Tenth Circuit Rules Against Insurer and Decides That Appraisers Can Decide Causation

Karl Schulz | Cozen O’Connor

In the continuing saga of what can and cannot be appraised in a property insurance appraisal, the Tenth Circuit, in contrast to many other courts, has ruled appraisers can determine coverage issues.

In Bonbeck Parker, LLC v. Travelers Indem. Co. of Am., 2021 U.S. App. LEXIS 29607 (10th Cir. October 1, 2021), a hailstorm damaged three buildings covered under a commercial property insurance policy.  A dispute between the insured and insurer arose over whether the hailstorm caused all of the damage claimed.  The insurer paid some of the claimed damage, but denied coverage for other claimed damage, asserting that it was caused by non-covered causes such as wear and tear.  The insured invoked appraisal. 

The insurer asserted that it would only participate in appraisal under certain conditions.  The insurer wanted to limit the appraisal only to undisputed hail damages.  Thus, the appraisal panel would be limited to deciding how much repairs would cost but not what caused the roofs to require repairs in the first place.  The insured objected. 

The insurer filed a declaratory judgment action.  On summary judgment, the district court sided with the insured and agreed that the appraisal clause allows appraiser to determine causation.  The parties had other disputes, but this blog entry focuses on the causation issue within appraisal.

The Tenth Circuit made an “Erie Guess” as to how the Colorado Supreme Court would rule on the issue.  The district court and Tenth Circuit focused on the appraisal clause’s statement that, if there is a disagreement as to the “amount of loss,” either party can demand appraisal of the loss.  The Tenth Circuit observed that “amount of loss” was not defined in the policy and consulted dictionary definitions.  The Tenth Circuit cited various definitions of “loss,” such as “the amount of an insured’s financial detriment by… damage that the insurer is liable for.”  The Tenth Circuit concluded that all of the definitions included a causation component.  Further, the Tenth Circuit surveyed case law from Minnesota, Iowa, and Delaware.  Perhaps the most emphatic citation was from an Iowa intermediate appellate court that held: “causation is an integral part of the definition of loss, without consideration of which appraisers cannot perform their assigned function.”

The Tenth Circuit rejected various arguments by the insurer.  For example, the insurer noted that the appraisal clause gives the insurer the right to deny coverage even after the appraisal is complete.  The insurer argued that denial could be based on any ground available in the policy, including that the damage resulted from an excluded cause of loss.  The insurer argued that the court could not give effect to the plain meaning of the sentence if the appraisal panel determines causation. 

The Tenth Circuit reasoned that the insurer’s argument could not be reconciled with the plain meaning of “amount of loss.”  The Tenth Circuit opined that “amount of loss” explained subjects on which the parties may request appraisal, while the “right to deny” concerns the insurer’s options after an appraisal on one of those subjects. 

Also for example, the Tenth Circuit rejected an argument by the insurer that the term “appraiser” reflected an intent to limit that person to making monetary determinations, thus precluding causation determinations.  The Tenth Circuit opined that determining the value of something includes a causation element because that “something” is the “amount of loss.”     

In conclusion, the Tenth Circuit cited the leading case from the Texas Supreme Court, State Farm Lloyds v. Johnson, 290 S.W.3d 886, 892 (Tex. 2009):

As the Texas Supreme Court observed, that kind of causation issue arises “in every case,” and if “appraisers can never allocate damages between covered and excluded perils, then [they] can never assess hail damage unless a roof is brand new.” Id. at 892-93. Such a result “would render appraisal clauses largely inoperative, a construction we must avoid.” Id. at 893. Other district-court decisions have recognized as much, and we find their reasoning persuasive. See, e.g., Auto-Owners Ins. Co. v. Summit Park Townhome Ass’n, 100 F. Supp. 3d 1099, 1103 (D. Colo. 2015).

Notably, the Texas Supreme Court in Johnson also opined as follows in what has become an oft-cited headnote:

Indeed, appraisers must always consider causation, at least as an initial matter. An appraisal is for damages caused by a specific occurrence, not every repair a home might need. When asked to assess hail damage, appraisers look only at damage caused by hail; they do not consider leaky faucets or remodeling the kitchen. When asked to assess damage from a fender-bender, they include dents caused by the collision but not by something else. Any appraisal necessarily includes some causation element, because setting the “amount of loss” requires appraisers to decide between damages for which coverage is claimed from damages caused by everything else.

