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When Must an Insurer Defend a Malpractice Claim?

An insurer can run into trouble after refusing to defend an attorney based on policy technicalities.

Insurer Can’t Avoid Payment After Failing to Defend Insured

Insurers can’t have it both ways.  From

Or as New York’s highest court explained, a liability insurer that breached its duty to defend may not later rely upon policy exclusions to escape its duty to indemnify the insured for the underlying judgment against him.

Two LLCs made a total of $2.83 million in loans secured by mortgages to a third LLC, which failed to repay the loans. Jeffrey Daniels, a lawyer for the mortgagee, failed to record the mortgages. When the loans went unpaid, one of the companies – K2 Investment Group – filed suit against Daniels, alleging malpractice.

Daniels’ insurer, American Guarantee and Liability Insurance Company, refused to provide either defense or indemnity coverage.

K2 eventually settled with Daniels for $450,000. He defaulted on payments and assigned his rights against the insurer to K2, which then filed suit against American Guarantee to recover the full $2 million of Daniels’ policy limit.

American Guarantee again refused to pay, pointing to two policy exclusions for “insured’s status” and “business enterprise,” arguing that the claims arose out of Daniels’ capacity as a member or owner of a separate business enterprise, not his work as a lawyer.

Without even reaching the application of the exclusions, the court affirmed summary judgment for K2 based on American Guarantee’s refusal to defend.

“[B]y breaching its duty to defend Daniels, American Guarantee lost its right to rely on these exclusions in litigation over its indemnity obligation,” the court said. The complaint in the underlying lawsuit against Daniels “unmistakably” pleads a claim for legal malpractice, the court noted, and while it was concededly unusual to have a principal of the borrower act as a lawyer, the parties said that’s what they did. The claim against Daniels may have been groundless, baseless, or not covered – but “it does not allow American Guarantee to escape its duty to defend,” the court said.

American Guarantee was also not allowed to assert that it would have defeated the underlying claims had it defended the case, the court added. The insurer took a risk that Daniels would obtain a judgment against him and then seek payment; in this case, the risk did not pay off.

“This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain,” the court reasoned. “It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured’s defense, could then require the insured to litigate the effect of the policy exclusions on the duty to indemnify.”

Exceptions to this rule may exist, the court acknowledged, like the possibility that coverage for intentional wrongdoing is contrary to public policy and therefore would not be covered even if the insurer had breached its defense obligation. However, no such policy arguments were available to American Guarantee.

Why it matters: A significant victory for insureds, the K2 decision sets forth a clear rule: If the disclaimer of a duty to defend is found bad, the insurance company must indemnify its insured for the resulting judgment even if policy exclusions would otherwise have negated the duty to indemnify. The court’s ruling could result in fewer insurers taking the risk of declining to provide defense coverage, fearing the loss of their right to challenge the merits of coverage

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