In its recent decision in Capitol Specialty Ins. Corp. v. Sanford Wittels & Heisler, LLP, 2011 U.S. Dist. LEXIS 68171 (D.D.C. June 27, 2011), the United States District Court for the District of Columbia had occasion to consider whether the insurer, as a result of its actions, was estopped from denying coverage to its insured.

The policy at issue in Capitol Specialty was a lawyers’ professional liability policy issued to a firm that was sued for malpractice in connection with its prosecution of a class action.  The insurer, Capitol Specialty, agreed to provide a the firm with a defense in the malpractice suit under a reservation of rights.  While the insured initially selected defense counsel of its own choice, Capitol Specialty subsequently exercised its right under the policy to pick counsel.  In doing so, Capitol Specialty specifically advised that if the insured did not want to cede control of the defense, Capitol Specialty would “disengage counsel and close this matter.”  Capitol Specialty’s letter regarding selection of counsel reiterated its earlier reservation of rights.  Nearly seven months later, Capitol Specialty denied coverage for the matter based on the policy’s prior knowledge exclusion.

In a subsequent declaratory judgment action, Capitol Specialty was successful in showing that the exclusion operated to preclude coverage.  The insured, however, argued that Capitol Specialty was estopped from denying coverage after having controlled the defense.  The court noted that while Capitol Specialty did control the insured’s defense, it did so under a proper reservation of rights.  Under the circumstances, explained the court, estoppel will lie only where the insured can show that it was actually prejudiced as a result of the insurer’s conduct.  Such prejudice could be shown by demonstrating that the insurer’s control of the defense harmed or hindered the insured by undermining its ability to defend itself.

The insured argued that Capitol Specialty was estopped from denying coverage because: (1) it initially advised that coverage was available for the underlying suit; (2) it assumed the defense of the underlying suit; (3) it waited too long before disclaiming coverage and (4) it prejudiced the insured’s defense.  The court easily rejected the first three points, explaining that these arguments were “not evidence of prejudice” in light of Capitol Specialty’s proper reservation of rights.  Turning to the fourth point, the court held that the insured failed to demonstrate that it had been actually prejudiced.  While Capitol Specialty did cause the insured to terminate its initial counsel, the court explained that this would be prejudicial only if the insured could demonstrate that counsel selected by the insurer performed demonstrably worse than preferred counsel would have performed.  Because the insured alleged no facts of “poor representation or malpractice” and because the insured never objected to Capitol Specialty’s conditional defense, the court concluded that the insured failed to show that it had been prejudiced.