “covered” by the policy in order for them to be recoverable as contract damages. It is foreseeable that a policyholder facing a liability claim could suffer such harms as the costs of defense and a potentially adverse verdict, and therefore reasonable steps it takes to mitigate those costs after the insurance company has breached the policy. As a result, these costs should be recoverable, even if not “covered.”

For example, much ink has been spilled in environmental coverage cases about whether a Potentially Responsible Party letter from the EPA constitutes a “suit” for the purposes of an insurance company's duty to defend “suits” seeking damages. See, e.g., Johnson Controls, Inc. v. Employers Ins. of Wausau, 665 N.W.2d 257, 281-85 (Wis. 2003). But in those cases where the insurance company has breached the policy by denying coverage for the occurrence on other grounds that a court later rejects, if the policyholder's response to a PRP letter is a reasonable approach to mitigating the effect of this breach, the costs of that response should be recoverable as contract damages, even if the letter is not considered a “suit” covered under the policy. In Travelers Insurance Co. v. Chicago Bridge & Loan Co., 442 S.W.2d 888, 901 (Tex. Civ. App. 1969), for example, the court found the insurance company's denial to be an anticipatory breach, rendering even the “pre-suit” defense costs of the policyholder recoverable as contract damages: “Even though part of the expense was incurred prior to the filing of action, it was a reasonably necessary expense incurred in defense of the action.”

Pittsburgh Plate Glass Co. v. Fidelity and Casualty Co. of New York, 281 F.2d 538, 542 (3d Cir. 1960), also demonstrates that particular costs incurred by a policyholder to respond to a covered action after a denial need not be “covered” by the policy to be recoverable as mitigation damages. The court found that the insurance company's denial was a breach of the policy, rendering it “liable to the insured for all damages directly resulting to it from the refusal to defend.” Id. These damages included not only the costs of hiring outside defense attorneys, but also the costs attributable to the work done by the policyholder's own in-house lawyers, because those costs served to mitigate the defense fees of the outside firm. Id.

In some jurisdictions, a finding that the insurance company breached its duty to defend renders it liable for any subsequent settlements in the underlying action under its duty to indemnify, without further showing. See, e.g., Missionaries of the Co. of Mary, Inc. v. Aetna Cas. & Sur. Co., 230 A.2d 21, 26 (Conn. 1967). Other jurisdictions have rejected this rule, holding that coverage for a settlement must be addressed under the more stringent standards of the duty to indemnify, even if the insurance company has breached the duty to defend. See, e.g., Servidone Constr. Corp. v. Security Ins. Co. of Hartford, 477 N.E.2d 441, 444 (N.Y. 1985). Even where the costs of a settlement are not automatically treated as damages for the breach of a duty to defend, however, courts upholding general contract principles should still allow policyholders to recover such costs as damages for the breach of the duty to defend, if the settlement meets the standards of mitigation damages resulting from the insurance company's breach.

The New York appellate term recognized this principle nearly a century ago in Lawrence v. Massachusetts Bonding & Insurance Co., 160 N.Y.S. 883 (N.Y. Supr. App. Term 1916). In Lawrence, the insurance company denied coverage for a wrongful death action against the policyholder. Rather than defend the case through trial, the policyholder elected to settle the action for $500. Id. at 884. The insurance company argued that the policyholder could not recover the costs of the settlement without meeting the standards of proof for recovery following a breach of the duty to indemnify, which at that time required the policyholder to prove its own liability in the underlying action. The court rejected this argument, and held that the policyholder “may recover the amount so paid [in settlement] without such proof [of its own liability] when the settlement is no more than the reasonable cost of defending the action.” Id. at 886. The court held that in the case of a settlement for less than the probable cost of defense, the settlement amounts are “damages directly caused by the failure of the insurer to defend the action.” Id. A concurring opinion set forth a different formula for calculating damages for breach of the duty to defend in the context of a nuisance settlement: the projected cost of a full defense, capped at the settlement amount. Id. at 887 (Pendleton, J. concurring). Under either measure, the policyholder can recover the amount of the nuisance settlement, if it can prove that a full defense would have cost more.

