Reservation of Rights

Introduction

In the context of liability insurance, a reservation of rights is like a slap in the face with a kid glove demanding a future duel. It gives fair warning that the giver and receiver of the slap are enemies who should protect themselves from each other, even as they maintain decorum off of the dueling field. A reservation of rights always creates an array of conflicts of interests: insurer vs. policyholder; insurer vs. plaintiff;

A reservation of rights by a liability insurance company warns its policyholder that it does not waive the right to later deny coverage for a plaintiff's liability dispute by paying to defend it.

Insurance regulations require that an adequate reservation of rights must be the product of a thorough investigation, disclose all then known bases to later challenge coverage, be in writing, and be timely. A reservation of rights does not require the policyholder's consent, but the insurer must respond to the policyholder's inquiry.

There are two primary purposes of a reservation of rights: 1) the insurer avoids a legal waiver of the right to later deny coverage; and 2) the policyholder may protect oneself from the insurer.

Insurers tend to assert reservations of rights in "mixed" actions with multiple claims, some of which may or may not be covered, such as business litigation, construction defect cases, professional malpractice claims, and any other civil lawsuit whose result could benefit the insurer at the policyholder's expense, or vice versa.

A reservation of rights creates a complex labyrinth of conflicts of interest among the insurer, its dependent counsel, the policyholder, and even the plaintiff. If the existence of coverage is "related" to any disputed issues of fact or law in the liability dispute, a reservation of rights creates a coverage contest, resolution of which overlays resolution of the liability dispute. If the coverage contest is related to the liability dispute, the policyholder may control the defense of a liability dispute at the insurer's expense because the insurer may not prejudice the policyholder's defense of the liability dispute in its efforts to win the coverage contest. Significantly, by faithfully fulfilling its duty to defend its policyholder while reserving its rights to later deny all coverage, the insurer may control settlement of the liability dispute.

A reservation of rights may challenge the interests of a plaintiff who may depend upon perfecting insurance coverage to fund a settlement or judgment, prompting the plaintiff to cooperate with the policyholder to resolve the coverage contest,1 to plead into coverage properly2, and to testify into coverage truthfully.3

Definition of Reservation of Rights

A liability insurance company's reservation of rights constitutes its conditional denial of two related claims: 1) a claim by an injured plaintiff to the insurer that the policyholder is legally liable to pay damages to the plaintiff; and 2) a claim by the policyholder to the insurer that the insurer is bound to defend and indemnify the policyholder in the plaintiff's lawsuit.

There are two primary and immediate consequences of an insurer's assertion of a reservation of rights: 1) the insurer preserves its right to prove that it never had any duty to defend and separately had no duty to indemnify its policyholder nor any duty to settle with the plaintiff; and 2) the policyholder may trump the insurer's contractual right to control the policyholders defense if a disqualifying conflict of interest exists. Among American jurisdictions nationwide, there are three incompatible tests for what constitutes a "disqualifying" conflict of interest: 1) two thirds of jurisdictions apply a "per se" test that all reservations of rights require a liability insurer to yield control of the defense to the policyholder because an insurer that denies coverage lacks the incentive to fund a vigorous defense and ethically conflicted dependent counsel cannot adhere to canons of ethics; 2) California and other jurisdictions modify the "per se" rule that the policyholder may control the defense unless the insurer's reservation of rights is limited to subject matters that have "nothing to do with" the plaintiff's liability dispute, such as non-
payment of premium; and 3) a few states allow the insurer to control the defense if the insurer and dependent counsel adhere to "enhanced duties" of disclosure and good faith and the policyholder fails to prove the existence of an actual conflict of interest.

There are two primary purposes of a reservation of rights: 1) the insurer may resist claims that it is estopped from asserting, has waived, and has forfeited coverage defenses; and 2) the policyholder and the plaintiff are forewarned to protect their interests from a reserving insurer.

Three Tussles

A reservation of rights triples the scope of controversy among the participants in civil litigation.

1. Liability Dispute

When a plaintiff sues a defendant in a civil lawsuit, they engage in a liability dispute. The judicial process of resolving a liability dispute will establish whether the defendant has legal liability to the plaintiff and if so, how much the defendant must pay to the plaintiff in damages. The liability dispute focuses upon the defendant's wrongful conduct and is generally governed by tort law.

2. Coverage Contest

When the defendant has liability insurance and the insurer issues a reservation of rights, the insurer and the policyholder also engage in a separate, but often related coverage contest. The process of resolving a coverage contest will determine whether the insurer has legal liability to the policyholder and if so, how much the insurer must pay to or on behalf of the policyholder in damages. The coverage contest focuses upon the provision of a policy as they relate to the facts of the liability dispute and is generally governed by contract law.

3. Ethical Imbroglio

An insurer's reservation of rights to later deny coverage to its policyholder always creates some conflicts of interest between the insurer and the policyholder, each of whom wants the other to pay for the liability dispute. If a reserving insurer hires a single lawyer to defend both the interests of the insurer and to defend the policyholder as a party to the liability dispute, the reservation of rights creates an ethical imbroglio for dependent counsel. The ethical imbroglio focuses upon the factual and legal issues that divide them and is generally governed by Canons of Ethics. Specifically, RPC Rule 3-310 prohibits a lawyer from representing dual clients with potentially conflicting interests, unless the lawyer analyzes the potential conflicts, makes written disclosure to and obtains informed written consent from both the policyholder and the insurer.

The Elements of an Adequate Reservation of Rights

1.	A Reservation Must Be "Adequate"

Liability insurance is a contract of indemnity. "Upon an indemnity against liability, the [policyholder] is entitled to recover [from the insurer] upon becoming liable [to a plaintiff]."4 But "if the insurer adequately reserves its right to assert the noncoverage defense later, it will not be bound by the judgment [against the insured]. If the injured party prevails, the insurer can raise the noncoverage defense previously reserved."5 "[A]n insurer that timely and adequately reserves its right to deny coverage and that does not subsequently intentionally waive its reservation of rights is not collaterally estopped by a judgment in favor of a third party against its insured."6

2.	An Insurer Must Conduct an Investigation Before Reserving Rights

A liability insurer may not knowingly commit or adopt unfair claims settlement practices, including "[f]ailing to adopt and implement reasonable standards for the prompt investigation of claims."7 "Upon receiving notice of claim, every insurer shall immediately, but in no event more than fifteen (15) calendar days later, begin any necessary investigation of the claim."8 "Every insurer shall conduct and diligently pursue a thorough, fair and objective investigation."9

3.	A Reservation of Rights Must Be "Timely"

Insurance regulations require an insurer to reserve its rights to later deny coverage immediately, but not later than 40 days.10 However, despite these regulations, California courts have permitted insurers to assert reservations of rights at virtually any time.11

4.	A Reservation of Rights Must Be In Writing

"Where an insurer denies or rejects a [policyholder's] first party claim, in whole or in part, it shall do so in writing"12

5.	A Reservation of Rights Must Disclose All Then Known Bases to Later Deny Coverage

"Where an insurer denies or rejects a [policyholder's] first party claim, in whole or in part, it shall provide to the [policyholder] a statement listing all bases for such rejection or denial and the factual and legal bases for each reason given for such rejection or denial which is then within the insurer's knowledge. Where an insurer's denial is based on a specific policy provision, the written denial shall include reference thereto and provide an explanation of the application of the provision to the claim."13

6.	An Insurer Must Respond to Inquiry

"Upon receiving any communication from a [policyholder], regarding a claim, that reasonably suggests that a response is expected, every [insurer] shall immediately, but in no event more than fifteen (15) calendar days after receipt of that communication, furnish the [policyholder] with a complete response based on the facts as then known by the [insurer]."14

7.	A Reservation of Rights May Be Unilateral

"[T]he insurer can reserve its right . . . by itself, without the insured's agreement. Such a view is in accord with the 'modern trend.' More important, it is sound. Because the right is the insurer's alone, it may be reserved by it unilaterally."15 Although rarely used, an insurer may enter into a bilateral non-waiver agreement with the policyholder.16 An "assured's silence will usually be deemed acquiescence. Courts have in general been fairly liberal in implying reservations."17

The Purposes of a Reservation of Rights Are to Avoid Waiver and Estoppel

"The purpose of a reservation of rights is to afford the insured a defense while protecting the rights of the carrier when the duties to defend and indemnify cannot clearly be determined. It allows both parties to the insurance contract the protection bargained for in connection with the third party suit and reserves coverage issues to a more appropriate forum and time."18 "Through reservation, the insurer gives the insured notice of how it will, or at least may, proceed and thereby provides it an opportunity to take any steps that it may deem reasonable or necessary in response - including whether to accept defense at the insurer's hands and under the insurer's control . . . or, instead, to defend itself as it chooses."19

Three legal principles may limit a liability insurer's ability to later challenge coverage: Forfeiture (that by itself alone has never been applied to a coverage contest), Estoppel (that requires an insurer's misleading statement and the policyholder's detrimental reliance), and Waiver that is the insurer's voluntary relinquishment of a known right.20

Insurers Often Reserve Rights In "Mixed" Actions

Liability insurers often reserve rights in business litigation, construction defect cases and other "mixed" actions, "in which some of the claims are at least potentially covered and the others are not."21

Reservations of rights letters often identify a few specific grounds to later deny coverage, broadly deny coverage on all possible grounds, and occasionally limit the scope of a reservation with a limited express waiver. Infrequently, a liability insurer may reserve the right to seek reimbursement of defense cost22 and settlement costs23, however the insurer must satisfy prescribed requirements to perfect each of these reservations.

A Reservations of Rights Always Creates Some Conflicts of Interest

"[W]hen coverage is disputed, the interests of the insured and the insurer are always divergent."24 "In some cases, there is a potential conflict of interest between the insurer and the insured [that usually involves] the insured trying to obtain coverage and the insurer trying to avoid it."25

The Consequences of a Reservation of Rights

1.	A Liability Insurer Must Hire Counsel to Fulfill Its Promise to Defend

"By its very nature the duty assumed by [the insurer] to defend its assured against suits must necessarily be classified as a delegable duty, understood by all parties as such, for [the insurer] had no authority to perform that duty itself and, in fact, was prohibited from appearing in the California courts. Since a carrier is not authorized to practice law, it must rely on independent counsel for the conduct of the litigation."26 "[W]hen the insurer agrees to defend upon a reservation of rights, Cumis counsel is required to represent the insured. At that point, the 'joint client' structure underlying the tripartite relationship clearly evaporates."27

2.	Dependent Counsel May Not Represent Dual Clients With Conflicting Interests

"A [lawyer] shall not [represent] a client without providing written disclosure to [and] without the informed written consent of each client in which the interests of the clients potentially conflict"28 under penalty of disgorging compensation.29 "[T]he Canons of Ethics impose upon lawyers hired by the insurer an obligation to explain to the insured and the insurer the full implications of joint representation in situations where the insurer has reserved its rights to deny coverage. If the insured does not give an informed consent to continued representation, counsel must cease to represent both."30

3.	Definition and Rationale of a Disqualifying Conflict of Interest

"Conflict of interest between jointly represented clients occurs whenever their common lawyer's representation of the one is rendered less effective by reason of his representation of the other."31 "A disqualifying conflict exists if [i]nsurance counsel had [an] incentive to attach liability to [the insured]."32 If a disqualifying conflict of interest33 exists, that "the insurer must pay the reasonable cost for hiring independent counsel by the insured. The insurer may not compel the insured to surrender control of the litigation."34 The insurer's coverage dispute cannot be allowed to prejudice the policyholder.35 In the absence of express waivers by the insurer, a reservation of rights is unlimited as a matter of law.36

