Court of Appeals Rules On Reargument That Liability Insurer’s Breach of Duty To Defend Did Not Preclude The Insurer From Relying On Policy Exclusions To Avoid Duty To Indemnify

On February 18, 2014, the Court of Appeals issued a decision in K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 2014 NY Slip Op. 01102, reversing on reargument a decision issued last year regarding the effect of a breach of an insurer's duty to defend.

In its earlier decision, the court held that "when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him." (Emphasis added). The defendant insurance company moved for reargument on the ground that this holding was inconsistent with earlier precedent, Servidone Const. Corp. v. Security Ins. Co. of Hartford, 64 N.Y.2d 419 (1985), which held that an insurer that breached its duty to defend was not precluded from relying on policy exclusions that do not depend on facts established in the underlying litigation to avoid its duty to indemnify the insured for a settlement of the underlying claims. Although K2 Investment Group involved a judgment against the insured rather than a settlement, the court found that this distinction was not dispositive:

A liability insurer’s duty to indemnify its insured does not depend on whether the insured settles or loses the case. It is true that a judgment, unlike most settlements, is a binding determination of the issues in the underlying litigation. Thus it can be said here, as it could not in Servidone, that the issues in the suit brought against the insured are now res judicata. But that is irrelevant, because [the insurance company] does not seek here, and the defendant in Servidone did not seek, to relitigate the issues in the underlying case. It is well established that such relitigation is not permitted after an insurer has breached its duty to defend. The issue in Servidone, as here, is whether the insurer may rely on policy exclusions that do not depend on facts established in the underlying litigation.

Finding that Servidone could not be distinguished, the court concluded that "to decide this case we must either overrule Servidone or follow it." The court concluded that there was "no justification for overruling Servidone":

Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise. In other words, the rule of stare decisis, while not inexorable, is strong enough to govern this case.

A dissenting opinion by Judge Graffeo (joined by Judge Pigott) argued that the court should have "adhere[d] to the general principle that a breach of liability insurer's duty to defend prohibits it from subsequently invoking policy exclusions to escape its corollary duty to satisfy a judgment entered against the insured by a third party." According to the dissenters,

[t]his rule makes sense for several reasons. An insurer should be subjected to some legal consequence for breaching its duty to defend an insured. Prohibiting exclusions from being collaterally invoked provides an insurer with an incentive to appear on behalf of the policyholder in the underlying lawsuit, as it agreed to do in return for the payment of premiums. It also encourages the initiation of a declaratory judgment by an insurer that seeks judicial authorization to rely on a policy exclusion to avoid indemnification. Bringing all of the interested parties – injured plaintiffs; insured defendants; and insurance carriers – together in a judicial forum further contributes to the efficient resolution of factual issues for the benefit of litigants without unduly burdening the ability of injured parties to obtain recovery for covered losses.

This decision has important implications for New York insurance law and Court of Appeals practice generally. As noted by the dissent, this decision eliminates one powerful incentive for insurance companies to err on the side of honoring the duty to defend, since a breach of the duty will not preclude the insurer from later invoking policy exclusions to disclaim coverage for a judgment entered against the insured. On the procedural side, this decision evidences the increasing willingness of the Court of Appeals to grant reargument. In its coverage of the decision, the New York Law Journal notes that the Court of Appeals "granted only one such motion between 2003 and 2011, but it reheard one previously decided case in 2012 and granted three reargument motions in 2013."