Nothing in this holding is inconsistent with the Servidone court's later rejection of the Missionaries of Mary rule, as the Lawrence court acknowledged a higher standard existed for proving a breach of the duty to indemnify. Lawrence simply applied basic contract law principles to recognize that even a potentially uncovered settlement can represent recoverable mitigation costs from the breach of the duty to defend, if it avoided even higher defense fees. While Lawrence was decided nearly a century ago in a context of a single claim with a nuisance settlement of $500, nothing in its reasoning would render it inapplicable to the mass tort situations of the present, where it sometimes is reasonable for an insured to pay millions to settle thousands of claims, each for less than the costs of defending that particular action.

Consequential Damages

In addition to mitigation costs, a breaching party also can be liable for consequential damages flowing from its breach:

A breaching party is liable for damages which are the direct, probable, and proximate result of its breach. The measure of damages for breach of contract is limited by what is reasonably foreseeable at the time the contract was entered into. Indiana Ins. Co. v. Plummer Power Mower & Tool Rental, 590 N.E.2d 1085, 1092 (Ind. Ct. App. 1992) (citing, inter alia, Hadley v. Baxendale (1854), 9 Ex. 341, 156 Eng. reprint 145, 5 Eng. Rul. Cas. 502).

Under this standard, courts have recognized that a breaching insurance company may be liable for a variety of consequential damages, beyond merely paying the covered loss it owes, with interest. See, e.g., Plummer Power, 590 N.E.2d at 1092 (upholding an award of interest and expenses as consequential damages resulting from delay in payment for loss of policyholder's business premises); Lawrence v. Will Darrah & Assocs., Inc., 516 N.W.2d 43, 43, 49 (Mich. 1994) (upholding an award of lost profits as consequential damages from the insurance company's delay in paying for loss by theft of policyholder's commercial vehicle); Miholevich v. Mid-West Mut. Auto. Ins. Co., 246 N.W. 202, 203-04 (Mich. 1933) (upholding an award of consequential damages compensating policyholder for the “shame and mortification as well as loss of time” resulting from his imprisonment for six days after his liability insurance company refused to pay a judgment against him). See also Alan D. Windt, 2 Ins. Claims and Disputes ' 6:39 (5th ed. updated 2012) (collecting cases).

One common area of dispute is whether a showing of bad faith is required for a recovery of consequential damages. Under general contract damages principles, such a showing should not be required. If the damages are the direct, probable, and proximate result of the breach and are reasonably foreseeable at the time of contracting, there is no basis in contract law to add an additional requirement of bad faith. In Burleson v. Illinois Farmers Insurance Co., 725 F. Supp. 1489, 1499 (S.D. Ind. 1989), in fact, the court frankly acknowledged that its holding that a finding of bad faith was required to recover consequential damages was “not supported by a pure contractual analysis,” and relied instead on arguments from a “public policy standpoint.” In Plummer Power, the Court of Appeals of Indiana rejected Burleson's reading of Indiana law, and held that the normal standards for consequential damages apply to breach of insurance policies, “whether as a result of good or bad faith.” 590 N.E.2d at 1092.

The issue of whether bad faith is a prerequisite for recovery of consequential damages from an insurance company currently is actively being disputed in New York. After the New York Court of Appeals affirmed a policyholder's right to recover consequential damages in Panasia Estates, Inc. v. Hudson Insurance Co., 886 N.E.2d 135 (N.Y. 2008), and Bi-Economy Market, Inc. v. Harleysville Insurance Co. of New York, 886 N.E.2d 127 (N.Y. 2008), courts have split on whether these holdings apply only when the breach was in bad faith. New York's First Department, in a subsequent decision in Panasia, held that no such finding was required beyond the normal standards for proof of consequential damages. Panasia Estates, Inc. v. Hudson Ins. Co., 889 N.Y.S.2d 452, 452 (App. Div. 1st Dept. 2009). Certain federal district courts have reached the opposite conclusion. See, e.g., Goldmark, Inc. v. Catlin Syndicate Ltd., No. 09-CV-3876 (RRM) (RER), 2011 WL 743568 at *3 n.1 (E.D.N.Y. Feb. 24, 2011).

