The Court of Appeals of New York recently revisited its decision in K2 Inv. Group, LLC v. American Guar. & Liab. Ins. Co., reversing its prior ruling and finding that an insurer that breaches its duty to defend is not estopped from contesting its obligation to indemnify the insured. 2014 N.Y. Slip Op. 1102(U). By vacating its earlier decision, the court has realigned itself with New York precedent and has settled the uncertainty created by its initial opinion.
In its initial decision, the court held that an insurer breaching its duty to defend may not later assert policy exclusions to escape its indemnification obligations. The court reasoned that once an insurer wrongly refuses to defend its insured under the policy, it forfeits all rights to contest its duty to indemnify and must cover the insured for the judgment. The ruling stemmed from the court’s broad application of a more narrowly applicable rule articulated in Lang v. Hanover Ins. Co., 3 N.Y.3d 350 (2004), which prevented insurers that declined to defend their insureds from later challenging the underlying judgment against the insured. The court extended the precepts of Lang to find that if an insurer wrongly disclaims its duty to defend then “the insurance company must indemnify its insured for resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.” K2 Inv. Group, LLC. v. American Guar. & Liab. Ins. Co., 21 N.Y.3d 384 (2013). But the court apparently read Lang too broadly and overlooked the precedent established in Servidone Constr. Corp. v. Security Ins. Co. of Hartford, 64 N.Y.2d 419 (1985).
The decision troubled insurers as it left them potentially exposed to automatic indemnification in the event they wrongly withheld a defense, and the court’s failure to address Servidone created uncertainty about the law.
Realizing this misstep, the court decided to reconsider its decision in order to account for Servidone. The Court of Appeals faced the same question in Servidone as in K2 but came to the opposite conclusion. Whereas the first K2 decision forced insurers to indemnify an insured if the insurer breached its duty to defend, Servidone stated that breaching the duty to defend does not automatically create a coverage obligation where one does not otherwise exist under the policy. In Servidone the court explained that the insurer’s duty to defend is “in a sense ‘litigation insurance’” but the duty to indemnify is “distinctly different” and requires an “actual basis for the insured’s liability.” The court concluded, “an insurer’s breach of duty to defend does not create coverage” because there must be a “covered loss” under the policy before the insurer has a duty to indemnify the insured.
Upon rehearing the case, the court in K2 recognized that its initial holding could not be reconciled with the explicit rule in Servidone. The court vacated its earlier decision, restoring New York law to the standard set forth in Servidone, which is also followed by a majority of states: A breach of the duty to defend may allow the insured to recover its defense expenses, but does not entitle the insured to automatic indemnification. Even after breaching its initial duty to defend, an insurer may still contest its obligation to indemnify the insured and assert all policy exclusions to this end.
The significance of the opinion lies not only in the rarity of New York’s highest court reversing itself but even more in the clarity offered to insurers moving forward. The court recognized the importance of maintaining consistency and clarity in the law and noted that “insurers and insureds alike should ordinarily be entitled to assume that the decision [of the Court of Appeals of New York] will remain unchanged unless or until the Legislature decides otherwise.” This ruling calms the waters that the original K2 decision had disturbed and removes a strict rule that had temporarily been placed on insurers. Nevertheless, insurers should consider the court’s guidance to “seek a declaratory judgment concerning the duty to defend or indemnify the purported insured” in situations where coverage may be arguable.
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