Applying Arizona law, the United States District Court for the District of Arizona held that an insurer that breached its duty to defend bears the burden of demonstrating that an allocation of defense costs between covered and non-covered claims is possible. Tapestry on Cent. Condo. Ass’n. v. Liberty Ins. Underwriters Inc., 2020 WL 4607248 (D. Ariz. Aug. 11. 2020).

The insured’s claims-made insurance policy included a contractual liability exclusion providing that the insurer “shall not be liable to pay any Loss in connection with any Claim . . . for any actual or alleged liability of any Insured under any contract or agreement, express or implied, written or oral[.]”  The exclusion also stated that it “shall not apply to the Insurer’s duty to defend and to pay Defense Costs.”  The insured was named in a lawsuit brought by two different plaintiffs alleging breach of three contracts. The insured sought coverage for defense expenses for the suit but did not pursue indemnity coverage.  The insurer maintained that the underlying Claim related to construction defects and denied a defense on the basis of an exclusion barring coverage for any Claim “arising from, or in any way related to any Construction Defect.”

In subsequent coverage litigation, the court held that the single lawsuit constituted two separate “Claims,” only one of which was subject to the construction defect exclusion.  The court determined that the second “Claim” thus triggered the insurer’s duty to defend.  The court then requested briefing on the issue of allocation of the insured’s defense costs between the covered claim and the uncovered claim.

Treating the issue as one of first impression under Arizona law, the court adopted the approach employed in “actions involving a breach of the duty to defend when some claims were covered and some were not by the policy’s indemnity provision.”  The court held that while the insured was required to document the defense costs incurred and their reasonableness, the insurer bore the burden of demonstrating that some apportionment of defense costs was possible, otherwise it was responsible for the entire amount.  The court held that the insurer’s burden of persuasion “as to whether those fees can be allocated and how they should be allocated is that of a preponderance of the evidence.”  The court found that while the insurer was able to demonstrate that a portion of the defense costs related solely to the non-covered claim, there was “uncertainty as to whether certain fees went to the defense of the noncovered versus the covered Claim[.]”  Consequently, the insurer was required to reimburse the insured for all fees and costs other than those that it established related solely to the non-covered claim because it failed to carry its burden as to the remainder.