Most policyholders would prefer that an insurer defend under a reservation of rights rather than deny coverage and a defense altogether. Not only does a defense under a reservation save the policyholder the cost of the defense, it also may trigger certain rights for the policyholder, such as the right to choose independent counsel.
It is not unusual for allegations in a complaint to include both covered and uncovered claims, and for allegations of intentional misconduct, if proven, to preclude coverage altogether. Given the small margin often present between some indication of coverage versus an indication of no coverage, policyholders seize on the former and hope to obtain a funded defense.
Similarly, an insurer often would prefer to defend under a reservation of rights so that it need not then expend substantial funds arguing about whether the complaint possibly could trigger a duty to indemnify and, therefore, a duty to defend. It often makes economic sense to defend the lawsuit and then argue about indemnification in the event of an adverse decision.
Therefore, an insurer’s defense under a reservation of rights often is the most economically efficient method of handling potential coverage disputes. Against this economic reality, some courts have recognized a policyholder’s right to claim bad faith damages where the insurer is providing a defense. The latest is a California federal court in Lehman Commercial Paper, Inc. v. Fidelity Nat’l. Title Ins. Co., Case No. SACV-12-570 (C.D. Ca. January 2, 2013).
In Lehman, the policyholder received a mortgagee title policy from Fidelity National Title Insurance Company (“Fidelity”) with respect to a loan in the amount of $235 million. The borrowers went into bankruptcy, and lien claimants asserted priority over the Lehman deeds of trust. Fidelity and another title insurer defended the lien claims at their own expense and resolved several lien claims via negotiated payments. At the time of the decision noted above, all lien claims either had been defended successfully or satisfied. Nevertheless, Lehman brought an action for bad faith alleging the loss of “intangible benefits.” The trial court denied Fidelity’s motion for summary judgment, holding that, even where an insurer is complying with its contractual obligations, it still may bear bad faith liability for “other conduct – such as unreasonably refusing to determine coverage . . . .” Id. at 8 (Emphasis by court).
Because the court was sitting under diversity jurisdiction, it applied California substantive law. The court cited language inDalrymple v. United Svcs. Auto Ass’n, 46 Cal. Rptr.2d 845, 854 (Cal. App. 1996), as follows:
There may be cases in which the insurer’s delay in paying the claim or other misconduct causes special harm to the insured even though the claim is ultimately paid or settled. Such payment fulfills the insurer’s contractual obligations. However, under appropriate circumstances, tort liability may still be imposed for the insurer’s misconduct apart from performance of its contract obligation.
Accord: James River Ins. Co. v. Hebert Schenk, P.C., 523 F.3d 915 (9th Cir. 2008) (applying Arizona law). Other courts disagree. Acuity v. Rana, 2012 WL 289860 (W.D.Mo. Jan. 31, 2012) (declaratory judgment action allows insurer to avoid liability for a bad faith refusal to defend); Cardenas v. Navigators Ins. Co., 2011 WL 6300253, *7 (W.D. Wash. Dec. 16, 2011) (bad faith claim dismissed where insurer defending under reservation of rights); Alaska Nat’l Ins. Co. v. Bryan,Wash. App. 104 P.3d 1, 9 (2004) (providing defense under reservation of rights precludes bad faith liability); Carolina Cas. Ins. Co., v. Draper & Goldberg, PLLC, 369 F.Supp.2d 667 (E.D.Va 2004) (not bad faith to defend under reservation).
When an insurer provides a defense, any intangible injury because coverage had not been accepted should be insufficient to state a claim. Not every potential legal and factual question related to coverage need be answered, the importance of lawyer employment notwithstanding. If the insurer funds the defense, other issues often resolve themselves through success in the underlying litigation. The law should encourage this type of reasonable behavior, regardless of the policyholder’s uncertainty.
Precluding bad faith liability for a reservation of rights would not allow insurers carte blanche to refuse to cover policyholders. If the underlying litigation is resolved against the insured, and the insurer refuses to indemnify, the usual risks of bad faith liability would apply. The law should encourage the economically reasonable interim step of allowing an insurer to defend under a reservation of rights without risk of bad faith liability. Those courts that disagree would say that an insurer has nothing to fear if its conduct is reasonable. Such assurances are of scant comfort when courts are so ready to toss the issue to a jury. There is a reason that jurors are not informed in tort cases that a defendant has insurance. Those same concerns mandate that reservations of rights be allowed without fear of bad faith liability.