Insurance companies that breach their contracts should not be given special protections from the ordinary contract law consequences of their breach. While an appropriate showing of bad faith may be required to award damages beyond those traditionally available for breach of contract, it is well settled under general contract law that consequential damages may be recoverable regardless of whether the breach was committed in good or bad faith.

Traditional Breach of Contract Damages Are Not 'Extra-Contractual'

Insurance companies and some commentators often refer to mitigation costs, consequential damages, or any costs other than the direct amount of coverage owed as “extra-contractual” damages. As established above, this term is inaccurate ' those costs represent traditional items of contract damages. In particular, insurance companies tend to describe as “extra-contractual” any liability beyond a policy's limits for covered losses. Those limits, however, do not define the insurance company's breach of contract liability: “The policy limits restrict the amount the insurer may have to pay in performance of the contract, not the damages that are recoverable for its breach.” Lawton v. Great Sw. Fire Ins. Co., 392 A.2d 576, 579 (N.H. 1978); see also SunTrust Mortg., Inc. v. United Guar. Residential Ins. Co. of N. Carolina, 809 F. Supp. 2d 485, 494-96 (E.D. Va. 2011) (“SunTrust II“) (insurance company's liability for prejudgment interest for the breach of its duty to pay not limited by policy's limits of liability for payment of losses).

Indeed, even if a showing of a breach of the duty of good faith were required in order to recover consequential damages following an insurance company's breach of contract, these would still be “contractual damages,” as “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Restatement (Second) of Contracts ' 205 (1981).

The misuse of the term “extra-contractual” to describe what actually are traditional contract damages misleadingly suggests that those damages require some heightened showing for recovery. Moreover, use of this imprecise term in a contract can have significant legal consequences. In Pacificare Health Systems, Inc. v. Book, 538 U.S. 401, 406 n.1 (2003), for example, the U.S. Supreme Court held that a prohibition in a contract “against an arbitrator's awarding 'extracontractual' damages is ' ambiguous. This language might mean ' that an arbitrator is prohibited from awarding any damages other than for breach of contract. But it might only mean that an arbitrator cannot award noneconomic damages such as punitive or mental-anguish damages.”

Excuse of Policyholder's Performance

The availability of various measures of damages is not the only consequence to an insurance company found to be in breach of its coverage obligations. A breach of a contract, if material, also may excuse the performance of the other party. In the insurance context, this could arise when an insurance company that has denied coverage or otherwise is in breach of its obligations seeks to avoid coverage by arguing that, after breach, the policyholder then incurred costs or settled the underlying action without the insurance company's consent. Courts generally reject insurance company efforts to enforce such provisions in contracts they already have breached: “[C]laimant should not be required to approach his insurer, hat in hand, and request consent to settle with another when he has already been told, in essence, that the insurer is not concerned, and he is to go away.” Vision One, LLC v. Philadelphia Indem. Ins. Co., 241 P.3d 429, 434 (Wash. Ct. App. 2010) (quoting Stephens v. State Farm Mut. Auto. Ins. Co., 508 F.2d 1363, 1366 (5th Cir. 1975)). Some courts may reach this same result through other theories, such as waiver of conditions. See, e.g., U.S. Guar. Co. v. Liberty Mut. Ins. Co., 12 N.W.2d 59, 61 (Wis. 1944).

A particularly dramatic, recent application of the excuse of a policyholder's performance as a result of an insurance company's breach appears in SunTrust II, 809 F. Supp. 2d at 489-92. There, the court found the insurance company to have materially breached its obligation to pay the policyholder's loss under a mortgage policy covering numerous loans. As a consequence of that breach, the court not only ordered the insurance company to pay tens of millions of dollars of covered losses and interest, but also excused the policyholder from payment of more than $90 million in future premiums it otherwise would have owed under the policy.

What Is a Breach?

