California Supreme Court addresses ‘illusory’ doctrine in new insurance decision

On Aug. 9, 2024, the California Supreme Court rendered its decision in John’s Grill, Inc. v. Hartford Financial Services Group, Inc., 2024 DJDAR 7524 (2024). The decision is another addressing insurance for losses associated with COVID-19. However, this decision does not address the primary question in so many COVID-19 insurance cases—whether the presence of SARS-CoV-2 can constitute “direct physical loss or damage to property” under a property insurance policy.

Instead, here the Court addressed an endorsement that generally excluded coverage for any virus-related loss but extended coverage for such loss if the virus resulted from any of a list of specified causes of loss, including windstorms, water damage, vandalism, and explosion. However, the list of specified causes did not include a pandemic.

The insured did not argue that its loss fell within the specified causes. Instead, the insured argued that the coverage extended by the endorsement was illusory because “the specified cause of loss limitation makes it impossible, or virtually impossible, for it to recover for virus-related loss or damage.” Therefore, the insured argued, “the limitation should be disregarded, and any virus-related loss or damage should be covered under the policy regardless of cause.”

While the Court of Appeal had accepted the insured’s argument, the California Supreme Court rejected it. It said that it “has never recognized an illusory coverage argument as such. The doctrine as articulated by [the insured] does not appear in our precedents.” The Court also held that, “Even with the specified cause of loss limitation, the policy offered [the insured] a realistic prospect for virus-related coverage.”

Because insureds often argue that policy language cannot be interpreted in any way that rendered coverage largely illusory, insurers no doubt will point to the Court’s decision as a categorical rejection of that notion. But the truth lies somewhere in between the two positions.

It is true that the Court rejected the insured’s argument here. But it did so after reaffirming that an insurer “‘can limit the coverage of a policy issued by it so long as such limitation conforms to the law and is not contrary to public policy.’” It also pointed out that “an insurer is not absolutely prohibited from drafting and enforcing policy provisions that provide or leave intact coverage for some, but not all, manifestations of a particular peril. This is, in fact, an everyday practice . . . .’”

So, what does John’s Grill portend for future insurance disputes? It does not mean that the notion of illusory coverage has no future role to play. Indeed, the Court discussed one of its earlier decisions, Safeco Insurance Co. v. Robert S., 26 Cal. 4th 758 (2001). There, as the Court noted, it had invalidated a policy exclusion because, if read broadly, “it would be ‘so broad as to render the policy’s liability coverage practically meaningless.’” However, the Court noted that in Safeco, it had considered an “insoluble ambiguity” in policy language, an ambiguity not found in John’s Grill, where the language was unambiguous.

The Court also recognized that an insured’s “reasonable expectations” could play a role in resolving coverage disputes. It said, “To the extent our precedents have discussed the concept of illusory coverage, we have . . . emphasized an insured’s reasonable expectations.” In practice, this means that an insured “would have to show that it had a reasonable expectation of coverage for its . . . losses.” Here, it found that the insured did not show such a reasonable expectation because “[a] reasonable insured would understand that virus coverage under the . . . endorsement was limited and would be available only if the virus resulted from certain causes.” But in so holding, the Court left open the possibility that coverage might be available under the illusory-coverage doctrine if a coverage-limiting interpretation were contrary to the insured’s reasonable expectations.

The California Supreme Court also recognized that it was not addressing all arguments that an insured might make for coverage. It expressly noted that the insured did not “contend the policy itself is unenforceable based on lack of consideration,” nor did the insured “assert any traditional contract defenses such as fraud, mistake, illegality, or unconscionability.” Thus, an insured still can argue any of these grounds in response to insurer denials of coverage. Indeed, because the Court recently recognized that misstatements in advertisements might evidence bad faith and support an insured’s claim under California Business and Professions Code section 17200, insureds still have arguments available. See Rosenberg-Wohl v. State Farm Fire & Cas. Co., No. S281510,2024 DJDAR 6839 (Cal. July 18, 2024) (citing Zhang v. Superior Court, 57 Cal. 4th 364, 368 (2013), in which the Court recognized that causes of action for false advertising “provide grounds for” a section 17220 claim).

The Court also acknowledged in John’s Grill that there are situations, even if limited, “where the plain language of an insurance policy will not be enforced.” It pointed out two situations, neither of which, it said, the insured argued. The first situation is one in which provisions that “take away or limit coverage reasonably expected by an insured” are not “‘conspicuous, plain and clear.’”

The second situation is one in which “’[p]olicy exclusions are unenforceable to the extent that they conflict with [Insurance Code] section 530 and the efficient proximate cause doctrine.’” (footnote omitted). It pointed out that it has “’rejected insurers’ attempts to contract around the proximate cause doctrine through sweeping language that would have rendered the policies’ coverage terms virtually illusory.’”

Thus, while the decision in John’s Grill may limit an insured’s ability to argue that unambiguous policy language limiting coverage is enforceable in many circumstances, it does not negate or limit other arguments that an insured may make. As the Court recognized, those arguments include interpreting ambiguous policy language in favor of coverage, interpreting policy language in accord with an insured’s reasonable expectations, rejecting exclusions and coverage limitations that are not “conspicuous, plain and clear,” rejecting exclusions contrary to California’s efficient-proximate-cause doctrine, and enforcing the doctrines of fraud, mistake, illegality, and unconscionability.