Breach of Duty to Defend Stands Out Among Noteworthy Issues

The past term’s significant insurance law decisions by the New York Court of Appeals resolved a variety of issues that will alter the practice of insurance law in important ways. Among the most notable of these decisions was K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co.,[1] where the court evaluated the consequences to an insurance carrier of its breach of the duty to defend its insured. Decided at the end of the term, and discussed at the end of this article, the decision is surely one of the most widely discussed and debated insurance law decisions rendered by the court in recent years. 

Judge Robert S. Smith wrote three opinions for the court, including the opinion in K2 Investment; all of Smith’s opinions were unanimous. Judge Carmen Beauchamp Ciparick, now retired, wrote two majority opinions. Judge Victoria A. Graffeo wrote one unanimous opinion,[2] while Judge Jenny Rivera, whom the New York State Senate confirmed on Feb. 11, wrote one opinion for a divided court.  The court affirmed three Appellate Division decisions, reversed three, and modified one.

Homeowner’s Insurance

Residency.  Dean v. Tower Ins. Co. of New York[3] arose after a couple purchased a home, discovered extensive termite damage, and began to repair and renovate it. Before they could complete the work and move in, their home was destroyed by fire. 

The couple notified their homeowner’s insurer, which disclaimed coverage on the ground that “the dwelling was unoccupied at the time of the loss” and, therefore, did not qualify as a “residence premises.”  They sued.

The majority decision, by Judge Ciparick, held that residency required at least some degree of permanence and intent to remain. The court found there were issues of fact that made summary judgment inappropriate, including whether the husband’s regular presence in the house to renovate it, coupled with his intent to eventually move in with his family, was sufficient to satisfy the policy’s “residence premises” requirement. More significantly, the court found that because the term “reside” was not defined in the policy, the term “residence premises” was ambiguous, and it ruled that it was “arguable that the reasonable expectation of an average insured” was that “occupancy,” a lesser standard than residence, would satisfy the policy’s requirements.

Earth Movement Exclusion

In 2009, in Pioneer Tower Owners Assn. v. State Farm Fire & Cas. Co.,[4] the court held that an “earth movement” exclusion in an insurance policy did not unambiguously apply to excavation, i.e., the “intentional removal of earth by humans.” This past October, in Bentoria Holdings, Inc. v. Travelers Indemnity Co.,[5] a case in which a building allegedly suffered cracks as a result of an excavation being conducted on the lot next door to it, the court was faced with a policy exclusion similar to the exclusion in Pioneer Tower except that the exclusion was expressly made applicable to “man made” movement of earth.

Smith held that this added language eliminated the ambiguity the court had found in Pioneer Tower, and that, therefore, the loss allegedly caused by the excavation was excluded from the policy. The court reasoned that by expressly excluding earth movement “due to man made or artificial causes,” the policy contradicted the idea that “the intentional removal of earth by humans” was not an excluded event.

Broker Liability

Ciparick’s second majority opinion came on Nov. 19, in American Building Supply Corp. v. Petrocelli Group, Inc.[6]

In this case, a company that subleased a building in the Bronx sued its insurance broker for failing to obtain adequate insurance coverage. The court found that issues of fact existed as to whether the company had requested specific coverage that was not provided, as required to set forth a case for negligence or breach of contract against an insurance broker.[7] 

Significantly, the court resolved an issue that it had left open in 2006 in Hoffend & Sons, Inc. v. Rose & Kiernan, Inc.[8]: whether a policyholder who had received an insurance policy and had had an opportunity to read it but had not requested any changes was barred from suing his or her broker.  The court acknowledged that it was “certainly the better practice for an insured to read its policy,” but it held that the failure to read a policy, “at most, may give rise to a defense of comparative negligence but should not bar, altogether, an action against a broker.”[9]

Asbestos Claims

Smith’s second unanimous opinion for the court came in February, in U.S. Fidelity & Guaranty Co. v. American Re-Ins. Co.,[10] a case in which an insurance company, United States Fidelity & Guaranty Company (“USF&G”), having settled asbestos claims for nearly $1 billion, sought to recover a share of its settlement payment – about $391 million – from its reinsurers.

The court explained that the reinsurance contracts contained a “follow the fortunes” or “follow the settlements” clause, which ordinarily barred challenge by a reinsurer to the decision of a party in USF&G’s position (the “cedent”) to settle a case for a particular amount. The court then specifically decided that a “follow the settlements” clause required “deference” to a cedent’s decisions on allocation.

