The Notice-Prejudice Rule

This article describes the relation between, late notice, the notice prejudice rule and the different types of policies issued by insurance companies such as: claims made; claims made and reported; and occurrence.

       I.            Introduction

Insurance companies are ubiquitous. Whether it is by billboard, internet or television ad it is hard to miss the catchy idioms:  “Like a good neighbor State Farm is there,” “Farmers. Gets you back to where you’re going” and the all too familiar jingle “Nationwide is on your side.” These are a few of many slogans used by insurance companies to generate business and instill a sense of fidelity with their client base. Although these slogans are far from truisms, insurance companies do provide a necessary service that keeps our businesses and society functioning—unfortunately the relationship between the insurer and the insured is a strained one akin to Dr. Jekyll and Mr. Hyde, a friend/foe dynamic.

Insurance companies provide their policyholders with the financial liability coverage necessary to conduct business in today’s society, leading the unwary to assume that they are the proverbial “knight in shining armor” whenever a claim is made and the policyholder faces the possibility of a business-crippling financial liability. However these champions of indemnity are actually companies—and at the end of the day their main concern is the bottom line and increasing investor stock value.[1] If insurance companies paid out every presented claim there would be no insurance industry. So it is between these two lines that insurance companies must navigate—being the “good neighbor” and paying out their customers’ claims, and being the business organization, denying customers’ claims in order to maintain the status quo or increase the profit margin (especially if a claim presents a substantial liability). An insurance company can take many routes in denying a policyholder’s claims, but this article will focus on one, late notice.

This article will describe the claims reporting process of three types of professional liability errors and omissions insurance policies: occurrence, claims-made and claims-made-and-reported. Each of these policies have their own set of reporting requirements, and this article will show how insurance companies attempt to use these reporting requirements to avoid paying out claims. Finally this article will explain how courts in equity have addressed these “denials of claims” based on failure of the reporting requirements by applying their own sets of common law rules (most notably the notice-prejudice rule) when determining if a claim has been sufficiently reported to trigger coverage within these different types of policies.

This article will show that although the notice-prejudice rule has only been traditionally applied to the “notice as soon as practicable” requirement of occurrence-based policies, it should also be applied to the notice step of the reporting requirements in a claims-made-and-reported policy when a claim is reported to the insurance company within the policy period but not “as soon as practicable.”

In Section II, this article will describe the three types of policies (occurrence, claims-made and claims-made-and-reported), taking note of their differences and how the notice-prejudice rule is currently being applied to each. In Section III, this article will show why the notice-prejudice rule should be applied to the notice requirement of claims-made-and-reported policies, the benefits of its application, why its application in this context is different from its application to the reporting requirement and how one jurisdiction has recently taken a similar view.

    II.            Background Information-- Different Insurance Policies, Their Notice-Related Requirements and How They Affect Insurance Claims

a.       Claim Denials Due to Policyholder Noncompliance With Policy Provisions 

Policyholders must be vigilant and proactive in understanding and complying with the requirements of their insurance policies as most policies are not self-executing. Lawsuits implicating insurance policies are so common they have become a part of the global culture. From the spurious[2] to the serious[3], insurance claims are on the rise.[4] In the recent years insurance companies have taken a fiscal hit due to the mass amounts of litigation ranging anywhere from class actions and product liability to discrimination and professional liability.[5] Possibly as a bi-product of such mass-litigation and settlement and maybe even as a matter of course, insurance companies scrutinize almost any noncompliance by a policyholder with their policy provisions, no matter how harmless, trivial or technical. Subsections b, c, and d will describe each relevant insurance policy, its notice requirement, and how courts have treated each policy in relation to the notice-prejudice rule. While reading these subsections it is important to understand the notice-prejudice rule and take note of the distinctions between the event that triggers coverage, the notice requirements and the reporting requirements of the three different policies; the notice-prejudice rule and these distinctions are summarily explained below.

