Seventh Circuit Holds that Actual Wrongful Act Must be Established to Trigger Prior Knowledge Exclusion

The United States Court of Appeals for the Seventh Circuit, applying Indiana law, has revived a coverage dispute over whether a medical malpractice insurer’s professional liability insurer must cover the malpractice insurer’s post-verdict excess settlement of an underlying wrongful death claim, finding that factual questions remain as to whether the malpractice insurer’s refusal to settle the wrongful death claim on behalf of its insured physician was an actual “Wrongful Act” triggering a prior knowledge exclusion.  Med. Protective Co. v. Am. Int’l Specialty Lines Ins. Co., 2018 WL 6613336 (7th Cir. Dec. 18, 2018).

In 2003, the family of a woman who died after routine surgery brought a wrongful death suit against the treating physician.  During the litigation, the family twice offered to settle the case for the physician’s $200,000 policy limit.  The physician’s malpractice insurer rejected both offers.  The case proceeded to trial where the jury returned a $14 million verdict, which the court later reduced.  Following the verdict, the physician’s malpractice insurer paid the family $1.7 million, the amount for which the physician was individually liable under the applicable statutory cap.  The family then sued the malpractice insurer for the remainder of the verdict.  The family’s lawsuit against the malpractice insurer settled for a confidential amount greater than $5 million.

During the underlying wrongful death suit, the physician’s malpractice insurer purchased its own $5 million insurance company E&O policy.  That policy provided specified coverage for “Wrongful Acts,” defined as “any breach of duty, neglect, error, misstatement, misleading statement, omission or other act done or wrongfully attempted.”

The malpractice insurer sought coverage under that policy for its confidential settlement with the family.  The E&O carrier denied coverage for the settlement based on a prior knowledge exclusion in the policy, which precluded coverage for any claim arising out of any “Wrongful Act” occurring prior to the inception of the policy if the malpractice insurer “knew or should have reasonably foreseen that such Wrongful Act could lead to a claim or suit.”  The malpractice insurer sued its carrier for breach of contract.

In the coverage action, the district court ruled in favor of the E&O carrier, holding that the prior knowledge exclusion applied because, when the parties first contracted, the malpractice insurer “knew or should have foreseen that its failure to settle with [the family] could lead to a claim or suit.”  The Seventh Circuit reversed on appeal.

In doing so, the court analyzed two questions:  Was there an actual versus a merely alleged Wrongful Act?  And if there was a Wrongful Act, could the malpractice insurer have foreseen, before the inception of the policy, that this act could lead to a claim or suit?  With respect to the first question, the Seventh Circuit explained that, under the definition of Wrongful Act and the terms of the prior knowledge exclusion, which referred expressly to a Wrongful Act in order for the prior knowledge exclusion to be triggered, mere allegations of wrongful conduct were insufficient.  To the contrary, the E&O carrier had the burden of proving that a Wrongful Act had actually occurred, i.e., of showing that the malpractice insurer had improperly failed to settle the family’s claims within the physician’s policy limits when it had the opportunity to do so.  As to this point, the Seventh Circuit concluded that a genuine issue of material fact remained.

Next, with regard to the second question, the Seventh Circuit affirmed the district court’s ruling, noting that the malpractice insurer “should have known that it was facing a potential claim” by the family for failure to settle.  Thus, assuming the failure to settle was a “Wrongful Act,” the prior knowledge exclusion would be triggered and bar coverage.

Finally, the court held that Indiana’s known loss doctrine, which precludes a party from obtaining insurance for a loss that has already occurred, did not apply, reasoning that it could not conclude that the malpractice insurer was facing a “virtually inevitable” loss when it bought the E&O policy.

The Seventh Circuit remanded the case to the district court for further proceedings.


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