What are the consequences of a liability insurer’s breach of the duty to defend its insured against a potentially covered claim?  Recent decisions from the New York Court of Appeals highlight differing views nationwide on whether the breaching insurer is prevented subsequently from contesting its duty to indemnify the insured.

An insured’s right to legal representation and the general liability insurer’s parallel duty to defend suits, however groundless, false or fraudulent, together provide the insured with the important benefit of “litigation insurance.”  This opportunity to call upon the insurer’s substantial resources and expertise to defend against third-party claims is an oft-cited motive for the purchase of liability insurance.  The duty to defend is broad; if at least some of the claims asserted against the insured potentially are covered, the insurer must defend without regard for whether the insured ultimately is liable to the third-party claimant.  Given the importance of the insurer’s duty to defend to the liability insurance contract, what are the consequences if that duty is breached?

The K2 Decisions

The New York Court of Appeals answered this question with two recent decisions in the same case, the second of which reversed the first.  K2 Inv. Grp., LLC v. Am. Guarantee & Liab. Ins. Co., 2014 WL 590662, at *1 (N.Y. Feb. 18, 2014) (K2-II), vacating 993 N.E.2d 1249 (N.Y. 2013) (K2-I).  This insurance coverage dispute arose out of a lawsuit between a real estate entity and its investors, who alleged that the real estate entity did not repay loans made by the investors.  One of the owners of the real estate entity—a lawyer—tendered the dispute to his professional-liability insurer, which disclaimed a duty to defend or indemnify.  The investors obtained a default judgment against the lawyer, who assigned all rights under the policy to the investors.  The investors filed a coverage action on behalf of the lawyer, alleging breach of the policy and bad faith failure to settle the underlying dispute.

The trial court entered summary judgment for the investors on their claims that the insurer breached the policy in failing to defend the lawyer, but dismissed the bad faith claim.  The intermediate appellate court affirmed this result, holding inapplicable the exclusions relied upon by the carrier.  The Court of Appeals affirmed but on a completely different ground.  The court began with a principle that most would concede is universal and that is enshrined in New York by Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004): disclaiming a duty to defend limits precludes an insurer from challenging the underlying liability or damages determination.  The court went further, however, holding that if the disclaimer of the duty to defend is not sustained, then “the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.”  The court acknowledged that its new rule had public policy exceptions—coverage bars based on legal principles rather than policy exclusions—but none of them applied in the case before it.

This sea change in New York law prompted the insurer to move for reargument.  The insurer’s principal basis for reargument was that the Court of Appeals overlooked one of its prior decisions, Servidone Construction Corp. v. Security Insurance Co., 477 N.E.2d 441 (N.Y. 1985), which held that a carrier in breach of its duty to defend could rely on policy exclusions to dispute a duty to indemnify.  The court acknowledged a conflict between Servidone and K2-I, and agreed to reconsider the latter.  The issue drew amici curiae in support of both sides of the dispute and was followed widely by insurance practitioners and commentators.

On reconsideration, the court reversed field and chose to follow Servidone.  The court made clear that it was not disturbing the principle that refusing to defend an insured precludes a carrier from relitigating in a coverage dispute issues that were litigated and resolved in the underlying dispute.  The court, however, drew a distinction between those issues and issues “that do not depend on facts established in the underlying litigation,” and restored a breaching insurer’s ability to litigate coverage issues based on facts unrelated to the underlying litigation.

Other Jurisdictions

As the court noted in K2-II, other jurisdictions divide on whether to apply the rule espoused in K2-I or a rule more similar to one expressed in Servidone.  Some hold that an insurer in breach of its duty to defend is precluded from contesting coverage for a subsequent judgment or settlement.  Many other courts embrace the distinction between the duty to defend and the duty to indemnify and allow the insurer to raise policy defenses despite a breach of the duty to defend.  These approaches, and the rationale for each, are summarized briefly below.

Courts Applying Rules Similar to that of K2-I

Courts in Illinois and Connecticut, among others, apply rules similar to that of K2-I.  Indeed, holding that an insurer in breach of its duty to defend is estopped from contesting its duty to indemnify is sometimes referred to as the “Illinois rule.”  In Illinois, an insurer that denies a duty to defend has two permissible options: defend the underlying suit under a reservation of rights or initiate a declaratory judgment action to obtain a finding of no coverage.  If the insurer fails to take either of these steps and later is found to have wrongfully refused to defend, the insurer is estopped from raising policy defenses to contest its duty to indemnify.

Courts recognizing the Illinois rule have identified only a handful of scenarios in which it may not apply, including if a true conflict of interest is present, such that the manner in which the underlying claim is defended could influence whether coverage exists; fact finding in a declaratory judgment action could harm the insured’s interests in the pending underlying action; or a prior adjudication already has established that the claim falls outside of coverage (i.e., a criminal conviction of the insured).

The stated rationale for the Illinois rule and others like it is that the insurer’s duty to defend under a liability insurance policy is so fundamental that a breach of that duty constitutes a repudiation of the contract.  If an insurer breaks the contract by failing to defend, it no longer can claim the protection of the contract by pointing to provisions that may defeat the duty to indemnify.  A further rationale offered by some courts is that allowing the breaching insurer to contest the duty to indemnify would unfairly shift the burden to the insured to prove a causal relationship between the insurer’s breach and the resulting consequences (i.e., a settlement or judgment in the underlying claim) suffered by the insured.

