When the literal language or structure of an insurance policy gives the policyholder the impression of coverage but effectively negates any meaningful coverage, coverage is said to be “illusory.” The theory of illusory coverage holds that policies should be construed so that coverage is “not a delusion to the insured.” This equitable doctrine serves to avoid an unreasonable result when a policy exclusion or limitation may otherwise unfairly deny coverage. Courts generally will not reform a policy on the basis of illusory coverage but the doctrine allows for some discretion and courts have viewed it with varying degrees of acceptance.
A few recent cases turned on courts’ acceptance or rejection of such illusory coverage arguments and illustrate how policyholders and courts use the doctrine to find coverage where policies may dictate otherwise.
Earlier this year, a Wisconsin court of appeals found that an exclusion in the excess policy for the innovative car-sharing service, Zipcar, rendered coverage illusory. In Hernandez v. Liberty Mut. Ins. Co., 844 N.W.2d 657 (Wis. App. 2014), Zipcar’s primary commercial policy covered Zipcar and any driver using a Zipcar vehicle, while its excess policy provided coverage only to Zipcar. In Wisconsin, an endorsement was added to extend excess coverage to anyone driving the vehicle with Zipcar’s permission. However, an “Other-Insurance” clause excluded that same coverage for all permissive drivers “when there is other valid and collectible insurance.” In short, “the permissive users added to the Excess Policy by the Wisconsin Endorsement were then excluded by the Other-Insurance Clause.” Finding that “coverage is illusory when an insured cannot foresee any circumstance under which he or she would collect under a particular policy provision,” the court rejected the construction of Zipcar’s policy as illusory and reformed the policy to provide excess coverage for the driver, consistent with the driver’s reasonable expectations. While other statutory considerations also influenced the case, the court was clear that where an endorsement grants all permissive users coverage in one breath and then excludes those same users from coverage in the next, coverage is illusory and the policy as written cannot fairly be supported.
An important case from the Alabama Supreme Court similarly turned on the court’s use of the illusory coverage doctrine. In Owners Ins. Co. v. Jim Carr Homebuilder, LLC, No. 1120764, 2014 Ala. LEXIS 44 (Ala. Mar. 28, 2014), the Alabama Supreme Court faced the much discussed question of whether faulty workmanship is covered by a commercial general liability policy and, using principles of illusory coverage, joined a growing number of jurisdictions that recognize coverage for defective construction claims.
Many courts have said that a CGL policy does not cover damage resulting from faulty workmanship because the faulty workmanship does not constitute an “occurrence” that triggers coverage. But the court in Jim Carr said that if damage to something other than the work itself is required to constitute an “occurrence,” then when the insured is constructing an entirely new building or completely renovating a building, coverage would be illusory as “there would be no portion of the project that, if damaged as a result of… faulty workmanship of the insured, would be covered under the policy.” Accordingly, the court said the term “occurrence” itself did not exclude coverage for damage from faulty workmanship.
In addition, even if constituting an “occurrence,” damages stemming from faulty workmanship have often been excluded by the “Your Work” exclusion. In this case, the “Your Work” exclusion barred coverage for “‘Property damage’ to ‘your work’ arising out of it or any part of it and included in the ‘products-completed operations hazard.’” In the interest of equity, the court found coverage to be illusory because the builder paid for coverage for “products-completed operations” and the “Your Work” exclusion improperly barred coverage “under every conceivable set of circumstances.”
The decision not only illustrates the trend in favor of coverage for damages resulting from faulty workmanship but also demonstrates how courts may use the illusory coverage doctrine to construe coverage and promote a public policy interest.
But courts are not always so quick to reform a policy on the basis of illusory coverage. In Liberty Mutual Ins. Co. v. Linn Energy, LLC, No. 13-20578, 2014 U.S. App. LEXIS 12353 (5th Cir. June 30, 2014), an insured argued that the policy’s Total Pollution Exclusion (TPE) endorsement improperly rendered the Underground Resources and Equipment Coverage (UREC) endorsement meaningless. According to the court, while the TPE severely limited the applicability of the UREC, such broad pollution exclusions have traditionally been upheld in Texas and the UREC “still provides coverage for all non-pollution property damage, such as depletion of a reservoir.” Despite the insured’s best efforts, the court was not persuaded that the exclusion made the UREC endorsement illusory and was not willing to contravene the plain, unambiguous language of the TPE exclusion, especially as the UREC endorsement still offered some coverage.
A number of other recent decisions similarly rejected arguments of illusory coverage, reasoning that broad exceptions may substantially limit coverage without necessarily rendering coverage illusory.
In Nat’l Union Fire Ins. Co. v. Papa John’s Int’l, No. 3:12-CV-00677-CRS, 2014 U.S. Dist. LEXIS 90792 (W.D. Ky. July 3, 2014), a Kentucky court rejected a policyholder’s arguments that certain broad exclusions contradicted coverage grants and rendered coverage illusory. The policy at issue provided coverage for “personal and advertising injury” but excluded coverage for “any violation… of any statute… by any person.” The policyholder argued that this broad exclusion effectively negated any coverage, but the court disagreed. The court explained that “coverage bought, paid for and reasonably expected” is illusory when that coverage is “given and then taken away by means of an [exclusion].” The court further stated that “the doctrine of illusory coverage is best applied… where part of the premium is specifically allocated to a particular type or period of coverage and that coverage turns out to be functionally nonexistent.” But the court concluded that coverage in this case was not illusory because “the exclusion does not entirely negate the policies’ coverage for personal and advertising injury” as damage could arise other than in violation of a statute.
Interpreting identical policy language, the Eleventh Circuit Court of Appeals came to the same conclusion in Interline Brands, Inc. v. Chartis Specialty Ins. Co., 749 F.3d 962 (11th Cir. 2014). The court similarly observed that “when limitations or exclusions completely contradict the insuring provisions, insurance coverage becomes illusory,” but thought the insured in the case overstated the extent to which the exclusion limited coverage and held the exclusion did not “render the policy absurd or completely contradict the insuring provisions.”
Likewise, in Associated Community Bancorp, Inc. v. St. Paul Mercury Ins. Co., 2014 NY Slip Op 4697 (N.Y. App. Div. 2014), a New York appellate court held that an exclusion in a Bankers Professional Liability Insuring Agreement broadly barring coverage for “the actual loss of money… in the custody or control of [the bank]” still provided a “range of coverage for liability that may arise in connection with [the bank’s] provision of ordinary banking services.” The court summarized that coverage is not illusory “if it provides coverage for some acts” or “simply because of a potentially wide exclusion.” As most courts have held, coverage is illusory only if the exception or limitation renders coverage nonexistent or functionally meaningless.
As these recent cases demonstrate, the doctrine of illusory coverage can be a useful tool, offering equitable protection for policyholders when the policy’s literal provisions lead to an unreasonable result. Courts are sensitive to policyholders’ rights and may use the doctrine to enforce public policy and find equitable coverage, but they generally prefer to enforce the policy as written, without interfering in the parties’ bargained-for exchange.
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