This of course does not mean appraisers can rewrite the policy. No matter what the appraisers say, State Farm does not have to pay for repairs due to wear and tear or any other excluded peril because those perils are excluded.

Johnson, 290 S.W.3d at 893. 

In a footnote, the Tenth Circuit cited authorities from the Supreme Courts of Alabama and Mississippi holding that appraisers cannot resolve causation issues.  The Tenth Circuit did not get into the rationales of those other courts, but stated that its decision was based on a conclusion of how the Colorado Supreme Court would resolve the issues.

The Tenth Circuit held that the district court properly granted summary judgment for the insured on its claim that the insurer breached the policy when it refused to allow the appraisal to proceed. 

Under Bonbeck, although appraisers may consider causation, the insurer was not wrong to be concerned that the appraisal process would be abused to sweep everything that was wrong with the insured’s buildings into the appraisal, resulting in an award that the insurer would be pressured to pay in full regardless of coverage.  It will be interesting to see how Bonbeck is applied and if a Colorado state court adopts the reasoning and its holding. 

Court in Montana Applies Anti-Concurrent Causation Clause to Earth Movement Exclusion

Alycen A. Moss and Elliot Kerzner | Property Insurance Law Observer

A district court in Montana recently applied an anti-concurrent clause in a property insurance policy to preclude coverage based on an earth movement exclusion. In Ward v. Safeco Ins. Co. of Amer., No. 1:19-CV-0133-SPW, 2021 WL 3492294 (D. Mont. Aug. 9, 2021), the insured’s tenant reported that water was leaking from a main pipe serving the insured’s property, and the leak caused some soft spots to form in the floor of the kitchen. The insurer and agent’s subsequent inquiries led to the understanding that a leak under a slab affected the soil, which caused the house to settle, which then caused damage to the house.

The insurer then retained an engineering firm to investigate the insured’s claim. Following an inspection of the property, the engineering firm reported that a portion of the cracks in the concrete perimeter were not new and were caused by the shape of the structure on which the house sat. As to the newer cracks in the foundation, the firm concluded that the settlement could have been caused by a lack of care taken to make sure the foundation was supported by consolidated soil during the excavation of the new water line.

Based on the engineering report, the insurer determined that coverage for the damage was precluded by the policy’s earth movement and water damage exclusions, and denied the claim. The insured then filed a claim with the Montana Commissioner of Securities and Insurance, which provided the insurer with a report from a structural engineer stating that the water line break was the cause of the soil settlement resulting in the floor slab settlement. The insurer stood by its position that the damage was not covered, and the insured sued for coverage in a Montana district court.

In her lawsuit, the insured argued that the exclusions relied on by the insurer were ambiguous. In particular, she contended that the earth movement exclusion was limited to large earth events. However, the court rejected the insured’s arguments, holding that the policy’s earth movement exclusion was unambiguous and applied to any earth movement, no matter how small. The court further held that the term “earth” was clearly intended to include all natural materials that comprise the surface of the earth, including rocks and soil.

The insured further argued that the loss should be covered pursuant to Montana’s proximate cause doctrine, which mandates coverage for excluded events when those events are caused by a covered peril. Even if there was earth movement, the insured contended that the proximate cause of the damage was the breaking of the water main, a covered peril.

The court rejected this argument based on the policy’s anti-concurrent clause, which stated that the insurer would not cover “loss caused directly or indirectly by any of the following [exclusions] . . . regardless of any other cause or event contributing concurrently or in any sequence to the loss.” Because the consolidation and shifting of the soil – an excluded peril – caused the claimed damage, coverage was precluded by the earth movement exclusion even if the damage was also caused by a covered peril. Accordingly, the court granted summary judgment to the insurer.

Under Ward, insurers in Montana can now rely on anti-concurrent causation clauses to deny coverage for property damage caused by an excluded peril, such as earth movement, even when the excluded peril is caused by a covered peril, such as a broken water pipe. Although Montana generally follows the proximate cause doctrine, parties may contract around this doctrine by including an anti-concurrent causation clause in their policies. As Ward demonstrates, a properly worded anti-concurrent causation clause serves to preclude coverage for excluded perils even when a covered peril may be the proximate cause of the loss.

