Denying a Hypothetical Claim for Extra Replacement Cost Coverage Does Not Result in a Breach of Contract

In Tarakanov v. Lexington Insurance Company,¹ the United States District Court Northern District of California dismissed the insureds’ suit, which included claims for breach of contract and breach of the covenant of good faith, among other claims. The fundamental dispute revolved around whether Lexington breached the insurance policy when it refused to pay Extra Replacement Cost Coverage before the insureds’ completed rebuilding the property. Did Lexington have a contractual obligation to pay what the court described as a “hypothetical claim?”

In October 2017, wildfires spread across Napa, Butte, Lake, Mendocino, and Solano Counties and destroyed the insureds’ home, among thousands of others. The home was insured by Lexington, under a policy which included Replacement Cost, Extended Replacement-Cost (“ERC coverage”) and Ordinance coverages. The policy contained the following notice regarding: “Demand Surge:”

After a widespread disaster, the cost of construction can increase dramatically as a result of the unusually high demand for contractors, building supplies and construction labor. This effect is known as demand surge. Demand surge can increase the cost of rebuilding your home. Consider increasing your coverage limits or purchasing Extended Replacement Cost coverage to prepare for this possibility.

The policy limits included up to $750,000 in ERC and $180,000 in Ordinance coverages. ERC coverage was subject to the following condition precedent: “We will pay no more than the actual cash value of the damage until actual repair or replacement is complete. Once actual repair or replacement is complete, we will settle the loss.”

What is a condition precedent? California codified a condition precedent ss one which is to be performed before some right dependent thereon accrues, or some act dependent thereon is performed. Cal. Civ. Code § 1436. Whether a condition precedent exists in a contract “normally depends upon the intent of the parties as determined from the words they have employed in the contract.”²

The insureds began incurring costs associated with rebuilding their home. They were competing with thousands of people in Napa, Solano, and Sonoma Counties, and others throughout Northern California, who were also trying to rebuild.³ This resulted in an overwhelming demand for architects, contractors, and construction workers, who often were victims of the fire too, which bogged down the permitting process. The insureds were among hundreds of homeowners for whom it was impossible to make meaningful progress on rebuilding their homes due to the effects of Demand Surge. Yet—like so many other homeowners in the region—the insureds had not received the additional recommended ERC Coverage and Ordinance Coverage.

In December 2018, the insureds’ then-counsel wrote Lexington demanding payment of $750,000 for ERC coverage and $150,000 for Ordinance coverage. In March 2019 letter, Lexington declined “to extend payment at this time” under the ERC coverage and Ordinance coverage provisions. Lexington’s coverage counsel wrote, “Lexington’s current coverage position [is] that its duty to pay the additional amount of insurance under the ERC Endorsement has not yet arisen” because under the policy terms, actual replacement and repair are conditions precedent to disbursement of ERC amounts under the ERC Endorsement. Lexington’s letter also noted the policy includes a time to file suit limitation:

G. Suit Against Us

No action can be brought against us unless there has been full compliance with all of the terms under Section I of this policy and the action is started within one year after the date of loss.

(emphasis added).

Both parties later acknowledged Lexington’s letter triggered the one-year suit limitation to file a suit. Faced with the inability to complete the rebuilding process within one year of the March 2018 letter, the insureds asserted they would have no recourse against Lexington if Lexington did not later pay the ERC and Ordinance coverages. After being denied ERC and Ordinance payments, the insureds sold their property at a significant loss and filed suit.

The Court Grants Lexington’s Motion to Dismiss

Lexington filed a Motion to Dismiss. A Motion to Dismiss under Rule 12(b)(6), Federal Rules of Civil Procedure, tests the sufficiency of the claims asserted in the complaint. The claim only survives dismissal when the underlying facts provide “plausible grounds” for relief and “raise a right to relief above the speculative level.⁴ In analyzing the pleadings, the court specifically noted the insureds claimed Lexington breached the policy:

[B]y failing to accept their claim for replacement coverage when tendered under the Policy. In sum, Defendant’s breach is for the failure to accept Plaintiffs’ claim for repair and replacement costs when presented, and acknowledge its obligation to reimburse Plaintiffs for repair costs once incurred. As alleged in the FAC, this breach forced the Plaintiffs to sell their property at a loss, incurring damages.⁵

However, the court granted Lexington’s Motion to Dismiss, finding the insured did not “plausibly plead Lexington breached its obligations under the policy.” The court found:

• The insureds’ letter did not ask Lexington to acknowledge its obligation or accept a hypothetical claim – it asked for disbursement;
• Lexington timely responded, explaining its duty to pay the ERC coverage “had not arisen.”

But what about the Suit Against Us language? Couldn’t Lexington simply later deny the ERC and Ordinance coverages, leaving the Insured no legal recourse? As the insured alleged:

Put simply, if Lexington’s interpretation of its contractual obligations holds true, it has devised a strategy to make its ERC Coverage and Ordinance Coverage provisions illusory should the insured’s property be lost as part of a widespread disaster event like that suffered by the Tarakanovs.⁶

The court found “that reality does not create any duty by Lexington to assure the plaintiffs that it would fulfill its obligations under the policy.” It may be arguable the ERC and Ordinance provisions are illusionary coverages in situations where Demand Surge prevents the insured from completing the rebuild when there is a one-year Suit Against Us provision. However, the court found nothing in the record to suggest Lexington was playing “gotcha.”

The court also dismissed the insureds’ bad faith claim finding: “without a breach of the insurance contract, there can be no breach of the implied covenant of good faith and fair dealing.”⁷ While the court dismissed the case, the court provided the insured twenty-one days to file an amended complaint. In adjusting a claim, you must be familiar with the impact of any clause limiting the time to file suit, and what triggers or tolls these time-limiting clauses.
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¹ Tarakanov v. Lexington Ins. Co., No. 3:19-cv-05666, 2020 WL 1059211 (N.D. Cal. Feb. 26, 2020).
² Realmuto v. Gagnard, 110 Cal. App. 4th 193, 199 (2003) (citing 13 Williston on Contracts (4th ed. 2000) § 38:16).
³ The situation was particularly acute in Napa. In a survey of Napa County residents, 17% reported that they would not rebuild, and 67% (of the 17%) reported that “their insurance company was restricting their benefits to buy elsewhere, in part because insurance companies were not willing to pay ERC Coverage or Ordinance Coverage.”
⁴ Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 555-56 (2007).
⁵ Tarakanov, 2020 WL 1059211 at *8.
⁶ Tarakanov, 2020 WL 1059211 at *6.
⁷ Manzarek v. St. Paul Fire & Marine Ins. Co., 519 F.3d 1025, 1034 (9th Cir. 2008) (citing Waller v. Truck Ins. Exch., 11 Cal. 4th 1, 36 (1995)); see also Love v. Fire Ins. Exch., 221 Cal. App. 3d 1136, 1153 (1990).