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When a policyholder seeks defense coverage from an insurer, the insurer may reserve its rights to recoup the costs if it's determined the policy does not cover the claim. Given differing court rulings, both sides should protect their interests, say William J. Carter, Mariana D. Bravo and Matthew D. Berkowitz of law firm Carr Maloney P.C. in Washington. These steps may decide an insurer's ability to recoup uncovered defense costs or a policyholder's ability to receive defense coverage.
Once a policyholder requests defense coverage from an insurer, the insurer essentially has three options. It may provide coverage completely and without reservation, disclaim coverage, or provide coverage and a defense subject to a reservation of rights.
“The purpose of a reservation of rights is to notify the insured of the insurer's potential coverage defenses and to permit the insurer to satisfy its duty to defend without forfeiting its right to disclaim” should it later be determined that the claim is not covered under the policy, a Brooklyn federal judge ruled in April in Travelers Indemnity Co. of America vs. Southern Gastronom Corp. et al.
To avoid estoppel or waiver, the insurer often will set forth several grounds to potentially deny coverage and identify a number of rights it may possess and later assert. Among potential insurer assertions is the right to recoup defense costs if it is determined subsequently that there was no right to coverage and, therefore, no duty to defend.
Hypothetical Bar & Grill received such a letter, which reserved the right to recover uncovered defense costs, when the insurer agreed to defend the neighborhood bar in a lawsuit alleging that one of Hypothetical's bouncers intentionally assaulted a patron. At trial, a jury found that the bouncer's conduct was intentional and not in self-defense and ruled in favor of the patron.
The owner was not surprised to learn that his business would not be indemnified for its loss because he knew his insurer did not cover bodily injury caused by intentional conduct. However, the owner was shocked when he received a letter from his insurer requesting that the fictional restaurant and bar reimburse the insurer for the noncovered defense costs as stated in the reservation of rights letter.
The owner vaguely recalled seeing a reservation to this effect, but simply glossed over the provision and never raised the issue with his insurer, assuming the insurer would not hold him to this. Unprepared for such a request, the owner called an attorney friend to find out whether he was obligated to reimburse the insurer or whether he would need to sell his bar to pay the legal fees.
The owner's dilemma is not uncommon. In recent years, whether an insurer is entitled to recover defense costs from its insured for uncovered claims has garnered great discussion.
So far, however, only a handful of courts have addressed this issue.
Those that have addressed the subject—the 8th U.S. Circuit Court of Appeals in Westchester Fire Insurance Co. vs. Douglas Wallerich et al. in 2009 and the 4th U.S. Circuit Court of Appeals in Perdue Farms Inc. et al. vs. Travelers Casualty & Surety Co. of America in 2006—split on the issue.
This article reviews both approaches, highlights differences in each method and sets forth a standard that a court likely would adopt in reviewing this issue for the first time. Finally, this article explains what the future standard means to insurers and policyholders.
The majority of courts that have addressed the issue have taken a view that “recognizes an insurer's right to reimbursement of defense fees paid where it is determined that the insurer had no duty to defend,” according to Wallerich, and “generally do(es) so under a quasicontract theory, allowing recovery to prevent unjust enrichment,” according to the Virgin Islands District Court in General Star Indemnity Co. vs. Virgin Islands Port Authority in 2007.
In the landmark 1997 case Jerry H. Buss et al. vs. Superior Court of Los Angeles County, the Supreme Court of California ruled that an insurer has a right to be reimbursed for defense costs for claims not even potentially covered under its policy. In that case, the insurer agreed to defend its insured in a defamation action—the only cause of 27 that the insurer believed may have been covered. The insurer reserved all of its rights, “including the right to deny that any cause of action was actually covered, and "(w)ith respect to defense costs incurred or to be incurred in the future...to be reimbursed and/or (to obtain) an allocation of attorney's fees and expenses in this action if it is determined that there is no coverage.'”
In recognizing an insurer's right to recovery for uncovered claims based on a quasicontract theory to prevent unjust enrichment, the court in Buss said the insurer “did not bargain to bear these costs. To attempt to shift them would not upset the arrangement.”
Of further significance, Buss also recognized that “to obtain a reimbursement of defense costs, an insurer must reserve its rights on this basis. It is not necessary that the insured agree with the insurer's reservation of rights to obtain a reimbursement of defense costs for it to be valid; "(b)ecause the right is the insurer's alone, it may be reserved by it unilaterally,'” the 8th Circuit ruled in Wallerich, citing Buss.
