In liability insurance, the duty to defend is broader than the duty to cover. Thus it is possible that an insurer that has a duty to defend a suit may not have the duty to cover the policyholder's liabilities in the suit. However, if the penalty for a breach of the duty to defend is limited to actual legal costs spent by the defendant, the insurer may have an incentive to refuse to defend, even when the duty to defend is clear. This occurs because the insurer will not internalize the consequences of an inadequate defense when it ultimately can avoid covering the claim. If the penalty for a breach of the duty to defend also includes a forfeiture of the right to contest coverage of the claim, the insurer will never refuse to defend when the duty to defend is clear, but such a penalty could induce an insurer to defend even when it has a good legal argument against the duty to defend. We argue that tying a forfeiture of the right to assert any defense of coverage to an unreasonable refusal to defend can give an insurer incentives to internalize the cost of an inadequate defense while allowing the insurer to make reasonable legal arguments challenging a duty to defend.
Baker, Tom; Friedman, Ezra; and Logue, Kyle D., "The Forfeiture of Coverage Defenses Rule: An Economic Analysis" (2017). Faculty Scholarship at Penn Law. 1855.