The New Jersey Supreme Court’s recent decision in Potomac Ins. Co. of Ill. v. Pa. Mfrs. Ass’n Ins. Co., No. 070756, 2013 N.J. LEXIS 847 (Sept. 16, 2013), is a mixed blessing for policyholders involved in construction defect litigation. The court clarified for the first time that the “continuous-trigger” theory of coverage applies to construction defect cases. That is good news for policyholders because it should lead to increased limits being made available to resolve construction defect claims. The court also held that, when the continuous trigger applies, insurers can assert a direct claim against a co-insurer for contribution to defense costs. That is good news for insurers. However, the court’s holding on contribution claims may inadvertently discourage early settlements or even put policyholders in the middle of a fight among insurers over their defense cost obligations. That is not good news for anyone.

Potomac’s facts are typical of a construction defect claim, alleging continuous property damage resulting from alleged faulty workmanship. In 1991, the Township of Evesham hired Roland Aristone, Inc., as the general contractor for the construction of its new middle school. Aristone completed the project in 1993. The following year, the school began to experience leaks and other damage related to a defect in the roof. In 2001, the school filed suit against Aristone for negligence and breach of contract. Aristone notified its insurers and demanded defense and indemnity coverage under its general liability policies.

Like many general contractors, Aristone had multiple insurers during the 10-year period between the date it was hired to perform the work and the date when the lawsuit was filed. For the first two years, Artistone was insured with Pennsylvania Manufacturers’ Insurance Company (PMA). In addition to PMA, Aristone was insured by Newark Insurance Company, Royal Insurance Company, OneBeacon Insurance Company and SelectiveWay Insurance Company. Selective and OneBeacon acknowledged their defense obligation and shared Aristone’s defense costs and fees. PMA and Royal disclaimed any coverage obligation for the claim. Aristone filed a declaratory judgment action against PMA and Royal.

Ultimately, Aristone settled with PMA. Under the terms of the settlement, PMA agreed to contribute $150,000 in exchange for a full release from Aristone, “including, without limitation, any and all claims by Aristone concerning PMA’s obligation to pay the attorneys’ fees and costs incurred in defense” of the underlying litigation. A few days later, Aristone and the school settled the case for $700,000. After the settlement, OneBeacon informed Royal and PMA that the defense costs for the suit totaled $528,868.54. OneBeacon proposed that, under the “continuous trigger” theory, PMA and Royal each owed 20 percent of the defense costs. PMA and Royal refused to pay, and litigation ensued.

The litigation among the insurers presented several novel issues. The first was whether an insurer with an obligation to defend and indemnify a policyholder has a direct claim for contribution from its co-insurers for defense costs arising from the alleged continuous property damage. The second issue was the effect a settlement and release between a policyholder and an insurer may have on the co-insurers’ rights to contribution.

PMA argued that any right of contribution is premised on subrogation principles, and an independent claim for contribution does not exist. OneBeacon countered that a direct claim for contribution is entirely consistent with New Jersey’s approach to allocating coverage responsibility among co-insurers where continuous damage is alleged.

The court’s analysis relied heavily on its decision in Owens-Illinois v. United Ins. Co., 138 N.J. 437, 475-76 (1994). In Owens-Illinois, the court adopted the “continuous trigger” theory for personal injury and property damage claims. Under the continuous-trigger theory, where “progressive indivisible injury or damage results from exposure to injurious conditions for which civil liability may be imposed, courts may reasonably treat the progressive injury or damage as an occurrence within each of the years of a [comprehensive general liability] policy.” Thus, a continuous-trigger theory is designed to greatly increase the number of policies available to a policyholder to defend and resolve long-term liability claims.

The court in Owens-Illinois held that when the continuous-trigger theory implicates multiple insurance policies, all affected insurers must respond to the claims presented. If the affected insurer denies full coverage, it must initiate proceedings to determine the appropriate apportionment of coverage responsibility among the insurers within the trigger period. To that end, the court adopted a pro-rata formula to allocate costs that was based on the number of years an insurer is on the risk and the comparative level of risk (policy limits) that insurer assumed within the triggered period.

Drawing on both the precedent and the public policy of Owens Illinois, the court in Potomac held that insurers can and should allocate defense cost responsibility in construction defect cases. The court reasoned that a claim for contribution would: (a) create a strong incentive for insurers to be proactive in defending their insureds; (b) promote the efficient use of judicial and party resources; (c) filter out meritless claims; (d) incentivize policyholders to maintain continuous coverage; and (e) promote early settlements. However, as discussed below, the Potomac decision may have unwittingly created barriers to achieving early settlements between policyholders and insurers.

The second major issue in Potomac was whether PMA’s settlement with Aristone effectively barred OneBeacon’s contribution claim. The court held that the release clearly did not bar OneBeacon’s claim for contribution for two reasons. First, OneBeacon was not a party to the settlement agreement and PMA was aware OneBeacon had no role in the negotiations. Therefore, the court held, it was illogical to conclude that OneBeacon waived its contribution claim. Second, the language of the release expressly stated that it applied to “all claims by Aristone concerning PMA’s obligation….” but it did not apply to claims “by an insurance carrier as a claimant or as a true party in interest to a claim” arising from the school’s lawsuit. Accordingly, PMA’s settlement with Aristone did not bar OneBeacon’s contribution claim against PMA.

Early settlement and efficient use of resources were influential and laudable policy themes in Potomac. Ironically, the decision unintentionally may create a barrier to policyholders’ maximizing recovery from all of their insurers if, as is typically the case, the insurers do not immediately and uniformly acknowledge their coverage obligations for a claim. Potomac reasons that an insurer anticipating “paying an allocated portion of the policyholder’s defense costs may factor those costs into a potential resolution of the underlying claim,” and therefore may be more motivated to settle.

However, the court overlooked that insurers may seek to put the policyholder in the middle of a defense-cost allocation dispute by offering a settlement to the policyholder that is conditioned on the policyholder’s agreeing to provide defense and indemnification to the insurer against future contribution claims. Indeed, insurers typically demand broad indemnifications from policyholders when they agree to pay a claim. In Potomac, the settlement agreement and release was clear that Aristone had no obligation to indemnify or defend PMA against disputes among other insurers. However, that is not necessarily the norm. Now, more than ever, policyholders must be very careful in drafting settlement agreements and negotiating the scope of any indemnification given to a settling insurer. To the extent provided, policyholders must take care to carve out insurer contribution claims that have been or may be asserted. Failure to do so may turn the entire concept of insurance on its head as the policyholder will become his insurer’s insurer. •