The Mechanics Of The Duty To Defend, The Duty To Indemnify, And Additional Insureds

• Published date: 12 September 2022
• Subject Matter: Corporate/Commercial Law, Insurance, Litigation, Mediation & Arbitration, Contracts and Commercial Law, Insurance Laws and Products, Personal Injury
• Law Firm: McCague Borlack LLP
• Author: Mr Garett Harper and Naomi Santesteban

The main purpose of commercial general liability insurance policies ("CGL policies") is to provide protection to an insured party against financial losses which may be incurred if the insured is sued by a third party. The relationship between an insurer and an insured party is dependent on the wording of the relevant insurance contract. Typically though, CGL policies, similar to other liability insurance policies, require an insurer to fulfill two distinct, but related duties. The first obligation is referred to as the "duty to defend". This entails the insurer paying for, and instructing, legal counsel in the defence of a claim brought against its insured by a third party. The second obligation is called the "duty to indemnify". This duty requires the insurer to pay for any judgment awarded to the third party against its insured or any settlement that the parties have reached in lieu of judgment.¹

The duty to defend when properly understood from the insurer's point of view is both a contractual obligation and a contractual right. The duty to defend acts as an obligation on an insurer for the obvious reason that it is invoked by its insured to shield the insured from the significant costs associated with defending an action. However, given that a typical CGL policy creates a duty on an insurer to indemnify its insured, having control of the defence of the lawsuit is advantageous for the insurer. Even if it is clear that the insured is liable, the insurer can attempt to minimize the damages attributable to its insured, thereby reducing the financial impact of the insurer's obligation to indemnify its insured. Having control of the defence then can be seen as a benefit to the insurer thus making the duty to defend a contractual right of the insurer as well.²

...the duty to defend (is) a contractual right of the insurer...

An insurer's duty to indemnify its insured will only be triggered after the merits of the law suit have been determined by a court or after a settlement agreement has been reached. This is non-controversial as the determination of liability and the quantum of damages must be resolved in order to determine if, and to what extent, they fall within the indemnity coverage provided by the liability insurance policy. This is not the case with an insurer's obligation to defend an insured against a lawsuit from a third party. Although the duty to defend is triggered well before the merits of the lawsuit are determined, when exactly the duty arises is a question courts have grappled with.³

In 1990, the Supreme Court of Canada ruled in Nichols v. American Home Assurance Co., that an insurer's duty to defend arises only if, assuming that the facts as alleged in the pleadings were proven true, an insurer would have an obligation to indemnify its insured.⁴ This decision cites a judgment from the British Columbia Superior Court that held, "the pleadings govern the duty to defend".⁵ Nichols stands for the proposition that in order for the duty to defend to arise, it is not necessary to prove that the duty to indemnify will certainly arise. Rather the "mere possibility that a claim within the policy may succeed" is enough to trigger the duty to defend.⁶

The True Nature of the Claim

Ten years after the decision in Nichols, a problem developed. It was thought that the ruling in Nichols incentivized parties who were issuing claims against defendants who were insured, to draft their pleadings in as broad a manner as possible to capture at least one allegation that would be covered by the "four corners" of the defendant's insurance policy. In doing so, plaintiffs were thought to be intentionally triggering the duty to defend on the part of the defendant's insurer and presumably hoping that the insurer would settle the claim before the merits of the action could be decided by a judge.⁷ Therefore in order to address this concern, the Supreme Court of Canada in Non-Marine Underwriters, Lloyd's of London v. Scalera, clarified what the analysis should be when determining whether an insurer's duty to defend is triggered.⁸

The facts of the Scalera decision are illustrative. Mr. Scalera was sued for damages arising from a series of sexual assaults that were allegedly perpetrated by him against a young woman over a period of several years.⁹ The pleadings raised numerous allegations including an allegation of negligent battery.¹⁰ Mr. Scalera sought coverage for the defence of this claim pursuant to his homeowner's insurance policy, as some of the allegations dealt with negligence, which he argued fell within the ambit of the policy.¹¹ The insurer refused to provide a defence, because the policy specifically excluded coverage for bodily injury caused by intentional or criminal acts, and the insurer claimed that sexual assault is always intentional.¹² The Court sided with the insurer and found that all of the allegations that were in the pleadings were based on the same set of facts and were "derivative of the claim for sexual battery" and therefore were also covered by the exclusion for injuries intentionally caused.¹³ The Court in Scalera clarified the Nichols ruling by stating that the connection between the duty to defend and the pleadings is not determined solely with regards to the language of the pleadings. Instead, the determination is based on what the pleadings reveal to be the "true nature of the claim".¹⁴ After the ruling in Scalera, the decision in Nichols can be said to stand for the proposition that, "having determined the nature of the claim, an insured need not further prove that the claim would succeed" in order for the duty to defend to be triggered.¹⁵

To determine the "true nature" of the claim, Courts have been encouraged to "look behind the literal terms of the pleadings" in order to assess which of the legal claims put forward by a plaintiff could be supported by the factual allegations.¹⁶ The purpose of the analysis is to discern the true "substance" of the allegation. The analysis should be framed by assuming the truth of the plaintiff's factual allegations and asking whether the pleadings could possibly support the plaintiff's allegations.¹⁷ In undertaking this analysis, courts are allowed to look at any extrinsic evidence that has been explicitly referred to within the pleadings to assist in determining "the substance and true nature of the allegations".¹⁸ However, the Ontario Court of Appeal recently clarified that extrinsic evidence not mentioned in the underlying action or "premature" evidence should not be considered in a duty to defend application, to avoid the risk of it becoming a "trial within a trial" and ensuring an expeditious determination of the issue.¹⁹ For the purpose of determining what the "true nature" of the claim is and whether a duty to defend arises from it, the term "pleadings" includes any cross claims or third party claims, in so far as they are relevant in defining the substance of the allegations.²⁰ Pleadings are also to be interpreted broadly, and any doubt is to be resolved in favour of the insured.²¹

Once the true nature of the claim has been determined, one must then consider whether the policy is triggered by the allegations. It is at this step of the process where the value of precise and unambiguous language in a CGL policy shines.

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