In light of the consequences from a finding of breach, it is important to determine what constitutes a breach by the insurance company. Obviously, a denial of coverage later determined to be incorrect can be a breach. Insurance companies, however, argue that a reservation of rights letter cannot be found to be a breach, as it is not a denial of coverage. See, e.g., First Am. Title Ins. Co. v. Nat'l Union Fire Ins. Co., 695 So. 2d 475, 477 (Fl. Dist. Ct. App. 1997). If that reservation, however, is not coupled with full performance of its obligations, the insurance company still would be in breach. As one court held, addressing a similar situation with an indemnification agreement: “Here, Federated suggested that it would defend under a reservation of rights. The problem, however, is that the [reservation of rights] letter was the last action taken. [The indemnitor and its insurer] did nothing further to act. In effect, the tender was rejected and [the indemnitee] was left to defend on its own.” Deminsky v. Arlington Plastics Mech., 657 N.W.2d 411, 426 (Wis. 2003). An insurance company that ultimately pays a loss still has breached, if its payments were not timely. See, e.g., SunTrust Mortg., Inc. v. United Guar. Residential Ins. Co. of N. Carolina, 806 F. Supp. 2d 872, 902 (E.D. Va. 2011).

Furthermore, “[w]hen performance of a duty under a contract is due any non-performance is a breach.” Restatement (Second) Contracts ' 235(2). Thus, an insurance company that pays for only part of a covered loss is in breach: “When performance is due, however, anything short of full performance is a breach, even if the party who does not fully perform was not at fault and even if the defect in his performance was not substantial.” Id. at cmt. b. An insurance company is in breach, for example, when it is paying for only a portion of the defense costs it owes, or when it is taking unjustified deductions from the amounts submitted.

In addition, a party commits “an anticipatory breach by making an express demand for a performance to which he or she is not entitled, as by, for example, a statement that the party will not perform except on conditions that go beyond the contract, or on terms different from the original contract.” 23 Williston on Contracts 63:47 (4th ed.) (footnotes omitted); see also Lombardi's Cucina, Inc. v. Harleysville Ins. Co., No. C09-1620-JCC, 2010 WL 3244908, *6 (W.D. Wash. Aug. 17, 2010) (such a demand constitutes a repudiation of the insurance policy). Thus, an insurance company is in breach when it offers to meet its obligation to defend only if the policyholder agrees to billing guidelines or rate caps not found in the policy. Similarly, an insurance company may also be in breach when it conditions a defense on the policyholder acquiescing to its assertion of a right to recoup defense payments if there is later determined to be no coverage. See, e.g., Am. & Foreign Ins. Co. v. Jerry's Sport Ctr., Inc., 2 A.3d 526, 544 (Pa. 2010) (“[T]he right Royal attempts to assert in this case, the right to reimbursement, is not a right to which it is entitled based on the policy.”).

While a breaching party is liable for contract damages resulting from its breach, to excuse future performance by the other party, the breach must be material. See, e.g., Metro. Nat'l Bank v. Adelphi Acad., 886 N.Y.S.2d 68, 2009 WL 1477998, *3 (N.Y. Sup. Ct. 2009).

Conclusion

Policyholders faced with a breach of contract by their insurance company may suffer harm that goes beyond the mere amount of the covered loss owed by the insurance company, including mitigation costs and consequential damages. These amounts should be recoverable upon the proper showing as required by general contract law principles, without the need to show that those particular costs would be “covered” by the policy, or within the policy limit that would apply had the insurance company performed its obligations. Moreover, these traditional items of contract damages should not require any heightened showing that the breach was in bad faith.

Michael T. Sharkey, a member of this newsletter's Board of Editors, is a partner with Perkins Coie LLP. He represents policyholders in insurance coverage cases nationwide.

A policyholder in an insurance coverage action generally seeks to prove that its costs were covered under the policies it purchased, and that its insurance company breached those policies. Under general contract law principles, however, a policyholder that establishes its insurance company was in breach need not necessarily show that particular costs were “covered” under the policy in order to recover them as contract damages resulting from the breach. Traditional items of contract damages such as mitigation costs and consequential damages can be recovered if they flow from the breach, even if those costs would not be “covered” by the policy or even fall within the policy's limits. Moreover, as traditional items of contract damages, recovery of such damages should not depend on any heightened showing of bad faith by the insurance company.