Identifying and Accessing Coverage in Complex Construction Claims

Jeffrey J. Vita and Michael V. Pepe | Saxe Doernberger & Vita

I. Introduction

First-party, third-party, builder’s risk, professional liability, commercial general liability, wrap-ups, and additional insured status are all potential sources of insurance coverage for a large construction loss. Therefore, it is critical for construction industry participants, from owners and developers to general contractors and their subcontractors, to have a functional knowledge of the different types of insurance coverage available to them and how those coverages intersect to respond to a loss. This paper presents a brief overview of the various types of coverage available to contractors, construction managers, and owners in a large construction loss and the risks each coverage is designed to insure.

In general, there are two forms of coverage: (1) First-party liability coverage, which protects an insured’s own losses on a project during construction; and (2) Third-party liability coverage, which insures the project participants for losses that become the subject of claims or suits brought against the project participants by third parties. When a loss occurs, such as property damage, both types of coverage can be implicated. For example, if a fire burns down a building under construction, the contractor likely would incur first-party losses such as cleanup costs. The contractor may also have third-party exposure if the owner alleges that the contractor was responsible for the fire. On the other hand, when a bodily injury occurs, all losses to the contractor will be third-party losses. A broad overview of each of these policies is provided below.

II. First-Party Insurance Coverage for Construction Projects

First-party coverage protects the insured or its property against a covered loss.

A. Builder’s Risk Builder’s risk is a form of commercial property policy that provides coverage for direct physical loss to the construction project while it is being built. Unlike liability policies, builder’s risk coverage does not require a claim or suit to be brought against the insured to trigger coverage. Rather, builder’s risk policies provide first-party coverage, i.e., coverage for the insured’s own property (the building that is being constructed), typically along with any materials and fixtures to be incorporated into the finished project.

Generally, builder’s risk policies are written on either an “all-risk” (often referred to as “special form” policies) or “named peril” basis. All-risk policies provide the broadest coverage. All-risk policies typically insure against all risks of loss except those specifically excluded. Most jurisdictions that have analyzed all-risk policies have held that all-risk policies cover all fortuitous losses, which cause some form of physical alteration to covered property.1 Some courts have gone a step further by not requiring any actual physical damage or alteration of property to trigger coverage.2 Courts agree that the initial burden of showing that coverage is triggered is on the insured. This is generally satisfied by proving that there was a fortuitous loss to covered property. Then the burden shifts to the insurer to prove that an exclusion unambiguously applies.3

In contrast, “named peril” policies insure against only those losses caused by a specifically listed peril or cause of loss. Named peril policies typically include coverage for fire, windstorms and hail, flood, earthquake, and other specific risks. The insured has the burden of proving that one of the listed perils caused its loss to obtain coverage.4 Generally speaking, policyholders prefer broad all-risk coverage for construction projects; however, all-risk coverage is more costly than named peril coverage and may not be feasible for every project.

Builder’s risk insurance policies vary widely. Insurance Services Office (“ISO”) has developed a standardized builder’s risk form (CP 00 20), but most carriers nonetheless choose to write builder’s risk policies on their own forms. Also, many policyholders look to the London markets for coverage. Because of the variation in terms, policyholders must carefully review their policies to ensure that they receive the coverage they expect.5

One area to pay particular attention to is who is insured under a builder’s risk policy. An owner may choose not to insure any contractors or only the prime contractor, when the owner purchases a builder’s risk policy. When an owner negotiates with the prime contractor for the prime contractor to purchase a builder’s risk policy, the prime contractor will often require that the owner, as well as upstream parties and lenders, be added as additional insureds. It is possible that a builder’s risk policy may insure only the party that purchased the policy or every party in the contractual chain from the landowner to the lowest tier subcontractor. In addition, most policies limit an insured’s status to the scope of their insurable interest in the project. Thus, a subcontractor may only have coverage for its own work or materials.

Perhaps one of the biggest impacts of who is an insured under a builder’s risk policy is related to subrogation. Parties must be very careful in drafting waivers of claims and waivers of subrogation with respect to first-party losses covered under a builder’s risk policy. Suppose a party that is an insured under a builder’s risk policy has not waived claims against a downstream party, and the downstream party is not an insured under the builder’s risk policy. In that case, the builder’s risk insurer may bring a subrogation claim against the downstream party if the downstream party caused the property damage for which a claim was paid.6 In this situation, the downstream party may be surprised to find out it has liability even though a builder’s risk policy was in place. This example illustrates the importance of carefully drafting risk transfer provisions and reviewing them in conjunction with the insurance that is purchased to ensure the risk transfer mechanisms work as intended.

