In an opinion filed January 11, 2017, the South Carolina Supreme Court held that an insurer’s reservation of rights must contain more than verbatim recitation of policy provisions to properly reserve its right to later dispute coverage. Harleysville Group Insurance v. Heritage Communities, Inc., et al., 2017 S.C. LEXIS 8 (Jan. 11, 2017). The state supreme court also upheld a pro rata allocation of progressive damages under a time-on-risk analysis, and rejected the argument that punitive damages were subject to the time-on-risk allocation. The decision emphasizes the importance of drafting reservations of rights specific to the facts of the case, and informing the insured of why certain provisions may limit coverage under the facts of the case.

The coverage action arose out of two underlying construction defect actions. Harleysville Group Insurance (“Harleysville”) insured related corporate entities that developed and constructed two separate condominium complexes (collectively referred to as “Heritage”), who were sued for damages arising out of alleged construction defects, including significant water intrusion damages. Harleysville agreed to defend under a reservation of rights and retained defense counsel. After verdicts against Heritage for actual and punitive damages were rendered, Harleysville filed a declaratory relief action to determine the amount of covered damages. The matter came before the state supreme court after certification by the court of appeals.

The court first addressed the adequacy of Harleysville reservation of rights, and concluded that the letters were not specific enough to contest coverage. Although Harleysville had quoted policy language verbatim in its initial reservation of rights, the court found that – except with regard to punitive damages – the letters failed to explain how specific policy provisions might preclude coverage and, to the extent exclusions may apply, did not inform the insured that Harleysville may seek declaratory judgment to allocate between covered and non-covered damages. As a result, Harleysville was precluded from raising coverage defenses regarding compensatory damages.

Although the court found Harleysville had properly reserved its rights regarding punitive damages, neither the policy’s insuring agreement nor its “expected or intended” exclusion applied to preclude coverage for punitive damages. According to the court, absent explicit language that excluded coverage for punitive damages, the insuring agreement could not be construed as limiting coverage to compensatory damages only. Regarding the exclusion, the court found Harleysville failed to meet its burden that Heritage acted intentionally and intended the specific type of loss or injury.

Finally, with regard to the compensatory damage award, the court upheld a pro rata allocation of the progressive damage. Because some definable portion of the damage in the underlying cases was unrelated to an injury during the policy period, a progressive damages analysis was proper for the compensatory damages, but not the punitive damage award.

There are various takeaways from this decision, but the most concerning is that the South Carolina Supreme Court expanded the scope of coverage beyond that provided by the policy because it found that the insurer did not properly reserve rights. To avoid such an absurd result, and to properly preserve coverage defenses, insurers should revisit the use of generic or form reservation of rights letters, and consider updating the reservation of rights letter during the life of the underlying case if certain provisions appear to be particularly relevant.