Mitigation Costs

When focusing on whether certain costs incurred by a policyholder are “covered,” parties and courts often overlook the fact that a policyholder can recover even “uncovered” costs, if it can establish that they are recoverable as costs mitigating an insurance company's breach. It is well settled that reasonable expenses incurred by the non-breaching party in an effort to mitigate harm that was reasonably foreseeable as a probable result of a breach are recoverable as damages for breach of contract. See, e.g., Spang Indus., Inc. v. Aetna Cas. & Sur. Co. , 512 F.2d 365, 371 n.7 (2d Cir. 1975). An important aspect of such mitigation efforts is that they need not be spelled out in the contract to be recoverable: “It is commonplace that parties to a contract normally address themselves to its performance and not to its breach or the consequences that will ensue if there is a default.” Id. at 369.

Thus, a policyholder should not be required to show that the expenses it incurred to mitigate its loss after the insurance company breached the policy are “covered” by the policy in order for them to be recoverable as contract damages. It is foreseeable that a policyholder facing a liability claim could suffer such harms as the costs of defense and a potentially adverse verdict, and therefore reasonable steps it takes to mitigate those costs after the insurance company has breached the policy. As a result, these costs should be recoverable, even if not “covered.”

For example, much ink has been spilled in environmental coverage cases about whether a Potentially Responsible Party letter from the EPA constitutes a “suit” for the purposes of an insurance company's duty to defend “suits” seeking damages. See, e.g., Johnson Controls, Inc. v. Employers Ins. of Wausau , 665 N.W.2d 257, 281-85 (Wis. 2003). But in those cases where the insurance company has breached the policy by denying coverage for the occurrence on other grounds that a court later rejects, if the policyholder's response to a PRP letter is a reasonable approach to mitigating the effect of this breach, the costs of that response should be recoverable as contract damages, even if the letter is not considered a “suit” covered under the policy. In Travelers Insurance Co. v. Chicago Bridge & Loan Co. , 442 S.W.2d 888, 901 (Tex. Civ. App. 1969), for example, the court found the insurance company's denial to be an anticipatory breach, rendering even the “pre-suit” defense costs of the policyholder recoverable as contract damages: “Even though part of the expense was incurred prior to the filing of action, it was a reasonably necessary expense incurred in defense of the action.”

Pittsburgh Plate Glass Co. v. Fidelity and Casualty Co. of New York , 281 F.2d 538, 542 (3d Cir. 1960), also demonstrates that particular costs incurred by a policyholder to respond to a covered action after a denial need not be “covered” by the policy to be recoverable as mitigation damages. The court found that the insurance company's denial was a breach of the policy, rendering it “liable to the insured for all damages directly resulting to it from the refusal to defend.” Id. These damages included not only the costs of hiring outside defense attorneys, but also the costs attributable to the work done by the policyholder's own in-house lawyers, because those costs served to mitigate the defense fees of the outside firm. Id.

In some jurisdictions, a finding that the insurance company breached its duty to defend renders it liable for any subsequent settlements in the underlying action under its duty to indemnify, without further showing. See, e.g., Missionaries of the Co. of Mary, Inc. v. Aetna Cas. & Sur. Co. , 230 A.2d 21, 26 (Conn. 1967). Other jurisdictions have rejected this rule, holding that coverage for a settlement must be addressed under the more stringent standards of the duty to indemnify, even if the insurance company has breached the duty to defend. See, e.g., Servidone Constr. Corp. v. Security Ins. Co. of Hartford , 477 N.E.2d 441, 444 (N.Y. 1985). Even where the costs of a settlement are not automatically treated as damages for the breach of a duty to defend, however, courts upholding general contract principles should still allow policyholders to recover such costs as damages for the breach of the duty to defend, if the settlement meets the standards of mitigation damages resulting from the insurance company's breach.