1.      The Notice-Prejudice Rule

The notice-prejudice rule is a very simple, equitable common law doctrine created to protect policyholders’ interests under their insurance policies. The notice-prejudice rule states that where notice is not an express condition precedent of the policy (i.e. where it does not define the scope of coverage under the policy) insurers will not be able to avoid coverage under the insurance policy for failure of a policyholder to provide timely notice, unless the insurer can show that the untimely notice prejudiced the insurer.[6]

2.      Occurrence-Based Insurance Policies

Occurrence-based insurance policies are policies that provide coverage for the acts of an insured that occur during policy period, regardless of when a claim is brought against the insured by a third party (exposing the insurer to unlimited prospective liability). The act that triggers[7] coverage under this policy is the actual occurrence (i.e. the insured against events:  the malpractice, negligence, etc. of the insured). The actual claim resulting from that occurrence is merely the temporal incident defining when the insurance company has to act—for instance by defending its insured (the policyholder) or settling the claim with the claimant (the individual affected by the insured’s actions and bringing the claim).

Once an insured is aware that a claim has been filed against her, she must—within a reasonable time—notify the insurer.[8] This notice requirement’s function is merely to enable the insurance company to effectively and efficiently investigate and defend the claim. Note that because this policy covers acts that occur during the policy period and a claim for those acts may not be brought until years after—this type of policy exposes the insurer to uncertain/unlimited future liability. This uncertain future liability also increases the costs of premiums.

3.      Claims-Made Insurance Policies

Claims-made policies are policies that provide coverage for claims made against the insured during the policy period and when notice is given to the insurer as soon as practicable (regardless of when the acts defining that claim took place). The claim being filed against the insured during the policy period and the claim being reported “as soon as practicable” are the actual triggers to coverage. Unlike occurrence policies, the “notice as soon as practicable” requirement does not only serve to aid the insurer it defense of the claim but it also enables insurers to fix their potential liability to a specific period of time (i.e. the policy period or a period shortly thereafter if that period is determined to be “as soon as practicable”). The ability of the insurers to fix their liability under this type policy to definite timeframe enables insurers to offer these policies at lower premiums to the public.

4.      Claims-Made-and-Reported Insurance Policies

Like claims-made policies, claims-made-and-reported policies are policies that provide coverage for claims made against the insured during the policy period and when notice is given to the insurer as soon as practicable, regardless of when the events leading up to that claim took place. But unlike claims-made and occurrence policies, claims-made-and-reported policies have one additional, express requirement: that the insured must report the claim to the insurer within the policy period.

b.      Occurrence Policies

Occurrence-based insurance policies are policies that provide coverage for acts that occur during the policy period, regardless of when a claim is brought against the insured (i.e. a lawsuit)[10]. The Supreme Court of New Jersey effectively summarized coverage under an occurrence-based policy when it stated that,

In the “occurrence” policy, the peril insured is the “occurrence” itself. Once the occurrence takes place, coverage attaches even though the claim may not be made for some time thereafter.[11]

This is what professionals in the insurance industry consider “long-tail” coverage as the act that triggers coverage under the policy is the actual occurrence (i.e. malpractice) and the actual claim resulting from that occurrence may not be brought by the injured party until years later, exposing the insurer to unlimited and uncertain future liability for any wrongful acts committed during the insured policy period.[12] Other than the requirement that the occurrence take place during the policy period, occurrence-based policies have one more affirmative duty that the policyholder must comply with, that duty being notice. Once a policyholder is aware that a claim has been filed against her, she must—within a reasonable time—notify the insurer.[13]

The purpose of this notice requirement under an occurrence-based policy is three-fold. First, it gives the insurer a meaningful opportunity to investigate the claim before “the trail has gone cold.”[14] Untimely notice after a policyholder has become aware of a claim could prejudice the insurer’s interests in effectively defending against the claim. It would be more likely that evidence could be lost or destroyed, that witnesses could go missing or become unascertainable and it may further deprive the insurer of meaningful time to develop its case.[15]   Second, it allows the insurer to determine whether the allegations of the claim state a claim that is covered under the insured’s policy.[16] Third, it allows the insurance company to seek any subrogation rights.[17]

Insurers have attempted to avoid coverage of claims under occurrence policies based on a policyholder’s late notice. This late notice defense, as applied to occurrence-based policies in a majority of jurisdictions, requires the insurer to show that the policyholder’s noncompliance with the notice provision somehow prejudiced the insurer.[18] The reasoning behind requiring insurers to prove that they were somehow prejudiced is directly related to how the notice provision serves a distinct purpose and that purpose can differ depending on whether it is used in an occurrence policy or claims-made type policies.

