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The number of jurisdictions in which an insurer can safely decline coverage based solely upon a good faith determination that coverage under its policy does not apply to a claim is rapidly diminishing.  In Wisconsin, consistent with that trend, the consequences of being wrong about coverage can be harsh, including the forfeiture of policy defenses and the award of contractual damages in excess of policy limits.  When an insurer believes coverage is not “fairly debatable,” the cautious approach for an insurer in Wisconsin is to file a declaratory judgment action to obtain a ruling on the coverage issues.  Since Wisconsin is a “direct action” State, the underlying litigation may be an available forum in which the insurer may be permitted to adjudicate coverage.

1. THE CONTRACTUAL OBLIGATION

Wisconsin views the insurance policy as a contractual agreement between the insurer and the insured.  The Wisconsin Supreme Court has placed great emphasis on the insurer’s contractual duty to defend:

In return for the premiums paid the by insured, the insurance company assumes the contractual duties of indemnification and defense for claims described in the policy….  An insurance carrier’s duty to defend its insured in a third party suit is broader than its duty of indemnification and is predicated on allegations in a complaint which, if proved would give rise to recovery under the terms and conditions of the insurance policy.

Elliott v. Donahue, 169 Wis.2d 310, 320, 485 N.W.2d 403 (1992).  Wisconsin heavily favors the insured with regard to the duty to defend.  Any doubt with regard to the duty to defend is resolved in favor of the insured.  Wausau Tile, Inc. v. Cnty. Concrete Corp., 226 Wis.2d 235, 266, 593 N.W.2d 445 (1999).

The duty to defend arises when allegations in the four corners of the complaint fall within the purview of the insurance contract.  The question of whether an insurer has a duty to defend rests with the court as the construction of a contract is a question of law.  Prof’l Office Bldgs., Inc. v. Royal Indemn. Co., 145 Wis.2d 573, 580, 427

N.W.2d 427 (Ct. App. 1988).  Thus, if there is any dispute regarding coverage, a court will consider only the four corners of the complaint.  The court will not consider extrinsic evidence to determine if coverage exists.  Grube v. Daun, 173 Wis.2d 30, 72, 496 N.W.2d 106 (Ct. App. 1992).  The policy’s insuring agreement is considered first.  If a court determines that the policy was not intended to provide coverage, then the inquiry ends.  Estate of Sustache v. Am. Family Mut. Ins. Co., 311 Wis.2d 548, 557, 751 N.W.2d 845 (2008) (citing Am. Family Mut. Ins. Co. v. Am. Girl, 268 Wis.2d 16, 673 N.W.2d 65).  Only after the insuring agreement is considered, will a court then examine the policy’s exclusions.  Of course, policy exclusions are strictly construed against the insurer if their effect is uncertain.  Am. Girl, Inc., supra, 268 Wis.2d at 32.

2. THE “FAIRLY DEBATABLE” STANDARD

Wisconsin has adopted the “fairly debatable” standard: an insurer has a duty to defend if the existence of coverage is fairly debatable.  Radke v. Fireman’s Fund Ins. Co., 217 Wis.2d 39, 44, 577 N.W.2d 366 (Ct. App. 1998).  The “fairly debatable” standard is judged from the insurer’s point of view.  A claim is fairly debatable where a genuine dispute arises over the status of the law or facts at the time the claim is tendered.  Madsen v. Threshermen’s Mut. Ins. Co., 149 Wis.2d 594, 614, 439 N.W.2d 607 (Ct. App. 1989).  However, the policy language is not tested by what the insurer intended the words to mean, but what a reasonable person in the position of the insured would have understood the words to mean.  U.S. Fire Ins. Co. v. Good Humor Corp., 173 Wis.2d 804, 820, 496 N.W.2d 730 (Ct. App. 1993).  Of course, a court will construe reasonable inferences in a complaint in favor of an insured.  Doyle v. Engelke, 219 Wis.2d 277, 284, 580 N.W.2d 245 (1998).  Any ambiguity regarding an insurer’s duty to defend then is resolved in favor of the insured.  Elliott, 169 Wis.2d at 320-21.

3. THE INSURER’S OPTIONS

Under Wisconsin law, an insurer has two options when faced with the duty to defend.  If the insurer believes that, based upon an analysis of the four corners of the complaint and its policy, it is not even fairly debatable that coverage applies, it can issue a declination of coverage.  However, an insurer that “declines to defend does so at [its own] peril.”  Prod. Stamping Corp. v. Md. Cas. Co., 199 Wis.2d 322, 327 (Ct. App. 1996).  The insurer is protected if either the insured fails to challenge its position or if the insured seeks a court’s declaration and the insurer’s position is found correct.  The insurer then has not waived its coverage defenses.

