Casualty insights: The $64,000 question – which law applies?

March 21, 2017
| United States

One of the most confounding issues in the world of insurance is which state’s law should be applied to any given commercial insurance policy. Because interpretation of contracts is entirely a matter of state law, every jurisdiction has developed its own body of case law relative to insurance policies. The fundamentals are generally consistent from state to state, but on the challenging and important issues, there are often divergent outcomes from one state to the next. And there usually is no principled reason for the differences — judges in one state simply went in a different direction than those in another state. So, when business people ask if a particular loss will be covered by insurance, they frequently are surprised and frustrated to learn that such a basic question cannot be answered with clarity — and choice of law is a big reason.

This article outlines how the applicable law is typically determined for insurance policies and suggests some practical shortcuts for making a reasonably accurate assessment of which state’s law is most likely to govern a particular insurance policy.

If no choice of law is specified in the contract, then a court presiding over an insurance coverage dispute must conduct a choice of law analysis.

As a starting point in any choice of law analysis, the policy should be reviewed for a choice of law provision. If the policy specifies that the law of a certain state applies, that provision is likely to control. However, it is rarely that easy. While choice of law provisions are fairly common in reinsurance contracts, they are surprisingly uncommon in direct insurance policies, and particularly so in commercial general liability policies. A cynic would suggest that insurers choose to omit such provisions because they want to leave themselves flexibility to argue for whichever state’s law best suits their purpose on a given issue. Regardless, insurers are often open to endorse their polices to include a choice of law provision when one is requested and where it makes sense for both parties.

When policies do contain a choice of law clause, frequently the state chosen is New York. New York is a common choice of law in many commercial contracts, extending beyond insurance policies, because of New York’s position as the epicenter of world commerce and its well-developed body of corporate law. Another reason why New York is frequently chosen by insurers is the perception, true or not, that New York law is favorable to insurers on various issues.

If no choice of law is specified in the contract, then a court presiding over an insurance coverage dispute must conduct a choice of law analysis, which typically plays out as follows.

Each state has its own choice of law test for determining the applicable law in a contract dispute, and a state trial court will apply the choice of law rules of its own state. If the trial court is a federal court, then it will apply the choice of law rules of the state in which it sits. The first step under any state’s choice of law test is for the court to compare the law of its own state to the law of whichever other state(s) any party contends should apply, and to determine whether or not there is an outcome-determinative difference (i.e., a “true conflict”). If there is no such conflict, then the court applies the law of its home state, and the choice of law analysis is complete.

But if there is a true conflict, then things get interesting. Most states follow one of three approaches to choice of law: (1) place of contracting, (2) most significant relationship or (3) governmental interest. These tests are the subject of countless court decisions and commentaries, and an in depth analysis is beyond the scope of this article. But, very simply, the tests work as follows. The place of contracting is exactly what its name suggests, i.e., the place where the parties carried out the acts necessary to form the contract. The most significant relationship test requires the court to weigh five factors: (a) the place of contracting, (b) the place of negotiation, (c) the place of performance, (d) the location of the insured risk and (e) the residence of the parties. The governmental interest test requires the court to balance the needs of each of the competing states in having its own laws applied, and apply the law of the state whose needs predominate.

Choice of law is the most significant and hotly disputed issue in insurance coverage litigation.

To state these tests is not difficult, but applying them to a complex insurance dispute is another matter. As in a game of chess, where each piece is permitted to make simple, well-defined moves but the combinations that play out in a game are infinite, the arguments that clever lawyers can make within the framework of each of these simple tests are practically endless. The task has become even harder in the 21st century when business is often conducted over email, cell phones, and other virtual means, so that the place where a negotiation happened or a contract was formed is often unclear. In spite of the many complications, courts routinely do their best to apply the tests outlined above to insurance disputes and conclude that one state’s law or another will apply when interpreting a given insurance policy. Often, choice of law is the most significant and hotly disputed issue in insurance coverage litigation; once the court makes its determination, the outcome of the case is fait accompli.

