When an insurer agrees to defend its insured against a potentially covered claim without reserving the right to deny coverage, the insurer usually has the right to control the defense of the underlying lawsuit. See 3 Jeffrey E. Thomas, New Appleman on Insurance Law Library Edition § 16.04(1) (LexisNexis). This right permits the insurer to dictate how much money will be spent on litigation, which tactical choices will be made, and whether and when the case will be tried or settled. The insurer loses the right to control the defense under Illinois law, however, if it reserves its rights to deny coverage pursuant to a coverage defense that turns on facts that may be developed in the underlying litigation. See Maryland Cas. Co. v. Peppers, 64 Ill. 2d 187, 197 (1976). For example, when an insurer agrees to defend a suit alleging both negligence and intentional misconduct, but reserves the right to deny coverage for damages because of intentional misconduct, it creates a conflict of interest. If the insured is found liable, the insurer would benefit from a finding that the liability was caused by uncovered intentional misconduct, yet the insured would benefit from a finding that the liability was caused by covered negligence. See Peppers, 64 Ill. 2d at 198-99. In other words, there is a risk that an insurer controlling the defense may “steer” the defense toward uncovered counts or theories of liability.

When a “Peppers” conflict arises, the insurer loses its right to select defense counsel or control the defense of the underlying action. Instead, the insurer is obligated to discharge its contractual duty to defend by reimbursing the insured “for the reasonable cost of defending the action” by “independent” counsel who is selected and controlled solely by the insured, and who represents the sole interests of the insured, and not the insurer. Id. The insurer must reimburse the insured for defense costs as they are incurred. See Ins. Co. of the State of Penn. v. Protective Ins. Co., 227 Ill. App. 3d 360, 368-69 (1st Dist. 1992). Of course, insurers and insureds do not always agree on how to measure what constitutes a reasonable defense cost, and disputes can arise between the insured’s right to direct its defense and the insurer’s right to limit defense expenditures to those that are reasonable and necessary.

Originally Published in IDC Quarterly - Third Quarter 2014.