Reservation of Rights Letters Help Avoid Prejudice in the Third Party Context

When discussing bad faith in the third party context, most of the discussion properly centers on the duty to settle a claim.  However, other actions taken by a policyholder and carrier can have an impact.  The recent case of State Farm v. El-Moslimany provides a good example.  In El-Moslimany, State Farm found itself defending its policyholder from a defamation claim.  After defending for two years, State Farm filed a declaratory action, contending that the defamation claim at issue was not covered by its policy.  A year after filing the declaratory judgment action, State Farm filed a motion for summary judgment.  The policyholder responded, in part, claiming that State Farm’s attempt to withdraw from its defense obligation was “bad faith.”  The policyholder argued that State Farm waited too long to seek declaratory relief and that a withdrawal of its defense would prejudice the policyholder.

The court granted State Farm’s motion for summary judgment.  When discussing the “bad faith” withdrawal and prejudice issue, the court pointed out that State Farm sent a reservation of rights letter and that at least some of the delay was the result of the policyholder attempting to evade service of process.  The court also noted that any delay in seeking declaratory relief simply provided the policyholder with additional paid defense items.

Cases like this demonstrate the value of open communication with a policyholder via a reservation of rights letter.  In those states which permit a carrier to withdraw a defense after an initial acceptance, the existence of a reservation of rights letter is very important.  So long as the potential exclusions to coverage are identified and made known to the policyholder, the policyholder will have trouble arguing prejudice by the withdrawal of the defense, even if the withdrawal comes after litigation has commenced.

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