Finally, it is important to be mindful of the temporary nature of builder’s risk insurance. Builder’s risk coverage ceases once construction is completed. Thereafter, the owner must procure appropriate property insurance to cover operations at its new premises. Some policies call for a specific expiration date of coverage, while others automatically terminate upon occupancy of the project, whether in whole or in part. This may cause a coverage issue if the project contemplates a phased roll-out or if the owner otherwise decides to start its business operations in one area of the project before the entire project is complete. Therefore, builder’s risk policyholders must work with their insurers to ensure that there is no gap in coverage in these scenarios. If there is an overlap, there are appropriate “other insurance” provisions to establish priority clearly.

B. Subcontractor Default Insurance Subcontractor Default Insurance (“SDI”) is a first-party coverage that indemnifies an insured contractor for losses resulting from a subcontractor’s default. SDI insures the cost of completing the work, the cost of correcting defective/non-conforming work, legal and other professional expenses, costs incurred in the investigation, adjustment, litigation, and defense of disputes related to the default and other expenses as set forth in the policy. SDI is often considered an alternative product to performance bonds and differs from such bonds in several respects:

SDI is a two-party insurance agreement between Contractor and Insured as opposed to a three-party guarantee arrangement between bonding company, subcontractor, and contractor. The Contractor prequalifies the subcontractors as opposed to the bonding company. Coverage extends to the policy limit, unlike a bond which is limited to the value of the contract. The insurer responds quickly to the claim as opposed to the bonding company, which can take considerable time to investigate the claim.

III. Third-Party Liability Insurance for Construction Projects

Third-party coverage protects the insured against claims made against it. The person or entity making the claim is the third party that suffered some loss for which it seeks to hold the insured liable.

A. Commercial General Liability Insurance Commercial General Liability (“CGL”) insurance is the most common form of third-party liability insurance purchased by businesses, including those operating in the construction industry. CGL policies are meant to provide the policyholder “with the broadest possible spectrum of protection and to transfer to the insurer the risk of all liabilities for unintentional and unexpected personal injury or property damage arising out of the conduct of the insured’s business.”7

CGL policies are primarily a standardized product, written on a form drafted (and periodically revised) by the ISO (form number CG 00 01). The standard policy form provides coverage for “those sums that the insured becomes legally obligated to pay as damages” because of “bodily injury” or “property damage” caused by an “occurrence,” or because of “personal and advertising injury,” which takes place within the coverage territory during the policy period.8 Standard CGL coverage applies to the insured’s operations nationwide. It is common, however, for construction project participants to purchase a specific CGL policy to cover a single project, such as wrap-up insurance policies which are discussed in more detail below.

CGL insurers have two key duties to their insureds in the event of a covered loss. The first key duty is the insurer’s duty to defend. In practice, the insurer’s duty to defend means that it will retain an attorney on the insured’s behalf when the insured is made party to a lawsuit or claim. This duty to defend may convert to a duty to reimburse,9 or the insured may have the right to select their own counsel, which the insurer pays in cases of a conflict of interest.10 The duty to defend, which essentially functions as “litigation insurance,”11 is typically provided outside of the policy’s limits of liability, meaning that all costs the insurer expends in defense of its insured will not count towards reducing or exhausting the per-occurrence or aggregate limits of liability. Whether an insurer has a duty to defend a given claim is dependent on the policy terms and state law. Most jurisdictions recognize that the duty is broad and is triggered whenever a claim is alleged against the insured that has the potential to invoke coverage under the policy, including those claims which may appear groundless, fraudulent, or false.12

The second key duty is the insurer’s duty to indemnify their insureds from any covered legal liability. Whereas the duty to defend depends on filing a suit against the insured,13 the duty to indemnify is typically triggered by entry of a final judgment, settlement, or other means of final resolution.14 “In short, whereas the duty to defend is measured by the allegations of the underlying complaint, the duty to indemnify is measured by the facts as they unfold at trial or are inherent in the settlement agreement.”15

Parties to construction contracts also may shift their risk by requiring “additional insured” status on another party’s CGL insurance. More specifically, an “upstream” party (e.g., an owner or general contractor) will require in its subcontracts that all “downstream” parties (e.g., subcontractors and suppliers) provide the upstream party with additional insured status on the downstream parties’ CGL insurance. Parties may specify terms such as limits of liability, coverage triggers, and scope of additional insured status. There are several benefits to additional insured status. First, the additional insured is typically entitled to the same coverages under the CGL policy as the named insured, subject to the “triggering” language of the additional insured endorsement, which usually requires some causal connection between the named insured’s work and the additional insured’s liability.16 Second, the upstream party protects its own insurance program by shifting risk from the upstream party’s insurance to the downstream party’s insurance. The upstream party’s limits are not exhausted, and the loss does not count against its loss/claim history. This benefits the upstream party because it avoids the possible negative impact on insurability or increased premiums on future policies.

