An Insurer’s Guide to Reserving Rights: Tips for Avoiding Waiver and Estoppel
Insurers know all too well that the penalties for an ineffective reservation of rights letter can be severe. It is not unusual for policyholders to contend that an insurer waived coverage defenses or is estopped from asserting that policy provisions bar coverage due to an allegedly defective (or untimely) reservation. Drafting a proper letter can therefore mean the difference between losing potentially valuable rights and successfully disclaiming coverage later. The good news is that there are some effective ways to help avoid the drastic consequences that were visited on insurers in two more recent appellate cases.
In July 2017, the Supreme Court of South Carolina held that an insurer had failed to preserve its rights to contest coverage for multiple multi-million dollar jury verdicts in underlying construction defect cases because its reservation of rights letters provided no discussion or explanation of its reasons for potentially denying coverage. Harleysville Group Ins. Co. v. Heritage Cmtys., Inc., 803 S.E.2d 288, 299 (S.C. 2017). According to the court in Heritage, a reservation of rights letter “must give fair notice to the insured that the insurer intends to assert defenses to coverage….” Id. at 297. The court further explained that “[i]f the insured does not know the grounds on which the insurer may contest coverage, the insured is placed at a disadvantage because it loses the opportunity to investigate and prepare a defense on its own,” and that “for a reservation of rights letter to be effective, [it] must be unambiguous….” Id. at 298; compare Hoover v. Maxum Indem. Co., 730 S.E.2d 413, 417 (Ga. 2012) (“[a] reservation of rights is not valid if it does not fairly inform the insured of the insurer’s position”).
The insurer’s reservation of rights letters in Heritage explained that the insurer would provide a defense in the underlying actions, provided contact information for the defense attorney selected, summarized the allegations of the underlying complaints, and incorporated a lengthy “excerpt of various policy terms” through a “cut-and-paste approach.” Heritage, 803 S.E.2d at 298-99. The letters did not include any discussion of the insurer’s position of the quoted policy provisions, any explanation of its reasons for potentially denying coverage, or the potential need for an allocated verdict in the underlying actions as between uncovered faulty workmanship damages and other potentially covered damages. Id. at 299-300. Consequently, the court concluded that the insurer’s letters were not sufficiently specific to put the insured on notice of the insurer’s potential coverage defenses. Accordingly, because of the insurer’s ineffective reservation of rights, the Court held that the insurer could not contest coverage for all of the actual damages in the underlying actions, including uncovered faulty workmanship damages that were part of the jury’s undifferentiated general verdicts. Id. at 301.
The Missouri Court of Appeals reached a similar conclusion in Advantage Buildings & Exteriors, Inc. v. Mid-Continent Cas. Co., 449 S.W.3d 16 (Mo. Ct. App. 2014). In that case, the court affirmed the insurer’s liability for “bad faith” and further held that the insurer was estopped from denying coverage for an underlying claim to the extent of its policy limits because its reservation of rights letters “did not constitute an effective reservation of rights.” Id. at 22-25. In Advantage Buildings, after the insured tendered an underlying construction defect case to its general liability insurer, the insurer promptly sent a letter informing the insured that it would “investigate the claim and perform a coverage analysis” but reserved the right to disclaim coverage. Id. at 20. In a second letter issued a short while later, the insurer indicated that it would conditionally accept the defense, appointed an attorney, and advised that it would “promptly inform” the insured if “other facts” came to its attention. Id. Nearly two years later, and four days before trial in the underlying action, the insurer sent a third letter informing the insured for the first time that its policy would not cover nearly all of the claims against the insured, whose $3 million potential exposure well exceeded the $1 million policy limit. Id. at 21.
After a bench trial, the court in the underlying action awarded approximately $4.6 million in damages to the plaintiff. Id. In the subsequent coverage action, the court concluded that the policy did not provide coverage for the underlying action. Id. Nevertheless, the court allowed the insured’s counterclaim for “bad faith” failure to settle within policy limits to go to the jury, which awarded $3 million in compensatory damages and a further $2 million in punitive damages against the insurer. Id. On appeal, the insurer asserted that there was no basis for the “bad faith” claim because it had properly agreed to defend the insured under a reservation of rights and the court determined that no coverage for the claim existed. Id. at 23.
The Missouri Court of Appeals rejected this argument, finding that the insurer’s reservation of rights letters were ineffective, which prohibited the insurer from challenging coverage for the underlying claim. Id. at 24. Like the South Carolina court in Heritage, the Missouri court in Advantage Buildings observed that the insurer’s first two letters generally discussed the underlying lawsuit, set forth policy provisions, and “only vaguely informed the insured” that the insurer was investigating and reserved its right to disclaim coverage. Id. at 23. It stated that “[n]either letter clearly and unambiguously explained how [the policy provisions] were relevant to [the insured’s] position or how they potentially created coverage issues.” Id. The court further determined that the insurer did not “promptly” advise the insured of its ultimate coverage determination – that no coverage existed for most of the underlying claim – until nearly two years after it had reached that conclusion internally and a mere four days before trial. Id. at 24. The court accordingly concluded that the determination that the policy did not provide coverage for the underlying action was irrelevant because the insurer was estopped from denying the claim to the extent of its policy limits. Id. As a result, the court explained, the trial court did not err in submitting the “bad faith” claim to the jury. Id.
