When Your Insurer Reserves the Right to Disclaim Coverage

When a contractor is sued for negligence, it must immediately notify its general liability insurer. That insurance includes two distinct coverages. The first is the right to have the insurer provide the legal defense. The second is the right to indemnification from the insurer up to the policy limit if liability is established. Both coverages are triggered by prompt notice of claim.

Except when the lawsuit claims damages not clearly excluded by the policy, insurers frequently respond by agreeing to assume the contractor's legal defense under a reservation of right to later disclaim liability. Insurers normally assume the contractor's legal defense even when they harbor doubts about policy coverage because courts have repeatedly held that an insurer's obligation to provide a defense is broader than its obligation to ultimately indemnify the contractor. An insurer must provide a legal defense if the underlying lawsuit shows even a possibility that the claim falls within the insurance coverage. As a result, insurers often seek to defend the insured contractor under a reservation to provide a future escape hatch for themselves.

The problem for a contractor is that an insurer who defends under a reservation (a) may be more interested in proving an absence of coverage than defending its insured from liability, or (b) may withdraw its legal defense in the middle of the lawsuit if it determines there is no coverage. For these reasons an insurer which insists on reserving a right to later disclaim liability under the policy has no right to insist that it retain control of its insured's legal defense.

Consequently, when an insurer agrees to defend under a reservation, a contractor has the right to require its insurer do one of two things. The contractor may demand its insurer either (a) give up its reservation to later disclaim liability or (b) give up control of the contractor's defense and instead reimburse the contractor for its legal costs. If the insurer drops its reservation, the insurer gets to control the contractor's legal defense, including the right to select counsel. If the insurer refuses to drop its reservation, the insurer loses the right to control the defense, the contractor gets to select its own defense counsel and the insurer must pay the contractor's legal fees.

At the conclusion of litigation, if the contractor is found liable and the insurer disclaims liability, the contractor may sue the insurer directly for a legal determination of whether coverage existed. If the Court decides there was coverage under the policy, the insurer must not only pay the amount of the claimant's judgment against the contractor, but must also reimburse the contractor for its legal costs in obtaining that determination.