B. Excess Liability and Umbrella Coverage For many construction projects, the project participants’ risk of potential liability exceeds the amount of coverage available on a primary basis. Accordingly, policyholders often purchase excess and umbrella insurance policies, which provide coverage over and above the insured’s primary insurance. Excess and umbrella coverage responds only once the primary policy or policies have paid their limits of insurance.17 Excess and umbrella insurance, though both purchased to meet this need, differ in function.18

Excess insurance applies only after a set amount of primary insurance exhausts. There are many types of excess forms. Some excess policies strictly “follow form” to the designated underlying policy, except for items specific to the excess policy (e.g., limits and policy period). The policyholder enjoys the same or substantially similar coverage from the first dollar of primary coverage to the last dollar of excess coverage. Other excess policies may only follow form for specific items but not for others. For example, excess policies may contain their own terms that apply to the excess coverage, which may not match all terms of the primary policy.19 As a general rule, excess coverage will not be broader than the underlying primary coverage.

Umbrella insurance is a subset of excess insurance that provides potentially broader coverage than what is provided by the underlying policy. An umbrella policy performs two key functions: (1) it provides an additional layer of insurance for losses that are generally covered by primary insurance; and (2) it provides additional coverage for those less common liabilities that are not usually covered by primary CGL insurance (e.g., malpractice coverage). Thus, umbrella coverage is often considered a hybrid contract, which combines “aspects of both a primary contract and a following form excess insurance contract.”20

C. Wrap-Up Insurance Policies It has become increasingly common for contractors and owners to purchase some form of consolidated or “wrap-up” insurance policy covering the project and all or some of the project participants. Wrap-ups consolidate what would otherwise be multiple policies held by the owner, general contractor/construction managers, and subcontractors into a single, unified insurance program.21 Most often, a wrap-up includes CGL and excess/umbrella insurance; although, a wrap-up may also include workers’ compensation insurance. A wrap-up is usually procured by either the owner (an “Owner Controlled Insurance Program” or “OCIP”) or the general contractor (a “Contractor Controlled Insurance Program” or “CCIP”). All project participants performing on-site work, with a few notable exceptions,22 are typically included as insureds on the wrap-up policies and have equal rights to coverage thereunder. Wrap-up policies provide many advantages to both the entity procuring the coverage and the other project participants. Given the economies of scale involved, the procuring party typically has greater bargaining power with potential insurers. As a result, it can often secure better coverage terms than any one party could obtain on its own. This is particularly important in jurisdictions where subcontractors struggle to procure quality coverage (whether due to poor insurance markets or lack of sophistication). In a “traditional” (i.e., non-wrap) project, the upstream parties must rely on downstream parties to secure appropriate coverage that will protect them as an additional insured. Procuring a wrap-up alleviates this concern. The party sponsoring the wrap-up controls the coverage it procures.

D. Professional Liability Insurance Professional liability insurance is another type of third-party liability coverage that is particularly important to construction project participants performing some form of design or engineering services. Most CGL policies specifically exclude, by endorsement, coverage for bodily injury or property damage “arising out of the rendering of or failure to render professional services.”23 Professional liability insurance is intended to dovetail with this exclusion, providing broad coverage for any kind of act or service that arises out of specialized knowledge, skill, or labor that is predominantly intellectual.24 Although design professionals are not generally required by law to purchase and maintain professional liability insurance; most project owners require that they do to ensure there is an adequate means to respond to a loss caused by a breach of their professional services contract.25

Typically, professional liability insurance is supplied on a “claims-made” basis. This means that the policy will respond to claims first made against the insured during the period when the policy is in effect.26 When a claim is “made” for purposes of triggering coverage, it is often defined as when the insured receives a demand for money or services or is made party to a lawsuit.27 Professional liability policies frequently include a “retroactive date,” a date in the past that cuts off coverage for claims that result from wrongful acts or omissions which took place prior to that date, regardless of whether the claim is made during the policy period. It is critical that construction industry policyholders ensure the retroactive date pre-dates the start of their services or work on the project to avoid incurring a gap in coverage.

