While “winning the battle and losing the war” may not be an apt analogy, a recent decision from a Federal court in New York illustrates the perils faced by an insurer in withdrawing a defense as soon as it believes a policy exclusion takes the claim outside the scope of coverage. Schlather, Stumbar, Parks & Salk, LLP v. One Beacon Ins. Co., 2011 U.S. Dist. LEXIS 147931 (N.D.N.Y., No. 5:10-cv-0167, December 22, 2011).

The underlying dispute involved a decision by one of the insured firm’s partners to voluntarily dismiss a wrongful death action, apparently without the express approval of the decedent’s widow. Prior to the application for the policy at issue, the widow notified the firm in writing that she did not consent to the dismissal. The facts established that her consent was solicited but, after it was not received after a passage of time, the firm proceeded to dismiss the action without notifying her.

In upholding the applicability of the policy’s “known claims exclusion,” the Court applied a subjective/objective standard used in New York and many other jurisdictions. Liberty Ins. Underwriters, Inc. v. Corpina Piergrossi Overzat & Klar, 78 A.D.3d 602 (App. Div. 2010). The Court held that the first and subjective prong of the standard was satisfied in that a firm partner knew of the client’s displeasure over the dismissal. The second and objective prong was also satisfied in that the Court held that a reasonable attorney knowing of this client’s displeasure should have anticipated that a claim might arise.

End of analysis and insurer wins?

Not quite.

The Court noted New York law holds that an insurer’s duty to defend is broader than its duty to indemnify, and that duty remains in effect until such time that it is “determined with certainty” that there is no coverage under the policy. Further, under New York law, the insurer’s defense obligation is determined by analyzing the coverage within the “four corners” of the Complaint. Here, the Court found that the allegations that the firm permitted the wrongful death action to be dismissed without the client’s consent and also failed to notify her of the dismissal was sufficient to trigger a duty to defend. The applicability of the known claims exclusion was not known with certainty until a later time. The Court strongly suggested that the best practice for an insurer to protect itself and establish the viability of any coverage defense would be to undertake the insured’s defense and initiate a coverage declaratory judgment action, unless the insured first institutes such an action.

Although not reduced to specific amounts in the Opinion, the Court ruled that the insured was entitled to general and consequential damages as a result of the insurer’s breach of the duty to defend, and ordered the parties to engage in “meaningful settlement discussions” to try to determine the amounts of these damages.

Many insurers are reluctant to incur the expense of a declaratory action, but this decision illustrates the wisdom of so doing.*

*The decision to initiate a declaratory action is even more painful in New York, where the initiating insurer can also be liable for the insured’s attorney fees and costs if it does not prevail.