Navigating the Product Liability Coverage Obstacle Course

High-tech companies are well advised to purchase errors and omissions insurance to protect against customer claims based on defective products or substandard services. But, accessing the benefits of that insurance policy can require carefully managing the perilous conflict between the business imperatives of restoring the customer relationship, on the one hand, and stringent insurance requirements, on the other.

Consider a typical scenario:
After Semiconductor Manufacturer ships tens of thousands of its state-of the-art chips, Major Customer angrily advises that the chips are flawed, that its product assembly has been delayed and that its costs are rapidly mounting as a result. Customer presses Manufacturer for immediate action, including requests for compensation.

When caught in the conflict between business imperatives and policy obligations, here are some of the obstacles that the policyholder manufacturer will likely encounter.

First Obstacle — Reporting the Claim Internally

Customers usually complain to sales personnel or the engineers who have day-to-day contact with the customer. These employees will likely be scrambling to address the problem and they may not even know that the company has purchased insurance for such situations. For customer complaints that constitute claims under errors and omissions policies (or for complaints that may later become claims), the corporate policyholder needs to make sure that information is conveyed on a timely basis to those who know about available insurance policies —  typically legal, risk management or finance personnel.

The imperative is inescapable: Because timely reporting claims to the insurer is a condition precedent to coverage, companies must set up reporting procedures so that information is collected internally, so that a deliberate and timely decision can be made on whether to give notice.

Second Obstacle — Notifying the Insurer

Here’s the reason why potential claims need to be reported and reported promptly: E&O policies typically require that a policyholder notify the insurer of a claim as soon as reasonably practicable or within a specified time period, often no later than within 45 or 60 days from receiving notice of the claim (or from the end of the policy period). Failure to provide the insurer with timely notice will result in rejection of the claim, because these policies are generally claims made and reported policies. That means making timely notice of a claim is required in order to obtain coverage.

This notice requirement can create challenges for the insured manufacturer. It can be challenging to determine what specifically constitutes a claim thereby triggering the notice requirement. For example, a customer’s notice of a flawed product does not necessarily constitute a claim. However, if the customer demands any kind of relief, this may fall within a broad policy definition of claim. If the customer demands compensation, then a claim is surely made.

Taking the first and second obstacles together: After the insured manufacturer receives a customer complaint that is potentially covered, and after the information is transmitted to the company’s risk manager or those who know about insurance, then it is time to evaluate (also promptly) if the circumstances constitute a claim under the policy. Often, the guidance of coverage counsel will prove invaluable. If a claim has been made, the corporation must promptly notify its insurer. Some E&O policies allow or even require the reporting of circumstances that are reasonably likely to give rise to a claim. These provisions require more difficult judgment calls as to when to report to the insurer; but they also increase the opportunities to preserve coverage. Let’s be clear — failure to give timely notice to the insurer most often eliminates coverage.

Third Obstacle — Evaluating Whether There is a Product Defect

E&O policies typically provide coverage for damages only if the product fails to perform as warranted or as it was meant to perform. In other words, the policy provides coverage if the company’s product was actually defective. Where deficient services are at issue, indemnity coverage exists if the policyholder commits an error or omission in the course of providing services to a customer. This third obstacle focuses on challenges the company may confront in obtaining indemnity coverage under its policy for it or actually defective product. (In contrast, the insurer’s defense obligation will be triggered by a potentially covered claim, such as the assertion of a defect.)

When the initial complaint is made, it may not be clear whether the product is actually defective. There may be factual and technical questions of which component or process actually caused the malfunction or whether the customer or someone else caused the flaw after the product was shipped. During the time that the nature and cause of the flaw remains uncertain, the policyholder manufacturer may not know whether its product is defective. But, that uncertainty should not delay notice to the insurer.

Second, the policyholder needs to be cautious not to make statements — even if pressured by the complaining customer — by which it admits that its products or services were defective. That is because E&O policies often prohibit the policyholder from admitting liability. Unless authorized by the insurer, any such admission will give the insurer a basis to deny indemnity coverage. (If the insurer has agreed to defend the claim under the policy, such admissions may also interfere with the insurer’s right to control the defense.)

Next, the policyholder could find itself in a situation where it believes its product was defective such that the indemnity coverage is triggered. But, the insurer may dispute coverage by claiming there was not actually a defect. For business reasons affecting its broader customer market or business reputation, the policyholder may not want to acknowledge that its products or services were defective. It certainly does not relish the need to publicly prove that its own products or services were defective in order to obtain indemnity from its insurer.