In sum, “(t)he majority position (generally) permits an insurer to seek reimbursement for defense costs when it is determined the insurer has no duty to defend or indemnify, the policy does not contain an express provision regarding reimbursement, and the insurer timely reserves its right (to) reimbursement in a specific and adequate notice,” a Tennessee federal judge ruled in 2006 in Cincinnati Insurance Co. vs. Grand Pointe L.L.C. Thus, an express agreement providing that the insurer may be entitled to reimbursement for noncovered claims is not required.
On the other hand, the minority position generally limits an insurer's right to reimbursement to situations where an express policy provision provides for reimbursement, the court in Grand Pointe said in citing the 2005 Illinois Supreme Court ruling in General Agents Insurance Co. of America Inc. vs. Midwest Sporting Goods Co.
In Midwest Sporting Goods, the insurer provided a defense to the insured pursuant to a full reservation of rights. When it was determined later that the insurer had no duty defend, the trial court held that the insurer adequately reserved its right to recoup defense costs and ordered reimbursement. Midwest Sporting Goods appealed and the Illinois Supreme Court reversed, holding that “we acknowledge that a majority of jurisdictions have held that an insurer is entitled to reimbursement of defense costs when the insurer did not have a duty to defend, the insurer timely and expressly reserved its right to recoup defense costs, and the insured either remains silent in the face of the reservation of rights or accepts the insurer's payment of defense costs. We choose, however, to follow the minority rule and refuse to permit an insurer to recover defense costs pursuant to a reservation of rights absent an express provision to that effect in the insurance contract between the parties.”
The Illinois high court said it would be unjust to allow an insurer to unilaterally modify its contract through a reservation of rights. To “recognize such an implied agreement effectively places the insured in the position of making a Hobson's choice between accepting the insurer's additional conditions on its defense or losing its right to defense from the insurer.”
In Midwest Sporting Goods, the court heavily relied on 3rd U.S. Circuit Court of Appeals' ruling in 1989 in Terra Nova Insurance Co. Ltd. vs. 900 Bar Inc. et al., an early case when there was limited law on this issue.
In Terra Nova, the 3rd Circuit rejected the insurer's right to be reimbursed for defense costs, reasoning that an insurer is not unjustly enriched because the insurer receives a benefit from providing a defense, which it controls.
Similarly, the 4th U.S. Circuit, applying Maryland law, ruled in Perdue that an insurer is not entitled to reimbursement for an uncovered claim. Unlike Midwest Sporting Goods, however, the 4th Circuit offered no guidance as to whether an insurer could recoup uncovered defense costs if the policy contained an express provision allowing it to do so.
The recent 8th Circuit ruling in Westchester perhaps provides the most instructive guidance on this unsettled area of law for courts facing the reimbursement issue for the first time. The court held that the insurer was not entitled to reimbursement because the policyholders explicitly rejected the terms of the insurer's reservation of rights letter. Had the policyholder accepted the defense and remained silent, a quasicontract would have formed and the 8th Circuit likely would have ruled differently.
Thus, courts determining for the first time whether an insurer is entitled to recoup defense costs for uncovered claims may elect to follow Wallerich and answer in the affirmative as long as the insurer explicitly reserves in a timely manner its right to recoup the costs, provides specific notice of the possibility of reimbursement, and the policyholder remains silent and accepts the defense.
Understanding these approaches may prove invaluable in your ability to recoup uncovered defense costs if you are the insurer, or enable you to retain a defense if you are the policyholder. Nonetheless, it is difficult to predict how a court would rule given the vastly unsettled area of the law and the differing court standards even within the majority and minority approaches. Therefore, there are a number of precautions both sides should take to protect their interests.
An insurer should always in a timely fashion, explicitly and specifically reserve its right to recoup uncovered defense costs. Furthermore, an insurer should consider including a provision in the policy that it is entitled to recover uncovered defense costs.
On the other hand, a policyholder should be aware that a majority of courts permit the insurer to recoup uncovered costs. If the policyholder objects to the insurer's reservation of rights, the policyholder should immediately notify the insurer in writing of this protest. However, the policyholder should be mindful that such an objection could lead to the insurer withdrawing the defense. Nonetheless, absent an express provision in the policy, a written objection likely would negate an insurer's ability to recover uncovered defense costs in most, if not all, jurisdictions following the majority approach.
As for the Hypothetical Bar & Grill, the owner now knows to object in writing to any reservation of rights by an insurer with which he disagrees. He also now knows not to hire hot-tempered bouncers with criminal convictions, even as a favor to his college roommate.
William J. Carter is managing attorney, Mariana D. Bravo is a member and Matthew D. Berkowitz is an associate at Washington-based law firm Carr Maloney P.C., which provides comprehensive legal services throughout the Middle Atlantic region with a particular focus on insurance representations and commercial litigation.