John S. Vishneski, Noel C. Paul and Jessica E. Brown of Reed Smith LLP on “With Reservations: Why Conflicts of Interest Arise when Insurers Reserve Their Rights, and What Insurers Must Do in Response”

John S. Vishneski, Noel C. Paul and Jessica E. Brown of Reed Smith LLP on “With Reservations: Why Conflicts of Interest Arise when Insurers Reserve Their Rights, and What Insurers Must Do in Response”

In an article focusing on Illinois law appearing in the Spring issue of Coverage, John S. Vishneski, Noel C. Paul and Jessica E. Brown of Reed Smith LLP submit that an insurer that improperly responds to a conflict of interest after reserving its rights should be entirely estopped from contesting coverage. Their article, “With Reservations: Why Conflicts of Interest Arise when Insurers Reserve Their Rights, and What Insurers Must Do in Response,” first illustrates why an insurer frequently faces a conflict of interest after reserving its right not to indemnify its policyholder if it is later determined that the policyholder is not entitled to coverage under the policy. The conflict arises from the fact that the attorney hired by the insurance company to defend in an action against the policyholder owes fiduciary duties to two clients: the insurer and the policyholder. There is a conflict of interest where the insurer’s appointed counsel cannot avoid advancing the interests of one of the clients to the detriment of the other. Under Illinois law, an insurer who either fails to explain the conflict of interest to the policyholder or fails to observe the policyholder’s rights may be estopped from denying coverage. The policyholder’s rights include:
 
  • The right to independent counsel;
  • The right to reimbursement of reasonable defense costs;
  • The right to reimbursement of defense costs as they are incurred; and
  • The right to reimbursement of all defense costs prior to a determination of noncoverage.
 
The article discusses each of these rights as interpreted by Illinois’ courts.
 
An insurer whose reservation of rights letter fails to fully and clearly advise the policyholder of the conflict of interest will be estopped from disclaiming coverage pursuant to Illinois court precedents. However, a few Illinois court decisions have held that a policyholder must prove that it was prejudiced by the insurer’s failure to disclose a conflict of interest for the insurer to be estopped. The authors submit “The better rule … find[s] de facto prejudice, and a breach of the duty to defend, where the insurer fails to disclose its conflict of interest when it first provides its defense” that “may and should lead to the insurer being estopped from contesting coverage.”
 
 

Comments

John Vishneski, Noel Paul, and Jessica Brown
  • 08-04-2009

Illinois is in a small minority of states in imposing estoppel to deny indemnification when an insurer breaches the duty to defend.  Because an estoppel is unrelated to the harm, if any, resulting from the breach, it is essentially a punitive sanction, awarded without any showing of the sort of malicious or oppressive conduct normally required for punitive awards.  The law generally disfavors extracompensatory awards for mere breach of contract.  (See the law on liquidated damages vs. penalties.)

William T. Barker, Sonnenschein Nath & Rosenthal LLP