Does an insurer have the right to "claw back" defense costs it paid to its insured under a reservation of rights even after a court determines that none of the underlying claims were covered under the relevant policy? No, says Judge Rya Zobel of the United States District Court in Boston. Recognizing that no Massachusetts court has ruled on this precise question, Judge Zobel placed the risk of making an initial determination to defend "potentially covered" claims squarely on the insurer, even where that determination is expressly made under a reservation of rights. (Order on Motion to Alter or Amend Judgment ("Order"), filed on February 9, 2011, in Welch Foods, Inc. v. Zurich American Ins. Co., et al., C.A. No. 09-12087-RWZ (D. Mass.)).

This coverage case arose out of a declaratory action brought by Welch Foods, Inc. against three of its insurers, arising out of two false advertising suits brought against Welch in California (one by an alleged competitor and another by a class of consumers). Only one insurer, Axis Surplus Insurance Company, agreed to advance a portion of defense costs, and it did so under a reservation of rights letter purporting to create a "right of reimbursement" of those costs in the event coverage for the claims was found lacking. Following the court's summary judgment finding that none of the claims were covered (which is now on appeal)1, Axis moved to amend the judgment to allow reimbursement of the defense costs it had advanced.

Judge Zobel noted that different states had come to different conclusions on the issue. California had concluded - in a matter in which the policyholder and insurer had an express contract calling for the insurer's reimbursement - that reimbursement of defense costs advanced for claims that are ultimately determined not to be covered are subject to reimbursement. Noting that a contrary decision would allow "the insured...[to] be unjustly enriched," the California decision hinged on the difference between "potentially" covered claims and claims that were not covered at all:

In an action in which all the claims are at least potentially covered, the insurer has a duty to defend and no right to reimbursement because it was paid premiums and bargained to bear those costs. Conversely, in an action in which none of the claims are even potentially covered, the insurer does not have a duty to defend because no such duty was contracted for, and is entitled to, reimbursement. (See Buss v. Superior Court, 16 Cal. 4th 35, 51, 939 P.2d 766, 769 (Cal. 1997)).

Pennsylvania, the court noted, has a contrary view in which an "insurer has an absolute duty to defend claims that are potentially covered, and this duty is not extinguished by a court's later determination that the claims are not covered." The duty to "determine whether a complaint is potentially covered is to be answered by the insurer upon receiving notice of the complaint from the insured, even though an erroneous decision to deny coverage may subject the insurer to liability for breach of contract." See Order, citing American & Foreign Ins. Co. v. Jerry's Sport Center, Inc., 2 A.3d 526, 541 (Pa. 2010).

In Welch's case, the policy was silent as to reimbursement, providing only that Axis had a duty to defend claims arising under the policy. Noting that the duty to defend is broader than the duty to indemnify, Judge Zobel ruled that "while the question whether a claim is covered may be difficult, it is the insurer's duty to make the decision," as they are "in the business of making this decision." In denying reimbursement even where the underlying claims were not covered, the court concluded that the insurer "bears the responsibility for making the [coverage] determination, and the concomitant risk if its decision to advance fees is wrong." Order at 6.

Of additional significance is the court's finding that Axis's letter accepting Welch's tender could not "unilaterally" condition acceptance of the tender on a right to reimbursement. Welch tendered pursuant to the policy, and, once Axis determined the claims were potentially covered, it could not condition payment of the defense costs on a newly imposed right to claw those costs back. (Order at 6, n. 2.).

While insurers may amend their policies to include an express right of reimbursement, Massachusetts (as several other states) will put the burden of determining - and living with - coverage decisions on the insurers. Initial denials of defense costs for potentially covered claims could lead to a finding that the insurer breached their contract once coverage was found, while paying costs under a reservation of rights may allow no reimbursement even where coverage is later denied