A recent decision by the California Supreme Court has examined the applicability and use of the “illusory coverage doctrine” as a tool to interpret insurance policies. The Court also questioned whether the doctrine could invalidate unambiguous policy language. While it is undecided whether the doctrine exists, or can exist under California law, the decision seems to provide a theoretical framework for a successful application of the doctrine in a coverage dispute.
Under the illusory coverage doctrine, if an insurance policy’s coverage is modified by an overbroad exclusion that functions to eliminate all reasonable possibilities of coverage, the insurer has not offered consideration necessary for a valid contract.[1] In such a circumstance, courts may not enforce the plain language of a policy if doing so would render the policy’s intended coverage illusory.[2]
In John’s Grill, Inc. v. The Hartford Financial Services Group, Inc.,[3] two insureds, John’s Grill, Inc. and John Konstin (together “Insureds”) operated a restaurant in San Francisco. Like many other businesses, the restaurant faced financial difficulties as a result of Covid-19 and the state and local public health orders that either prohibited or limited indoor dining. The Insureds sought coverage for damages under their property policy’s “Limited Fungi, Bacteria or Virus Coverage” endorsement (the “Endorsement”). The Endorsement added a broad exclusion for damages caused by viruses and other microorganisms. However, under an exception, it would provide coverage for damages if the viruses and other microorganisms were caused by a specific listed cause of loss, such as a windstorm, aircraft, riot, vandalism, volcanic action, or weight of ice. The insurer denied the Insureds’ claims, in part, because the claimed damages did not fall within the Endorsement.
The Insureds argued that an endorsement for limited fungi, bacteria, or virus coverage should be expected to provide some level of coverage for damages caused by viruses. As a corollary, the Insureds argued that coverage under the Endorsement was illusory where the specified causes of loss would likely never bring about viruses, thereby triggering the illusory coverage doctrine. The Court was unpersuaded by the Insureds’ argument that the Endorsement provided illusory coverage. The Court reasoned that the Insureds did not adequately demonstrate, for example, why a windstorm could not carry viruses to a restaurant. It was additionally stated that an explosion, act of vandalism, or riot could also transmit viruses in the same way. The Court found that. as applied to the facts, the Endorsement provided theoretically plausible coverage and was, therefore, not illusory.
The Court’s decision does not, however, rule out the use of the illusory coverage doctrine to invalidate unambiguous policy language. Rather, the Court noted that where the illusory coverage doctrine is applicable, any argument successful in invalidating unambiguous policy language must show: (1) a reasonable expectation that the policy would cover the insured’s claims or damages; (2) bear the burden of alleging facts sufficient to support the application of the doctrine; and (3) must demonstrate that as applied to the facts, the policy’s language is so restrictive that the prospect of triggering coverage is unrealistic.
Accordingly, policyholders should recognize that it is extremely difficult, but possible, to invalidate unambiguous policy language using the illusory coverage doctrine.
[1] Scottsdale Ins. Co. v. Essex Ins. Co., 119 Cal. Rptr. 2d 62 (2002).
[2] Croskey et al., Cal. Practice Guide: Insurance Litigation § 4:29.
[3] John’s Grill, Inc. v. The Hartford Fin. Servs. Grp., Inc., 552 P.3d 1045 (Cal. 2024).