Expert Commentary

Should Insurance Policies Have "No Hair?"

In insurance disputes, courts must determine the parties' intent in entering into the contract. Here, Kenneth Wollner discusses why some courts ignore extrinsic evidence when interpreting insurance policies.

Drafting and Interpreting Policies
September 2002

"[There is no] Lawyer's Paradise [where] all words have a fixed meaning ... and where, if the writer has been careful, a lawyer, having a document referred to him may sit in his chair, inspect the text, and answer all questions without raising his eyes."

—J. Thayer, A Preliminary Treatise on the Law of Evidence 428-429 (1898) (quoted in E. Allan Farnsworth, Farnsworth on Contracts 239 (1990))

An event horizon is a boundary in space-time which, loosely speaking, divides the inside of a black hole from the outside. The gravitational attraction of a black hole is so strong that any object that crosses the event horizon, including light, can never escape out of the black hole. Theoretical astrophysicists tell us that all knowledge of objects falling into a black hole is lost once they cross the event horizon. This idea prompted John Wheeler of Princeton to proclaim that "black holes have no hair."

According to many courts, when the insurance company and the policyholder enter an insurance contract, the transaction, metaphorically speaking, crosses an event horizon. The understanding of the parties, the broker, or other persons involved in the placement is not considered for the purpose of insurance policy interpretation. Neither are advertising copy, insurance industry representations to regulators and the general public, drafting history, trade custom and usage, and even extracontractual statements by the parties themselves. The only source of information about the bargain—or at least the insurance company's promises—is the "hairless" policy text.

The main purpose of judicial interpretation of an insurance policy or other contract is to determine the objective intent of the parties. So why is it that some courts ignore evidence of the parties' intent other than the insurance policy text?

The Parol Evidence Rule

Let's say you are a judge called upon to interpret an insurance policy provision. You know nothing about the circumstances of the insurance transaction or trade custom and usage. The policyholder and the insurance company advocate conflicting textual interpretations. However, no matter how long you stare at the policy language, you can't detect an ambiguity. You think the meaning is plain and definite. One or both of the litigants proffer additional evidence, such as the coverage proposal or an alternative standardized endorsement form that precisely addresses the issue giving rise to the dispute. Do you admit such "extrinsic" evidence?

If you follow the pattern in many, if not most, coverage actions, the answer is no. According to many judges, oral (parol) or other "extrinsic" evidence is barred by the parol evidence rule or its stepchild, the plain meaning rule. (My book How to Draft and Interpret Insurance Policies contains a plain English explanation of these rules and their exceptions.) In other words, extrinsic evidence may be used to interpret an insurance policy provision only if, in the opinion of the judge, the provision is ambiguous.

This circularity (remember God's reply to Moses: "I am that I am") often results in absurdities. In the first article in this series, we looked at a case turning on the meaning of the phrase "the Insured's duties as investment counselors." There, the U.S. Court of Appeals for the Second Circuit found the term to have a "plain meaning." Ironically, the Second Circuit's "plain meaning" differed from the interpretation of the lower court, the interpretation advocated on behalf of the policyholder, and the interpretation advocated on behalf of the insurance company. Nowhere in the written opinion of the court is mention made of the parties' understanding of "investment counselors." Nor is there discussion of what ideas the language of the insurance policy may have conveyed based on the surrounding facts and circumstances, including the fact that the primary business of the policyholder is investment banking.

Judges routinely exclude even the most relevant and potent proofs in insurance coverage actions. Perhaps the most widely known example is interpretation of the "sudden and accidental" exception to the qualified pollution exclusion in comprehensive or commercial general liability policies. Policyholders have proffered the regulatory and drafting history to show that the insurance industry claimed that the exclusion (1) is intended to apply only to Superfund liability and hazardous substances as defined by the Environmental Protection Agency and (2) is not intended to preclude coverage for products, completed operations, and certain off-premises claims. Judges that barred admission of such extrinsic evidence reached different conclusions about the meaning and application of the exclusion. In contrast, as of 1997 (the last time I researched this issue), courts that have reviewed the drafting and regulatory history almost invariably find for the policyholder.

Censorship of extrinsic evidence increases the chance that a judge will get it wrong, at least from the standpoint of insurance professionals who know (or should know) more about the intent of parties to an insurance transaction. A more subtle effect is increased litigation vagaries. The meaning of words in an insurance policy is rendered more uncertain because such words are not bounded by the context in which they are used. Instead, the parties are encouraged to focus on hyper-literal or other analysis having little to do with the main function of the court—to determine the shared understanding of the parties.