In these countervailing circumstances, finding the right path will require legal and business personnel to coordinate their evaluation of the business imperatives and policy requirements. The policyholder needs to ensure that its personnel do not admit fault until the facts are known. Moreover, any such admission should wait until legal advisors have evaluated the implications for coverage and, if appropriate, sought and obtained the insurer’s consent. One tactic may be to notify the insurer of the circumstances, but also explain that the existence and nature of the defect remains under investigation. This provides the insurer with timely notice of the claim, but will avoid the risk that the insurer refuses coverage due to an unapproved admission.

Fourth Obstacle — Controlling Negotiations With the Customer

Now let’s add more facts to our scenario:
The manufacturer has tendered the claim, the E&O insurer has acknowledged coverage and now the insurer asks to participate in negotiations to resolve the customer’s claim.

Policy terms may give the insurer the contractual right to associate or participate in the defense of any claim, including participation in negotiations that result in the insurer paying a settlement. Most policies go further and give the insurer the absolute right to control settlement of claims. But, those requirements create a very real conflict for the manufacturer.

Understandably, a manufacturer confronted with a displeased customer will be laser-focused on preserving the relationship, a task that may require sensitive and strategic handling by a select team. Also understandably, the manufacturer’s team does not relish the prospect of an insurance claims representative intruding into those negotiations or second-guessing the approach. However, if the manufacturer expects its insurer to pay, then cooperation with the insurer is imperative.

Perhaps, in some circumstances, the company may decide that business reasons or the nature of the customer relationship weigh in favor of resolving a claim without the insurer’s participation or consent. Choosing that path is choosing to ignore policy requirements and will almost always result in forfeiting the company’s rights to insurance coverage. In our view, such a choice should be made carefully and knowledgeably, and only after considering the implications of losing any insurance coverage.

Thus, the manufacturer faces a difficult choice: Take the business risk of damaging customer relations by allowing the insurer’s representatives some level of control over those sensitive negotiations? Or, proceed to resolve the claims without insurer, thereby losing the coverage that is otherwise available under the insurance policy.

Fifth Obstacle — Compensating the Customer

Like all insurance policies, E&O policies prohibit the policyholder from making payments or agreeing to a settlement, without the insurer’s consent. These are barred by what is commonly known as voluntary payments provisions. This is why it is so important to notify the insurer of the claim at the outset, to keep the insurer apprised of settlement efforts and to avoid making binding commitments without the insurer’s consent.

Conflict with those best practices can arise if the disappointed customer demands that the manufacturer take immediate steps to address the defect — such as providing replacement products, agreeing to a discount or rebate or reimbursing expenses the customer incurred because of the product problem. In some situations, the customer will press for assurances and promises (perhaps even written assurances) that the manufacturer will provide compensation for future expenses. If the manufacturer agrees to remedial action or promises compensation without the insurer’s participation or consent, any such payments or assurances will likely bar coverage. Thus, the policyholder manufacturer is well advised to obtain the insurer’s consent before agreeing to remedial action or promising compensation to the customer.

Sixth Obstacle — Recovering Reimbursement From the Insurer

E&O insurance policies typically define the types of expenses that are covered and often have exclusions that specify expenses that are not covered. Expenses paid to compensate a customer for loss arising from the use of a defective product are usually covered. But, policy exclusions frequently exclude expenses incurred to recall a defective product, for example. More subtle is the situation where the insured manufacturer wants to reimburse expenses (such as staff time or engineering costs) that the customer incurred to address the problem. While it may be good customer relations to reimburse those costs, the insurance company may argue that those expenses are not covered.

Navigating the Labyrinth of Obstacles

The obstacles described above raise subtle and difficult questions. There are no easy answers. Ignoring the conflicts does not help — delay can have dire consequences. The company may lose its policy benefits entirely if it does not give the insurer timely notice and the opportunity to participate in negotiations. It may also lose policy benefits if it does not seek the insurer’s consent before agreeing to pay for any related expense or loss.

When these sorts of problems arise, company personnel are understandably focused on fixing the problem and restoring the customer relationship. In order to make use of the valuable protections available in the insurance purchased by the manufacturer, however, it is wise for the manufacturer to consult with coverage counsel early in the process so the company understands how these requirements may conflict with business and customer concerns.