The insurer’s second option is to provide its insured with a defense while seeking an adjudication of its duty to defend from the court.  The Wisconsin Supreme Court has established the proper procedure for an insurance company to follow when coverage is disputed: request a bifurcated trial on the issues of coverage and liability and move to stay any proceedings on liability until the issue of coverage is resolved¹.Newhouse v. Citizens Sec. Mut. Ins. Co., 176 Wis.2d 824, 836, 501 N.W.2d 1 (Ct. App. 1993).  Because Wisconsin is a direct action state, generally, the insurer already is a party to the action². If the insurer is not a party to the action, the insurer may seek to intervene.  Fire Ins. Exchange v. Basten, 202 Wis.2d 74, 89, 549 N.W.2d 690 (1996).

In Wisconsin, the consequences for an insurer that refuses to defend its insured may be harsh.  Given that Wisconsin views the relationship as a contractual, an insurer that refuses to defend its insured will be held to have breached a contractual provision of the insurance contract.  Newhouse, supra, 176 Wis.2d at 836.  A breach of contract then renders the insurer liable to the insured for all damages that naturally flow from the breach.  These damages may include: (1) the amount of any settlement or judgment plus interest; (2) costs and attorneys’ fees incurred by the insured in defending the lawsuit; and (3) any additional costs that the insured can show naturally resulted from the breach.  Radke, 217 Wis. 2d at 46.

 An insurer that fails to provide an insured with a defense and later is held to have breached its contractual obligations also risks exposure beyond its limits.  In Newhouse, the insurer failed to defend its insured and a judgment in excess of the policy limits was entered against the insured.  Ultimately, the Wisconsin Supreme Court held that the insurer was responsible for the judgment in excess of policy limits.

In Newhouse, four-year-old Robert Newhouse was seriously injured while on a farm with his uncles.  One uncle was insured under a homeowner’s policy with a maximum limit of $50,000.  Robert and his parents sued the uncles.  The insured uncle tendered the claim to his insurer, which insurer then commenced an action seeking the court’s determination of whether it had a duty to defend.  The trial court issued a declaration that the homeowner’s policy did not apply.  There was no appeal on the declaratory action.  The insurer then was joined as a defendant in the liability action in which the court again ruled that there was no coverage and dismissed the insurer.  The Newhouses and uninsured defendants appealed the court’s ruling dismissing the insurer from the liability action.  The liability action then went to trial where each of the defendants settled with the Newhouses except the insured uncle.  Trial against the insured uncle proceeded without participation of the insured or its insurer.  Prior to trial, the insurer was asked by the court if it wanted a continuance pending the decision in the coverage appeal, which the insurer declined.  Judgment was rendered against the insured uncle for $588,003.70.  On appeal, the court of appeals found that the insurer’s policy provided coverage for the claim.  The insurer then paid its policy limits ($50,000), plus $77,000 in interest and costs.  The insurer also paid its insured’s attorneys’ fees. 

The insured then assigned his rights under the policy to the Newhouses who initiated a lawsuit against the insurer for several claims including breach of contract and bad faith.  The trial court awarded the Newhouses $724,003.92, which included the amount awarded against the insured in the underlying case.  This was on the breach of contract claim; the court dismissed the remaining claims.  The court of appeals reversed, finding the proper measure of damages for an insurer’s breach of the duty to defend was limited to the policy limits plus interest and attorneys’ fees in defending the lawsuit.

On appeal to the highest court, the Wisconsin Supreme Court disagreed and held:

an excess judgment is properly included in the damages for breach of an insurer’s duty to defend, if the excess judgment was a natural or proximate result of the breach.  The insurance company must pay damages necessary to put the insured in the same position he would have been in had the insurance company fulfilled the insurance contract.

Newhouse, supra, 176 Wis.2d at 838. Therefore, the policy limits did not restrict the damages recoverable by an insured for breach of the contract by the insurer.  Id. at 836.  In the end, the insurer paid more than 1300% of its limits for not defending its insured.

4. CONCLUSION

Wisconsin goes to great lengths to protect its insureds.  To avoid unanticipated exposure, unless a claim is clearly outside the realm of coverage, an insurer must seek a court’s declaration of whether it has a duty to defend – through appeal.  Otherwise, the insurer risks being found to have breached its duty to defend, and possible exposure beyond its policy limits.