NEARLY ALL RISK MANAGERS and other buyers of insurance know that a liability insurer owes a broad duty to defend its insured against third-party lawsuits, even where it ultimately turns out that there is no duty to indemnify. Most of these buyers are probably aware that this broad duty to defend may require the insurer to defend an entire lawsuit even though some of the claims in that suit (e.g., contract claims or punitive damages claims) are not covered under the policy. But few policyholders appreciate the serious risk that an insurer, having provided a defense in a lawsuit including both covered and non-covered claims, will later make a claim against its policyholder for reimbursement of some or nearly all of those defense costs.

The risk of a defense cost reimbursement claim has expanded over recent years as the cost of defending claims -- which often surpasses the cost of paying settlements or judgments -- has soared. Insurers have increasingly searched for ways to reduce or avoid their defense obligations.

The frequency of insurers pursuing reimbursement claims is likely to increase in the wake of recent court decisions. Just last year, the California Supreme Court, often at the vanguard of insurance law, issued back-to-back opinions allowing an insurer to recover defense costs from its policyholder if the insurer proves that it is more likely than not that the defense costs were incurred solely in defending against a claim, or even a part of a claim, that was not even potentially covered under the policy. Two cases -- Jerry H. Buss et al. vs. Superior Court of Los Angeles and Aerojet-General Corp. vs. Transport Indemnity Co. -- illustrate two common reimbursement scenarios that policyholders must understand and anticipate. In Buss, the policyholder, Jerry Buss, owned several professional sports teams, including the Los Angeles Lakers (BI, Aug. 4, 1997). He was sued under 27 causes of action by a company providing advertising services. Mr. Buss's insurer, Transamerica Insurance Co., agreed to defend Mr. Buss based solely on one cause of action for defamation, reserving its rights to obtain reimbursement of defense costs as to the other 26 non-covered claims. Mr. Buss eventually settled the lawsuit for $8.5 million, but Transamerica refused to contribute.

Transamerica, which had paid over $1 million to defend Mr. Buss, then sought reimbursement of all defense costs except for some $21,000 to $56,000, which it believed was the only amount attributable to defending the defamation cause of action. The California Supreme Court ruled that Transamerica had the right to go after Mr. Buss to recover defense costs incurred solely in defending the 26 non-covered causes of action. Thus, the policyholder, Mr. Buss, was left facing a reimbursement claim of nearly the entire $1 million spent to defend the underlying lawsuit.

Aerojet presented a different scenario by which a policyholder may be forced to pay for its own defense. There, the policyholder tendered to its insurers' suits claiming contamination of property through the operation of manufacturing plants. The insurers sought a declaration that they did not owe a duty to fund Aerojet's entire defense based on the presence of deductibles or retained limits in several of Aerojet's policies. The California Supreme Court ruled that the insurers had a duty to defend the entirety of claims against Aerojet but could recover defense costs from Aerojet to the extent they can prove that the defense costs were incurred solely in defending non-covered claims or parts of claims. The potentially non-covered claims or parts of claims principally related to contamination occurring outside the policy period, and Aerojet will have to reimburse the insurers to the extent they prove that defense costs were incurred solely in defending such non-covered claims or parts of claims.

Rulings such as in Buss and Aerojet will likely result in more significant disputes between insurers and policyholders on the issue of who ultimately pays for defense costs. A policyholder, happy to learn that an insurer has agreed to defend a lawsuit, may be extremely displeased to learn months or often years later that the insurer is seeking to have some or nearly all of the substantial defense costs thrown back on the policyholder.

If the policyholder is unwilling to submit to the insurer's demand for reimbursement of defense costs, the policyholder may find itself the target of a further legal action by the insurer to recover those defense costs. The policyholder's displeasure would, no doubt, be magnified where the insurer is demanding reimbursement of defense costs incurred by counsel of its choice, who could have steered the underlying lawsuit in a direction favoring the insurer's later reimbursement claim.

All is not lost for policyholders, however. Armed with the understanding that any lawsuit could trigger a defense cost reimbursement claim by the insurer, a policyholder can avoid or minimize the consequences of a later reimbursement dispute by careful attention to the following issues:

* Does the claim carry the potential for a later reimbursement dispute? The policyholder first needs to determine whether the insurer has the right to later assert a claim for reimbursement of defense costs. This will hinge on at least four factors.

1. Does the complaint allege any claims or parts of claims that are not covered by the policy? If not, then there is no basis for the insurer to seek reimbursement.

2. Does the applicable law allow an insurer to defend a lawsuit but later force the policyholder to bear some or all of the defense costs? In other words, the policyholder must determine whether the insurer has the right to seek reimbursement of defense costs in the first place.

3. Has the insurer promptly and specifically reserved the right to later seek reimbursement of defense costs? If not, the insurer may have waived the right to do so. However, caution must be exercised because some jurisdictions might allow an insurer to assert a claim to recover defense costs despite the absence of a prompt and specific reservation of that right.

