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This is the first in a series of discussions about issues that arise on a regular basis after policyholders file an insurance claim.

Many liability insurance policies require the insurer to defend the insured. This “duty to defend” usually includes the right to select defense counsel – typically “panel counsel” from a list of pre-approved law firms – and control the defense. The relationship between the insurer, defense counsel, and the policyholder is known the “insurance triangle” (think Bermuda triangle) because it is laden with pitfalls.

Specifically, when an insurer reserves its right to later deny coverage, the interests of the policyholder and insurer are not aligned. The policyholder is not only confronted with potentially uninsured liability, but the possibility that at any point, the insurer may cease paying attorneys’ fees and costs, and perhaps assert it is entitled to reimbursement of the fees and costs already paid.

Conflicts That Can Arise from a Reservation of Rights

A reservation of rights may also create a conflict of interest that entitles the policyholder to select its own counsel paid for by the insurer. Conflicts most frequently arise when a complaint alleges a mix of claims, with some claims covered and others not. Mutually exclusive claims are especially problematic – for example, if negligence is established, the insured has coverage, but if intentional conduct is proved, there is none. 

The crux of the problem is the insurer’s financial interest in a result supporting non-coverage. The chief concern is “steering” – the possibility that defense counsel could steer the litigation in favor of non-coverage by developing facts or pursuing a strategy that leads to judgment on an uncovered cause of action. The insurer and panel counsel likely have a long-standing relationship and panel counsel has a personal financial interest in continuing to get the insurer’s work. If the insurer believes there will ultimately be no coverage, defense counsel may mount a less than robust defense.

When Is Independent Counsel Required?

States have taken different approaches to determining when a reservation of rights triggers the right to independent counsel. In a few states, like Mississippi, the right arises automatically when an insurer reserves rights. On the opposite end of the spectrum, there is no right to independent counsel in Hawaii, where defense counsel are solely responsible for managing conflicts of interests under rules of ethics. Some states, like Washington and Alabama, impose an enhanced obligation of good faith on both appointed counsel and the insurer.

Most states, like Texas, require a case-by-case examination of the facts and a showing of an actual, present conflict of interest. The analysis focuses on how the potential coverage issues intersect with the issues of fact in the underlying litigation. Generally, if coverage depends on the same facts to be decided in the underlying suit, the insured is entitled to independent counsel. Another relevant factor is whether the insurer could obtain privileged information from defense counsel that could be used to defeat coverage. When there is a conflict of interest, the insured’s contractual duty to cooperate with the insurer does not require waiver of the attorney-client privilege.

Policyholders should routinely consider potential conflicts of interest upon receipt of a reservation of rights letter and reassess periodically as the underlying litigation progresses.  Insurers are unlikely to raise the issue unprompted.

Invoking the independent counsel rule, when warranted, not only prevents entanglement in a conflict of interest, but it may ultimately prevent a second litigation between the policyholder and insurer over coverage.