So attorneys resort to exotic inferences from the policy text or other sources that could not possibly have been contemplated by the insurance company and the policyholder. An example of this phenomenon is litigation seeking to transfer the cost of Y2K remediation to insurance companies via the "sue and labor" clause in some property insurance policies.

The Non-History of the Insured versus Insured Exclusions

Like the pollution exclusions, the insured versus insured exclusions in directors and officers liability insurance has been the subject of a great deal of discussion and analysis. The "insured versus insured" exclusion came into widespread use during the mid-1980s in response to suits by corporations not in bankruptcy (e.g., Bank of America) against their directors and officers, and suits by quasi-governmental agencies (e.g., Resolution Trust Corporation) against executives of failed financial institutions. Teams of lawyers and law firms were kept occupied in D&O coverage litigation. Standard form policy provisions were changed and changed again. The different versions of the insured versus insured exclusion have been (and continue to be) vetted ad nauseam. It is on the basis of such information that insurance companies market their products, consultants score coverage, brokers sell insurance, underwriters submit coverage terms, and policyholders select from among proposals.

Beginning in 1992, the reliability of this information was called into question because of court decisions. In Reliance Insurance Co. of Illinois v Weiss (In re Reliance Insurance), 148 BR 575 (E D Mo 1992), aff'd in part, 5 F3d 532 (8th Cir 1993, cert den 510 US 1117 (1994), a committee of unsecured creditors of the debtor corporation asserted a claim against the corporation's former directors and officers. The district court held that the insured versus insured exclusion barred coverage. In the latest ruling, the court in Cohen v National Union Fire Insurance Co. (In re County Seat Stores, Inc.), Adv Pro No 01-2366 (July 10, 2002) (Bankr SD NY) held that the insured versus insured exclusion did not preclude coverage for a claim brought by a trustee in Chapter 11 proceeding.

The published opinions make it abundantly clear that the pivotal issue is the distinction between a pre-petition corporation and a trustee of the bankruptcy estate. Courts that held that the exclusion did not apply to trustee claims recognized that a trustee is not the "alter ego" of the debtor corporation and represents separate interests and obligations. A few courts discussed the purpose of the exclusion, explaining that because the trustee was acting with genuine adversity to the defendants, coverage of his lawsuit would not clash with the exclusion's function of weeding out collusive litigation. Otherwise, evidence of understanding of the parties to the insurance contract was either not discussed in the opinions, censored under the parol evidence rule, or discounted as "non-probative."

I single out the opinion in Molten Metal Technology v Executive Risk Indemnity, 271 BR 711 (Bankr D Mass 2002), for two reasons. First, Bankruptcy Court Judge Carol J. Kenner wrote a clear and well-organized opinion. Second, the number of arguments discussed in the opinion and length of the opinion (over 11,000 words) indicate that substantial financial and intellectual resources were deployed in the dispute over the meaning and application of the phase "brought by any Insured or the Company."

In her opinion, Judge Kenner dismissed every argument from both sides based on extrinsic evidence. With regard to the backdrop of prior litigation, she stated:

The Trustee [argues] that, in view of the numerous decisions against National Union [the underlying insurer] in the 1980s in which courts held that an insured-versus-insured exclusion did not bind a trustee in bankruptcy (or other successor to the company), National Union would expressly have mentioned trustees in bankruptcy in the exclusion if it had intended to exclude their claims from coverage. The Court rejects this argument. The language of the agreement unambiguously supports the Trustee's proposed interpretation, so this appeal to extrinsic evidence—the record of adverse decisions—is neither justified nor necessary.


In their article "Parol Evidence Myths in Insurance Coverage Litigation," Journal of Insurance Coverage 1, no. 3 (Summer 1998), John D. Shugrue and Timorthy W. Burns correctly argue that the use of the parol evidence rule in many coverage actions is "fundamentally at odds" with general contract law. Decisions handed down by a few courts may signal a trend to bring interpretation of insurance policies more in line with modern jurisprudence. (See, e.g., Lynott v National Union Fire Ins. Co., 123 Wash 2d 678 (1994) and Key Tronic Corporation v Aetna, 124 Wash 2d 618 (1994).) Until that day comes, if it ever does, individuals involved in insurance transactions should be aware that in the view of many judges an insurance policy has no hair.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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