The insurer’s duty to defend a claim made against its insured is inextricably tied to coverage: there can be no duty to defend without a likelihood that indemnity for the claim will be covered under the insurance contract. The insurer’s duty to defend usually arises at the outset of a legal proceeding – and puts the merits of the claim under scrutiny before the insurer has obtained any information through the discovery process within the litigation. Insurers must understand both how to determine whether it owes its insured a duty to defend in a particular context, and when to raise coverage issues with the insured.

On receipt of a claim, insurers sometimes face situations where a claim quite clearly falls outside of coverage. But often, they find themselves in one of two trickier situations:

• When the insurer has what it believes is sufficient information to deny a claim from the outset and refuses to involve itself in the third party litigation at all.
• When the insurer doesn’t have a clear picture of how the facts will unfold, and thus whether there are coverage issues, until after the discovery process is completed.

An insured’s failure to defend when the duty is owed can lead to claims against the insurer for damages, in particular bad faith. Yet if an insurer adopts the insured’s defence at the outset, it becomes more difficult to withdraw the coverage as time passes. Here’s a look at the risks of denying coverage too early and denying too late, and three practical and strategic practices an insurer can adopt to protect its interests in both situations.

Denying Too Early: Duty of Good Faith & Duly Diligent Investigation

When an insurer denies coverage of a claim early and swiftly, it risks that, after the third party litigation is complete, the insurer will face claims not only for indemnity and reimbursement of any defence costs the insured incurred – but also for claims of bad faith and unfair dealing with the insured. 

The Duty of Good Faith. The insurer’s duty of good faith to its insured is wide reaching, as laid out by the Supreme Court of Canada in its 2002 decision in Whiten v. Pilot Insurance Co. and its 2006 decision in Fidler v. Sun Life Assurance Co. of Canada. Both remain the primary authorities for this principle, and both place a heavy onus on insurers to give their insureds the benefit of the doubt when considering whether to cease coverage or to deny it completely from the outset. 

The Duty to Investigate. Whiten revolved around the insurer’s lack of appropriate investigation and reliable information when denying the insured’s claim and stands for the general proposition that an insurer’s failure to adequately consider and give weight to the insured’s statements can lead to very hefty awards of aggravated and punitive damages against it. The 2015 decision of the N.S. Court of Appeal in Industrial Alliance Insurance and Financial Services Inc. v. Brine, while in the context of a first party claim against a disability insurer, is helpful to an understanding of what the insurer’s duty of good faith means in practice. There, the Court reinforced that, “[t]he insurer’s duty to act fairly applies to ‘the manner in which it investigates and assesses the claim and to the decision whether or not to pay it’.”

The Coverage Conflict. The duty to sufficiently investigate in the context of the duty to defend and the pleadings rule creates an inherent conflict: the pleadings rule states the court must only consider the allegations in the pleadings when determining whether there’s a duty to defend; yet the duty of good faith lends itself to obtaining more information in order to adequately assess the claim and the duty to defend. The pleadings rule comes from a number of Supreme Court of Canada cases beginning with its 1990 decision in Nichols v. American Home Assurance Co. The Nichols decision states that in deciding whether a defence is owed to an insured, the court (and therefore the insurer) should not look past the pleadings (usually the Statement of Claim) in determining whether there is any possibility of coverage. If there is a possibility of coverage for an allegation within the pleadings, then the duty to defend is triggered. The duty to defend can arise irrespective of the ultimate duty to indemnify. This begs the question: why must the insurer go any further than the pleadings when considering whether coverage will apply? The Ontario Court of Appeal addressed this question in its oft-cited 2000 decision in Longo v. Maciorowski. There, the Court acknowledged the challenge:

• If an insurer could escape the duty to defend based on a mere allegation that the insured breached a condition of the insurance contract, an impecunious insured would be forced to provide and pay for their own defence. Even if they could successfully sue their insurer later on, they are forced to take up their defence on their own with significant uncertainty before them.

• Conversely, if an insurer is always obligated to defend, even in the face of a likely breach of condition by the insured, the insurer would be forced to later sue a potentially impecunious insured to recover the costs of the defence.

The Court rejected the solution of pausing the claim against the insured while a court decides the coverage issue in an expedited manner; acknowledging that while this could be practical in some circumstances, it’s not in most others. Instead, the Court preferred a flexible, case-by-case, assessment where the insurer identifies a potential policy breach at the outset of the third party litigation (at para. 36):

Thus, rather than establishing an immutable legal principle, I would suggest that the question should be determined upon consideration of the circumstances of each case, including the relative strength of the positions asserted by the insurer and the insured and the necessity and urgency to furnish the insured with a separate defence.

