Rector, Wardens and Vestrymen of St. Peter’s Church v. American National Fire Insurance Company, 97 Fed.Appx. 374 (3rd Cir. 2004)
Background. A recent case illustrates a number of important points about church insurance. A church was served with a lawsuit and promptly forwarded the papers to its liability insurance company (the “insurer”). The church hired a local law firm several days later so that an answer could be filed to the lawsuit within the 30 days mandated by state law.
The insurer sent the church a “reservation of rights letter” agreeing to provide the church with a legal defense of the lawsuit while reserving the right to deny coverage and discontinue a defense of the case if it turned out that the church’s alleged wrongs were not covered under the insurance policy. The insurer’s letter also informed the church that the case was being referred to a different law firm than the one the church had retained to file an answer.
In the five months following the filing of the lawsuit the insurer provided no defense and made no reimbursement of legal expenses incurred by the church. At various times during this period the insurer considered different law firms, but ultimately rejected each one except one that refused the engagement because the insurer’s maximum rate of compensation ($130 per hour for a partner, and $110 for an associate) was unacceptable.
Five months after the lawsuit was filed, the church determined that its insurer had breached its legal duty to provide the church with a legal defense of the lawsuit, and it so informed the insurer. It also informed the insurer that it would continue to be represented by the law firm it had hired to file an answer to the lawsuit, and that it expected the insurer to reimburse this firm for legal fees it paid. The letter concluded: “In sum, it is clear that you have an obligation to reimburse the church for the defense costs that it has incurred to date. Please contact us to discuss the amount of costs which should be reimbursed to the church immediately.” By the time the church wrote this letter, it had incurred nearly $300,000 in legal fees in the defense of the lawsuit.
The insurer rejected the church’s demand, and the church responded by suing its insurer for reimbursement of the legal fees it had paid.
A state appeals court concluded that the insurer had breached the insurance contract by failing to provide the church with a defense of the lawsuit. It noted that “an insurer’s failure or refusal to defend a claim within the scope of an insurance policy constitutes a breach of contract for which it is subject to damages.” This duty obligated the insurer to provide legal counsel “able and willing to undertake representation of the church in the underlying litigation, and it failed to do so despite the fact that the suit was over five months old.”
The insurer insisted that it had attempted to hire a law firm within a reasonable amount of time that refused the engagement because of the unacceptably low hourly rate the insurer was willing to pay. The court disagreed, noting that an offer to hire a law firm on terms the firm was unwilling to accept “clearly did not satisfy the duty to defend.” As a result, the church was entitled “to declare the insurer in breach, provide its own defense, and look to the insurer for reimbursement of the reasonable costs of that defense.” The insurer also pointed out that over a year after the lawsuit was filed it agreed to pay this same firm an hourly rate of $200. But this belated offer did not satisfy the insurer’s duty to defend, the court ruled.
The court concluded, “An insurer’s failure to fulfill its duty to defend subjects it to liability to the insured for the costs and fees expended in successfully opposing a claim for damages. The church has done so and is therefore entitled to the judgment in its favor.
Relevance to church treasurers. This case is instructive for the following reasons:
1. Duty to defend. Most church insurance policies obligate the insurer to provide the church with a legal defense of claims that are potentially covered under the policy. Another way of saying this is that “the duty to defend is greater than the duty to indemnify.” The word “indemnify” refers to the payment of legal claims (whether a verdict or out-of-court settlement). As a result, your insurer may provide a legal defense for a claim even though coverage is unclear or disputed.
The court in this case noted that “an insurance company is obligated to defend an insured whenever the complaint filed by the injured party may potentially come within the policy’s coverage, and that duty remains with the insurer until the insurer can confine the claim to a recovery that is not within the scope of the policy.”
The duty to defend is one of the most valuable features of most insurance policies since it relieves churches of the time and expense of finding, and compensating, an attorney. While a church may successfully defend against an uninsured claim, the legal fees can be substantial.
Key point. Note that the duty to defend under some insurance policies may be limited. For example, legal fees may be payable out of the insurance coverage limits, or the insured may be obligate to pay all attorney fees up to a specified amount, such as the $15,000. This amount is sometimes referred to as a “retention” since the obligation to pay legal fees up to this amount is “retained” by the insured.
2. Breach of the duty to defend. An insurer that fails to provide a church with a legal defense of a lawsuit may be in breach of the insurance contract. As this case illustrates, this may obligate the insurer to pay legal fees incurred by the church while waiting for the insurer to hire an attorney.
Further, an insurer may not satisfy its duty to provide its insured with a legal defense to a lawsuit by offering law firms hourly rates of compensation that are unacceptably low.
In general, however, it is important to understand that it is the insurer, and not the insured, that selects the attorneys who will defend against a lawsuit. As the court in this case observed, “we assume that the insurer retains the right, as well as the duty, to select and pay counsel.”
3. Reservation of rights letters. The church received a “reservation of rights” letter from its insurer shortly after submitting a copy of the lawsuit. Church leaders often are confused about the meaning and legal significance of such letters.
A reservation of rights letter is often sent by an insurer to an insured after the insured places the insurer on notice of a lawsuit or potential claim. Such a letter informs the insured that the insurer will provide a legal defense of a lawsuit, but under a “reservation of rights,” meaning that it reserves the right not to “indemnify” (pay damages) the insured if it later determines that the claims are not covered under the insurance policy.
If your church is sued, and you submit the lawsuit to your insurer, you should not be surprised to receive a reservation of rights letter in return. The insurer agrees to provide your church with a legal defense of the lawsuit, but reserves the right not to pay any damages for (1) a theory of liability that is not covered under the insurance policy, or (2) a wrong occurring outside the “coverage period” of the policy.
Key point. In many cases, a lawsuit will recite several theories of liability (the “shotgun” approach), only some of which are covered under the church’s insurance policy. If a court awards damages based on a theory of liability that is not covered under the policy, then the insurer is not obligated to pay the judgment even though it has paid for the defense of the case. This is not a common occurrence, but it does happen. When it does, it comes as a surprise to church leaders who assume that the insurer’s defense of the lawsuit meant that it would indemnify the church against any damages.
In summary, an insurer will not be required to indemnify a church against a judgment or settlement based solely on its decision to provide a legal defense of the case. Rather, the insurer’s duty to indemnify is based solely on proof that the claim was a covered loss under the insurance policy.
This article first appeared in Church Treasurer Alert, May 2005.