Finally, additional insured status is not available on professional liability insurance, so upstream parties should not expect that project consultants can supply the upstream parties with that coverage. There are, however, specialized products available for those project participants who may be concerned about incurring liability on a vicarious basis for the errors and omissions of their consultants. Those products are known as owner’s or contractor’s protective indemnity policies. These protective indemnity policies are a source of recovery for losses incurred by a contractor or owner because of a consultant’s professional negligence.

E. Other types of Coverage Other lines of insurance coverage that may be implicated in a large construction project include, but are not limited to:

Pollution Liability Protects against injury or damage caused by pollution, which is generally excluded under CGL policies. Pollution liability policies can provide coverage for both first-party and third-party losses. Pollution liability policies are often “claims-made” policies, meaning that coverage expires when the project is completed. However, insureds can often purchase a “tail” to provide continued coverage after project completion.

Workers Compensation Worker’s compensation is a type of first-party insurance that protects an insured’s injured workers and limits the insured’s liability for claims.

Business Auto Policy The Business Auto Policy (“BAP”) is an ISO commercial auto policy that provides coverage for both auto liability and physical damage. Auto liability insurance covers third-party loss resulting from accidents caused by vehicles used in the policyholder’s business. Auto physical damage insurance covers first-party loss resulting from loss events, which include, but are not limited to, collisions, hail, theft, and vandalism.

Policyholders may expand coverage available under a BAP by endorsement.

Cyber Cyber risk insurance provides both first-party loss and third-party liability coverage for data breach events, privacy violations, and cyber-attacks. There are variations in the types of cyber insurance policies available; however, cyber insurance generally provides risk shifting for costs associated with having to respond, investigate, defend, and mitigate loss arising from a cyber-attack.

Inland Marine Originally covering ocean materials and vessels, inland marine insurance has expanded to cover various types of property, including tools and mobile equipment at or in transit to a project site.

“Rip and Tear” Third-party coverage insuring contractors from costs to remove and replace defective work.

Crisis Management First-party coverage that protects the contractor for professional responsibility and response costs in a publicized event.

IV. Conclusion In any given construction project, policyholders are faced with a multitude of potential risks. It is critical that policyholders carefully consider and evaluate potential risks in determining which types and amounts of insurance coverage will provide the best protection from those risks. Parties to a construction contract should first obtain some form of first-party insurance: generally, a builder’s risk policy, to protect the property of the insured during the project, and some form of third-party insurance, generally in the form of a CGL policy, to protect parties in the case of third-party claims In addition to those policies, policyholders should consider the advantages of obtaining additional insurance, such as (1) excess coverage to cover losses that exceed the limits of the primary policy; (2) professional liability coverage, to cover risks relating to the performance of a specialized or design-related nature; (3) pollution liability coverage, to cover any risks associated with the release of contaminants and/or mold; (4) a performance bond, to ensure completion of the project; and/or (5) SDI insurance to cover risks associated with subcontractor default.

Once policyholders have obtained coverage for their construction project, they should carefully maintain records evidencing that coverage. Because most third-party coverage is “occurrence” based, policies may still hold value years after the construction project is completed. If policyholders do not carefully maintain records, they may find themselves in a position, years after project completion, where they are forced to pay out-of-pocket because there is no record of the policy in place for that year. Thus, policyholders should carefully evaluate what coverage is necessary and maintain records of that coverage in case of future claims.

Insurers Need to Do Their Homework: Review of the Use of Data, Algorithms, and Predictive Models

Jamie Bigayer and Ann Young Black | Carlton Fields

On July 6, 2021, the governor of Colorado signed Senate Bill 21-169 prohibiting insurers’ use of external consumer data and information sources (external data), as well as algorithms and predictive models using external data (technology) in a way that unfairly discriminates based on race, color, national or ethnic origin, religion, sex, sexual orientation, disability, gender identity, or gender expression (protected status). Bill 21-169 notes that while these tools may simplify and expedite certain insurance practices, “the accuracy and reliability of external consumer data and information sources can vary greatly, and some algorithms and predictive models may lack a sufficient rationale for use in insurance practices.” New section 10-3-1104.9 becomes effective on September 6, 2021, and any rules adopted by the insurance commissioner may not be effective before January 1, 2023.

