On March 7, 2013, the Supreme Court of Washington joined a growing number of states holding that an insurance company cannot recoup defense costs paid or incurred under a reservation of rights defense, even where a court subsequently rules that the carrier does not have a duty to defend. This opinion, a 5-4 decision in National Surety Corp. v. Immunex Corporation, No. 86535-3, 2013 WL 865459 (Wash. March 7, 2013) (en banc) (“Immunex”), rejects an insurer’s attempt to have it both ways by enjoying the protections, but subsequently seeking to shirk the costs, associated with defending pursuant to a reservation of rights. The court’s well-reasoned opinion properly places on the insurance company the “risk of the defense decision,” and soundly rejects reimbursement of defense costs as a unilateral amendment of the insurance contract and an erosion of the broad duty to defend.

This coverage dispute arose from a series of underlying complaints filed against Immunex, beginning in 2001, alleging that the company reported inflated average wholesale prices of its drugs, which allowed providers of the drugs to receive Medicare and other reimbursements in amounts greater than what they actually paid. Id. at *1. On October 3, 2006, Immunex tendered defense of the litigation to National Surety. In a March 2008 reservation of rights letter, National Surety disclaimed any duty to defend or indemnify, but agreed to pay Immunex’s defense costs “until such time as [National Surety] can obtain a court determination confirming its coverage decision.” Id. at **1-2. National Surety also purported to “reserve the right to recoup the amounts paid in defense if it is determined by a court that there is no coverage or duty to defend and that [National Surety] is entitled to reimbursement[,]” Id. at *2, despite the fact that the policy did not include a reimbursement clause. National Surety then filed a declaratory judgment action against Immunex. Id.

In April 2009, the trial court held that National Surety did not have a duty to defend the complaints but nevertheless was responsible for the defense costs Immunex incurred prior to the ruling, unless National Surety could show that it was substantially prejudiced by Immunex’s untimely notice of the claim. The Washington Court of Appeals affirmed. Id. In affirming the Washington Court of Appeals, the Washington Supreme Court, resolving a matter of first impression in Washington, ruled that an insurer “may not seek to recoup defense costs incurred under a reservation of rights defense while the insurer’s duty to defend is uncertain.” Id. at *9.

The Washington Supreme Court rejected the reasoning of and refused to follow “the leading California decision allowing recoupment of defense costs,” Buss v. Superior Court, 16 Cal. 4th 35 (1997) (“Buss”), as well as similar opinions from other jurisdictions (including Colorado, Connecticut, Florida, New Jersey, and Tennessee). Id. at *5. Instead, the court endorsed the reasoning and holdings of a more recent line of cases, including decisions issued by state supreme courts in Illinois, Pennsylvania and Wyoming, which refused “to allow reimbursement of defense costs based on a later determination of no coverage.” Id. at *6. These cases characterized reimbursement as a unilateral modification of an insurance contract and as a “retroactive erosion of the broad duty to defend.” Id. at *6 (citations and inner quotation marks omitted).

In so ruling, the court discussed the benefits an insurance carrier receives, as well as the risks it assumes, when deciding whether to defend its policyholder. On the one hand, providing a defense benefits the insurance carrier by allowing it to “monitor the defense and better limit its exposure,” and defending subject to a reservation of rights “insulates [the carrier] from potential claims of breach and bad faith, which can lead to significant damages, including coverage by estoppel.” Id. at *7 (citation omitted). In exchange, however, the carrier must pay for the policyholder’s defense until a court declares that no defense is owed. Id. On the other hand, “when an insurer declines to defend altogether, it saves money on legal fees but assumes the risk it may have breached its duty to defend or committed bad faith.” Id.

The court rejected National Surety’s view that an insurer can have the best of both worlds: (1) “protection from claims of bad faith or breach,” without (2) having “any responsibility for the costs of defense if a court later determines there is no duty to defend. This ‘all reward, no risk’ proposition renders the defense portion of a reservation of rights defense illusory.” Id. The court further reasoned that disallowing reimbursement of defense costs was “most consistent with Washington cases regarding the duty to defend, which have squarely placed the risk of the defense decision on the insurer’s shoulders.” Id.

The court also addressed National Surety’s two, related untimely notice defenses, and thus considered: (1) whether the carrier is liable for pre-tender defense costs, and (2) whether National Surety could show, as a matter of law, “actual and substantial prejudice” as a result of Immunex’s untimely notice. As to the first issue, the court reasoned that the duty to defend arises upon the filing of a complaint alleging facts that potentially fall within the policy’s coverage, not at the time notice of the claim is tendered. Id. at *10. Accordingly, unless National Surety could show that late notice caused substantial prejudice, Immunex could recover fees and costs incurred from the date the complaint was filed through the date that the trial court ruled that National Surety did not have a duty to defend. Id. Addressing the second issue, the court recognized that an insurer is excused from paying defense costs where the policyholder’s late notice caused actual and substantial prejudice. Id. at * 10 and n.4. Because “questions of prejudice generally involve disputed facts[,]” the court remanded this issue to the lower court to determine whether National Surety could prove “actual and substantial prejudice flowing from its insured’s untimely tender of the claim.” Id. at *10.

The Immunex decision is particularly instructive for policyholders whose insurance carriers provide them with a defense pursuant to a reservation of rights. Where the policy is silent on recoupment of defense costs, it is important for policyholders to push back against carriers’ attempts to purport to reserve reimbursement rights when no such right ever even existed (in the policy or elsewhere). While the law on this issue is clearly mixed, many states have not yet addressed this issue, and the Immunex decision provides another piece of persuasive authority rejecting a carrier’s attempt to have its cake and eat it, too.