Reservation of Rights: Insurer Liable for Non-Covered Claims Due to Faulty Letter

South Carolina Supreme Court finds “generic,” “cut and paste” letter failed to adequately state basis for non-coverage.

The South Carolina Supreme Court, applying South Carolina law, held that an insurer’s reservation of rights was ineffective because it  failed to adequately inform the insured of the reasons why the insurer may not be obligated to provide coverage.   As a consequence of this holding, the insurer was held liable for both covered and non-covered claims.

The insurance coverage dispute stems from the defective construction of two condominium complexes constructed between 1997 and 2000.  The purchasers of the condos discovered significant construction problems and, in 2003, the purchasers’ property owners’ associations (“POAs”) filed suits against Heritage Group Communities, Inc.  and related entities (“Heritage”) for actual and punitive damages for the construction defects under theories of negligent construction, breach of fiduciary duty, and breach of warranty.  Harleysville Group Insurance (“Harleysville”) issued commercial general liability insurance policies to Heritage between 1997 and 2000.  After receiving notice of the lawsuits, Harleysville informed Heritage that it would defend under what it believed to be a full reservation of rights.  The only contested issue in the underlying lawsuits was the nature and extent of the damages resulting from the admitted negligent construction.  Following the jury verdicts against Heritage, Harleysville filed a declaratory judgment action to determine what portion of the judgments in the underlying lawsuits would be covered under the policies.

Under South Carolina law, the cost of repairing faulty workmanship is not covered under a commercial general liability policy, but the resulting property damage, beyond the defective work product itself, is covered.   The scope of an insurer’s duty to indemnify is limited to damages accrued during the insurer’s time on the risk.  Under the state law “where it is impracticable to calculate the exact measure of damages attributable to the injury that triggered each policy, the default rule is that an insurer’s pro rata share of the damages is a function of the total number of years damages progressed and the portion of those years a particular insurer provided coverage.”   The Special Referee found that Harleysville failed to properly reserve the right to contest coverage for faulty workmanship claims and ordered the full amount of the actual damages in the construction-defect suits to be calculated as Harleysville’s pro rata portion of the progressive damages based on the time on the risk.   The Special Referee also found that punitive damages were covered by the Harleysville policies.  The parties appealed.

The South Carolina Supreme Court agreed that “generic denials of coverage coupled with furnishing the insured with a verbatim recitation of all or most of the policy provisions (through a cut-and-paste method) is not sufficient.”  According to the court, “[i]t is axiomatic that an insured must be provided sufficient information to understand the reasons the insurer believes the policy may not provide coverage.”  The court found that with the exception of claims for punitive damages, the reservation of rights letters failed to specify the particular grounds upon which Harleysville disputed coverage.   Most importantly the court noted that none of the reservation of rights letters advised Heritage of the need for allocation of damages between covered and non-covered losses or referenced a possible conflict of interest or Harleysville’s intent to pursue a declaratory judgment action following any adverse jury verdicts.   Harleysville did effectively reserve its rights with regard to claims for punitive damages, but because the policy did not unambiguously exclude punitive damages, the court affirmed the finding that punitive damages were covered under the policy.  Harleysville Group Ins. v. Heritage Group Communities, Inc., No. 2013-001281 (S.C. Jan. 11, 2017).