New York’s highest court recently held that an insurer that does not defend its insured may, if later sued by the policyholder seeking coverage, plead policy exclusions as a defense to the coverage claim.

The decision, in K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 2014 WL 590662 (Feb. 18, 2014) (“K2 II”), vacates a 2013 decision by the Court in the same action, and reaffirms long-standing New York authority affirming that an insurer, in declining to defend a claim against its policyholder, does not thereby waive its coverage defenses.

In K2 II, a case involving coverage for legal malpractice claims, the professional liability insurer declined to defend its policyholder, a law firm, because certain policy exclusions barred coverage for the plaintiffs' claim. The policyholder did not defend itself. A default judgment was entered against the policyholder, who then assigned to the underlying plaintiffs whatever coverage rights it may have. In a 2013 decision (“K2 I”) in the same action (published at 21 N.Y.3d 384 [2013]) the Court of Appeals determined that the insurer had improperly declined to defend the case, and in so doing waived its right to assert policy exclusions in defense of the coverage claim. The insurer moved for reargument, on grounds that the K2 I decision conflicted with Court of Appeals authority dating back at least to 1985.

In a rare about-face, the Court of Appeals in K2 II agreed with the insurer, vacating its own 2013 K2 I decision, and finding that since at least 1985 New York has recognized an insurer’s right to assert coverage defenses, even if the insurer defaults in defending its policyholder.

The K2 II Court made clear that it makes no difference whether the insurer’s defenses are based upon the policy’s exclusions, or the policy’s coverage grant. As the K2 II Court recognized, the “policy exclusion vs. coverage grant” distinction is valid in cases evaluating timeliness of disclaimer under Insurance Law §3420, but not applicable where (as here) the disclaimer is timely.

Lessons for Insurers

The K2 II holding helps resolve confusion caused by the Court’s K2 I decision, which suggested a significant departure from nearly three decades of well-established case law. Even taking into account the assurances provided in the K2 II decision, insurers are well-advised to remember the significant consequences that may attach to an insurer’s denial of a duty to defend or indemnify.

For example, an insurer failing to timely disclaim coverage as required under Insurance Law §3420 may thereby be deemed to have waived coverage defenses based upon late notice and policy exclusions. Significantly, however, such a waiver would not extend to the defense that the claim falls outside the policy’s coverage grant.

And, as the K2 II Court noted, an insurer declining to defend its policyholder thereby waives its right to contest liability or damages determinations in the underlying proceeding. This may come into play if an unsatisfied judgment is obtained against the policyholder on default or otherwise, and the injured plaintiff later brings an action directly against the insurer under Insurance Law §3420(b)(1).