The New York Court of Appeals rendered a decision June 11, 2013 holding “when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on Policy exclusions” to avoid indemnification.

The ruling in K2 Investment Group, LLC, et al v. American Guarantee & Liability Insurance Company, 2013 NY Slip op. 4270 (N.Y., June 11, 2013) will significantly affect an insurer’s assessment of its duty to defend a claim tendered under a liability policy. The court held an insurer may be deprived of the ability to contest coverage for the indemnity of a claim when it determines not to afford a defense to the insured.

The case arose under a legal malpractice liability policy. Plaintiffs extended a loan secured by a mortgage. When the borrower defaulted it was discovered the mortgage had not been recorded. Plaintiff sued the borrowers and their principals. One principal was an attorney whom Plaintiff alleged acted for them and negligently failed to record the mortgage.

The legal malpractice insurer declined defense and indemnity for the claim contending the alleged conduct was outside the insured’s role as an attorney. The insured defaulted yielding a judgment excess of the policy limit following which the insured assigned all claims under the policy to the judgment creditor, who commenced suit against the policy for the full limit and bad faith.

The Court of Appeals refused to entertain the insurer’s defenses based upon the policy exclusions. Rather, the Court held that the insurer’s failure to meet its duty to defend the insured deprived it of the right to rely upon policy exclusions to its indemnity obligation.

The Court initiated its analysis by reviewing the off-stated proposition that the “duty to defend is broader than the duty to indemnify”, and then found that the underlying suit against the insured was unmistakably covered. The Court affirmed that when an insurer disclaims its duty to defend, and its disclaimer is found to be error, “the insurance company must indemnify its insured for the resulting judgment, even if the Policy exclusions would otherwise have negated the duty to indemnify”. The Court justifies the rule stating it gives insurers an incentive to defend cases they are bound to defend where it would be unfair to permit an insurer, having wrongfully abandoned its insured’s defense to require the insured to litigate the policy exclusions on the duty to indemnify. The K2 Court noted possible exceptions such as where it would be contrary to public policy to indemnify the insured liability for intentional conduct.

K2 marks a significant turn by New York State’s highest court. The ruling appears to have overlooked the Court’s opinion in Servidone Construction Corp. v. Security Insurance Company 64 N.Y. 2d 419 (NY 1985) where it stated “an insurer’s breach of duty to defend does not create coverage and that . . . there can be no duty to indemnify unless there is first a covered loss.”

The K2 ruling is somewhat confusing. On one hand, the Court reaffirmed its 2004 decision in Lang v. Hanover Insurance Co., 3 N.Y. 3d 350 [2004] in which it held that an insurer who declines a defense and chooses not to participate in the underlying lawsuit “may litigate only the validity of its disclaimer and not challenge the liability or damage determination underlying the judgment”. Lang precluded an insurer from contesting the underlying liability it elected not to defend; it did not prohibit the insurer from raising questions of coverage for the liability. By affirming Lang’s rule that an underwriter retains the ability to litigate “the validity of its disclaimer”, the Court suggests an underwriter may still litigate the questions of coverage set forth in its disclaimer, and only “if the disclaimer is found bad” is indemnity owed. Nonetheless, the K2 Court states it extends the rule in Lang to hold “the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify”. This apparent discrepancy is certain to be the subject of debate. During the interval, underwriters should consider the Lang Court’s advice “to seek a declaratory judgment concerning the duty to defend or indemnify…. if it disclaims and declines to defend in the underlying suit without doing so, it takes the risk that the insured party will obtain a judgment against the purported insured and then seek payment ….” which it may not be able to contest.