Section 10-3-1104.9 requires the commissioner to adopt rules based on the different insurance types and insurance practices, which is defined as “marketing, underwriting, pricing, utilization management, reimbursement methodologies, and claims management in the transaction of insurance.” To do so, the commissioner is required to call on stakeholders and to consider factors and processes relevant to each type of insurance.

This means insurers must start their homework early so they can be ready to explain to the commissioner what data they use; from whom the data is obtained; how it is used, including whether it is used as part of an algorithm or predictive model; and whether the use of the data results in unfair discrimination as defined in section 10-3-1104.9(8)(e).

Required Rulemaking Under Section 10-3-1104.9

From the stakeholder information, the commissioner is required to adopt rules imposing reporting and governance obligations on insurers.

  • Reporting Rules – These rules must seek information on (i) an insurer’s use of external data in the development and implementation of technology; (ii) the manner in which the insurer uses external data; and (iii) the manner in which the insurer uses technology. The information is to be reported by type of insurance and insurance practice.
  • Governance Rules – These rules must require insurers to (i) establish and maintain a risk management framework reasonably designed to determine, to the extent practicable, whether the insurer’s use of external data and technology unfairly discriminates against a protected status; (ii) assess the risk management framework; and (iii) obtain officer attestations as to the implementation of the risk management framework. 

In adopting the required rules, the commissioner must (i) consider the impact of any rules on the solvency of insurers; (ii) provide a reasonable time for insurers to remedy any unfair discrimination impact of any employed technology; and (iii) provide a means by which insurers can use external data and technology that the insurance division has found not to be unfairly discriminatory.

Questions Raised by Section 10-3-1104.9

As part of the rulemaking process, insurers may want to raise their hands to ask questions on section 10-3-1104.9. Some questions  include:

What is unfair discrimination?

In response to industry concerns regarding the definition of unfair discrimination, section 10-3-1104.9(8)(e) imposes a three-prong test:

  • The use of external data or technology has a correlation to a protected status;
  • The correlation results in a disproportionately negative outcome for such protected status; and
  • The negative outcome exceeds the reasonable correlation to the underlying insurance practice, including losses and costs for  underwriting.

To better understand this three-prong test, insurers at the stakeholder meetings should seek clarification. For example:  

  • How is the correlation between the use of the external data or technology and the protected status determined?
  • How can an insurer test for the correlation, when section 10-3-1104.9(7)(a) makes clear that insurers are not required to collect information regarding protected status from applicants or policyholders? At the NAIC Special (EX) Committee on Race and Insurance during the 2021 NAIC Summer National Meeting, Colorado Commissioner Michael Conway noted that insurers do not need to collect specific data on race to be able to test for discriminatory outcomes, and Colorado will expect insurers to do such testing.
  • How is a negative outcome on protected status determined and then quantified to determine if it exceeds a reasonable correlation?
  • What is a reasonable correlation to determine what exceeds such correlation?

What is “to the extent practicable”?

An insurer’s risk management framework will be required to be reasonably designed to determine, to the extent practicable, whether the insurer’s use of external data and technology unfairly discriminates against a protected status.

The terminology “to the extent practicable” was added in response to insurer concerns that they may not have the tools available to design the risk management framework. As the commissioner considers rulemaking, insurers may wish to ask whether “to the extent practicable” will take into account:

  • The size of the insurer or the amount of business for a particular type of insurance that the insurer conducts.
  • The fact that the insurer does not have the information to assess whether third-party vendor technology uses external data. And what happens if the third- party vendors refuse to share the information.

What is meant by algorithm?

Section 10-3-1104.9(8)(a) defines an algorithm as “a computational or machine learning process that informs human decision making in insurance practices.” However, this broad definition leaves insurers to wonder whether “algorithm” would be interpreted to include even the use of simple computational programs such as Excel or other automation tools in connection with traditional underwriting. How far does the definition go?

What is external data?

Section 10-3-1104.9(8)(b)(I) defines external data as “a data or an information source that is used by an insurer to supplement traditional underwriting or other insurance practices or to establish lifestyle indicators that are used in insurance practices.” Section (8)(b)(I) gives the following examples: credit scores, social media habits, locations, purchasing habits, homeownership, educational attainment,  occupation, licensures, civil judgments, and court records. However, many of these data points and other “lifestyle indicators” are obtained directly from the consumer as part of the application. Before the final exam, insurers might want to attend office hours to understand:

  • Is information acquired in an application considered external data?
  • Does such information become external data if it is used in an algorithm or predictive model?

