Applying Illinois law, the United States Court of Appeals for the Seventh Circuit has held that an insurer who initially refused to defend its insured and waited five years to bring an action for declaratory relief was precluded from raising policy defenses to indemnity.  Title Indus. Assurance Co. v. First American Title Ins. Co., 2017 WL 1314934 (7th Cir. Apr. 10, 2017).

The insured, a title company, was sued in Illinois state court in 2008 by a title insurance company and two financial firms.  The insured tendered the lawsuits to its errors and omissions liability insurer.  The insurer refused to defend the suits, asserting that the policy’s exclusions for claims relating to “any dishonest, fraudulent, criminal, malicious or intentional wrongful acts” and claims arising out of or relating to “any defalcation, commingling of, or failure to pay any funds, notes, drafts, or other negotiable instruments” barred coverage.  In 2014, one of the claimants in the underlying actions filed a fourth amended complaint.  The insurer then appointed counsel to defend the insured.  At the same time, the insurer sought a declaratory judgment in federal court that coverage was precluded by the two policy exclusions, as well as by the policy’s prior knowledge provision.

The Seventh Circuit first addressed the insurer’s reliance on the policy’s prior knowledge provision.  While concluding that the insurer did not waive the defense by failing to cite the provision in its letters denying coverage, the court held that the insurer did waive it by only first raising the defense in its motion for summary judgment (as opposed to in its complaint).  The court went on to hold that in any event, the prior knowledge provision did not justify the insurer’s refusal to defend because the complaints originally tendered to the insurer for coverage did not implicate the insured in any misconduct occurring before the relevant date – i.e., the effective date of the policy – nor did they otherwise provide a basis to conclude that the insured had the requisite knowledge for the provision to apply to bar coverage.

Next, the court held that the dishonesty/fraudulent acts exclusion did not relieve the insurer from its duty to defend because the allegations in the underlying complaints did not “indisputably remove the complaint[s]” from coverage.  According to the court, because “just one path toward a covered claim” triggers the duty to defend, and the complaints “did not compel the conclusion that the claimants’ losses were attributable to intentional wrongdoing,” the exclusion did not excuse the duty to defend.  Likewise, the court found that the commingling exclusion as applied to the underlying complaints “[was not] clear enough to establish that no claim could possibly fall within the scope of coverage.”

After concluding that the insurer had breached its duty to defend, the court noted that Illinois law requires that an insurer either defend its insured subject to a reservation of rights or timely bring suit for declaratory relief.  Here, according to the court, the insurer’s suit was untimely as a matter of law, as the insurer did not bring it until after one of the underlying actions had been resolved by settlement.  The court therefore held that the insurer was estopped from invoking any policy defenses to coverage that might otherwise apply and was obligated to indemnify any judgment against or reasonable settlement by the insured.