Accordingly, parties are wise to determine at the outset of any insurance claim, long before litigation is filed, which state’s law would best advance its position. Once a party determines that it wants application of the law of a particular state, the key to achieving that result is to file suit in a state whose choice of law rules will require application of that state’s law. While counter-intuitive, the better strategy might be to file suit in a state other than the state whose substantive law a party wants to be applied. If state A has favorable substantive law on a particular point but follows the most significant relationship test for determining choice of law, and state B has unfavorable law but follows the governmental interest test, a party should file suit in the state whose choice of law rules will yield the law of state A, even if that happens to be state B. There is a myth, which sometimes proves to be accurate, that judges prefer to apply the law of their home state. A corollary is that even when judges do apply the law of a different state, they tend to do so, intentionally or not, in a manner that reflects and leans toward the law of their home state. Therefore, it is a difficult and daring decision, even if analytically correct, for a party to file suit in a state other than the one whose law it wants applied, on the premise that state B will apply the law of state A.

When weighing which state will most likely yield the desirable choice of law, it is important not to conflate the separate concepts of choice of law and choice of forum. Both choices often lead to disputes, but they are different issues judged by different legal standards. Parties file suit in a particular court not only to secure a favorable choice of law, but also for other strategic reasons — a hometown advantage, a friendly jury pool, receptive judges, convenience, lower costs, to name a few. Parties will often dispute their adversary’s choice of forum, and/or file a competing action in another court, requiring judges to choose the most appropriate forum. Therefore, it is not unusual for parties to have one dispute over the proper forum and a second battle over choice of law, before the merits of the insurance claim are even addressed.

Not only is it often complicated and hard fought for a party to achieve the forum and the choice of law that it desires, it is often not an easy decision for a party to decide which state’s law it wants to be applied. A complex insurance claim is akin to a Rubik’s Cube, often requiring different issues to be solved in conjunction with one another. The law of a particular state may be strong on some issues and weak on others, and care must be taken to choose a state whose law is favorable, or at least silent or tolerable, on every issue. The challenge is compounded by the fact that not all disputed issues are known at the outset of a case — often discovery into the claim, or the ingenuity of the insurer’s team, will raise new hurdles to coverage that were never anticipated. Therefore, choosing which law is desirable often requires a series of educated guesses as to which issues will be at the forefront by the time the lawsuit reaches the summary judgment or trial stage.

When a matter is not yet in litigation, the parties can only speculate as to where litigation will be filed.

The foregoing discussion assumes that an insurance dispute is actually in litigation. The analysis becomes even harder if parties are negotiating resolution of a dispute, or if one party is evaluating the strength of its insurance claim before deciding whether or not to file suit. When a matter is not yet in litigation, the parties can only speculate as to where litigation will be filed, and therefore there will be uncertainty over (1) which choice of law rules will apply, and (2) what will be the forum state’s law for purposes of the initial comparison to identify a true conflict. Without these two pieces of information in hand, any attempt to predict which law would apply can feel like sheer guesswork.

Brokers and policyholders, however, do not have the luxury of avoiding decision-making due to the lack of clear information. No client wants to be told that we cannot make an informed assessment of insurance coverage because there are too many uncertainties over choice of law. To assist in that respect, the following are some general, non-scientific predictors of which state’s law is most likely to apply to a given dispute. It bears emphasis that the following factors are not set forth in quite this manner in any choice of law test, any rule book or in any single court decision. Rather, they are the product of the authors’ many years litigating insurance coverage disputes, and observing how the various tests play out in practice, and what factors have resonated most with different judges sitting on various state and federal courts.

The following factors, listed in descending order, are likely predictors of which state’s law ultimately will apply:

Likely predictors of which state’s law ultimately will apply

The domicile of the insurance company, while potentially relevant under all three tests, is often afforded little weight. While there are certainly no guarantees, the first factor alone is often a good predictor of which law will apply in many cases. If two or more of the factors stated above coincide in one state, the chances are strong that the law of that state will apply. And, if these factors are evenly divided between two or three states, then a reliable evaluation of the claim will need to consider the law of each potential state on the relevant issue(s).

A concluding thought: “Be careful what you wish for.” State law is not stagnant and often can be a moving target during the course of a coverage litigation that spans several years. A perfect example is New York, which as noted above, is often the state law of choice for insurers, due to the perception that New York law is pro insurer. However, changes in the law of New York have made it more inviting to policyholders on two key issues, i.e., the scope of coverage (all sums vs. pro rata/time on the risk) and the consequences of late notice. Indeed, the law of many states, for good or for bad, changes from year to year as courts render decisions and legislatures pass insurance-related statutes. The evolution of state law on key coverage issues only serves to underscore the complexity and importance of fully working through the choice of law analysis at the start of any coverage claim.