In two recent cases, Advantage Builders & Exteriors v. Mid-Continent Casualty Co. No. WD 76880 (Mo. Ct. App. Sept. 2, 2014) and EAN Services, LLC v. Brunson, No. 2-14-118 (Ill. Ct. App. September 8, 2014), the courts remind insurance carriers that an ineffective reservation of rights can be costly. In Advantage Builders, the Missouri appeals court affirmed the trial court’s finding that the insurer was liable for compensatory damages for bad faith failure to settle. It is only small comfort that the damage figures of $3 million in compensatory damages and $2 million in punitive damages will be retried due to an issue with the allocation of the damages. The EAN Services decision, while not having the same financial impact as Advantage Builders, follows its logic and serves as a cautionary tale. 

In Advantage Builders, the insurer was defending a construction defect claim under a reservation of rights and filed a declaratory judgment action where the Missouri trial court found that it owed no coverage. On appeal, the court reversed, finding that since the reservation letters were ineffective, it was estopped from denying coverage. 

Similarly, in EAN Services, an automobile case, the carrier was purportedly defending its insured under a reservation of rights, and the court held that it did not. 

In neither case was the length of the reservation letter at issue. In fact, inAdvantage Builders, the insurer issued two lengthy reservation of rights letters setting out the underlying facts, containing voluminous policy language and stating that it was reserving its rights. The Advantage Builders court actually attached both letters as part of the appendix to the decision to illustrate its point.

Specifically, the Advantage Builders court held: “[A] ‘proper’ reservation of rights must be both clear and timely, and the insured must fully understand the insurer’s position.… Here, both letters only vaguely informed the insured that [the insurer] would investigate and perform a coverage analysis and that it was reserving its right to assert that there may be no duty to defend or indemnify against the claims. The letters generally discussed the nature of the underlying lawsuit and set forth various provisions of [the insured’s] general liability policy. Neither letter clearly and unambiguously explained how those provisions were relevant to [the insured’s] position or how they potentially created coverage issues.”(Emphasis added.)

As a result, the Advantage Builders court held that “[d]efending an action with knowledge of non-coverage under a policy of liability insurance without a proper and effective reservation of rights in place will preclude the insurer from later denying liability due to non-coverage.” (Emphasis added by court.) 

Similarly, the court in EAN Services held: “[The reservation of rights mustadequately inform the insured of the rights which the insurer intends to reserve, for it is only when the insured is adequately informed of the potential policy defense that he can intelligently choose between retaining his own counsel or accepting the tender of defense counsel from the insurer. Accordingly, bare notice of a reservation of rights is insufficient; the notice must make specific reference to the policy defense which ultimately may be asserted and to the potential conflict of interest….” (Emphasis added.)

The irony is that the insurer in Advantage Builders took the proper subsequent measure of filing a declaratory judgment action and obtained a summary judgment finding of no coverage. Since the Missouri appeals court held that the reservation of rights was ineffective, however, the insurer was found to have a coverage obligation despite the court’s favorable ruling in the declaratory judgment action.

Practical Lesson

The takeaway from Advantage Builders and EAN Services is that insurance carriers need to be aware of the potential pitfalls of the initial “acknowledgement” or “placeholder” letters. Such letters, while a common practice in the industry, if not prepared properly initially with the assistance of counsel create a false sense of security. Specifically, they are usually not reviewed after they are issued until the underlying mediation/trial approaches, and by then, the insurance carrier may be estopped from denying coverage or amending its position. 

As a matter of good practice to protect its coverage position, as soon as practicable after coverage investigation is completed, an insurer should as a matter of course supplement any initial “acknowledgment” or “placeholder” letter with a detailed reservation of rights letter. To be “proper and effective,” the reservation of rights letter must not only recite the policy language on which the insurer is basing its reservation but also, to paraphrase Advantage Builders, clearly and unambiguously explain how those provisions were relevant to the insurer’s position or how they potentially created coverage issues.