A New York Court of Appeals decision issued this week could make it more difficult and problematic for insurers to decline to defend an action. In its opinion in K2 Investment Group, LLC v. American Guar. & Liab. Ins. Co., the New York Court of Appeals ruled, “[W]hen a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him.”

This decision seems to mark a change in New York insurance law, and it serves as a cautionary tale for insurance claims professionals every time they receive a new claim and the insurer’s duty to defend is questionable.

K2 Investment involved a loan transaction gone wrong, where two private lenders sued a borrower and its principals. The insurer of one principal (a lawyer) declined to defend the suit on grounds that the claim was not based on the provision of covered legal services. The insurer later relied on two policy exclusions in arguing the eventual judgment against the insured was not covered, but both the trial and appellate courts rejected that, holding the insurer breached its duty to defend and therefore was liable for the full amount of its policy limit.

The Court of Appeals decided not to even reach the issue of whether the exclusions applied, because “by breaching its duty to defend,” the insurer “lost its right to rely on these exclusions in litigation over its indemnity obligation.” Building on its precedent in Lang v. Hanover Ins. Co. (2004) – which held that an insurer wrongfully denying a duty to defend loses the ability to contest the insured’s underlying liability for any judgment against the insured – the Court expanded the penalty against insurers which wrongfully deny defense coverage. The Court then held that “[i]f the disclaimer is found bad,” the insurer cannot use policy exclusions as a defense to coverage but instead must indemnify the underlying judgment.

Though it did not go into great detail, the Court indicated there may be exceptions to this new rule, such as in a case where public policy would trump an insured’s right to insurance recovery. Yet the Court swiftly held the public policy exception did not apply – nor did any other nondescript exceptions for that matter – in the case of K2 Investment’s insurer.

In the long term, this decision could mean insurers will be even more cautious in denying a defense. In many of those cases, we might expect an increase in declaratory judgment filings, as insurers look for certainty and comfort in understanding whether there is or is not a duty to defend. That certainly seems counter to the Court of Appeals’ reasoning in adopting its new rule – i.e., that it will avoid “unnecessary and wasteful litigation” by not requiring “the insured to litigate the effect of policy exclusions on the duty to indemnify.” But that may be the best and most certain way for both insurers and policyholders to know for sure whether a disclaimer of defense would be “found bad” or good.