The best approach to a coverage decision regarding the duty to defend is therefore one based on both sufficient facts and the strength of the coverage argument. When this decision is made will be specific in each case. Needless to say, however, there are perils in both waiting too long to raise coverage issues, and in denying coverage too soon.

Denying Too Late: Estoppel 

Part of the reason courts have adopted the “any” possibility test for determining the existence of a duty to defend is to give the insured the benefit of the doubt and access to defence costs until the discovery process is completed, and the insurer can properly ascertain and assess any facts relevant to coverage. Yet when an insurer embarks on a defence of an insured and ultimately denies coverage, it risks being estopped from later withdrawing either defence or indemnity coverage.

Rationale. The idea of estoppel is that the insured has been operating all along under the assumption that there is coverage, relied on that, and suffers a detriment if the insurer later withdraws coverage.

Estoppel Examples. Examples of situations in which courts have found insurers estopped from withdrawing coverage include:

• In the 2006 decision of the Alberta Court of Queen’s Bench in McConnell v. Aviva Insurance Co. of Canada Ltd., the insurer filed a defence on behalf of a company and its employees, personally named as defendants. After moving the matter through some steps in the litigation process, the insurer attempted to withdraw its defence of the two employees. The Court found the insurer was estopped from withdrawing its defence for one of the employees because it had represented there was coverage when it defended, and it could not then change its position without consequences. The Court had concerns the defendant employee was “lulled into [a false sense of] security” by the insurer’s involvement and management of the litigation, all done without his input. He might have taken a very different approach had he known there were potential coverage problems and was therefore prejudiced by the insurer’s conduct.

• A similar problem arose in the Ontario Court of Appeal’s 2019 decision in The Commonwell Mutual Insurance Group v. Campbell. The insurer defended the insured in an action for 10 months before advising him of a potential coverage issue. The Court held that because the insurer had defended the insured for so long, including filing a “detailed Statement of Defence” and making various “tactical litigation decisions”, the insured had relied on its conduct and representation to his detriment. The insurer was therefore estopped from denying coverage.

• Similarly, in the Ontario Superior Court’s 2008 decision in Logel (Litigation Administrator of) v. Wawanesa Mutual Insurance Company, affirmed by the Ontario Court of Appeal (leave to appeal to the Supreme Court of Canada denied), the Court decided the insurer had waived its right to raise an exclusion in the policy after defending the insured over a three and one-half year period.
• In contrast, the Supreme Court of Canada, in its 2021 decision in Trial Lawyers of British Columbia v. Royal & Sun Alliance Insurance Company of Canada, refused to find an insurer was estopped from making its coverage defence where it first learned at the discovery stage that its insured breached the policy by consuming alcohol.

3 Practices to Mitigate Your Risks 

Here are three practical and strategic practices an insurer can adopt to protect its interests and mitigate its risks in situations of both early and late coverage concerns. 

Benefit of the Doubt. Be careful not to rush to judgment on coverage without sufficient facts to back up the off-coverage position. The insurer’s duty of good faith to the insured is grounded in broader considerations than just the pleadings rule. Bear this in mind whenever the insured makes factual representations that would lead to coverage under the policy, give them the benefit of the doubt, and consider them carefully. For example, if a claim against an insured by a third party alleges fraud and negligence, and the insurer’s investigation leads it to conclude the insured likely did commit fraud (which the insured denies), the insurer might still owe the insured a duty to defend for the negligence allegation – even if fraud is later proven at trial and there’s no resulting duty to indemnify. 

Reservation of Rights & Non-Waiver Agreement. While giving the insured the benefit of the doubt, however, it’s critical that an insurer be clear with the insured up front with respect to its coverage concerns. In cases where there are questionable facts at the outset, and the insurer needs more information to draw any factual conclusions, the best course of action is to agree to defend the insured under a reservation of rights and non-waiver agreement. With its rights reserved, the insurer can proceed to obtain more information – without waiving any of its rights to exclude coverage later. This puts the insured on notice that there’s a potential problem and makes it more difficult for them to object if and when the insurer later withdraws coverage for the defence, raising issues of good faith along with it.

Coverage Counsel. It’s also important that the liability insurer retain separate coverage counsel when dealing with these two parallel disputes: the third party claims on the one hand, where the defence counsel takes instruction from the liability insurer, but is legally the lawyer for the insured tortfeasor; and the coverage dispute for that defence. This will avoid issues of conflicts of interest and divided loyalties.

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Please contact your McInnes Cooper lawyer or any member of our Insurance Defence Team @ McInnes Cooper to discuss when to raise coverage concerns in your cases.