Liability insurance written on a claims made basis is designed to protect an insured against claims asserted following the policy’s inception even if the acts giving rise to the claim took place prior to policy inception. But if prior to policy inception the insured was aware of facts or circumstances that could have reasonably led the insured to believe a subsequent claim would be asserted during the policy period, then coverage might be challenged.

Liability carriers have sought to address this by including “prior knowledge” exclusions in their policies. Under those exclusions, coverage may be barred if prior to policy inception an insured reasonably anticipated that a pre-policy inception act or omission on its part would likely lead to the assertion of a claim. "Like the exclusion of a known preexisting condition from a health insurance policy, the exclusion from a claims-only policy of claims based on conduct that occurred before the policy was issued and that was known to have claim potential is uncontroversially proper." Truck Ins. Exch. v. Ashland Oil, Inc., 951 F.2d 787, 791 (7th Cir. 1992). 

Attempts to exclude conduct beyond that known to have claim potential can land carriers in trouble. Carriers relying on these kinds of exclusions should be aware of the cautionary tale reflected in a recent case. Among other things, the case stands for the proposition that while insurers may rely on exclusions designed to bar coverage for known liability risks at the time a policy is purchased, courts may decline to enforce broadly drafted prior knowledge exclusions if the enforcement of such exclusions would interfere with the fundamental nature of the coverage provided under the policy.

OneBeacon Ins. Co. v. T Wade Welch & Assocs., 841 F.3d 669 (5th Cir. 2016), dealt with whether a malpractice suit against a lawyer was covered under the lawyer’s professional liability policy. The “prior knowledge” exclusion encompassed “any claim arising out of a wrongful act occurring prior to the policy period if, prior to the effective date of the [policy] ... [the insured] had a reasonable basis to believe that [it] had committed a wrongful act, violated a disciplinary rule, or engaged in professional misconduct.”

The insurer (OneBeacon) denied coverage when it's insured (T. Wade Welch & Associates) was sued by a former client (DISH) for malpractice.  Although the malpractice lawsuit was filed during the policy period, OneBeacon argued that because the law firm had been sanctioned for discovery misconduct prior to policy inception in connection with its representation of DISH, the firm had a reasonable basis to believe that it had committed a wrongful act at the time it purchased its malpractice coverage. OneBeacon unsuccessfully sought summary judgment on its defense based on the “prior knowledge” exclusion. Among other things, the court declined to enforce that exclusion as written, finding that a literal reading of the exclusion would render coverage illusory. The district court turned to the insured’s interpretation of the policy, which read the policy in conjunction with the required disclosures in the 2007 policy application and construed the exclusion to apply only to a claim arising out of a wrongful act that the insured could reasonably foresee would result in a claim. The Fifth Circuit then went on to affirm the District Court’s decision:

“The district court could not apply the literal policy language because of the extreme overbreadth of the wrongful act definition used in the exclusion: ‘any actual or alleged act, error, omission or breach of duty arising out of the rendering or the failure to render professional legal services.’ On its face, this covers every single thing an attorney does or does not do, wrongful or not. As written, then, the exclusion renders the coverage illusory and is facially absurd. Indeed, OneBeacon concedes that the exclusion requires some modification, it simply disagrees with the district court's approach. [¶] The exclusion in the context of this policy must be directed at a ‘wrongful act’ reasonably likely to lead to a malpractice claim.” 841 F.3d 669, 676-677.

Thus, despite the actual language of the prior knowledge exclusion, the court limited its application only to those circumstances where the insured had knowledge of a wrongful act that it could reasonably have expected to give rise to a claim. The court’s restriction of the scope of that exclusion is consistent with other decisions in which courts have simply declined to enforce provisions that would interfere with or frustrate the fundamental nature of the coverage provided under the policy.  See, e.g., Underwriters of Interest v. ProBuilder’s Specialty Insurance, 241 Cal.App.4th 721, 730 (2015) (Declining to enforce “other insurance” provision as written where it would amount to an “escape clause” for the carrier who declined to participate in the defense of its insured in a liability action).