What is meant by traditional underwriting?

Section 10-3-1104.9(7)(b)(II) and (IV) note that insurers are not required to test “traditional underwriting factors being used for the exclusive purpose of determining insurable interest or eligibility for coverage” or “longstanding and well-established common industry practices in settling claims or traditional underwriting practices” unless they are included in the insurer’s testing of its use of technology. But the following questions remain:

  • What is meant by traditional underwriting factors and traditional underwriting practices? Are traditional factors and practices in an electronic medium or process now considered nontraditional?
  • If traditional underwriting factors and practices are lumped in with an insurer’s use of technology, what is really exempt from having to be tested?

How Insurers Can Start Preparing for Class

  • Begin to inventory what data is used, from whom the data is obtained, and how it is used, including whether it is used as part of an algorithm or predictive model, for each type of insurance the insurer issues and for each insurance practice where data is used. This includes seeking information from the insurer’s marketing, product design, underwriting, administrative services, claims, and fraud units. Insurers should take a broad view of data, algorithms, and predictive models to ensure everything that might be scrutinized by Colorado is considered.
  • Inform the insurer’s marketing, product design, underwriting, administrative services, claims, and fraud units that subject matter experts from different business units will be needed for consultation as the Colorado insurance department holds stakeholder meetings and in developing governance around the use of data, algorithms, and predictive models.
  • Review third-party contracts to determine what rights the insurer has (i) to obtain information about the data being used and the construction and operation of any algorithms and predictive models and (ii) to require the cooperation of the third party in the face of a regulatory review. Additionally, these rights and obligations should be incorporated into any new third-party contracts.
  • Begin to outline a plan for satisfying the reporting and governance rules outlined above. This includes determining how the various business units will coordinate to compile the required information to be reported, as well as how each business unit will participate in and be responsible for the ongoing requirements of the risk management framework to be developed.

Insured Versus Insured Exclusion Does Not Bar Coverage for Claims Brought by Member of Insured LLC

Katelyn Cramp | Wiley Rein

Applying Washington law, a federal district court has held that an insured versus insured exclusion does not bar coverage for claims asserted by a member of an insured limited liability company. Starr Indem. & Liab. Co. v. Point Ruston LLC, 2021 WL 3630511 (W.D. Wash. Aug. 17, 2021). The court also held that a lawsuit is not brought “on behalf of” an insured solely because an insured is a principal of the claimant.

The insurer issued a claims-made policy to a limited liability company. The policy excluded coverage for “any Loss in connection with any Claim . . . brought by or on behalf of an Insured” (the “IvI Exclusion”). The Policy defined Insured to include an “Insured Person,” which included an “Executive.” The Policy further defined “Executive” to include a “management committee Member” and “Member of the board of managers.” “Member” was in turn defined as the “owner of a limited liability company represented by its membership interest, who may serve as a Manager.”

On March 11, 2020, sixteen Insureds were named as defendants in a lawsuit alleging that they mismanaged a commercial housing development project in which the plaintiffs invested.  The first investor entity plaintiff was a member of multiple limited liability companies that were Insureds under the policy and defendants in the underlying lawsuit.  The president of the second investor entity plaintiff was also a principal of the first investor plaintiff and an Insured under the policy.  The insurer brought suit seeking a declaration that the policy’s IvI Exclusion barred coverage for the underlying lawsuit.

On summary judgment, the insurer argued that the first investor entity plaintiff constituted an insured because it was a member of multiple Insured limited liability companies. The court held that the entity was not an “Executive” under the policy because it was not a Member of an Insured’s “management committee” or “board of managers.” The court rejected the insurer’s argument that this reading rendered the definition of “Member” superfluous, holding that the policy instead clarified that not all “Members” of an Insured limited liability corporation were “Managers.”

The insurer also argued that the IvI Exclusion barred coverage for the underlying lawsuit because the investor entity plaintiffs brought the lawsuit “on behalf of” their principal, who was also an Insured under the Policy. In support of this argument, the insurer noted that the principal signed the verification in the underlying complaint on behalf of, and served as the authorized representative of, the first investor entity plaintiff. The court rejected this argument, holding that the investor plaintiffs were distinct legal entities from their members, owners, and principals, and that the underlying lawsuit could not be construed as being brought “on behalf” of said members, owners, or principals.