As the court in Heritage explained: “[a]lthough a reservation of rights may protect an insurer’s interests, it also is intended to benefit the policyholder by alerting the policyholder to the potential that coverage may be inapplicable for a loss; that conflicts may exist as between the policyholder and the insurer; and, that the policyholder should take steps necessary to protect its potentially uninsured interests.” Heritage, 803 S.E.2d at 295 (quoting 12 New Appleman on Insurance § 149.02[a]). A letter that properly addresses these and other issues will reduce the risk of misunderstanding and confusion. It may also become a critical piece of evidence on the insurer’s behalf in the event of a coverage dispute. While there is no universal “template” to follow, cases like Advantage Buildings and Heritage suggest ways for insurers to maximize the effectiveness of their reservation of rights letters. Some of the questions for claims examiners to consider when drafting reservation of rights letters include:
- Has the letter been timely issued, and is it as complete and transparent as possible?
- Does the letter reference the potentially relevant policies and clearly and explicitly state that its purpose is to provide the insured a defense subject to a full and complete “reservation of rights,” including the right to deny coverage?
- Have the potential bases to reserve been identified and explained as plainly and completely as possible? That is, does the letter “fairly inform” the insured of the potential reasons why the insurer may deny coverage later?
- Does the letter cite to the allegations against the insured and connect them to relevant policy provisions, indicate how those provisions apply to the claims at issue and why coverage may not exist in whole or in part, and explain what happens if the allegations are proven?
- Are there other issues the insured may need to be reminded of (e.g., responsibility for deductibles, policy aggregates, that defense costs erode limits, and the possibility of an excess verdict)?
- Has the proposed arrangement for the insured’s defense been explained, and has appointed defense counsel been identified?
- Have any conflicts of interest been identified? If so, does the letter address those and notify the insured of the right to so-called “independent counsel” where applicable?
- Does the letter indicate that the insured should take steps to protect any uninsured interests, and that it can retain separate counsel at its own expense to advise it with respect to any uninsured interests?
- If an allocated verdict (e.g., between any covered and non-covered claims/damages) or special interrogatories may be needed in the underlying case to resolve coverage issues, does the letter explain that and advise that the insurer may intervene in the underlying action for those purposes?
- Are other, more general “reservations” addressed, such as the insurer’s rights to file a coverage action to determine the rights and obligations of the parties, withdraw from the defense, and seek reimbursement if coverage is found not to exist (if appropriate)?
- Does the letter contain a broad, general reservation of all rights, including the right to supplement/amend the letter to raise other defenses, as well as a statement that the letter is not intended to modify any policy terms or legal rights or requirements?
- Does a previously-issued letter need to be supplemented (e.g., if the allegations against the insured change, or if the insurer needs additional information)?
The above considerations are just some of the many drafting points to be evaluated. It is also generally advisable, for instance, to invite the insured to supply any further information it wishes the insurer to consider, ask the insured to notify other carriers, and remind the insured of its obligation to cooperate with the insurer where appropriate. Insurers can also take additional steps to help avoid common traps, such as:
- Assessing the impact of the potentially applicable laws and the existence of a conflict of laws that will need to be resolved.
- Monitoring any deadlines and acting promptly (be sure to follow any statutory timing requirements applicable to the issuance of reservation of rights letters in some jurisdictions).
- Reviewing relevant prior communications with the insured and other records (e.g., prior reservation of rights letters and claims correspondence issued for previous claims raising the same or similar coverage issues). This can be particularly important in more complex cases or where there is a long history of similar claims made against the insured.
- Separately reserving as to every person or entity claiming coverage (again, note any specific legal notice requirements).
- Creating a “reservation of rights checklist” to track the development and analysis of potential coverage issues and follow up on previous information requests, as the underlying action proceeds.
There are some special circumstances worth keeping in mind when issuing reservation of rights letters. For example, under New Jersey law, a liability insurer is not permitted to control the defense of the insured under a reservation of rights unless the insured consents to the conditions of that representation. e.g., Merchants Indem. Corp. v. Eggleston, 179 A.2d 505, 512 (N.J. 1962). This means that where an insurer seeks to control the insured’s defense in New Jersey under a reservation of rights, the reservation of rights letter should offer to provide a defense to the insured under proposed terms, and it should fairly inform the insured that the offer may be accepted or rejected.
Additionally, where the insurer provides excess coverage with respect to a particular claim, such that it has no immediate duty to defend or indemnify at the outset, it may nevertheless be helpful for the excess insurer to issue an early reservation of rights letter to the insured advising of any potential coverage issues apparent at the time with respect to the excess coverage. This may be especially useful when the excess coverage potentially may be implicated after the insured’s exhaustion of a significant self-insured retention layer, i.e., where it is the insured’s obligation to manage its own defense of an underlying action at the outset. Finally, it may be appropriate to send a reservation of rights letter to the insured when a claim has been asserted but no underlying suit has yet been filed. An example would be if the insurer has identified potential coverage issues and plans to participate in a pre-suit mediation or settlement conference.
Ultimately, there is no “magic formula” for drafting reservation of rights letters that is applicable in every case. Each letter must stand on its own and be tailored to the circumstances and coverage issues presented. The general guidelines and suggestions described above are intended to help guard against the very real risks to liability insurers of issuing ineffective reservation of rights letters. As always, we welcome reader questions and comments.***
*** This article is adapted from the presentation “Friends Don’t Let Friends Lose Coverage Defenses: How to Avoid Waiver and Estoppel” given by Sean P. Mahoney and John S. Anooshian on October 26, 2017 at the annual Coverage College® hosted by White and Williams LLP.