May a liability insurance carrier that breached its duty to defend thereafter refuse to pay a judgment based upon a policy exclusion? Answer: Yes.

In K2 Investment Group, LLC v. American Guarantee Liability Insurance Company, 21 N.Y. 3d 384 (2013) [decided June 11, 2013 and featured in Issue No. 2] (“K2-I”), the Court of Appeals held that “when 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 against a judgment against him.” Id. at 387.

Upon re-argument, in a remarkable about-face, on February 18, 2014 the Court of Appeals  reversed itself,  vacated the decision in K2-I  and confessed error “by failing to take account of a controlling precedent.” K2 Investment Group, LLC v. American Guarantee & Liability Insurance Company, 2014 NY Slip Op 01102 (“K2-II”).

The “controlling precedent” that the Court of Appeals overlooked in K2-I was Servidone Construction Corp v. Security Insurance Company of Hartford, 64 N.Y. 2d 419 [1985]. In K2-II the Court of Appeals stated:

In Servidone — a case in which, as in this one, the insurer was relying on policy exclusions in defending against a suit for indemnification — we stated the question as follows:

"Where an insurer breaches a contractual duty to defend its insured in a personal injury action, and the insured thereafter concludes a reasonable settlement with the injured party, is the insurer liable to indemnify the insured even if coverage is disputed?"  (64 NY2d at 421.)

We answered the question in Servidone no. In K2-I, we held that "when 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" (21 NY3d at 387). The Servidone and K2-I holdings cannot be reconciled. Id. at 2.

And the Court of Appeals concluded that:

There is much to be said for the rule of K2-I, as our previous opinion shows; but, as the Servidone opinion shows, there is also much to be said for the Servidone rule. Several states follow the Servidone approach (e.g., Sentinel Ins. Co. v First Ins. Co. of Hawai'i, Ltd., 76 Hawaii 277, 290-297, 875 P2d 894, 907-914 [1994]; Polaroid Corp. v Travelers Indemnity Co., 414 Mass 747, 760-766, 610 NE2d 912, 919-923 [1993]), while others adopt a rule like that of K2-I (e.g., Employers Ins. of Wausau v Ehlco Liquidating Trust, 186 Ill2d 127, 150-154, 708 NE2d 1122, 1134-1136 [1999]; Missionaries of Co. of Mary, Inc. v Aetna Cas. and Sur. Co., 155 Conn 104, 112-114, 230 A2d 21, 25-26 [1967]). A federal district judge, writing in 1999, said that "the majority of jurisdictions which have considered the question" follow the Servidone rule (Flannery v Allstate Ins. Co., 49 F Supp 2d 1223, 1227 [D Colo 1999]).

Under these circumstances, we see no justification for overruling Servidone. Plaintiffs have not presented any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985. When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise. In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case. Id. at 3-4.