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Supreme Court Fails to Answer Whether the Duty to Defend Constitutes a First-Party Claim

December 6, 2004

On July 2, 2004, the Texas Supreme Court addressed the issue of an insurer’s right to control the defense of an insured without breaching its duty to defend in the context of a venue dispute. See Northern County Mut. Ins. Co. v. Davalos, 140 S.W.3d 685 (Tex. 2004). The Court held that the insurer did not breach its duty to defend where the insured disagreed with his defense in a third-party claim. (This aspect of the case is discussed in related article The Unqualified Defense Under Traver and Davalos). Equally significant, however, is the Court’s failure to determine whether the insured’s request for a defense constitutes a first-party claim, subjecting the insurer to liability under Art. 21.55 of the Texas Insurance Code. As a result, the question remains unresolved under Texas law.

Timoteo Davalos, a resident of Matagorda County, Texas, was injured in an automobile accident in Dallas County, Texas. Davalos filed suit against the driver of the other vehicle in Matagorda County. The other driver subsequently filed suit against Davalos and a third driver involved in the accident in Dallas County. Matagorda County is generally considered to be significantly more liberal and plaintiff-oriented than Dallas County.

At the time of the accident, Davalos was insured by Northern County Mutual Insurance Company (“Northern”). Rather than request a defense from Northern, Davalos sought representation in the Dallas litigation from the attorneys representing him as a plaintiff in Matagorda County. The attorneys filed an answer in the Dallas lawsuit and moved to transfer venue to Matagorda County. The attorneys then notified Northern of the Dallas lawsuit.

After receiving notice of the Dallas lawsuit and the pending motion to transfer venue, Northern advised Davalos that it had chosen counsel to represent him in the Dallas lawsuit and that it opposed the motion to transfer venue. Northern further advised Davalos that if Davalos’ personal attorneys continued to defend him in the Dallas lawsuit and pursue the motion to transfer venue, Northern would take the position that there was no liability protection under the policy. In response, Davalos asserted that Northern’s demands were unconscionable, insufficient to satisfy its duty to defend, and imposed a conflict of interest preventing Northern from conducting Davalos’ defense.

Davalos’ Matagorda lawsuit ultimately was transferred to Dallas County upon the motion of another party and Northern settled the claims against Davalos in the Dallas lawsuit. Prior to the settlement, however, Davalos sued Northern in Matagorda County, alleging that Northern breached its duty to defend Davalos in the Dallas action, engaged in bad faith and violated the Texas Insurance Code. Because the Texas Supreme Court ultimately determined Northern did not breach its duty to Davalos, the Court declined to consider whether Davalos’ claim constituted a first party claim entitling him to relief under Art. 21.55. As a result, Texas law remains unsettled regarding whether the duty to defend is considered a first-party claim triggering an insurer’s liability under Art. 21.55.

The prompt payment provisions in Art. 21.55 define a claim as “a first-party claim made by an insured or a policy holder under an insurance policy…that must be paid by the insurer directly to the insured or beneficiary.” See Art. 21.55, Section 1. Significantly, the statute does not define “first-party.”

Several federal courts applying Texas law hold that a claim pertaining to the duty to provide a defense and pay for defense costs fits within the definition of a first-party claim for purposes of Art. 21.55. See Travelers Indem. Co. of Conn. v. Presbyterian Healthcare Resources, 313 F.Supp.2d 648 (N.D. Tex. 2004); Mt. Hawley Ins. Co. v. Steve Roberts Custom Builders, Inc., 215 F.Supp.2d 783, 794 (E.D. Tex. 2002); E&R Rubalcava Construction, Inc. v. Burlington Ins. Co., 148 F.Supp.2d 746 (N.D. Tex. 2001).

In E&R Rubalcava, the insurer refused to pay the insured’s defense costs. Because of the nature of the claim involving the delay of the insurer’s payment of defense costs, the court determined that the claim became a first-party claim invoking the statutory penalty under Art. 21.55. See E&R Rubalcava Construction, Inc., 148 F.Supp.2d at 750. In Mt. Hawley, the insured relied upon Ryland Group, Inc. v. Travelers Indem. Co. of Illinois, 2000 WL 33544086 (W.D. Tex. 2000) in which the court concluded that the insured’s claim for defense costs fits within the definition of a claim under Art. 21.55

In Hartman v. St. Paul Fire and Marine Ins. Co., 55 F.Supp.2d 600 (N.D. Tex. 1998), the court adopted the opposite view and held that Art. 21.55 does not provide relief to an insured seeking indemnification of defense costs. In reaching its decision, the court considered that the insured was not presenting a “claim” for acceptance or rejection as contemplated by Art. 21.55, but instead an action pursuant to the execution of an adjudicated right. The court also ruled that a claim for statutory penalties under Art. 21.55 for failure to timely pay a claim is not a separate cause of action. See Id. at 604, citing Lusk v. Puryear, 896 S.W.2d 377, 380 (Tex. App. - Amarillo 1995, no writ). However, at least one court has held that it was not persuaded by Hartman in determining that an insured’s claim arising out of the duty to defend is a first-party claim. See Mt. Hawley Ins. Co. v. Steve Roberts Custom Builders, Inc., 215 F.Supp.2d 783, 794 (E.D.Tex. 2002).

On February 25, 2004, the Dallas Court of Appeals issued an opinion in TIG Ins. Co. v. Dallas Basketball, Ltd., 129 S.W.3d 232 (Tex. App. - Dallas 2004, reh’g overruled - a petition for review was filed in May of 2004, and has not yet been granted or denied), and held that a claim for a defense is not a first-party claim and does not trigger Art. 21.55. The court noted that claims for a defense are fundamentally different than first-party claims for payment based upon a loss suffered by the insured, and that Art. 21.55 applies only to claims triggering the insurer’s duty to pay the insured under the policy. See Id. at 239. The court also held that a claim for reimbursement of defense costs incurred as a result of the insurer’s refusal to provide a defense is not a first-party claim to be paid directly to the insured. Id. at 240. In reaching its conclusion, the court recognized that its ruling was contrary to the holdings of Mt. Hawley and E&R Rubalcava because it considered the analyses relied upon in these cases to be insufficient to support the proposition that an insurer’s failure to provide a defense is a first-party claim. The court also acknowledged what it believed to be the Texas Legislature’s intent that the deadlines and penalties imposed in Art. 21.55 do not apply to a claim for a defense.

As a result of the Texas Supreme Court’s failure to rule on Davalos’ entitlement to relief under Art. 21.55, Texas law remains unsettled and insurers continue to face the spectre of an 18% penalty if they fail to timely assume defense of a covered claim.