Courts look at the purpose of an insurance contract’s provisions to aid in its interpretation.[19] Courts that have interpreted the purpose of the notice provision in an occurrence policy have reached the conclusion that “[t]he notice requirement in a classic occurrence policy does not define the coverage provided by the policy, but rather is included to aid the insurance carrier in investigating, settling, and defending claims.”[20] What defines an occurrence-based policy is that some covered act took place during the policy period.[21]

Therefore, an insurer will not be able to deny a policyholder’s claim unless it can prove that it was somehow prejudiced by that policyholder’s late notice.[22] Courts have reached this result by reasoning that, in an occurrence-based policy, the material risk insured against is the occurrence of a wrongful act during the policy period. Once that act has occurred coverage is triggered.

Allowing insurers to deny coverage under an occurrence policy due to failure to comply with a policy condition that was never implicated would be tantamount to a forfeiture.[23] The standard suit by an insured seeking to have coverage enforced is illustrative. In such a case the insurer has incorporated the “notice as soon as practicable” condition into the occurrence policy to protect it from being prejudiced in administering a claim due to a policyholder’s late notice; the covered occurrence takes place during the policy period but the policyholder does not immediately forward notice to the insurer; the insurer is not prejudiced by the late notice but nevertheless denies coverage based on the failure of that condition. In such a situation the dangers that the notice provision sought to eliminate are non-existent. Under these circumstances courts have held that insurers will not escape liability due to a policyholder’s failure to meet a non-material policy provision–to do so would be to invite insurers to hunt for failures of even the most trivial policy conditions.[24]

c.       Claims-Made Policies

At the heart of the difference between occurrence and claims-made policies is what triggers each policy’s coverage. In occurrence policies that trigger is the actual occurrence of a covered event during the policy period. Quite differently, in claims-made policies the trigger is the making of a claim against the insured during the policy period (regardless of when the events leading up to that claim took place) and the reporting of that claim as soon as practicable.[25] These different triggering events effectively define the coverage period for each respective policy.

In explaining what defines coverage under a claims-made policy, the Supreme Court of Kentucky stated that “[i]t is important to remember that the reporting period is what defines coverage under claims-made policies of insurance. It is this very requirement which distinguishes claims-made policies from occurrence-based policies.”[26] Unlike occurrence policies which expose insurers to uncertain, continuous prospective liabilities for acts that were committed during the covered policy period; claims-made policies are restricted to a certain time period (called the “reporting period” under the insurance policy). Under this type of policy the notice provision serves a purpose in addition to its original function under the occurrence based policy. While the notice provision’s original purpose of enabling the insurer to properly manage the claim is still implicated, under claims-made policies the notice provision also serves to restrict the insurers’ liability period to claims “noticed” to the insurer as soon as practicable (this limits the insurers liability for claims brought against the insured to the fixed time frame of the policy period or shortly thereafter—eliminating any prospective liability beyond that point).

An example is instructive: under the occurrence policy the policyholder is covered for any actions committed in 2006—whether the lawsuit or claim is brought in 2014 or 2040 does not matter (this exposes the insurer to unlimited prospective liability). However, under the claims-made policy the policyholder is only covered for those lawsuits or claims brought against her in the year 2006 and reported to the insurer as soon as practicable (this exposes the insurer to an almost definite liability period of the year 2006 or shortly thereafter).

Therefore, any extension in time for reporting far beyond the year 2006 to accommodate a policyholder’s untimely reporting would be “tantamount to an extension of coverage to the insured[,] [a] gratis, something for which the insure[d] has not bargained.”[27] This would frustrate purpose of claims-made policies and the insurer’s intention of limiting its liability to a fixed period of time. Applying the notice-prejudice rule in this situation would rewrite the contract between the insurer and the policyholder and extend coverage beyond the bargained for policy period.