The court added, however, that a cedent’s allocation decisions were not “immune from scrutiny.”  It decided that “objective reasonableness” ordinarily should determine the validity of an allocation, meaning that the reinsured’s allocation must be one that the parties to the settlement of the underlying insurance claims might reasonably have arrived at in arm’s length negotiations if the reinsurance did not exist. The court then held that there were issues of fact in the particular allocation in this case.

Occurrences

On May 7, the court decided Roman Catholic Diocese of Brooklyn v. National Union Fire Ins. Co. of Pittsburgh, PA.[11] The case was unusual in that it was heard by only five judges, and because it resulted in three separate decisions.  Rivera’s first insurance law decision for the court was joined by Judges Susan Phillips Read and Eugene F. Pigott, Jr.; Smith concurred in the result, while Graffeo concurred in part and dissented in part. Chief Judge Jonathan Lippman took no part in the case; Judge Sheila Abdus-Salaam, who was confirmed by the Senate on May 6, also did not participate. 

The dispute involved the apportionment of liability for a settlement between the Roman Catholic Diocese of Brooklyn and a minor plaintiff in an underlying civil action charging sexual molestation by a priest. The insurance carrier contended that alleged incidents of sexual abuse constituted a separate occurrence in each of the seven implicated policy periods, and required the exhaustion of a separate $250,000 self-insured retention (“SIR”) for each occurrence covered under any policy from which the Diocese sought coverage. For its part, the Diocese argued that the alleged sexual abuse constituted a single occurrence requiring the exhaustion of only one SIR.

Addressing for the first time the meaning of “occurrence” in the context of claims based on numerous incidents of alleged sexual abuse of a minor by a priest spanning several years and several policy periods, the court held that they constituted multiple occurrences. Rivera’s plurality opinion found that each alleged incident involved a “distinct act of sexual abuse perpetrated in unique locations and interspersed over an extended period of time,” and that they should not be grouped into one occurrence. Both Smith and Graffeo concluded that there was only one occurrence.

All five Judges, however, agreed it was appropriate to have a pro rata allocation of the loss across all seven of the insurance policies that were in effect when the alleged abuse had occurred. All five judges rejected the Diocese’s argument that the allocation of liability should be pursuant to a joint and several allocation method, under which the entire settlement amount could be paid for with two particular policies of its choosing.

Finally, the court decidedK2 Investment Group, LLC v. American Guarantee & Liability Ins. Co.,[12] one of the most controversial insurance law decisions issued by the court in recent memory.

The facts were fairly simple. A lawyer was sued for malpractice and his malpractice carrier disclaimed coverage and refused to provide a defense. The plaintiffs obtained a default judgment against the lawyer, which they sought to recover from his insurance company pursuant to Insurance Law § 3420. The insurer moved for summary judgment, claiming that two policy exclusions established that it had no obligation to provide indemnity to its insured. After the Supreme Court ruled in favor of the plaintiffs, a divided Appellate Division affirmed, and the case reached the court.

The court, in a decision by Smith, affirmed. The Court held that when a liability insurer breached its duty to defend its insured, the insurer could not later rely on policy exclusions to deny its obligation to indemnify its insured for a judgment. The court found that the insurer in this case had breached its duty to defend the lawyer, and concluded that, as a consequence, it had “lost its right” to rely on the policy’s exclusions in litigation over its indemnity obligation to the insured.

Controversy over this decision stems both from its holding – expanding the consequences for a breach of a duty to defend – and from its reasoning. Almost 30 years ago, in Servidone Construction Corp. v. Security Ins. Co. of Hartford,[13] the court held that an insurer’s breach of its duty to defend did not create coverage and that there could be no duty to indemnify unless there was a covered loss. The decision in K2 Investment is plainly inconsistent with Servidone, at least so far as indemnity defenses based on exclusions are concerned. Yet, there was no mention of Servidone in K2 Investment. Even more curious, the authority relied on by the court for its ruling, Lang v. Hanover Ins. Co.[14] involved a wholly discrete issue and only touched on this issue in dicta, also without mentioning Servidone.

The long term impact of K2 Investment remains to be seen. There undoubtedly will be opportunities for the court itself, and for lower courts, to provide further guidance as to the holding’s applicability to different circumstances. In the short term, the most immediate result will be an increase in declaratory judgment actions brought by insurance carriers to adjudicate their obligations to provide a defense while, concomitantly, they actually provide a defense. In that scenario, insurers will be able to preserve their ability to resolve their indemnity obligations on the merits, although policyholders will be required to engage in litigation on multiple fronts, and courts will be forced to resolve multiple actions.