New York Insurers Breaching Duty to Defend May Not Assert Policy Exclusions

The New York Court of Appeals has reaffirmed the importance of the insurer’s duty to defend its insureds, holding that when an insurer breaches its duty to defend, it may not rely on exclusions in the policy to avoid coverage obligations, “even if the exclusions would otherwise have negated the duty to indemnify.” The decision sets forth a stark rule that deviates from the general rule previously followed in New York and supported by a majority of other jurisdictions.

In K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 2013 NY Slip Op 4270, an attorney was sued for legal malpractice. He notified his malpractice insurer but the insurer refused to defend or indemnify the claim, stating that the claim was not based on “rendering or failing to render legal service for others” as required by the policy for coverage. When the plaintiffs offered to settle the case, the attorney sent the settlement demand to his insurer, but again the insurer rejected it. After a default judgment was entered against the attorney in the underlying case, the attorney assigned his rights against the insurer to the plaintiffs who promptly sued the insurer for breach of contract for failure to defend and indemnify the claim.

Insurers owe their insureds two distinct duties: the duty to defend claims made against the insured and the duty to indemnify the insured for covered losses. The duty to defend is broad and requires the insurer to “provide a defense whenever allegations of the complaint suggest a reasonable possibility of coverage.” The duty to indemnify is much narrower and is determined on the actual basis of the insured’s liability as it applies to the terms and conditions of the policy. Insurers must navigate these two duties as they address claims from their insureds.

Here, the trial court found, and the appellate court agreed, that the insurer breached its duty to defend the attorney. On appeal to the State’s highest court, the insurer did not contend the lower courts’ findings that it had breached its duty to defend but argued that it had no duty to indemnify the insured for the loss because of the exclusions in the policy. The court was faced with the question of whether an insurer that breaches its duty to defend may later escape its duty to indemnify by asserting policy exclusions.

While the lower appellate court analyzed the policy exclusions in light of the insurer’s breach of its duty to defend, the Court of Appeals determined that such an analysis was not necessary, and that the breach of the duty to defend alone decided the question. The court held that by breaching its duty to defend the insured, the insurer forfeited all rights to avoid coverage under the policy and was now obligated to pay for the insured’s loss. “By breaching its duty to defend… American Guarantee lost its right to rely on these exclusions in litigation over its indemnity obligation.”

In coming to its decision, the court relied on the ruling in Lang v. Hanover Ins. Co., 820 N.E.2d 855 (N.Y. 2004), which provided that if an insurer disclaims coverage and declines to defend the insured in the underlying lawsuit, then the insurer can later “litigate only the validity of its disclaimer and cannot challenge the liability or damages determination underlying the judgment.” Acknowledging that the rule in Lang did not dispose of the present case and involved a different situation, the court nevertheless extended the rule from Lang to address the current case.

Broadly applying the rule from Lang, the court held that, “If the disclaimer [of the duty to defend] is found bad, 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 reasoned that this would give insurers an incentive to defend the cases they are bound by law to defend and ensure that policyholders receive the “full benefit of their bargain” with the insurer. According to the court, “It would be unfair to insureds… if an insurer, having wrongfully abandoned its insured’s defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify….” The only exception identified by the court would be in cases where forcing indemnification upon the insurer would violate public policy, such as where an insured seeks coverage for intentional wrongdoing.

Curiously, in its analysis, the court disregarded its previous ruling in Servidone Constr. Corp. v. Security Ins. Co., 477 N.E.2d 441 (N.Y. 1985), where it stated, “an insurer’s breach of duty to defend does not create coverage and … there can be no duty to indemnify unless there is first a covered loss.” The court in Servidone had identified the two distinct duties arising under the insurance policy—defense and indemnity—and found that a breach of the duty to defend does not alter the coverage terms so as to create a coverage obligation where none exists.

Other courts interpreting New York law have also supported this position, finding that, “It is impermissible for a court to enlarge the bargained-for coverage as a penalty for breach of the duty to defend.” CGS Indus. v. Charter Oak Fire Ins. Co., 2013 U.S. App. LEXIS 11700 (2d Cir. June 11, 2013) citing Hotel des Artistes, Inc. v. General Accident Ins. Co. of America, 75 N.Y.S.2d 262 (N.Y. App. Div. 2004).

In addition, the majority of states hold that an insurer that breaches its duty to defend is not estopped from asserting coverage defenses. See e.g., Western Alliance Ins. Co. v. Northern Ins. Co. of N.Y., 176 F.3d 825 (5th Cir. 1999) (applying Texas law); Flannery v. Allstate Ins. Co., 49 F.Supp. 2d 1223 (D.Colo. 1999) (listing majority decisions); Johnson v. Studyvin, 839 F.Supp. 1490 (D.Kan. 1993); St. Paul Ins. Co. v. Bischoff, 389 N.W.2d 443 (Mich. Ct. App. 1986).

The court’s heavy-handed decision in K2 establishes a harsh rule for insurers. By extending the rule from Lang to preclude insurers that breach the duty to defend from asserting policy exclusions to avoid indemnification obligations, the court appears to have deviated from New York precedent and encroached on the rule that was articulated in Servidone. But by failing to address Servidone in its opinion, the court may have left opportunities to clarify, refine, and distinguish the rule, which litigants will likely explore in future cases. Nevertheless, the ruling stands as the law in New York and reinforces the importance of the insurer’s duty to defend. With the court’s decision in K2, insurers should approach the duty to defend carefully, seeking declaratory judgments and defending under a reservation of rights where necessary to preserve their rights.