Susan C. Jacobs ()
The insurer’s duty to defend is exceedingly broad, but the duty is not interminable. As long as there are allegations of covered claims the duty includes an obligation to defend allegations not covered by the insurance policy. Professional liability policies—the Errors & Omissions (E&O) and analogous Directors and Officers (D&O) policies—permit the insurer to “clawback” defense costs if a judicial finding is made that the alleged acts are excluded from coverage or are otherwise not covered. The insurer’s success depends upon the wording of the policy, a finding by a court and the insurer’s explicit reservation of rights letter explaining its coverage position including that it would seek recoupment of defense costs if coverage were found inapplicable or excluded.
The Duty to Defend
The insurer must provide a defense to the action if the complaint, liberally construed, sets forth any claim which can reasonably be said to fall within the coverage provided by the insurance policy, or if the carrier has actual knowledge of facts which tend to establish the reasonable possibility of coverage. In New York, insurers may not look beyond the “four corners of the complaint” to avoid the obligation to defend. Even if extensive facts suggest the claim may ultimately prove meritless or outside the policy’s coverage the insurer must initially provide a defense.
Only when the insurer can establish that there is no possible factual or legal basis to indemnify the insured, either because no reading of the policy language encompasses the loss at issue or the alleged act is excluded from coverage, will the insurer be relieved of its obligation to defend. Once the insurer commences a defense it should continue to defend until a court finds it has no coverage obligation, or a jury issues a finding concerning the alleged misconduct that shows the loss to be one that is excluded or outside the boundaries of coverage.
An insurer is obligated to pay or advance defense costs as they are incurred, “subject to recoupment in the event it is ultimately determined no coverage was afforded[.]“1 Language allowing the insurer to recoup defense costs may appear in either the E&O or the D&O policies. In addition, if a policy is properly rescinded the insurer may be able to recover defense costs.
The First Department in Certain Underwriters at Lloyd’s London v. Lacker Lovell-Taylor recently reaffirmed the principle that recovery of the defense costs will be permitted if the policy language provides for the recovery of defense costs and the insurer has explicitly reserved its rights to seek reimbursement of defense costs once there is a finding of no coverage.2
An insurer who notifies the insured of the policy rescission may refuse to pay defense costs. The insurer, however, remains obligated to defend its insured until a court finds the rescission is proper. It may then be entitled to clawback the defense costs.
Interestingly, a 2012 decision in the Southern District of New York, XL Specialty Ins. v. Level Global Investors, drew a distinction between rescission and other types of insurance coverage disputes when it considered an insurer’s obligation to advance defense costs. There, the insured sought an injunction requiring advancement of defense costs by its professional liability insurer.3 The insurer claimed it had no obligation to defend or indemnify, relying on policy exclusions.
While recognizing the “irreparable harm” component was satisfied by the insured’s “need to access additional legal costs,” the court disagreed that New York law compelled the advancement of defense costs if the coverage was excluded by policy language. The court explained that “[m]andating advancement while even dubious assertions of coverage are resolved would invite abuse” and ultimately “would only serve to drive up the costs of insurance[.]“4
Rescission of the Policy
Proper rescission occurs when the insurer returns the premium paid and the insurer is able to establish that but for a misrepresentation that was so material the insurer would not have issued the policy had it known the truth.
Section 3105 of New York’s McKinney’s Insurance Law “Representation by the Insured” governs the insurer’s right to rescind a policy. Section 3105 (1) defines “representation” as: “a statement as to past or present fact, made to the insurer by, or by the authority of, the applicant for insurance or the prospective insured, at or before the making of the insurance contract as an inducement to the making thereof.”
The insurer must return the paid premium when it notifies the insured of the rescission and should be prepared to litigate the validity of the rescission. If the insured wins, the insurer may be responsible for the costs in the litigation concerning rescission as well as in the underlying action.
The insurer may recover the defense costs expended on behalf of the offending party if the rescission is successful. Rescission without court approval does not provide retroactive effect for recovery of defense costs.
Unique Terms in Policies
The ability of an insurer to void the insurer’s contract based on a material misrepresentation may be limited by a severability clause. The policy in issue in the seminal case Federal Ins. v. Kozlowski5 (Tyco) contained a severability clause so that misrepresentative statements made by one director or officer did not apply to the interpretation of the application concerning another. In the Tyco case the insurer also relied on financial statements not attached to the application to bolster its misrepresentation claim. The court held the information was insufficient to prove the officer in issue had the specific knowledge required to rise to the level of “a false representation, and the facts misrepresented are those facts which make the representation false.”6
Another severability clause relates to certain policy exclusions, including the personal profit and fraud exclusions. Both severability clauses preclude the carrier from imputing to an insured person any facts or knowledge of other insured persons “to determine if coverage is available.” Only after the issue is resolved will there be an apportionment of legal fees for covered and uncovered claims.
The severability clauses are protection for the innocent lawyers and/or officers and directors. Generally a firm and/or corporation is sued along with the offending directly involved lawyers, directors and/or officers. The defense remains an integral part of the policy since defense costs are so high in professional liability actions.
Allocation of Defense Costs
An insurer is required to defend an action alleging a mixture of covered and uncovered claims. Once an action is resolved, the insurer may allocate defense costs between covered and uncovered claims, provided the policy language permits an allocation and it is feasible to do so.7
The D&O and E&O insurer “has a duty to pay all defense costs until it can confine its duty to pay only on those claims it has insured the policy holders against.”8 There must be a factual basis for the allocation.9 If the insurer cannot clearly distinguish between costs paid for defending covered and non-covered claims, “it must pay all defense costs as incurred, subject to recoupment” after the underlying action has ended.10
Although the duty to defend is exceedingly broad it is not absolute and not without the possibility that the insurer will be able to be reimbursed for some amount of defense fees expended. Whether the insurer will be able to clawback defense fees in the professional liability area depends upon the policy language, a finding by the court of no coverage and the insurer’s coverage position stated in its reservation of rights or a declaratory action seeking rescission of the policy.
Sue C. Jacobs is a member of Goodman & Jacobs. Howard M. Wagner, an associate at the firm, contributed to this article.
1. Federal Ins. v. Kozlowski, 18 A.D.3d 33, 42, 792 N.Y.S.2d 397 (1st Dept. 2005) (interpreting D&O policy).
2. Certain Underwriters at Lloyd’s London v. Lacker Lovell-Taylor, 2013 WL 6284081, —A.D.2d— (1st Dept. 2013).
3. XL Specialty Ins. v. Level Global Investors, 874 F.Supp.2d 263 (S.D.N.Y. 2013).
5. Kozlowski, 18 A.D. 3d 33.
6. N.Y. Insurance Law §3105 (McKinney 2013).
7. Kozlowski, 18 A.D.3d at 41 (holding that “under this type of defense coverage [under a D&O policy] the insurer is entitled to differentiate between covered and uncovered claims”).
8. Pepsico v. Continental Casualty, 640 F.Supp 656, 660 (S.D.N.Y. 1986).
9. Clifford Chance Liability Partnership v. Indian Harbor Ins., 14 Misc.3d 1209(a) (Sup. Ct., N.Y. Cty. 2006), aff’d 41 A.D.3d 214 (1st Dept. 2007).
10. Kozlowski, 18 A.D.3d at 42-43 and Trustees of Princeton Univ. v. Nat’l Union Fire Ins., 15 Misc.3d 1118(a) (Sup. Ct., N.Y. Cty.), aff’d 52 A.D.3d 247, leave to appeal denied, 11 N.Y.3d 847 (2008).