The New York appellate term recognized this principle nearly a century ago in Lawrence v. Massachusetts Bonding & Insurance Co. , 160 N.Y.S. 883 (N.Y. Supr. App. Term 1916). In Lawrence, the insurance company denied coverage for a wrongful death action against the policyholder. Rather than defend the case through trial, the policyholder elected to settle the action for $500. Id. at 884. The insurance company argued that the policyholder could not recover the costs of the settlement without meeting the standards of proof for recovery following a breach of the duty to indemnify, which at that time required the policyholder to prove its own liability in the underlying action. The court rejected this argument, and held that the policyholder “may recover the amount so paid [in settlement] without such proof [of its own liability] when the settlement is no more than the reasonable cost of defending the action.” Id. at 886. The court held that in the case of a settlement for less than the probable cost of defense, the settlement amounts are “damages directly caused by the failure of the insurer to defend the action.” Id. A concurring opinion set forth a different formula for calculating damages for breach of the duty to defend in the context of a nuisance settlement: the projected cost of a full defense, capped at the settlement amount. Id. at 887 (Pendleton, J. concurring). Under either measure, the policyholder can recover the amount of the nuisance settlement, if it can prove that a full defense would have cost more.

Nothing in this holding is inconsistent with the Servidone court's later rejection of the Missionaries of Mary rule, as the Lawrence court acknowledged a higher standard existed for proving a breach of the duty to indemnify. Lawrence simply applied basic contract law principles to recognize that even a potentially uncovered settlement can represent recoverable mitigation costs from the breach of the duty to defend, if it avoided even higher defense fees. While Lawrence was decided nearly a century ago in a context of a single claim with a nuisance settlement of $500, nothing in its reasoning would render it inapplicable to the mass tort situations of the present, where it sometimes is reasonable for an insured to pay millions to settle thousands of claims, each for less than the costs of defending that particular action.

Consequential Damages

In addition to mitigation costs, a breaching party also can be liable for consequential damages flowing from its breach:

A breaching party is liable for damages which are the direct, probable, and proximate result of its breach. The measure of damages for breach of contract is limited by what is reasonably foreseeable at the time the contract was entered into. Indiana Ins. Co. v. Plummer Power Mower & Tool Rental , 590 N.E.2d 1085, 1092 (Ind. Ct. App. 1992) (citing, inter alia , Hadley v. Baxendale (1854), 9 Ex. 341, 156 Eng. reprint 145, 5 Eng. Rul. Cas. 502).

Under this standard, courts have recognized that a breaching insurance company may be liable for a variety of consequential damages, beyond merely paying the covered loss it owes, with interest. See, e.g., Plummer Power, 590 N.E.2d at 1092 (upholding an award of interest and expenses as consequential damages resulting from delay in payment for loss of policyholder's business premises); Lawrence v. Will Darrah & Assocs., Inc. , 516 N.W.2d 43, 43, 49 (Mich. 1994) (upholding an award of lost profits as consequential damages from the insurance company's delay in paying for loss by theft of policyholder's commercial vehicle); Miholevich v. Mid-West Mut. Auto. Ins. Co. , 246 N.W. 202, 203-04 (Mich. 1933) (upholding an award of consequential damages compensating policyholder for the “shame and mortification as well as loss of time” resulting from his imprisonment for six days after his liability insurance company refused to pay a judgment against him). See also Alan D. Windt, 2 Ins. Claims and Disputes ' 6:39 (5th ed. updated 2012) (collecting cases).

One common area of dispute is whether a showing of bad faith is required for a recovery of consequential damages. Under general contract damages principles, such a showing should not be required. If the damages are the direct, probable, and proximate result of the breach and are reasonably foreseeable at the time of contracting, there is no basis in contract law to add an additional requirement of bad faith. In Burleson v. Illinois Farmers Insurance Co. , 725 F. Supp. 1489, 1499 (S.D. Ind. 1989), in fact, the court frankly acknowledged that its holding that a finding of bad faith was required to recover consequential damages was “not supported by a pure contractual analysis,” and relied instead on arguments from a “public policy standpoint.” In Plummer Power, the Court of Appeals of Indiana rejected Burleson's reading of Indiana law, and held that the normal standards for consequential damages apply to breach of insurance policies, “whether as a result of good or bad faith.” 590 N.E.2d at 1092.

