Which is better: Deny coverage or defend under a reservation of rights?
When coverage is doubtful, insurers should consider the cost of a bad faith suit against seeking reimbursement from the insured.
An insurer is faced with two options when its insured tenders a suit and coverage is doubtful: (1) deny coverage but risk a bad faith suit in retaliation; or (2) defend under a reservation of rights and seek reimbursement in another action.
The first option, to deny coverage, comes with the risk of defending against a bad faith suit. The insurer could be hit with extracontractual damages in addition to the costly litigation to defend such a suit.
The safer route is to defend under a reservation of rights, which typically avoids the bad faith suit. However, seeking reimbursement takes time, sometimes years, and usually requires significant attorney fees and costs. As is the case in many actions, an insurer could recover substantially less than the full value of the defense/indemnification — making it not worth the reimbursement action to begin with.
Does coverage apply?
To prevent the unexpected pitfall that might come with defending under a reservation of rights, an insurer should invest in a thorough investigation at the outset to determine if denial of coverage is supported. Even if the insurer has to defend against a bad faith suit, that may not be as detrimental as seeking reimbursement, especially when the denial of coverage is handled in good faith and well supported.
Take the following situation as a case study — where an insurer defended under a reservation of rights when coverage did not exist and later sought reimbursement.
An insurer issued a commercial general liability policy that covered “personal and advertising” injury. The insured was sued over several intellectual property infringements, which included violations of copyright, trademark and trade secrets. The insured tendered to the insurer believing that coverage existed for an advertising injury. For numerous reasons, the policy did not provide coverage.
Only the copyright violation had the potential to be covered if the infringement related to an advertising injury. Interestingly, the insured never contended that the copyright action resulted in an advertising injury; rather, the insured argued that the advertising injury resulted from the trademark and trade secret violations. That argument failed because the underlying plaintiff did not allege an advertising injury at all, just that it discovered the trademark and trade secret violations by a video posted on YouTube.
Even if the insured could establish advertising injury, several exclusions precluded coverage. The policy contained an intellectual property exclusion that explicitly barred coverage for trademark and trade secret infringements — so, even if those violations were caused by an advertising injury coverage did not exist under the policy.
The policy also excluded prior publication of an advertising injury. It is well-settled law that when the wrongful conduct began prior to the effective date of the insurance policy, the prior publication exclusion precludes coverage. The video the underlying plaintiff relied upon to establish the trademark and trade secret violations was posted years before the policy became effective, and the insured knew about the plaintiff’s contentions and impending lawsuit before procuring the subject policy. The insured never disclosed the intellectual property violations when obtaining the policy but nonetheless wanted the insurer to pick up the legal bill.
Lastly, there is a known injury exclusion which also prevented coverage since the insured knew about the intellectual property infringements long before seeking a policy.
Defending under a reservation of rights
Although the policy did not provide coverage, the insurer decided to defend under a reservation of rights because of the potential for coverage for the copyright infringement resulting from a purported advertising injury (which was never really the case).
The action went to mediation, and the insurer funded the settlement, then brought an action against the insured to seek reimbursement of the settlement and the cost of defense.
The insurer successfully prevailed in the reimbursement action and defended that judgment in the Ninth Circuit. That victory came at a cost, however, because the insurer should have denied coverage at the outset.
The key takeaway is to deny coverage when appropriate and defend against a bad faith action if brought by the insured. In the example here, it is unlikely that the insured would have brought a bad faith action because of the tenuous link to coverage. Had the insurer denied coverage, that would probably have been the end of it, but even if there was a bad faith suit, that would likely have been more cost-efficient than seeking reimbursement in a subsequent action.
Of course, an insurer should only deny coverage with caution. The insurer should seek advice from coverage counsel before making that decision.
Michael Gelfound is a senior associate in Selman Breitman’s Los Angeles office and is a member of the firm’s insurance, commercial litigation, and commercial transactions practice groups. He can be reached at mgelfound@selmanlaw.com.
Related: