Defending Under a Reservation of Rights: Practical Insights for Insurers from the US

A recent decision from the Southern District of New York offers valuable perspective on the procedures and obligations that arise when an insurer defends a claim under a reservation of rights.

Background

The case involved a professional negligence action against an attorney, following an alleged failure to sue all responsible parties in a prior medical negligence matter. The insured sought coverage under a claims-made professional liability policy, but the insurer defended the action under a reservation of rights while simultaneously seeking a declaratory order that no coverage was owed.

Policy Terms

The policy in question provided coverage only for claims arising from legal services performed after a specified retroactive date, and expressly excluded claims where the insured knew or should have known, prior to the policy period, that their actions could give rise to a claim. The court ultimately sided with the insurer, finding that the legal work at issue predated the retroactive date and that the exclusion for known claims applied, thereby relieving the insurer of any duty to defend or indemnify.

Reservation of Rights and Conflict of Interest

A key aspect of the dispute centred on the insurer’s conduct in defending under a reservation of rights. The insured argued that the insurer should be estopped from denying coverage due to alleged improper handling of the claim, including a failure to establish an internal wall between the coverage investigation and the defence of the underlying action. The court rejected this argument, clarifying that a conflict of interest requiring such measures does not automatically arise whenever an insurer defends under a reservation of rights. Instead, the right to independent counsel or to be advised of such a right only arises where there is a demonstrable conflict between the interests of the insurer and the insured.

Best Practice Followed by Insurer

The court noted that the insurer had “followed a textbook course of action” by providing a defence under a reservation of rights and promptly seeking a declaratory order to clarify its coverage obligations. This approach allows the insurer to fulfil its broad duty to defend while preserving its ability to later deny coverage if warranted by the facts or policy terms. The reservation of rights letter serves to notify the insured that some or all aspects of a claim may not be covered, enabling the insured to take steps to protect their own interests if necessary.

Key Takeaways for Insurers and Insureds

This decision reinforces several important principles for both insurers and insureds when claims are defended under a reservation of rights:

• An insurer may defend under a reservation of rights to investigate and protect its position without waiving its right to later deny coverage.
• The mere existence of a reservation of rights does not automatically entitle the insured to independent counsel; a genuine conflict of interest must be shown.
• Insurers are not required to create internal walls between coverage and defence teams unless a specific conflict arises.
• Prompt and clear communication of the insurer’s position, including the issuance of a reservation of rights letter and, where appropriate, seeking declaratory relief, is considered best practice.