4. Is the insurer promptly and fully providing a defense? Some jurisdictions will allow an insurer to recover defense costs from the policyholder only if the insurer provided a prompt and full defense.

* What is the risk and extent of a potential reimbursement claim? To properly assess the risk and extent of a later reimbursement claim, a thorough legal analysis of the coverage afforded the third-party claims (and parts of claims) must be performed. Questions to address include:

1. Are there any claims (or parts of claims) that are clearly outside the scope of coverage? If so, to what extent do the non-covered claims predominate the covered claims? The policyholder should consider whether it would be advisable either to defend itself or to negotiate up front a reasonable defense cost sharing agreement.

2. Do the covered and non-covered claims involve the same factual issues? For example, has the third-party claimant alleged that the policyholder's misconduct was negligent (in one cause of action) and intentional (in another cause of action)? Does the defense against contract and tort claims hinge on proof of essentially the same facts? The more the covered and non-covered claims implicate the same factual issues, the more likely the insured will succeed in defeating the insurer's reimbursement claim, since the insurer will have considerable difficulty demonstrating that any portion of the defense costs was incurred solely because of the non-covered claims.

* Should the policyholder cut a deal on reimbursement? Assuming that the applicable law affords the insurer the right to seek reimbursement of defense costs, the policyholder should consider whether it makes sense to try to make a deal to share defense costs.

For example, after a third-party claim has been asserted, the policyholder could explore an agreement with the insurer establishing a dollar cap, percentage cap, or other formula for sharing defense costs. The cap or formula would vary depending on the nature of the claims alleged in the underlying lawsuit, including the relative importance of the covered vs. non-covered claims and the extent to which such claims are factually intertwined.

A defense cost sharing agreement could inure to the benefit of both sides by decreasing the uncertainty and risk of an unliquidated reimbursement claim, avoiding the cost of litigating the reimbursement claim down the road, allowing the policyholder and insurer to defend the third-party claim with a united front, and avoiding disputes over conflicts of interest in the retention of defense counsel.

* How can the policyholder minimize the impact of a reimbursement claim? A policyholder should be proactive to protect or even improve its position in any later reimbursement dispute. Although the strategy in minimizing the impact of any reimbursement claim will be dictated by the circumstances surrounding the claim, a few general approaches should be considered.

First, the policyholder should consider whether the insurer can be persuaded to abandon the reimbursement claim. One "persuasion point" might be to demand that the insurer appoint independent counsel. Generally, where defense counsel's handling of the underlying lawsuit can influence the outcome of a coverage dispute, the policyholder is entitled to independent counsel at the insurer's expense. Such a conflict of interest might arise if the insurer were to appoint defense counsel from its panel of law firms and yet reserve its right to recover defense costs from the policyholder. The risk of having to pay the additional expense of independent counsel may persuade the insurer to forgo a reimbursement claim altogether.

Second, consider whether it is advantageous to tender the suit to the insurer in the first place. If the non-covered claims predominate the covered claims, and the insurer refuses to waive its right to seek reimbursement, the policyholder may be better served to select and retain control over defense counsel, even though it means possibly forgoing any contribution by the insurer to the cost of defense. This would allow the policyholder to use defense counsel of its own choosing and to decide how much to spend on defense and how to allocate those defense dollars in the most efficient manner.

Third, the policyholder should plan and budget for the possibility of a reimbursement claim. The financial impact of a reimbursement claim can be softened considerably if the policyholder prepares for that potentiality. Further, the policyholder, having analyzed the likelihood and estimated amount of a reimbursement claim, can take that risk into consideration in assessing how to respond to the third-party suit. This analysis will help the policyholder determine how to approach defense and settlement.

In conclusion, a policyholder need not find itself defenseless in the face of an insurer's claim or potential claim for reimbursement of defense costs. However, the insured must first understand the risk of such a claim. Armed with this knowledge, the insured is in a much better position to assess (1) whether the insurer has the right, under the applicable law, to recover defense costs in the first place; (2) if such a right exists, whether the insurer should nonetheless be prevented from asserting that right; (3) the risk and potential exposure of a reimbursement claim; (4) how the impact of a reimbursement claim can be minimized; and (5) whether some kind of a sharing agreement should be negotiated with the insurer. Assessing these issues in a timely manner will help to avoid, or at least minimize, the consequences of an insurer's claim for reimbursement of defense costs.

Jerry H. Buss vs. Superior Court of Los Angeles (1997) 16 Cal.4th 35 and Aerojet-General Corp. vs. Transport Indemnity Co. (1997) 17 Cal.4th 38.

Daven G. Lowhurst is a partner and Ross M. Petty is a senior associate at Thelen Reid & Priest L.L.P. in San Francisco, Calif., where they advise and represent policyholders in pursuing coverage claims. The views expressed herein are solely those of the authors.