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Reservation of rights: What does the insured do?

In a perfect world a person or an entity purchases an insurance policy from an insurance company. That person or entity becomes a policyholder. The policyholder has a loss and notifies the insurance company. The insurance company either pays the claim or defends the policyholder. Everybody is happy. End of story.

However, we all know this is not a perfect world. Life is just not that simple. Many claims clearly are covered, many clearly are excluded, but, all too often, some claims fall into a gray area. When claims do fall into that gray area, insurers are faced with a dilemma. What should they do? Do they accept the claim and provide defense for the insured? Do they reject coverage and abandon the insured? Or do they accept the claim subject to certain conditions?

If the insurer accepts the claim, provides defense, and then later determines the claim is not covered, the insurer may be prevented from abandoning the claim. A court might wonder why the insurer abandoned the claim after it initially thought it was covered. The court could say that by its own acts, the insurer waived its rights to deny coverage. The legal system often refers to this as “bad faith.”

If the insurer denies the claim, walks away from the insured, and it’s determined later that the loss is covered, a court very likely will say the insurer breached its contract with the insured, and again use that term “bad faith.” If the claim is not clearly excluded, this option is certainly the most perilous for the insurer.

The third option is the safest – accept the claim subject to certain conditions. This allows the insurer to tell the insured, “We’ll take care of you now, but if certain conditions develop, we may walk away.” In order to protect its rights to walk away from this claim in the future, the insurer will send the insured a reservation of rights letter. The concluding language of a typical reservation of rights letter often looks like this:

Nothing herein, nor any action taken by us, including but not limited to, investigation, defense, settlement, or adjustment, shall be construed as a waiver of right to deny coverage, and is subject to a full reservation of rights.

A reservation of rights letter does not mean the claim isn’t covered. It notifies the insured that the insurer thinks that upon further investigation there might be grounds to deny all or parts of the claim. Sometimes months may pass before the insurer knows enough to determine if coverage exists. As controversial as reservation of rights letters tend to be, they allow the insurer to steer between the twin perils of total acceptance or total denial of coverage.

When an insured receives a reservation of rights letter, what are the options? There are several.

  • Ignore it. This could be a dangerous option, especially if it’s later determined that the loss is not covered.
  • Dispute it. Go on record immediately and advise the insured why you disagree with the interpretation of the policy. Press the insurer to give specific reasons why it could potentially deny the claim. This creates a paper trail which could be helpful later on.
  • Put the insurer on the clock. A reservation of rights letter is not forever. Push the insurer to make a decision. Eventually the insurer must get off the fence.
  • Notify your attorney. Keep in mind that the insurer may decide to withdraw, and then you’re on your own. If you and your attorney are confident that coverage exists, you may want to seek a declaratory judgment.

What if the reservation of rights letter has the following statement?

Subject to the foregoing, and without waiving any of its rights and defenses, including the right to recover any defense costs paid if it is determined the Company does not owe the Insured a defense in this matter, the Company agrees to provide the Insured a defense in the captioned suit.

Does this mean the insurer must be reimbursed for any amounts it spent defending the insured for an uncovered claim? Once it’s determined that the claim is not covered, whether an insurer must be reimbursed for its costs and expenses incurred defending that claim is dependent on the specific facts of the case as well as the jurisdiction.

On Aug. 17, 2010 the Supreme Court of Pennsylvania ruled in the case of American and Foreign Ins. Co. v. Jerry’s Sports Center, Inc. that the insurer could not obtain reimbursement of defense costs of $309,216 for a claim which a court later determined was not covered. This ruling was made even though the insurer attempted to reserve its right to be reimbursed in a series of reservation of rights letters sent to the insured.

Many courts, including those in Hawaii, Illinois, Wyoming and the U.S. Court of Appeals for the Third Circuit have agreed with Pennsylvania and refused to enforce a reservation of rights for reimbursement of defense costs. However, the courts of California, Florida and Colorado, as well as the federal district courts of Colorado, Louisiana and Minnesota plus the U.S. Court of Appeals for the Fifth, Sixth and Ninth Circuits have taken the opposing view. Their rationale is that the insurer should not be obligated to pay for non-covered claims when it does not receive a premium for the defense of those non-covered claims.

A reservation of rights letter is a red flag. The insurer is alerting the insured that coverage may not exist and, if not covered, the insurer has reserved its rights to walk away from the claim. A reservation of rights letter allows the insurer to tell the insured, “We told you this might happen. You should have been prepared.”

Jerry Milton, CIC, contributed this resource. The legal profession recognizes him as an expert on insurance coverages. He is also an education consultant for IA&B, working with CISR, CIC and continuing education programs.


The information contained in this resource is current as of the date published.
Published date:  March 2012


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