In Pitzer College v. Indian Harbor Insurance Company, the California Supreme Court resolved two previously open questions in insurance law: (1) it concluded that the notice-prejudice rule is a fundamental public policy of California, and (2) it concluded that the notice-prejudice rule applies to consent provisions, but only in first-party policies.
This decision provides three primary lessons to insureds. First, when a first-party insurer cites a strict notice provision as a complete bar to coverage, a California policyholder should respond by citing the notice-prejudice rule, even if the policy selects the law of a state that does not follow the notice-prejudice rule. Second, the insured should do the same if a first-party insurer cites a consent provision as a basis to limit coverage for otherwise-covered expenses. In both cases, the notice-prejudice rule may override the choice of law provision and preserve coverage unless the insurer was actually and substantially prejudiced by the delayed notice/consent. Third, in the case of third-party policies, the insured should continue to promptly notify the insurer in the event of a claim and should seek consent before incurring otherwise-covered expenses. The insured should not rely on the notice-prejudice rule to potentially save coverage where it delays notice or fails to seek consent for expenses under a third-party policy.
Pitzer College v. Indian Harbor Insurance Company, __ P.3d__, 2019 WL 4065521 (Cal. August 29, 2019) (“Pitzer”), involved a coverage dispute between Pitzer College and Indian Harbor (XL), Pitzer’s Pollution and Remediation Liability insurer. The existence of coverage turned on the application of the “notice-prejudice” rule to two provisions in the policy: a notice provision requiring that the insured notify the insurer of potential claims and, in the event that such notice was provided orally, to provide a written report “as soon as practicable,” and a consent provision stating that the insured could not incur expenses, make payments, or commence remediation without Indian Harbor’s written consent except in cases of emergency. The policy contained a choice of law clause selecting New York law. New York does not follow the notice-prejudice rule for policies issued to out-of-state insureds like Pitzer. See id. at *1.
In January 2011, the insured discovered darkened soils near a construction site for a new dormitory. The insured investigated and learned that the soil was contaminated, necessitating certain remedial work before construction could continue. Because of certain time constraints regarding the construction of the new dormitory, Pitzer moved quickly to select and execute a remediation plan. The remediation work started in March 2011 and was completed by April 2011. The work cost nearly $2 million. Id. at *2.
Indian Harbor did not receive notice of the claim until July 2011, five months after the contamination was discovered, and roughly three months after remediation was completed. In March 2012, Indian Harbor denied coverage, citing the notice and consent provisions of the policy. Id. at *2.
Pitzer sued for breach of contract. Indian Harbor moved for summary judgment, arguing that the notice and consent clauses barred coverage. Id. at *2.
The district court granted Indian Harbor’s motion. The court applied the policy’s New York choice of law clause, rejecting the argument that the notice-prejudice rule was a fundamental public policy of California. In effect, this determination amounted to a finding that the notice-prejudice rule did not apply to the policy. In the absence of the notice-prejudice rule, the court found that Pitzer failed to comply with the notice provision and failed to seek Indian Harbor’s consent before incurring the $2 million in remediation costs. Id. at *2-3.
California Supreme Court’s Decision:
Pitzer appealed, and the Ninth Circuit certified two questions to the California Supreme Court: “(1) Is California’s common law notice-prejudice rule a fundamental public policy for the purpose of choice of law analysis? 2) If so, does the notice-prejudice rule apply to the consent provision of the insurance policy in this case?” Id. at *1.
The California Supreme Court first determined that the notice-prejudice rule is a fundamental public policy. In reaching this conclusion, the Court observed that fundamental public policies satisfy three criteria even in the absence of a legislative mandate: they cannot be contractually waived, they protect against otherwise inequitable results, and they promote the public interest. It then stated that the notice-prejudice rule satisfied all three criteria. It also rejected Indian Harbor’s argument that the fundamental public policies must be enshrined in constitutional or statutory provisions or be a rule of unconscionability. (It also distinguished bad faith case law on the grounds that the covenant of good faith and fair dealing supplements, rather than overrides, policy terms.) Id. at *4-5.
The Court left the Ninth Circuit and district court to decide whether California had a materially greater interest in the determination of the coverage issue than New York. If it did, the notice-prejudice rule would override the otherwise-valid choice of law clause. Id. at *6.
The Court next determined that the notice-prejudice rule would apply to the consent provision of the policy, but only if that policy were found to be a first-party contract. It first described the purpose of notice provisions in an insurance policy, noting in particular that those provisions protect the insurer’s interests in performing its duties under the contract. Id. at *7. The Court added that in the absence of actual prejudice, mere delay does not provide a basis to deny coverage, and that strict application of notice provisions tends to give the insurer an “unfair windfall” if there has been no actual prejudice. Id. It then observed that consent provisions serve a similar purpose, at least in first-party policies – they protect the insurer’s ability to investigate the claim, assess its rights and liabilities, and take control of proceedings. The court concluded that the notice-prejudice rule should apply to consent clauses in these circumstances. Id. at *7-8.
But the court distinguished the role of consent and notice provisions in third-party policies and noted that prior decisions of the Courts of Appeal have refused to extend the notice-prejudice rule to consent provisions in those policies. Id. at *8. Citing those prior decisions, the Court noted that “the insurer’s right to control the defense and settlement of claims is paramount” in third-party policies, and that “no voluntary payment” clauses enable responsible insurers to assume control of the defense and settlement of a claim and prevent “coverage by fait accompli.” Id. (internal quotations and citations omitted).
The Court ultimately remanded the case to the lower courts to determine whether the Pitzer policy provided first or third-party liability coverage in this instance. Id. at *9.
How a policyholder views this case ultimately depends on whether it is seeking coverage under a first- or third-party liability policy. On the one hand, the decision clarifies that the notice-prejudice rule is a fundamental public policy of California and confirms that it may override choice of law clauses in certain instances; it also confirms that the notice-prejudice rule applies to consent provisions in first-party policies. (Though notably, the Court left open the question of whether New York or California had a materially greater interest in seeing its law applied to the coverage issue. As a result, it stopped short of saying that California’s fundamental public policy necessarily voids the choice of law provision. While reporting on this case has generally glossed over this point, it is important for policyholders to understand that a choice of law provision favoring the law of a state that has not adopted the notice-prejudice rule may be enforceable if that state has a materially greater interest in resolving the coverage issue, in which case the notice-prejudice rule would not apply.) On the other hand, the decision stops short of extending the notice-prejudice rule’s protections in the third-party context, leaving undisturbed existing Court of Appeal decisions.
Policyholders should continue to closely monitor and comply with their policies’ notice and consent requirements. While they should not rely on the notice-prejudice rule to save coverage following delayed notice, they should remain aware that the insurer’s burden to disclaim coverage is high, particularly for first-party policies, and they should not give up the notice-prejudice argument merely because a choice of law provision selects less favorable law.
 As explained by the California Supreme Court, California’s notice-prejudice rule “requires an insurer to prove that the insured’s late notice of a claim has substantially prejudiced its ability to investigate and negotiate payment for the insured’s claim. A finding of substantial prejudice will generally excuse the insurer from its contractual obligations under the insurance policy, unless the insurer had actual or constructive knowledge of the claim. [citations].” Id. at *3. Importantly, the insurer has the burden of proof to establish “actual and substantial prejudice,” and delay alone does not satisfy that burden. See id. at *6.