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New York’s Highest Court Re-Establishes the Rule That an Insurer’s Failure to Defend Does Not Prevent It from Relying on Policy Exclusions

Blogs, Insurance Coverage

In 2013, New York’s Court of Appeals unintentionally departed from existing precedent and ruled that an insurer who breached its duty to defend is precluded from subsequently relying on policy exclusions. This unexpected and unusual holding was reversed when the Court allowed re-argument, vacated its prior decision, and issued a new decision on the grounds that it had “failed to take account of controlling precedent.” K2 Investment Group, LLC v. American Guarantee & Liability Ins. Co., 22 N.Y.3d 578 (N.Y. 2014).

The case involved a legal malpractice claim arising from loans backed by mortgages that K2 made to a company partly owned by the attorney. The attorney had failed to record the mortgages. The insurer declined to defend, relying on the “insured’s status” and “business enterprise” exclusions. It later conceded that the refusal to defend was wrong.

In its first decision, the Court of Appeals did not address its prior case, Servidone Construction Corp. v. Security Ins. Co., 64 N.Y.2d 419 (N.Y. 1985). Upon reconsideration, the Court found that its first K2 decision and Servidone “cannot be reconciled,” and that “to decide this case we must either overrule Servidone or follow it. We choose to follow it.” Thus it re-affirmed the rule that an insurer who breaches its duty to defend may later assert policy exclusions that do not rely on the facts established in the underlying litigation.

This was a 4-2 decision. That is, two of the Judges would have been happy to overrule Servidone sub silento. Likely in response to the dissenters, the majority wrote that “[w]hen our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise.” 

The Court made another observation. In an earlier case, Lang v. Hanover Ins. Co., 3 N.Y.3d 350 (2004), the Court had said that “an insurance company that disclaims in a situation where coverage may be arguable is well advised to seek a declaratory judgment.” The K2 Court said “[t]hat continues to be sound advice.”