The issue of whether bad faith is a prerequisite for recovery of consequential damages from an insurance company currently is actively being disputed in New York. After the New York Court of Appeals affirmed a policyholder's right to recover consequential damages in Panasia Estates, Inc. v. Hudson Insurance Co. , 886 N.E.2d 135 (N.Y. 2008), and Bi-Economy Market, Inc. v. Harleysville Insurance Co. of New York , 886 N.E.2d 127 (N.Y. 2008), courts have split on whether these holdings apply only when the breach was in bad faith. New York's First Department, in a subsequent decision in Panasia, held that no such finding was required beyond the normal standards for proof of consequential damages. Panasia Estates, Inc. v. Hudson Ins. Co. , 889 N.Y.S.2d 452, 452 (App. Div. 1st Dept. 2009). Certain federal district courts have reached the opposite conclusion. See, e.g., Goldmark, Inc. v. Catlin Syndicate Ltd., No. 09-CV-3876 (RRM) (RER), 2011 WL 743568 at *3 n.1 (E.D.N.Y. Feb. 24, 2011).

Insurance companies that breach their contracts should not be given special protections from the ordinary contract law consequences of their breach. While an appropriate showing of bad faith may be required to award damages beyond those traditionally available for breach of contract, it is well settled under general contract law that consequential damages may be recoverable regardless of whether the breach was committed in good or bad faith.

Traditional Breach of Contract Damages Are Not 'Extra-Contractual'

Insurance companies and some commentators often refer to mitigation costs, consequential damages, or any costs other than the direct amount of coverage owed as “extra-contractual” damages. As established above, this term is inaccurate ' those costs represent traditional items of contract damages. In particular, insurance companies tend to describe as “extra-contractual” any liability beyond a policy's limits for covered losses. Those limits, however, do not define the insurance company's breach of contract liability: “The policy limits restrict the amount the insurer may have to pay in performance of the contract, not the damages that are recoverable for its breach.” Lawton v. Great Sw. Fire Ins. Co. , 392 A.2d 576, 579 (N.H. 1978); see also SunTrust Mortg., Inc. v. United Guar. Residential Ins. Co. of N. Carolina , 809 F. Supp. 2d 485, 494-96 (E.D. Va. 2011) (“ SunTrust II “) (insurance company's liability for prejudgment interest for the breach of its duty to pay not limited by policy's limits of liability for payment of losses).

Indeed, even if a showing of a breach of the duty of good faith were required in order to recover consequential damages following an insurance company's breach of contract, these would still be “contractual damages,” as “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Restatement (Second) of Contracts ' 205 (1981).

The misuse of the term “extra-contractual” to describe what actually are traditional contract damages misleadingly suggests that those damages require some heightened showing for recovery. Moreover, use of this imprecise term in a contract can have significant legal consequences. In Pacificare Health Systems, Inc. v. Book , 538 U.S. 401, 406 n.1 (2003), for example, the U.S. Supreme Court held that a prohibition in a contract “against an arbitrator's awarding 'extracontractual' damages is ' ambiguous. This language might mean ' that an arbitrator is prohibited from awarding any damages other than for breach of contract. But it might only mean that an arbitrator cannot award noneconomic damages such as punitive or mental-anguish damages.”

Excuse of Policyholder's Performance

The availability of various measures of damages is not the only consequence to an insurance company found to be in breach of its coverage obligations. A breach of a contract, if material, also may excuse the performance of the other party. In the insurance context, this could arise when an insurance company that has denied coverage or otherwise is in breach of its obligations seeks to avoid coverage by arguing that, after breach, the policyholder then incurred costs or settled the underlying action without the insurance company's consent. Courts generally reject insurance company efforts to enforce such provisions in contracts they already have breached: “[C]laimant should not be required to approach his insurer, hat in hand, and request consent to settle with another when he has already been told, in essence, that the insurer is not concerned, and he is to go away.” Vision One, LLC v. Philadelphia Indem. Ins. Co. , 241 P.3d 429, 434 (Wash. Ct. App. 2010) (quoting Stephens v. State Farm Mut. Auto. Ins. Co. , 508 F.2d 1363, 1366 (5th Cir. 1975)). Some courts may reach this same result through other theories, such as waiver of conditions. See, e.g., U.S. Guar. Co. v. Liberty Mut. Ins. Co. , 12 N.W.2d 59, 61 (Wis. 1944).

