What it means
When a business is sued or suffers a loss, it notifies its insurer and expects support. Sometimes the insurer is not sure the policy covers the event, but it needs to act quickly, and a reservation of rights letter is the way to do both.
The letter sets out the reasons for the doubt, which might include an exclusion in the policy, a late notice of the claim, a question about whether the event happened within the policy period, or a claim that is only partly covered. It also states that by taking action the insurer is not giving up its right to rely on those points.
Without the letter, an insurer that takes control of a defence might later be said to have waived (given up) its right to deny cover, or to be estopped (prevented) from doing so. The reservation avoids that outcome and keeps the insurer's position open.
For the policyholder, the letter has real consequences. In some legal systems, a conflict of interest created by the reservation lets the policyholder choose its own lawyer, with the insurer paying reasonable fees, and the policyholder should discuss this with legal counsel at once.
From a finance viewpoint, the letter changes how the claim is treated in the accounts. The business cannot safely book an insurance recovery until it is virtually certain, and it may need to record a provision for the full cost of the claim, with disclosure of the uncertainty.
The best response is calm and organised. The business should read the letter closely, answer any requests for information, keep its own records of every step and avoid admitting liability or settling without advice.
Contact with the insurer should be in writing where possible, so there is a clear record of what was said.
In practice
Real-world examples.
Example
A restaurant is sued by a customer for food poisoning, and its insurer says it will pay for a defence lawyer under a reservation of rights because the policy excludes some contamination events. The owner keeps accruing the legal costs until the position is clearer and asks the broker to explain which part of the policy applies. The broker's explanation becomes part of the claim file.
Example
A software company reports a data breach several months late. The insurer sends a reservation of rights letter pointing to the late notice and says that it will examine whether the delay prejudiced its position before deciding on payment.
Example
A construction company receives a claim for $2,500,000 of damage, but the insurer's letter says some of the loss may fall under a faulty workmanship exclusion. The finance director records a provision for the exposure and does not book any insurance recovery. She also tells the lenders, because a large unresolved claim can affect borrowing covenants.
Case study
Seen in the real world.
Birchfield Joinery is an illustrative, fictional furniture manufacturer. A customer sued it for $800,000 after a fire that the customer blamed on a faulty heater sold by Birchfield, and the company's liability insurer accepted the defence under a reservation of rights.
The letter explained that the policy excluded losses caused by products Birchfield had modified, and the insurer wanted to find out whether the heater had been altered. Birchfield's finance director recorded a provision for the legal costs and a contingent liability note for the claim, and she did not book any expected insurance recovery.
After six months the investigation showed that the heater was unmodified, and the insurer withdrew its reservation and accepted the claim in full. The illustrative lesson is that a reservation of rights letter is not a denial, but until it is resolved the accounts should reflect the uncertainty. Birchfield's auditors agreed with this approach and asked for the insurer's letter to be kept with the working papers.
Watch out
Common mistakes.
- Reading the letter as a refusal of the claim, when it usually says the insurer will keep acting while it investigates.
- Ignoring the letter or letting a deadline pass, which can harm the business's position in a later dispute over cover.
- Booking an insurance recovery in the accounts as soon as the claim is notified, before the insurer has confirmed it will pay.
Questions
People also ask.
Does a reservation of rights letter mean the insurer will deny the claim?
No, it means the insurer has doubts and is protecting its position, and many claims are accepted in full after the investigation.
Can the business choose its own lawyer?
In some legal systems it can when the reservation creates a conflict of interest, but the rules vary, so the business should take legal advice quickly.
Who sends the letter?
The insurer or its claims handler, usually after it has reviewed the claim and the policy, and it is often sent early in the process, sometimes within days of the claim being notified.
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