4.	Not Every Reservation Creates Disqualifying Conflicts of Interest

"[A] conflict of interest does not arise every time the insurer proposes to provide a defense under a reservation of rights."37 "[N]ot every conflict of interest triggers an obligation on the part of the insurer to provide the insured with independent counsel at the insurer's expense."38 "Of course, the insurer may have more than one defense to coverage. In that event, [one] will need to consider each defense separately."39

5.	Disqualifying Conflicts of Interest Are Recognized by the "Related" Test

A reservation of rights creates a disqualifying conflict of interest if any ground to later deny coverage is "related" to disputed issues of fact or law in the liability dispute. California courts has expressed this "related" test in a variety of ways, using disparate language to capture a consistent concept. "It is only when the basis for the reservation of rights is such as to cause assertion of factual or legal theories which undermine or are contrary to the positions to be asserted in the liability case that a conflict of interest sufficient to require independent counsel, to be chosen by the insured, will arise."40 A disqualifying conflict of interest exists unless "the coverage question is logically unrelated to the issues of consequence in the underlying case"41, factual or legal disputes in the liability action "have nothing to do with"42, are "irrelevant"43 to, are "independent of, or extrinsic to"44 bases reserved to later deny coverage. A disqualifying conflict of interest exists if coverage issues "overlap"45 issues in the third party liability action, if coverage turns on the nature of the policyholder's conduct,46 or "the outcome of the coverage issue can be controlled by the way counsel defends the case."47

Appropriate Procedures and Timing to Resolve a Coverage Contest

1.	Ten Procedural Options to Resolve a Coverage Contest

When a liability insurer creates a coverage contest by reserving its rights to later deny coverage, there are as many as ten procedural options available to resolve the controversy.48

2.	Early Resolution May Not Prejudice the Policyholder

"[L]itigating the duty to defend in the declaratory relief action may prejudice the insured in the liability action. To prevent this form of prejudice, the insurer's action for declaratory relief may be either stayed or dismissed."49 "When the courts talk about prejudice to the insured from concurrent litigation of the declaratory relief and third party [liability] actions, [1] the insurer must not join forces with the plaintiffs to defeat coverage [2] the insured is compelled to fight a two-front war [and 3] the insured may be collaterally estopped from relitigating any adverse factual findings. [T]he trial court should balance conflicting concerns [including] severance."50

3.	The Parties May Promptly Resolve Non-prejudicial Coverage Issues

A coverage contest may be promptly resolved without prejudice to the policyholder defense if the coverage issue turns on "facts that the insured does not dispute [and] coverage hinges on factual issues that are unrelated to the issues in the third party liability action."51

The following coverage issues may be promptly resolved while the liability dispute is still pending: denial of all coverage,52 control of the defense,53 dependent counsel's compliance with Rule 3-310,54 the insurer's obligation to pay for independent counsel,55 how much the insurer must pay to independent counsel,56 how often the insurer must pay independent counsel,57 and other declaratory relief relating to the insurer's ongoing failure to discharge its duty to defend.

A Reservation of Rights Does Not Impact Control of Settlement

An insurer that reserves its right to later deny coverage to its policyholder and faithfully discharges its duty to defend is entitled to control settlement.58 "[T]he insurer has the right to control defense and settlement of the third party action against its insured, and is generally a direct participant in the litigation."59

"[W]hen a liability insurer wrongfully denies coverage or refuses to provide a defense, then the insured is free to negotiate the best possible settlement consistent with his or her interests. Such a settlement will raise an evidentiary presumption in favor of the insured with respect to the existence and amount of the insured's liability. The effect of such presumption is to shift the burden of proof to the insurer to prove that the settlement was unreasonable or the product of fraud or collusion."60