But in addition to restricting the application of the prior knowledge exclusion, the district court also made two other important determinations:

First, it adopted the mixed objective-subjective standard for evaluating whether an insured could have reasonably expected that a claim would be asserted - i.e., “what an objectively reasonable [insured] would expect given the subjective knowledge of the particular [insured] involved.” OneBeacon Ins. Co. v. T. Wade Welch & Assocs., 2014 U.S.Dist.LEXIS 85486, at *37 (S.D.Tex. June 24, 2014). The focus on the subjective knowledge of the particular insured involved is a key factor which has been adopted in other cases in this area.  See, e.g., Colliers Lanard & Axilbund v. Lloyds of London, 458 F.3d 231 (3rd Cir. 2006); HSB Group Inc. v. SVB Underwriting, Ltd., 664 F.Supp.2d 158, 193 (D. Conn. 2009) (subjective-objective test requires first, whether the insured had actual (i.e., subjective) knowledge of a “suit, act, error or omission”; and second, whether a reasonable person in the insured’s position might expect a claim or suit to result). Versions of this mixed objective-subjective standard for interpreting Prior Knowledge exclusions has been employed by courts around the country. Alps Prop. & Cas. Ins. Co. v. Kalicki Collier, LLP, 526 F. Supp. 3d 805, 816 (D.Nev. 2021); Capitol Specialty Ins. Corp. v. Big Sky Diagnostic Imaging, LLC, 2019 U.S.Dist.LEXIS 45234, at *26-27 (D.Mont. Jan. 30, 2019); Am. Special Risk Mgmt. Corp. v. Cahow, 286 Kan. 1134, 192 P.3d 614, 625 (Kan. 2008).

Second, the court determined that the question about the foreseeability of a future claim (from the insured’s point of view) could not be resolved on summary judgment. In other words, it ruled that “[w]hether a claim was foreseeable is thus a question of fact appropriate for the jury.” Other cases in this area have also found this question to be one of fact and hence not amenable for resolution via summary judgment. See James River Ins. Co. v. Hebert Schenk, 523 F.3d 915 (9th Cir. 2008) (summary judgment denied where the claim at issue was not necessarily “reasonably foreseeable”); HSB Group, Inc. v. SVB Underwriting, Ltd., 664 F. Supp. 2d at 194 (genuine issue of material fact concerning whether professional in insured’s position would reasonably foresee that a claim would be made against it); cf. Selko v. Home Ins., Co., 139 F.3d 146 (3rd Cir. 1998) (affirming summary judgment for insurer under “prior knowledge” exclusion).

But the real lesson in OneBeacon was not revealed until the case went to the jury. At trial the jury found that the insurer had wrongfully based its coverage denial on the dubious merits of the prior knowledge exclusion. In this regard, the jury apparently found that it was not objectively reasonable for the law firm to have foreseen that a malpractice action would be filed by its former client. Rejecting OneBeacon’s claim that coverage was barred under that exclusion, the jury awarded the insured law firm $34 million in damages, including punitive damages and damages awarded under the Texas claims handling statute. The Fifth Circuit affirmed the jury’s award.

Notably, however, subsequent cases indicate that the Fifth Circuit’s holding may be somewhat limited, based on the extreme overbreadth with which the term “wrongful acts” was defined. For example, the Northern District of Illinois recently considered a “claims made” policy with a provision that—like that at issue in OneBeacon—“did not limit its application to knowledge of facts or circumstances likely to give rise to a claim.” U.S. Specialty Ins. Co. v. Vill. of Melrose Park, 455 F. Supp. 3d 681, 689 (N.D.Ill. 2020). Notwithstanding the breadth of the exclusion, the court found that it did “not exclude coverage when the facts giving rise to the claim occur in the same policy year as the claim” and as a result, it did not render coverage illusory.  Id.; see also Weeks & Irvine LLC v. Associated Indus. Ins. Co., 433 F. Supp. 3d 791, 803 (D.S.C. 2020) (distinguishing OneBeacon on the grounds that the insured would have had coverage, had they properly reported the claim under the first policy). These more recent cases underscore the importance of careful policy drafting. For policies intended to provide retroactive coverage on a claims made basis, courts may not look favorably on overbroad definitions of prior “wrongful acts.”