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Insurance Law

Duty to Defend – New Appleman on Insurance Law Library Edition, Chapter 17

   By Seth D. Lamden, Partner, Neal, Gerber & Eisenberg LLP

The chapter identifies and discusses many key issues that arise in the context of the duty to defend.  This chapter begins in Section 17.01[1][a] with an overview of the scope and purpose of a liability insurer’s agreement to defend its insured.  This section notes that insureds often regard a liability insurer’s agreement to defend them against claims seeking covered damages as equal in value to the insurer’s duty to pay covered damages on their behalf.  Courts give effect to the purpose of so-called “litigation insurance” by interpreting the duty to defend as broadly as possible and in favor of coverage.  Section 17.01[1][b] explains that a liability insurer that has agreed to provide a defense for all suits “seeking” covered damages must defend against any suit that presents the potential that the insured may be held liable for covered damages, regardless of the legal merits of the claim or the claimant’s likelihood of success at trial.

The determination of whether an insurer must defend a suit generally is based on a comparison of the “four corners” of the complaint and the “four corners” of the policy. Section 17.01[2][a] discusses the manner in which courts have applied this standard.  As a general matter, if the factual allegations in the complaint, if proven true at trial, could subject the insured to liability for damages covered under the policy, the insurer must defend the suit.  An insurer only may properly decline to defend a claim if it can show that, as a matter of law, the allegations of the complaint do not present any potential for covered liability.  Section 17.01[2][b] notes that courts are split regarding whether facts of which the insurer is aware that are not alleged in the complaint could obligate the insurer to defend the suit.  A majority of courts have held that an insurer cannot ignore facts known to it that create the duty to defend, while other courts have held that facts not alleged in the complaint have no bearing on the evaluation of an insurer’s duty to defend. A number of courts have recognized that extrinsic facts not at issue in the underlying action may be considered with regard to whether an insurer must defend a claim if they relate solely to an issue of policy coverage.  Examples include nonpayment of policy premiums or the existence of the policy.

Some lawsuits against seek both covered and noncovered damages.  Section 17.01[3][a] notes that an insurer must defend the entire suit if even one count seeks potentially covered damages.  Section 17.01[3][b] explains that courts are split on the issue of whether an insurer that defends a suit seeking both covered and noncovered damages is entitled to reimbursement of the costs of defending the noncovered counts.  Some courts hold that an insurer never is entitled to reimbursement of any defense costs unless reimbursement is expressly authorized by a policy provision. In contrast, others hold that an insurer may be entitled to reimbursement of defense costs that are capable of being allocated as long as the insurer expressly reserved its right to recoup the costs of defending noncovered claims and the insured accepted the defense subject to the reservation of rights.

Although most liability policies grant the insurer the right to control the insured’s defense, the insurer is not entitled to exercise this right when its interests are in conflict with those of its insured.  When conflicts of interest preclude the insurer from directing the defense of the insured, the insurer must reimburse the insured for the costs of independent defense counsel.  Section 17.02 notes when there is such a conflict of interest, the insurer and insured must balance the insurer’s obligation to only pay for a reasonable and necessary defense with the insured’s right to a defense that is free from any insurer control.

Section 17.03 explains the difference between self-insured retentions and deductibles with regard to an insured’s obligation to pay defense costs.

When the insurer and insured are not represented by the same attorney, complex issues may arise regarding whether the attorney-client privilege protects communications between the insurer and the insured.  Section 17.04[1] notes that communications between an insurer and its insured generally are not privileged.  Section 17.04[2] explains that while a minority of courts have held that an insured’s disclosure of privileged communications to its insurer does not constitute a waiver of the privilege because the insurer and insured share a common interest, most courts have held otherwise.   Section 17.04[3] notes that disclosure of attorney defense invoices to a third-party auditor retained by the insurer may constitute a waiver of the privilege, and Section 17.04[4] identifies some strategies that insurers and insureds may employ to avoid waiving the privilege.

Section 17.05 discusses the effect that developments during the course of litigation have on an insurer’s duty to defend. Section 17.05[1] notes that amendments in pleadings may create or extinguish an insurer’s duty to defend, and Section 17.05[2] states that facts that emerge during discovery also may create a duty to defend.  Section 17.05[3] explains that some jurisdictions permit an insurer to stop defending its insured if the adjudication of facts during the course of litigation establishes that there no longer is any potential for covered liability.

Section 17.06 discusses whether an insurer may extinguish its duty to defend by tendering its limits to an excess insurer, the insured or the underlying claimant without obtaining a settlement of the claim on behalf of the insured.  While the majority rule is that an insurer cannot extinguish its defense obligation without exhausting the limits by payment of covered losses, this rule generally is derived from policy language conditioning exhaustion on payment of covered losses.  Some courts have held that where the policy language permits an insurer to extinguish its defense obligation by tendering its limits, an insurer may stop defending upon tender of its limits, regardless of whether it obtains a release for its insured.

When an insurer breaches its duty to defend, it is liable to the insured for damages that flow from the breach.  Section 17.07[1] explains that an insurer that breaches its duty to defend is liable for the reasonable and necessary costs incurred by the insured in defending the underlying action.   Section 17.07[2] explains that if an insurer breaches its duty to defend, the insured is entitled to settle the underlying claim without the consent of the insurer.  Section 17.07[3] notes that some courts hold that an insurer that breaches its duty to defend cannot raise any coverage defenses with regard to its obligation to pay the resulting settlement or judgment.  Section 17.07[4] examines the bases upon which courts have found insurers liable for the insureds’ attorneys’ fees incurred in seeking declaratory judgment that the insurer breached its  duty to defend.

Section 17.08 examines whether an insurer’s duty to defend is subject to an implied covenant of good faith and fair dealing.  Section 17.08[1] notes that not all courts agree that an insurer may be subject to tort liability for a breach of the duty to defend.  Section 17.08[2] identifies several fact patterns where courts have held that an insurer breached the covenant of good faith and fair dealing, and Section 17.08[3] discusses the consequences of a breach of the duty to defend found to be in breach of the implied covenant of good faith and fair dealing.

Seth D. Lamden is a partner with the law firm of Neal, Gerber & Eisenberg LLP in Chicago, Illinois.  Mr. Lamden has a nationwide practice representing policyholders in complex insurance coverage disputes.  The views expressed in this chapter are those of the author only and do not necessarily represent the views of his law firm or clients.

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