The notice provision’s ability, under a claims-made policy, to fix liability to a specific period of time has the resulting benefit of cheaper premiums.[28] Courts uniformly state this as a reason for the inapplicability of the notice-prejudice rule to claims-made policies when a policyholder fails to provide notice to the insurer within the policy period or shortly thereafter. The 8th Circuit Court of Appeals, in rejecting application of the notice-prejudice rule to claims-made policies, stated that:

Notice in a "claims made" policy provides the insurer with the knowledge that after a certain date the insurer is no longer liable under the policy, and accordingly allows the insurer to more accurately fix its reserves for future liabilities and compute premiums with greater certainty. Such a policy reduces the potential exposure of the insurer, thus reducing the policy cost to the insured.[29]

Unlike occurrence policies, whose notice provision functions only to prevent prejudice against the insurer due to “stale evidence” (as coverage has already been triggered by an occurrence taking place during the policy period) the notice provision in claims-made policies actually serves to trigger coverage—to extend that coverage beyond the policy period due to untimely notice would be tantamount to granting the policyholder more than they bargained for and effectively convert a claims-made policy into an occurrence policy. As a result, a majority of jurisdictions refuse to apply the notice-prejudice rule to claims-made policies. The only state currently applying the notice-prejudice rule to claims-made policies is California.[30] California courts reach this result because they interpret the “notice as soon as practicable” provision in claims-made policies as serving the same investigative and claim management purposes as the “notice as soon as practicable” provision in occurrence policies and adamantly state that such provisions in claims-made policies do not define the scope of coverage under the policy.[31]

d.      Claims-Made-and-Reported Policies 

Like claims-made policies, claims-made-and-reported policies are policies that provide coverage for covered claims made against the policyholder during the policy period and reported to the insurer as soon as practicable, regardless of when the events leading up to that claim took place. But unlike claims-made policies, claims-made-and-reported policies have one additional, express requirement: that the insured must report the claim to the insurer within the policy period.[32] This is in addition to the requirement that notice be given as soon as practicable.

This requirement can be distinguished from the claims-made requirement insofar as there is no express requirement in a claims-made policy that states that the policyholder must report the claim to the insurer within the policy period—all claims-made policies require is that (1) a covered claim be made against the policyholder within the policy period and (2) that the policyholder provide notice to the insurer as soon as practicable.[33]

This is what allows claims-made policyholders some “wiggle room” in providing notice to the insurers of a claim outside of the policy period—but that additional window of time is extremely narrow, almost to the point where  some courts have vitiated any distinction between the two and treat claims-made and claims-made-and-reported policies synonymously[34]. Although all of the case law discussed in subsection c. directly applies to claims-made-and-reported policies, all courts strictly construe the reporting period in claims-made-and-reported policies due to the policies’ express requirement that the claim be reported within the policy period. Therefore, claims-made-and-reported policies have three express requirements: (1) that the insured reports the covered claim within the policy period, (2) that notice must be given “as soon as practicable” and (3) that the claim be made against the insured during the policy period.

 III.            The Notice-Prejudice Rule Should be Applied to the “Notice as Soon as Practicable” Provision of Claims-Made-and-Reported Policies

When the notice-prejudice rule applies has become a very convoluted issue. This is, in part, a result of the varied contexts in which it has been brought up (its application to the reporting requirement versus the “notice as soon as practicable” requirement), the types of policies it has been applied to (occurrence, claims-made and claims-made-and-reported) and the facts of the cases to which it has been applied (which helps answer the question as to whether the insurer was actually prejudiced).

The main principle that has directed courts on the applicability of the notice-prejudice rule to notice provisions is whether the notice provision defines coverage under the policy.[35]  When courts state that they are concerned with whether a provision “defines coverage” under the policy, what they are concerned with is whether the provision at issue is a provision that definitely fixes the boundaries of coverage or whether it is a provision meant to serve a different purpose (such as convenience or management).[36]

Below I will discuss this principle in the context of its application to the “notice as soon as practicable” requirement of claims-made-and-reported policies, showing that this “notice as soon as practicable” provision in claims-made-and-reported policies is synonymous with the “notice as soon as practicable” provision in occurrence policies when the policyholder has reported a claim to the insurer within the policy period but has not done so “as soon as practicable.”[37] This is also supported by the fact that the reporting requirement of claims-made-and-reported policies serves the same function as the “notice as soon as practicable” requirement in claims-made policies—defining the policy/liability period. 