A particularly dramatic, recent application of the excuse of a policyholder's performance as a result of an insurance company's breach appears in SunTrust II, 809 F. Supp. 2d at 489-92. There, the court found the insurance company to have materially breached its obligation to pay the policyholder's loss under a mortgage policy covering numerous loans. As a consequence of that breach, the court not only ordered the insurance company to pay tens of millions of dollars of covered losses and interest, but also excused the policyholder from payment of more than $90 million in future premiums it otherwise would have owed under the policy.

What Is a Breach?

In light of the consequences from a finding of breach, it is important to determine what constitutes a breach by the insurance company. Obviously, a denial of coverage later determined to be incorrect can be a breach. Insurance companies, however, argue that a reservation of rights letter cannot be found to be a breach, as it is not a denial of coverage. See, e.g., First Am. Title Ins. Co. v. Nat'l Union Fire Ins. Co. , 695 So. 2d 475, 477 (Fl. Dist. Ct. App. 1997). If that reservation, however, is not coupled with full performance of its obligations, the insurance company still would be in breach. As one court held, addressing a similar situation with an indemnification agreement: “Here, Federated suggested that it would defend under a reservation of rights. The problem, however, is that the [reservation of rights] letter was the last action taken. [The indemnitor and its insurer] did nothing further to act. In effect, the tender was rejected and [the indemnitee] was left to defend on its own.” Deminsky v. Arlington Plastics Mech. , 657 N.W.2d 411, 426 (Wis. 2003). An insurance company that ultimately pays a loss still has breached, if its payments were not timely. See, e.g., SunTrust Mortg., Inc. v. United Guar. Residential Ins. Co. of N. Carolina , 806 F. Supp. 2d 872, 902 (E.D. Va. 2011).

Furthermore, “[w]hen performance of a duty under a contract is due any non-performance is a breach.” Restatement (Second) Contracts ' 235(2). Thus, an insurance company that pays for only part of a covered loss is in breach: “When performance is due, however, anything short of full performance is a breach, even if the party who does not fully perform was not at fault and even if the defect in his performance was not substantial.” Id. at cmt. b. An insurance company is in breach, for example, when it is paying for only a portion of the defense costs it owes, or when it is taking unjustified deductions from the amounts submitted.

In addition, a party commits “an anticipatory breach by making an express demand for a performance to which he or she is not entitled, as by, for example, a statement that the party will not perform except on conditions that go beyond the contract, or on terms different from the original contract.” 23 Williston on Contracts 63:47 (4th ed.) (footnotes omitted); see also Lombardi's Cucina, Inc. v. Harleysville Ins. Co., No. C09-1620-JCC, 2010 WL 3244908, *6 (W.D. Wash. Aug. 17, 2010) (such a demand constitutes a repudiation of the insurance policy). Thus, an insurance company is in breach when it offers to meet its obligation to defend only if the policyholder agrees to billing guidelines or rate caps not found in the policy. Similarly, an insurance company may also be in breach when it conditions a defense on the policyholder acquiescing to its assertion of a right to recoup defense payments if there is later determined to be no coverage. See, e.g., Am. & Foreign Ins. Co. v. Jerry's Sport Ctr., Inc. , 2 A.3d 526, 544 (Pa. 2010) (“[T]he right Royal attempts to assert in this case, the right to reimbursement, is not a right to which it is entitled based on the policy.”).

While a breaching party is liable for contract damages resulting from its breach, to excuse future performance by the other party, the breach must be material. See, e.g., Metro. Nat'l Bank v. Adelphi Acad. , 886 N.Y.S.2d 68, 2009 WL 1477998, *3 (N.Y. Sup. Ct. 2009).

Conclusion

Policyholders faced with a breach of contract by their insurance company may suffer harm that goes beyond the mere amount of the covered loss owed by the insurance company, including mitigation costs and consequential damages. These amounts should be recoverable upon the proper showing as required by general contract law principles, without the need to show that those particular costs would be “covered” by the policy, or within the policy limit that would apply had the insurance company performed its obligations. Moreover, these traditional items of contract damages should not require any heightened showing that the breach was in bad faith.

Michael T. Sharkey, a member of this newsletter's Board of Editors, is a partner with Perkins Coie LLP. He represents policyholders in insurance coverage cases nationwide.