Insurance law practitioners learn on day one that the duty to defend is broader than the duty to indemnify, encompassing even uncovered claims if at least one claim against the insured is potentially covered. See Bridge Metal Indus., L.L.C. v. Travelers Indem. Co., 812 F. Supp. 2d 526, 544-45, 545 n.14 (S.D.N.Y. 2011). Because the cost of defending against a lawsuit can sometimes exceed any ultimate liability, courts have described this defense cost coverage as crucial “litigation insurance.” Perdue Farms, Inc. v. Travelers Cas. & Surety Co. of Am., 448 F.3d 252, 258 (4th Cir. 2006) (quoting Brohawn v. Transamerica Ins. Co., 347 A.2d 842, 851 (Md. 1975)). It is therefore troubling that some courts allow insurers to claw back amounts expended on claims that turn out to be uncovered, even if the policy at issue provides for no such right to recoupment.
In attempting to justify this purported right to recoup defense costs, insurers have relied primarily on two legal theories: unjust enrichment and implied contract. That the right to recoupment does not fit neatly into either of these doctrinal boxes—or, frankly, any other—is illustrated by the Tenth Circuit Court of Appeals’ recent attempt to understand Colorado’s rationale for recognizing the right—an attempt that ultimately proved unavailing. See Valley Forge Ins. Co. v. Health Care Mgmt. Ptrs., Ltd., 616 F.3d 1086, 1094 (10th Cir. 2010) (“Regardless whether the Colorado courts situate the rule in equity, contract, policy, rule of court, or someplace else—whatever doctrinal pigeonhole best fits—one thing is clear: Colorado permits insurers to recoup defense costs . . . .”). Imagine the frustration of the policyholder in Valley Forge when it was stripped of its bargained-for defense cost coverage—a benefit conferred explicitly on page one, paragraph one of most commercial general liability (“CGL”) policies—based on no discernable legal theory whatsoever.
In what is probably the seminal case recognizing the right to recoupment, Buss v. Superior Court, the California Supreme Court found that CGL insurers have a “quasi-contractual” right to recoup costs incurred in the defense of “claims that are not even potentially covered.” 939 P.2d 766, 776-77 (Cal. 1997). The Buss court reasoned that because insurers do not receive premiums for uncovered claims and have not bargained to bear the costs of defending against such claims, the right to recoupment is necessary in order prevent the policyholder from being unjustly enriched. What the Buss court ignored, however, is the fact that an insurer has “not only the duty to defend, but the right to defend” as well. Am. & Foreign Ins. Co. v. Jerry’s Sport Ctr., Inc., 2 A.3d 526, 545 (Pa. 2010). This arrangement benefits both parties: the insured receives a defense at the insurer’s expense, while the insurer can “protect itself against potential indemnity exposure” by controlling the defense. Id. Thus, while an insurer is always entitled to deny coverage for uncovered claims, it should not be allowed to exercise its right to conduct the insured’s defense and then, once the dust has settled and certain claims are found to be uncovered, seek recoupment of sums expended. Because those sums were expended, in part, to protect the insurer’s own interests, the unjust enrichment theory fails to justify the right to recoupment.
Even less compelling than Buss’ unjust enrichment formulation is the notion that policyholders who accept a defense under a reservation of rights have implicitly agreed to any terms listed in the insurer’s reservation-of-rights letter. According to courts that have adopted this theory, an insurer had the right to condition its provision of a defense upon terms not contained in the policy, including the right to recoup defense costs. See Colony Ins. Co. v. G&E Tires & Servs., Inc., 777 So. 2d 1034 (Fla. Dist. Ct. App. 2000). Supporters of the right to recoupment have argued that this arrangement benefits policyholders as well as insurers, because the right encourages insurers to provide a defense in close cases rather than to deny coverage from the outset. See J. Carbin & A. Christie, An Insured’s Obligation To Reimburse Its Insurer For Costs Expended In The Defense Of Non-Covered Claims, 16 Mealey’s Emerging Insurance Disputes 21 (Nov. 3, 2011). This contention is misguided, however, because policyholders gain nothing by receiving a temporarily “free” defense only to have to reimburse the cost of the defense at a later date. In fact, a policyholder may very well be harmed in such cases if, for example, he cannot afford to pay for the defense or if counsel provided by the insurer proves to be ineffectual. And this is to say nothing of possible conflicts of interests, which courts have recognized may arise when an insurer’s pecuniary interests would be best served by focusing on defeating covered claims at the expense of uncovered ones. See San Diego Fed. Credit Union v. Cumis Ins. Soc’y, Inc., 208 Cal. Rptr. 494 (Cal. Ct. App. 1984).
Moreover, proponents of the implied contract justification for the right to recoupment misapprehend the duty to defend as being somehow discretionary. It is not. Under the plain language of most CGL policies and under well-settled law, an insurer must defend its insured if faced with a potentially covered claim. See, e.g., Gray v. Zurich Ins. Co., 419 P.2d 168, 174-76 (Cal. 1966) (en banc). Thus, allowing an insurer to condition its provision of a defense on the right to recoup defense costs effectively grants the insurer the right to unilaterally amend the terms of the insurance contract. This outcome “amount[s] to a retroactive erosion of the broad duty to defend . . . by making the right and duty to defend contingent upon a court’s determination that a complaint alleged covered claims,” thereby “narrow[ing] [the] long-standing view that the duty to defend is broader than the duty to indemnify.” Jerry’s Sport Ctr., 2 A.3d at 544.
Contrary to insurers’ self-interested protestations, the right to recoupment finds support in neither law nor equity. Because an insurer that fulfills its duty to defend its insured simultaneously exercises its right to do so, the insured is not unjustly enriched by receiving a defense even if the underlying claims prove, in hindsight, to be uncovered. Moreover, because the duty to defend is not optional, insurers have no right to condition their defense on terms not found in the subject policy. Allowing insurers to do so “effectively places the insured in a position of making a Hobson’s choice between accepting the insurer’s additional conditions on its defense or losing its right to a defense from the insurer.” Gen. Agents Ins. Co. of Am., Inc. v. Midwest Sporting Goods Co., 828 N.E.2d 1092, 1102 (Ill. 2005). The great majority of CGL policies prohibit this result, and more courts should do the same.