Mind the Warning Signs

When dealing with an unresolved coverage question in the context of a personal services declination, an insurer may issue a reservation of rights letter in conjunction with filing a declaratory action. It is often possible, after all, to advance defense costs while simultaneously disputing coverage

When faced with this situation, there may be options to save some, or most, of the policy limits. For example, when an insurer has a valid and good-faith coverage defense and is merely paying one firm for the defense of the underlying claim while litigating the coverage issue with the insured, it is unlikely, in many professional liability claims, that the policy limits will be exhausted simply by the payment of defense fees. Claims are often settled with a recognition on the part of the plaintiff in the underlying action that the claim is not covered.

However, while this option is generally effective in the above context, it does not operate effectively for directors and officers (D&O) insurers, where the costs of defense can be substantial and may exceed available limits.

New York courts, like others, have viewed the duty to defend as extremely broad. In In Re Worldcom Inc. Sec. Litig., the court held the duty “exists whenever a complaint against the insured alleges claims that may be covered under the insurer’s policy.” The interpretation of “may be covered” is often read broadly in favor of the insured when seeking the advancement of defense costs, even if coverage for indemnity is in dispute.

When faced with an obligation to defend or advance costs, D&O insurers may seek recoupment, which is a mechanism recognized by courts where the insurer can assert the right to seek the return of defense costs advanced if the insurer formally establishes that no coverage applies (see, for example, Women’s Integrated Network Inc. v. U.S. Specialty Ins. Co., which permitted a D&O insurer to recoup defense costs when the insurer prevailed in coverage action). The practicalities of recoupment, however, can be potentially challenging.

D&O cases often follow one of two patterns: Either the insurer issues a declination of coverage and the insured files a declaratory action seeking coverage, or the insurer files the declaratory action in conjunction with a declination of coverage or strong reservation of rights. In the course of the declaratory action, a court will be presented with the coverage issues, but it may not be in a position to determine those issues at summary judgment if factual issues remain unresolved. Certain coverage disputes that hinge on exclusions, for example, may not be determinable until the underlying claim is developed through extensive discovery, or even fully adjudicated.

Another example is when the insurer is seeking rescission, such as in Federal Ins. Co. v. Kozlowski, where the court found that “until [insurer’s] rescission claims are litigated and determined in its favor, the policy obligation to defend or pay for a defense remains in effect.” In these situations, the coverage issue and the development of the underlying claim may not address or uncover facts or details relating to policy issuance.

Recoupment remains an option for the insurer, as it may be able to recover its outlay of defense fees if the insurer’s position is upheld in the coverage action. However, recoupment may present practical challenges, particularly when insured individuals or entities experience financial difficulties and lack the assets to repay the amounts when the opportunity to seek recoupment of defense costs finally arises. This is of particular concern in matters involving criminal or governmental investigations. Most carriers will not endure such expense because it does not make economic sense when actual recoupment is unlikely.

Notwithstanding these issues, recoupment may still be an option to consider and pursue in seeking the recovery of fees advanced that are ultimately determined to be excluded from coverage. In addition, although recoupment is generally recognized as a matter of law, insurers may wish to consider specific policy wordings to ensure an insured’s ability to repay in the event recoupment is ordered.

Warranty Warning Signs

Coverage declinations based on exclusions, warranties, and rescission all appear to be situations in which the insurer is likely obligated to advance defense fees first and litigate the coverage issue second. A well-meaning underwriter may believe that he is insulated from events known to the insured but not revealed during the underwriting process, only to discover that a question has been created concerning the applicability of the warranty used to guarantee that such losses will not be covered and the carrier has to advance defense costs.

Given the state of law pertaining to such disputes and the practicalities of recoupment, it is best to seek out warning signs before agreeing to the risk. A common sign may be the addition of new, increased limits of insurance to an existing tower. In Patriarch Partners LLC v. Axis Ins. Co., the excess carrier, which ultimately prevailed in its coverage dispute, added $5 million in new limits to a tower of existing insurance.

Insurers may be more protected if they seek out warning signs during the underwriting process rather than to count on discovery of such issues once significant costs are advanced.