Another proffered public policy reason to prevent a breaching insurer from contesting the duty to indemnify is to encourage the settlement of underlying claims and reduce court congestion.  Conversely, without this rule, insurers would be incentivized to disclaim their duty to defend in almost every case, as they have everything to gain and nothing to lose.  In other words, if the worst that can happen is that the insurer must pay defense costs—amounts it would have had to pay anyway if it acknowledged immediately its duty to defend—then it might as well roll the dice on a denial.

Courts Applying Rules Similar to that of K2-II and Servidone

K2-II, Servidone and aligned courts in Massachusetts, Hawaii and Idaho (among others) offer both a spirited defense of their approach and a point-by-point refutation of the Illinois rule.

These courts have held that awarding indemnification to the insured solely on a theory of waiver or estoppel, based upon the insurer’s failure to defend, subverts any meaningful distinction between the duty to defend and the separate duty to indemnify.  By requiring the insurer to indemnify due solely to its failure to acknowledge the possibility of coverage—the test for determining the duty to defend based solely upon the four corners of the underlying complaint—the court enlarges the bargained-for contract as an improper penalty upon the insurer.  This remedy goes beyond the natural consequences of the insurer’s breach and the scope of the insurer’s contractual undertaking.

Moreover, the appropriate remedy for breach of contract is to compensate the non-breaching party for losses suffered due to the breach, not to punish the breaching party.  Precluding an insurer from proving it was correct that no coverage exists because previously it asserted incorrectly there was no “possibility” of coverage is punitive, not compensatory.  Courts often are reluctant to enforce penalties in contracts, and other remedies, including potential tort remedies if bad faith conduct is proven, are preferable.

Other courts have questioned whether an insurer’s breach of the duty to defend can satisfy the traditional elements of estoppel, as the remedy afforded by the Illinois rule is characterized.  If the insurer contends it has neither a duty to defend nor a duty to indemnify the insured, even if that contention turns out to be incorrect, it is not a misrepresentation on which the insured has relied to its detriment.

Courts also have found inapplicable the principle that when one party breaches a contract and prevents a primary purpose from being fulfilled (i.e., the insurer’s breach of the duty to defend), the breaching party cannot seek enforcement of other parts of the contract (i.e., relying on policy provisions to deny a duty to indemnify).  In reality, it is the insured seeking enforcement of the policy in the form of the duty to indemnify, not the insurer.

Courts also have noted that allowing a breaching insurer to contest the duty to indemnify does not create an “everything to gain and nothing to lose” scenario.  The insurer loses the benefit of controlling the defense, including but not limited to the right to approve any settlement, and risks a litigation result (either by settlement or judgment) that is worse than if the insurer became involved.  In addition, common law and statutory prohibitions on bad faith conduct provide a powerful counterweight, as do reputational concerns in the competitive commercial insurance marketplace.

And finally, some courts have questioned whether encouraging underlying settlements always is appropriate, particularly where it is clear the underlying claim does not implicate the insurer’s duty to indemnify.  In such circumstances, encouraging the insured to lay down and settle at any price just to resolve coverage issues in its favor does not promote the interests of justice and, instead, provides the insured with an undeserved windfall.  In particular, the insured would benefit disproportionately if facts are developed in discovery or trial of the underlying claim to establish that the insured was not entitled to any coverage under the policy.

Additional Consequences if the Breach Is Found to Be In Bad Faith

Additional consequences may follow if the insurer is determined not just to have breached its duty to defend, but to have done so in bad faith.  The implied covenant of good faith and fair dealing applies to insurance contracts, although its basis for a cause of action against the insurer varies from state to state.  In many states bad faith is a common law tort concept, while in others it is subsumed in unfair claims practices statutes that offer a private right of action against insurers.

The standard for determining whether the insurer acted in bad faith when refusing to defend also varies by jurisdiction, but the erroneous interpretation of a policy provision typically is viewed only as a breach of contract and will not suffice.  Conversely, proof of a “sinister motive” or “dishonest purpose” is not required to establish bad faith in most jurisdictions.  Most states employ a test somewhere between these two possibilities.  For example, in New York, the insurer’s conduct must reflect a “gross disregard” of the insured’s interests that goes beyond “ordinary negligence.”  In California, the breach must be “unreasonable,” and a legitimate dispute founded on a reasonable basis under all the circumstances will not suffice.  In Illinois, the refusal to defend must be “vexatious and unreasonable” to warrant statutory damages.

If bad faith is established, additional remedies potentially are available to the aggrieved insured.  The remedies again vary by jurisdiction, but they may include compensatory damages in excess of the policy limits, attorneys’ fees and costs, punitive damages, and statutory penalties.

Ramifications for Insurers and Policyholders

The insurer’s determination whether a suit against the insured gives rise to the duty to defend is a key moment in any liability insurance claim.  As illustrated by the K2 decisions and judicial opinions nationwide, an incorrect determination could have an impact on not just the defense, but also the potential duty to indemnify and the availability of other remedies.  Where the duty to defend is subject to dispute, consult your insurance advisors regarding applicable law and identify next steps to obtain the most favorable outcome for your company.