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MAXIMIZING INSURANCE COVERAGE for consulting and investigation costs associated with potential environmental problems requires understanding exactly what your insurance coverage entitles you to and carefully planning and documenting the necessary expenditures that you incur.

Under standard-form liability policies, insurance companies owe several duties to their policyholders, including the duty to indemnify and the duty to defend.

Usually, there is no dispute concerning which claim costs are from defense and which are from indemnity. However, in the environmental context, where the costs of determining the existence, cause, nature and extent of property damage and a cost-effective means of remediation often total millions of dollars, insurance companies and policyholders frequently disagree about whether such costs should be characterized as costs of indemnity or costs of defense.

In the typical environmental case, the policyholder is sued or receives a letter as a potentially responsible party, or PRP.

The policyholder then hires counsel and environmental consultants with the hope of eliminating, or at least reducing, potential damages. The policyholder submits lawyer and consultant fees to its insurers, expecting them to pay these items pursuant to the insurers' duty to defend.

Insurance companies commonly pay at least some of the attorney fees, albeit with some prodding. However, they routinely refuse to pay the consultant expense as a defense cost, arguing that it is payable, if at all, only under the duty to indemnify.

In the insurers' view, such costs are a necessary component of remediation. Because an insurance company's exposure on the duty to indemnify is capped by its policy limits, this position, if sustained, would materially reduce the insurer's potential exposure.

This is no mere semantic dispute. If investigatory expense is a defense cost, it is recoverable as incurred wherever there is a potential of coverage. If it is an indemnity cost, it is recoverable only at the end of coverage litigation, if coverage actually has been established.

It is particularly important because an insurance company's duty to defend is not tied to the coverage limits in the policy.

As a result, the insurer's duty to pay defense costs may be even more valuable to a policyholder than the coverage limits themselves.

What the duty to defend means

The duty to defend and the duty to indemnify are separate and distinct. The duty to defend, in fact, is much broader than the duty to indemnify. While the insurance company is required only to indemnify the policyholder for losses actually covered by the insurance, the insurer must defend the policyholder in a lawsuit or other adversarial proceeding if there is a mere potential the claims may be covered. The determination whether a claim made against a policyholder could be covered by the policy, thus triggering the duty to defend, must be made with the information available at the start of the lawsuit or other proceeding-not with the advantage of hindsight at the end of the matter.

A policyholder's entitlement to a defense does not depend on its ability to escape all liability to the third-party claimant: Black's Law Dictionary defines "defense" as "That which is put forward to defeat or diminish recovery." Thus, in fulfilling its duty to defend, the insurance company must take all steps necessary to defeat or reduce its policyholder's liability, including asserting any and all affirmative defenses available to the policyholder and providing counsel with adequate funds to conduct the defense of the suit. Any reasonable attempt to defeat or reduce liability before entry of a final judgment, even if ultimately unsuccessful, logically should be classified as a defense cost.

Why environmental investigation

expenses are defense costs

In environmental matters, investigation costs are a necessary component of defending the actions brought by regulatory agencies. In fact, in many cases, the only reason the investigation is undertaken is because litigation has begun. Without the information derived from the investigation, the lawyers would be unable to competently determine the nature and extent of any potential liability, explain the potential liability to management in developing a settlement position or convince the government that the company's settlement proposal was acceptable. Thus, the investigation is necessary both to:

Attempt to defeat liability, such as showing that other parties, not the policyholder, were responsible for any contamination.

Reduce liability, such as persuading the regulatory agencies to accept a smaller settlement payment or a less expensive cleanup plan.

Those are the quintessential defense goals, and investigation expenses incurred in service of those goals logically are covered by the insurer's duty to provide a defense.

Few courts, however, have considered whether environmental investigation costs are costs of defense, which do not count against the policy limits, or costs of indemnity, which do. Among those courts in California, for example, that have considered the issue, the prevailing view is that at least some environmental investigation costs can be recovered as costs of defense.

For example, one court has ruled that at least two categories of investigation costs qualify as defense costs: the cost of investigation to determine the nature and extent of contamination, and the study of cleanup options and strategies.

Another court has held that any investigation costs incurred before the government approves a remediation plan for a site can be recovered as defense costs. Because before the government approves such a plan, the policyholder has not officially incurred any liability, and therefore the duty to indemnify does not yet apply, the court ruled.

Recovering investigation expenses

as defense costs

The question of whether environmental investigation costs can be recovered as defense costs is an unsettled one in many jurisdictions. Insurers typically do not reimburse such costs as defense costs unless litigation forces them to do so. Policyholders faced with a potential environmental problem should anticipate the possibility of such litigation from the outset and take steps to increase the likelihood of winning it or settling it on favorable terms.

A policyholder can do several things to increase the likelihood of recovering this type of expense. The simplest would be to have investigatory work performed by a different consultant from that used for remedial work. This would permit a clear delineation of task by provider, facilitating payment. However, in some circumstances, a policyholder may find it is necessary or desirable for a single consultant to perform both the investigation and remediation. In such a case, it would be desirable for the policyholder to develop and implement an accounting procedure with a work-order number structure. Such a procedure would eliminate much of the subjectivity from the cost characterization process, increase the likelihood that records are maintained in a consistent manner and help segregate defense and indemnity expenses. This last factor increases in importance as years pass and memories fade.

Before developing the work-order structure, the company should attempt to determine the legal standard that may be applied in the applicable jurisdiction down the road in determining which costs should be attributed to defense. One possible standard may be that defense costs include any expenses incurred at the direction of the lawyers who assist them in:

Determining whether to recommend to management pursuing litigation or settlement.

Deciding what would constitute a desirable settlement from the company's standpoint.

Convincing the regulators that the remedial plan the policyholder proposes is sound.

Under this standard, defense costs would include the expense of developing an appreciation of the geology and hydrogeology of the site, determining the nature and extent of chemicals present in soil and ground water as well as the toxicology of those chemicals, identifying and evaluating remediation options and the relative costs of those options, and other similar expenditures.

Once the standard is determined, the work-order structure will write itself. Expense categories that may be useful include:

Searching for other PRPs.

Investigating the nature and extent of the presence of chemicals in ground water soil.

Investigating alternative technologies for remediation.

Monitoring the effectiveness of ground water remediation.

The precise categories will need to be tailored to fit the nature of the expense incurred and contemplated.

Insurance companies may attempt to avoid paying environmental investigation costs under their duty to defend by trying to use the descriptions of the work maintained by policyholders for bookkeeping purposes against them. Policyholders should not fall into this trap. They should make certain each investigation expense is described fully and properly in all internal writings to increase the likelihood that each such expense will be recoverable as a defense cost.

Investigation costs are among the most financially burdensome for businesses and other organizations involved in environmental cleanup actions. By carefully planning, tracking and describing such expenditures, policyholders can help maximize the chance that such expenses will be recoverable as defense costs, thus getting the most out of their insurance coverage.

Scott DeVries and Tad Pethybridge are attorneys in the San Francisco office of Nossaman, Guthner, Knox & Elliott. They represent policyholders in litigation with insurance companies.