In K2 Investment Group, LLC v. American Guar. & Liab. Ins. Co., 21 N.Y.3d 384 (2013), the Court of Appeals held that because an insurer breached its duty to defend, it “lost its right” to rely on policy exclusions to deny coverage for indemnification. This unanimous ruling arguably rewrote New York law and placed New York in the small minority of states that recognize the doctrine of coverage by estoppel.

With the K2 holding, the Court of Appeals may also have (intentionally or unintentionally) expanded its decision in Lang v. Hanover Insurance Co., 3 N.Y.3d 350, 356 (2004). Under Lang, when an insurer breaches its duty to defend, it may still litigate its defenses to indemnification unless the issue determinative of the duty to indemnify was already decided in the underlying action. In K2, the court appears to have gone a big step further, holding that, under Lang, if the insurer breaches its duty to defend, it must indemnify its insured, “even if policy exclusions would otherwise have negated the duty to indemnify.” 21 N.Y.3d at 391. Under K2, this rule arguably applies, even if the exclusions are unrelated to the underlying judgment.

In K2, the Court of Appeals may also have overlooked, or overruled, its oft-cited decision in Servidone Construction Corp. v. Security Insurance Co., 64 N.Y.2d 419 (1985). In Servidone, the court held that an insurer's breach of the duty to defend does not create coverage for indemnification. Without even mentioning the Servidone decision, the court may have overruled it.

Needless to say, the K2 decision generated more questions than answers. It also generated dozens of articles addressing whether the Court of Appeals intended to create coverage by estoppel in New York.

The Court of Appeals Grants Reargument

In New York, a court will grant reargument where the court overlooked or misapprehended relevant material or legal issues in its decision. The New York Court of Appeals grants reargument less than one percent of the time—fewer than once every 10 years.

In K2, American Guarantee sought reargument, asserting that the court misapprehended Lang and overlooked Servidone. American Guarantee took the position that, under Lang and Servidone, an insurer that breached its duty to defend was permitted to rely upon exclusions applicable to its duty to indemnify so long as the insurer did not challenge the findings from the underlying judgment. American Guarantee argued that the court's interpretation of Lang is inconsistent with its prior unwillingness to confer upon the insured more coverage than it bargained for. American Guarantee asserted that the different standards for an insurer's duty to defend and indemnify should prohibit courts from expanding the bargained-for coverage as a penalty for breach of duty to defend.

The Court of Appeals granted reargument in K2. On January 7, 2014, the New York Court of Appeals will hear reargument of its controversial decision. The parties to K2, as well as amici curiae, have filed briefs in anticipation of reargument.

Positions on Reargument

On reargument, American Guarantee emphasizes that courts should refrain from making a determination on the duty to indemnify without a finding as to the facts that may determine whether exclusions apply.

American Guarantee also argues that the court overlooked the application of the policy exclusions to the insured's claim for indemnification: the insured status and business enterprise exclusions. In the Appellate Division, although the Justices disagreed as to whether the exclusions applied, all Justices agreed that American Guarantee could raise the exclusions in defense of the claim for indemnification, even if it had wrongfully disclaimed its defense obligation. The Court of Appeals did not even address these exclusions.

An amici curiae brief in support of American Guarantee's position was filed jointly by the New York Insurance Association, Inc., The National Association of Mutual Insurance Companies, Property Casualty Insurers Association of America and the Federation of Defense and Corporate Counsel. The amici argue that while an insurer that rejects a valid request for defense is bound by facts decided in the underlying action, the terms of the policy determine the scope of coverage. They note that precedent spanning 30 years establishes an insurer's right to litigate the applicability of its coverage defenses. The amici contend that an insurer that wrongfully declines to defend its insured does not thereby expand its policy to provide coverage beyond the contract it made.

The amici next assert that policy provisions should control an insurer's obligation to indemnify. They note that in some situations, facts established by the underlying judgment resolve the coverage questions. However, in other situations, they do not. An example given by the amici involves a business pursuits exclusion in a homeowners policy. A person is injured in the basement of an insured's home. The insurer discovers that the insured was operating a hair salon in her basement; the policy excludes coverage for business pursuits. The insurer declines to defend the insured and a default judgment for negligence is entered against the insured. Lang instructs that, if the insurer breached its duty to defend, it will be bound by the finding of negligence in a later action to determine indemnity coverage. However, the question as to whether the business pursuits exclusion applies remains open.

An amici curiae brief in support of American Guarantee's position was also filed jointly by the American Insurance Association and the Complex Insurance Claims Litigation Association. These organizations point out that the remedy for breach of the duty to defend should relate to the harm resulting from that breach – namely, the cost of the defense. They note that the “vast majority” of jurisdictions (20 of them) hold that an insurer's wrongful refusal to defend does not bar the insurer from later denying coverage for indemnification. The K2 decision, they conclude, places New York in the minority.

Next, the amici argue that conflating the duties of defense and indemnification contradicts fundamental contract principles by placing an insured in a better position than if the insurer had performed. Negating a policy's terms and conditions related to indemnity, they assert, amounts to an inappropriate extra-contractual penalty. The amici also note important policy considerations against coverage by estoppel, including permitting insurers to accurately appraise their exposure and avoiding increased premiums.

In its brief, K2 Investment Group contends that the court's decision was correct, and that reargument is not appropriate. K2 Investment Group argues that the K2 decision provides guidance for insurers considering denying their duty to defend an insured and to New York courts determining liability for an insurer's wrongful disclaimer. K2 Investment Group also asserts that the K2 decision furthers public policy by giving insurers an incentive to defend cases and giving insureds the full benefit of the policy for which they bargained. K2 Investment Group goes on to argue that the court did not misapprehend Lang, but clarified how it requires the result reached in this case. Additionally, K2 Investment Group takes the position that the court did not overlook Servidone; rather, it is inapplicable to the facts of K2.

United Policyholders submitted an amicus brief in support of K2 Investment Group and policyholders, asserting that the K2 decision applies a remedy that was already set forth in Lang and its progeny. United Policyholders takes the position that, after Lang, courts instructed insurers to seek declaratory relief before denying a defense to their policyholders. They contend that “[i]t is entirely appropriate for the insurance company to bear the consequences of its wrongful decision to disclaim coverage by later facing the related obligation to pay the judgment entered against its policyholder.” Brief at p. 12.

If the K2 decision is reaffirmed following reargument in January, then insurers will be well-advised to consider filing a declaratory judgment action before disclaiming the duty to defend in New York. Regardless of the outcome, the court's decision on reargument will affect claims handling in New York for years to come.

Cozen O'Connor Global Insurance Department Attorney Melissa Brill represents insurers in first- and third-party insurance coverage litigation nationwide. Practicing in the firm's New York office, Brill also renders coverage opinions and advises insurers on many insurance-related matters.