Reservations of Rights Letters

What do these letters mean?

Background. Churches sometimes will receive a "reservation of rights" letter from their insurer when they are sued. A reservation of rights letter usually 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) on behalf of the insured if it later determines that the claims are not covered under the insurance policy. A recent federal appeals court ruling addressed a church's response to a reservation of rights letter.

A church was sued by a minor who alleged that he had been molested on six occasions by two ministers. The church notified its liability insurance company of the lawsuit. The insurer agreed to defend the church, subject to a "reservation of rights." In its reservation of rights letter, the insurer indicated that it was reserving the right not to indemnify the church on the ground that the ministers' acts may fall under a policy exclusion for "intentional acts." The church later entered into an out-of-court settlement with the victim, and submitted the settlement to its insurer for payment. The insurer declined on the ground that the theory of liability was not covered under the church's insurance policy.

The church asked a court to rule that the insurer had a duty to defend and indemnify it up to the policy limits for damages incurred in the underlying lawsuit. A trial court ruled that the insured did have a duty to indemnify the church based on its duty to defend the lawsuit. The insurer appealed, claiming that the duty to defend is broader than the duty to indemnify, and that an insurer's decision to provide a defense to a lawsuit does not necessarily mean that it has a duty to indemnify (pay damages) based on a settlement or judgment. It relied on an earlier case in which a court ruled that "the duty to defend is measured against the allegations in the lawsuit but the duty to pay is determined by the actual basis for the insured's liability to a third person."

The appeals court concluded that the trial court erred by incorrectly assuming that the insurer had a duty to indemnify the church based solely on its duty to defend. Instead, the trial court "should have determined whether the church had shown that the settled claim was a covered loss under the insurance policy." The court was unable to determine whether the church's claim was a covered loss under the policy because of the lack of evidence regarding the dates of the molestation of the minor. The church argued that there was no doubt that the minor was molested during the policy period based on the fact that the ministers both pleaded guilty to molesting the minor during the summer of 1997, which is within the policy period. The insurer disagreed. The appeals court sent the case back to the trial court to determine whether or not the claim was covered under the policy. If it was, then the insurer was obligated to pay the settlement amount on behalf of the church.

Relevance to church treasurers. 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 based on a theory of liability that is not covered under the insurance policy.

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. This case illustrates that 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."

American States Insurance Company v. Synod of the Russian Orthodox Church, 335 F.3d 493 (5th Cir. 2003).

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