2.2.2 Defense Under Reservation

• Jurisdiction: Arizona

Prior to the landmark decision of Damron v. Sledge,^[71] insurance carriers were historically faced with a Hobbesian's choice in deciding to defend their insureds in personal injury actions where there was doubt as to whether the insurance policy provided coverage for the claim being asserted. On the one hand, the carrier could refuse to defend its insured and risk a large judgment the carrier might be obligated to pay if it failed to establish a valid basis for denying coverage. On the other hand, the carrier could defend the lawsuit and use its best efforts to prevent an excessive verdict, but in so doing, the carrier risked waiving its rights to raise a policy defense or exclusion to coverage under its policy at a later date.

The court's holding in Damron v. Sledge allowed insurance carriers to avoid the Hobbesian's choice that had previously confronted them in cases where coverage was questionable, by recognizing the validity of a carrier's defense of its insured under a reservation of rights to later contest coverage.^[72] The purpose of defending an insured under a reservation of rights and litigating coverage in a collateral proceeding was discussed in Kepner v. Western Fire Insurance Co.^[73] The court stated:

Where there are facts which might exclude coverage, the insurer cannot always defend with complete fidelity. There must be a proceeding at which the insurer and the insured are each represented by counsel of their own choice to fight out their differences. Such a testing of the insurer's liability may take the form of a declaratory judgment brought in ad-vance of the third party's action or proceedings on garnishment following the trial of the third party's action as in the instant case. If the insurer refuses to defend and awaits the determination of its obligation in a subsequent proceeding, it acts at its peril, and if it guesses wrong it must bear the consequences of its breach of contract (citations omitted).^[74]

If the insurance carrier defends its insured when a coverage defense is contemplated, the carrier "must do so under a properly communicated reservation of rights to later litigate coverage."^[75] The reservation, to be effective, must fairly inform the insured of the basis upon which the carrier is questioning coverage.^[76] The reservation of rights notice must, in a straightforward manner, inform a reader of average intelligence that while the carrier is providing a defense, it is doing so without waiving any rights to contest liability under the policy.^[77] Ambiguities in the reservation notice will be construed against the carrier.^[78]

The reservation of rights notice must be timely given to the insured.^[79]

An insured is entitled to know early in the litigation process whether the insurer intends to honor that duty in order that the insured may take steps to defend himself. [Citations omitted.] If in fact the insurer undertakes that defense the insured may reasonably rely upon the non-existence of policy defenses. To hold otherwise would allow the insurer to conduct the defense of the action without the knowledge of the insured that a conflict of interest exists between itself and the insurer. The conflict is that the insurer retains a policy defense which would relieve the insurer of all liability while simultaneously depriving the insured of the right to conduct his own defense. [Citations omitted.] It is the reliance of the insured upon the insurer's handling of the defense and the subsequent prejudice which gives rise to an estoppel in the first instance against the insurer from raising policy defenses.^[80]

In Hagen v. United States Fidelity & Guaranty Insurance Co.,^[81] the court of appeals held that an insurance carrier has a duty to promptly notify its insured of its desire to assert its non-liability under the policy.^[82] "Failure to act promptly may result in a waiver of the right to deny coverage or an estoppel to assert an exclusion."^[83] The court in Hagen discussed the scope of the carrier's duty to notify its insured of its assertion of non-liability where the true facts show no policy coverage or duty to defend:

Without any attempt at close analysis, the cases have generally addressed this question in a loose context of "waiver" or "estoppel," ending with a determination of whether under the particular circumstances involved the insurer should be held liable. These cases consider such factors as prejudice to the insured resulting from a delay in notification and the reasonableness of the delay. In our opinion, the question of the insurer's liability is more correctly determined by the application of ordinary negligence principles. Has the insurer failed to make a reasonable effort to advise its insured of its disclaimer of all obligations under the policy? Our analysis in this regard is consistent with the Arizona Supreme Court's decisions in Lindus v. Northern Insurance Co., 103 Ariz. 160, 438 P.2d 311 (1968) and Carpenter v. Superior Court, 101 Ariz. 565, 422 P.2d 129 (1966). In those cases, the court recognized an insurer's obligation to show that the insured knew of the insurance coverage or that the insurer made a reasonable effort to inform the insured of the policy and its conditions when the insurer claims to have been relieved of liability.^[84]

The court of appeals' analysis in Hagen was expressly approved by the supreme court.^[85]

The insured may not condition the carrier's right to defend upon an agreement by the carrier to waive its right to later litigate the question of coverage.^[86]

An insurance company's reservation of its rights to disclaim policy duties and indemnification must be clearly communicated in a timely manner. There is no requirement that the reservation of rights be set forth in a written communication. There is no practical reason why a verbal reservation of rights statement by the insurance company to its insured is invalid. Whether the reservation of rights position of the insurance company has been fairly communicated to its insured, and the scope of the reservation of rights communication will be subject to evidentiary proof. It is the better practice to communicate the existence and scope of a reservation of rights in a written format.

In United Services Automobile Association v. Morris,^[87] the Arizona Supreme Court noted that when the insured refuses to sign a "nonwaiver" agreement and the insurance company continues in its defense does not mean that the insured is being defended unconditionally.^[88] The court in Morris discussed the importance of the intent of the parties. The court pointed out that the insurance company had placed in a motion for summary judgment that the defense was being provided under a reservation of rights^[89] and that the insured also acknowledged, in an affidavit, that he was being defended under a reservation of rights.^[90] By way of summation, the court found significant that "both insurer and insured acknowledged that USAA undertook the defense pursuant to a reservation of rights." ^[91] Thus, despite the fact that a formal reservation of rights letter was not produced until the day prior to the settlement, the court found a valid reservation of rights to be present based upon the evidentiary proof.

In Equity General Insurance Co. v. C & A Realty Co., Inc.,^[92] the court was confronted by a situation where the insurer attempted to reserve its rights by sending a reservation of rights letter to the policyholder but inadvertently sent the letter to the insured and not the attorney representing the insured.^[93] The case proceeded and the court held that despite the insurance company never mentioning the reservation of rights letter to the insured's attorneys, the reservation of rights was valid.^[94] Central to the court's holding was the court's observation that despite the insured's representative not understanding what the letter was, "the notice of reservation of rights fairly informed the insured of the insurer's position and did so in a timely fashion."^[95] The court did not find that the insurance company control of the settlement negotiations was inconsistent with its reservation of rights letter.^[96]

Both Morris and Equity General are cases that...