(1)   The Notice Provision in a Claims-Made-and-Reported Policy Does Not Define the Policy 

Courts have consistently held that when a notice provision defines coverage under a policy, that policy provision must be strictly construed and may not be altered ex-post through judicial application of the notice-prejudice rule.[38] The applicability of the notice-prejudice rule to claims-made-and-reported policies depends on whether it is applied to the “notice as soon as practicable” or reporting provision of the policy. Claims-made-and-reported policies have three requirements. First, a claim must be made against the insured during the policy period. Second, the insured must reportany claim made against it during the policy period to the insurer before that policy period expires. This requirement is known as the reporting requirement. Courts will strictly construe the reporting requirement as this requirement is what defines or “triggers” the insurance coverage.[39] The reporting requirement, for the purposes of this subsection, is irrelevant as it is assumed for purposes of my argument that the policyholder has reported the claim within the policy period. The third requirement requires the policyholder to report the claim “as soon as practicable,” this is known as thenotice requirement.

The notice requirement requires a policyholder to provide notice to the insurer of claims brought against the policyholder “as soon as practicable.” Courts should not strictly construe this requirement under claims-made-and-reported policies, as it is not a trigger to the coverage, nor is it a material aspect of the bargain reached between the insurer and the policyholder under the insurance contract.[40] The notice requirement in claims-made-and-reported policies, again, like the notice requirement in occurrence policies, only serves to protect the insurer from being prejudiced in its administration of the claim and only the reporting of the claim within the policy period defines the insurance contract under a claims-made-and-reported policy.

To date, only one court, the Texas Supreme Court, has recognized this distinction in this context. In allaying the insurance industry’s fears and claims of  possible harm that may be implicated by application of the notice-prejudice rule in this context, the Texas Supreme Court in Financial Industries Corp. v. XL Specialty Ins. Co., 285 S.W.3d 877, 878 (Tex. 2009) stated:

[F]or the insurer, the inherent benefit of a claims-made policy is the insurer's ability “to ‘close its books' on a policy at its expiration and thus to attain a level of predictability unattainable under standard occurrence policies,” … [a policyholder’s] alleged failure to give notice “as soon as soon as practicable” …[is] immaterial because it …[does] not interfere with this benefit.

The Texas Supreme Court based its reasoning on a ruling it had just issued on that very same day in Prodigy Communications Corp. v. Agricultural Excess & Surplus Insurance Co., 288 S.W.3d 374 (Tex. 2009). The court stated in its ruling in Prodigy that, “[i]n a claims-made[-and-reported] policy, when an insured notifies its insurer of a claim within the policy term or other reporting period that the policy specifies, the insured's failure to provide notice ‘as soon as practicable’ will not defeat coverage in the absence of prejudice to the insurer.”

 All courts should take note of both of these decisions and their reasoning as they correctly apply the notice-prejudice rule through the court’s recognition of the notice provision’s materiality and purpose in the context of claims-made-and-reported policies. The court recognized that the notice provision in claims-made-and-reported policies was not material to the insurance contract, was not a provision that defined the policy and further had no effect on the coverage being triggered.

 IV.            Conclusion

The notice-prejudice rule should apply to the “notice as soon as practicable” requirement in the context of claims-made-and-reported policies. The notice requirement is not a material aspect of the bargain reached relative to the insurance contract[41]  nor is it the triggering mechanism for coverage. The application of the notice-prejudice rule in this context does not pose the risk of rewriting the insurance contract or extending coverage that was not bargained for, as under these circumstances coverage has already been triggered (by the reporting of the claim within the policy period, albeit untimely). This places these types of cases squarely within the courts’ equitable powers to prevent insurers from avoiding coverage on the failures of technical, non-material policy provisions.

Ultimately, courts should require insurers to show that they were somehow prejudiced in order to avoid coverage of a claim when a policyholder fails to satisfy the notice requirement but has reported the claim within the policy period. Otherwise, allowing insurers to avoid coverage in such circumstances would be to “impose draconian consequences for even de minimis deviations from the duties the policy places on insureds.”[42]