FEATURE STORIES | APRIL 2008

The Pitfalls of Arbitration Provisions in Insurance Policies

By Christopher H. Yetka
Lindquist & Vennum, PLLP

Arbitration provisions are common in first-party property insurance policies. They are usually invoked when an insurer and policyholder cannot come to agreement on the value of lost or damaged property. They are usually referred to as "appraisal clauses," and the standard language provides for appraisal if the parties disagree on the value of property or the amount of loss. Pursuant to the provision, each party selects an impartial appraiser, and the two appraisers then select an additional appraiser to serve as an umpire. If the first two appraisers fail to agree on price, they submit their differences to the umpire. A decision by any two is binding. Parties typically bear the costs of their own appraiser and half the cost of the umpire.

Similar language has begun to creep into third-party liability policies. While not the norm, arbitration provisions have begun to appear in directors and officers (D&O) policies and employment practices liability (EPL) policies. In addition, since 1985, they have been available as an endorsement to commercial general liability (CGL) policies. Inclusion of an arbitration provision in a third-party liability policy poses a more significant issue, and a potential barrier to recovery. Rather than simply requiring the parties to arbitrate the amount of coverage, the new provisions require the parties to arbitrate the existence of coverage.

A typical provision in a D&O or EPL policy requires that any dispute based on, arising from, or in connection with coverage be submitted to binding arbitration. Typically it allows the parties to first pursue nonbinding mediation. If that is unsuccessful, binding arbitration is required, pursuant to American Arbitration Association or similar rules. As with the appraisal provisions above, each side chooses an arbitrator, and those two arbitrators choose a third.

Pursuant to the 1985 ISO form endorsement (CG 24-02-11) to the CGL policy, if there is a disagreement over coverage, either party can make a written demand for arbitration. In that case, each party selects an arbitrator, both of whom together select a third. Again, the two parties pay for their own arbitrator, and the cost of the third arbitrator is split. In this form, the location of the arbitration is the county listed in the declarations page.

For many companies, arbitration provisions are initially attractive because they are thought to reduce the expense of litigation. However, the opposite may be true. Where an arbitration provision exists, some or all of the following situations may arise:

1. Most courts require some form of alternative-dispute-resolution procedure prior to trial of the matter. The parties can select arbitration to resolve the claim in the context of litigation. Importantly, other forms of ADR, such as mediation or mini-trial, are also available.
   
   
2. The binding arbitration provisions listed above take away the right of appeal. In addition, because the decision is binding and not subject to review, arbitrators may be more inclined to "split the baby." Moreover, the only way to overturn a decision is to show some form of significant bias. When the very existence of coverage is at stake, rather than simply valuation, an unfavorable and inequitable outcome in arbitration eliminates coverage, with no recourse.
   
   
3. Arbitration, particularly before the American Arbitration Association, is often in practice as expensive as full-fledged litigation, and includes discovery, motion practice, and the arbitration itself.
   
   
4. It can be very difficult to get a strong advocate as an arbitrator. While arbitrators are supposed to be neutral, insurance companies use the same arbitrators time and again, and they are almost universally strong advocates for the insurers’ positions. Policyholders must make sure that their arbitrators are equally strong, or run the risk of losing control of the process. This is particularly important since the two arbitrators are typically picking a third, "neutral" umpire. Again, because insurers will come before umpires time and again and a policyholder is unlikely to do so, it is important to make sure that the umpire is in fact not biased in any way. Even if not overtly biased, an umpire can unconsciously be swayed by the prospect of future work.
   
   
5. The location of the arbitration may be at issue. Policyholders should not be forced to travel to participate in mandatory arbitrations if they could have instituted a lawsuit in their home jurisdictions.
   
   
6. The arbitration provision can threaten legal presumptions in the interpretation of insurance contracts. Most courts treat insurance contracts as contracts of adhesion, and all ambiguities and uncertainties must be interpreted in the policyholder's favor. There is a risk that those same presumptions will not be applied by arbitrators, especially if the arbitrators are not lawyers or intimately familiar with insurance law.
   
   
7. If more than one policy is triggered, an arbitration provision may double the litigation costs. For example, if an action against directors and a company implicates both D&O coverage and separate EPL coverage, and one policy contains an arbitration provision, a policyholder may be forced to invoke arbitration to obtain coverage under one policy and litigation for the other. A more efficient approach, precluded by the provision, would be to bring one combined action in the court of the policyholder's choice.

For the reasons listed above, when an arbitration provision shows up in a liability policy, policyholders are well advised to seek the advice of counsel and their broker to determine if the provision threatens to reduce the very coverage they are seeking. Often these provisions can be eliminated by endorsement. Avoiding arbitration provisions will often outweigh any perceived cost reduction.

ABOUT THE AUTHOR

Christopher H. Yetka is a trial attorney with Lindquist & Vennum, PLLP. Chris's practice is devoted to commercial litigation, particularly insurance recovery disputes. He has successfully enforced the coverage rights of policyholders across the country in cases relating to nearly every type of insurance policy, including transportation, environmental, employment, and professional liability, as well as homeowners, life, and excess insurance. Chris can be reached by phone at 612-317-2416 and by e-mail at cyetka@lindquist.com.

This article is only a general summary for informational purposes and does not constitute legal advice. Consult a qualified and experienced insurance advisor for your specific situation or particular questions.

riskVue | The webzine for risk management professionals
April 2008