Earlier this year, New York’s highest court, the Court of Appeals, issued one of its most important insurance coverage decisions in recent memory, holding that an insurer which breaches its duty to defend does not lose its right to rely upon policy exclusions as a basis to deny indemnity coverage. See K2 Inv. Group, et al. v. Am. Guar. & Liab. Ins. Co., 2014 NY Slip Op 1102(U), 2014 N.Y. LEXIS 201 (N.Y. Feb. 18, 2014). In so holding, the court reversed its prior decision in this case, which conflicted with established New York precedent concerning an insurer’s indemnity obligations, as well as the rule followed by the majority of jurisdictions in the United States. The K2 Inv. Group decision is significant for all insurers who write business in New York, as the Court of Appeals declined to follow the minority view adhered to by certain U.S. courts, which penalizes insurers that are found to have breached their duty to defend by denying those insurers the right to disclaim indemnity coverage where a settlement or judgment falls within the scope of a policy’s exclusion. Instead, the court reaffirmed the principle that an insurer’s duty to indemnify is distinct from its duty to defend, and that the terms of an insurance policy dictate the scope of coverage afforded.

K2 Inv. Group involved a dispute between a professional liability insurer and its insured, an attorney. The insured was sued for failing to record two mortgages, and sought defense and indemnity coverage from the insurer. The insurer denied that it had a duty to defend or indemnify the insured in the underlying action on the grounds that the claims alleged in the lawsuit fell outside of the scope of the policy’s coverage because they were “not based on the rendering or failing to render legal services for others.” The insured subsequently defaulted in the underlying lawsuit and the claimants obtained a default judgment against the insured in excess of the policy’s limits. The insured then assigned all of his rights against the insurer to the claimants, who brought suit against insurer for breach of contract.

The insurer moved for summary judgment, relying on two policy exclusions as a basis to deny indemnification, rather than its initial defense that the underlying claims fell outside the policy’s insuring agreement. The plaintiffs cross-moved for summary judgment, arguing that the insurer breached its duty to defend and was thus bound to pay the judgment obtained against the insured up to the limits of the policy, regardless of whether the policy exclusions relied upon by the insurer were applicable.

Both the trial court and a majority of the Appellate Division ruled in the claimants’ favor. See K2 Inv. Group, et al. v. Am. Guar. & Liab. Ins. Co., 91 A.D.3d 401, 403 (N.Y. App. Div. 1st Dep’t 2012). The case proceeded to the Court of Appeals, which affirmed the prior courts’ rulings, holding that the insurer was barred from relying upon the exclusions in the subject policy as a basis to deny indemnity because the insurer had breached its duty to defend. In so holding, the court noted:

[A]n insurance company that has disclaimed its duty to defend ‘may litigate only the validity of its disclaimer.’ If the disclaimer 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.1<

The insurer moved for reargument on the basis that the Court of Appeals’ decision conflicted with its prior ruling in Servidone Const. Corp. v. Security Ins. Co., 64 N.Y.2d 419 (1985) (holding that where an insurer breaches its contractual duty to defend its insured, and the insured thereafter enters into a reasonable settlement with the underlying plaintiff, the insurer is not liable to indemnify the insured if a policy exclusion operates to bar coverage). Amicus curiae briefs were filed in support of the insurer’s position by the Complex Insurance Claims Litigation Association, the American Insurance Association and the National Association of Mutual Insurance Companies. The filing of those briefs demonstrates the significance of the Court of Appeals’ decision to the insurance industry.

Although the Court of Appeals rarely agrees to hear reargument, it granted the insurer’s motion and reversed its prior ruling, finding that the insurer did not lose the right to rely on policy exclusions as a defense to indemnity coverage, even where the insurer had breached its duty to defend. The court noted that its earlier decision conflicted with the controlling precedent of Servidone, from which the court should not depart.

The significance of the Court of Appeals’ decision cannot be overstated. While an insurer’s defense obligation is generally triggered where an underlying claim against the insured is even potentially covered by the applicable policy, an insurer’s duty to indemnify is limited to circumstances in which the ultimate judgment rendered against, or settlement entered into, by the insured is actually covered. Thus, even where an insurer has a duty to defend, it still has a right to assert that an underlying judgment or settlement is not covered pursuant to a policy’s terms and conditions. Had the court not reversed its prior ruling, an insurer involved in a coverage dispute arising under New York law would have potentially faced substantial and unjustified consequences by having to provide indemnity coverage where the insurer was ultimately found to have breached its duty to defend, even if the insurer has no contractual obligation under the policy.