A few months ago, the NY Court of Appeals put the insurance industry into a tizzy by holding that if an insurer wrongly refuses to defend its insured in a lawsuit, it will later not be allowed to raise policy exclusions as a defense to providing coverage. More specifically, if the insurer refuses to hire lawyers to defend the insured, and a judgment is subsequently entered against the insured, the insurer will be responsible for satisfying it. The case was K2 Investment Group v. American Guarantee & Liability Insurance Company.
In a February 18, 2014 decision, the Court of Appeals reversed itself – something that happens very rarely. Now when an insurance company wrongly refuses to defend its insured, it can still raise a policy exclusion as a defense to its obligation to indemnify the insured and satisfy the judgment. You may ask, does that mean there aren’t any adverse consequences if the insurer wrongfully decides to leave its insured in the lurch? If you answered yes, you are correct.
The specific question in K2 that confronted the court was if the insured, who was both a lawyer and the principal of a company, committed acts that were covered under his lawyer’s professional liability insurance policy or instead were solely done in a business capacity. This was significant because his policy contained an exclusion for business activities. If the insured was acting as a lawyer, he would be covered; if he was acting on behalf of his business, he would not be, and hence an exclusion would apply.
In dissent, Judge Graffeo made a convincing argument that if the liability insurer breaches its duty to defend, it should not be allowed to subsequently invoke policy exclusions. Rather, it should have to satisfy the judgment entered against its insured. “This rule makes sense,” she wrote, because “[a]n insurer should be subjected to some legal consequence for breaching its duty to defend its insured.” This creates an incentive for the insurer to provide a defense in the liability case. Further, “[i]t also encourages the initiation of a declaratory judgment by an insurer that seeks judicial authorization to rely on a policy exclusion to avoid indemnification.” In other words, if the insurer seeks not to defend its insured in a lawsuit, there will be an incentive for it to first ask the court for permission to escape its obligations, instead of simply bailing on its insured.
Judge Graffeo, in my opinion, has it right. If an insurer takes such a bold and momentous step as to leave its insured on its own to defend a lawsuit, there should be consequences. It shouldn’t later be allowed to raise policy exclusions because that creates a double standard. The insured has suffered from the insurer’s refusal to defend, seeing that, at least in K2, a judgment has been entered against him. But the insurer is not in a disadvantaged position as it can argue for policy exclusions. In my view, the court had it right the first time.