On August 3, 2012, the California Court of Appeal, Second Appellate District, after affirming a trial court’s ruling that a liability policy did not provide coverage for tenants’ claims against apartment owners for unsafe and unsanitary conditions at the apartments, further affirmed that the insurer was entitled to be reimbursed by the insureds for the full amount the insurer had paid in settlement of the tenants’ action.  The decision is Axis Surplus Ins. Co. v. Reinoso.

In so doing, the Court found that, having timely reserved its rights and having notified the insureds of the intent to accept a proposed settlement offer and affording the insureds the opportunity to assume the defense if the insureds did not agree to the proposed settlement offer, the insurer was entitled to be reimbursed by the insureds for the indemnity payment once it established the claim against the insureds was not covered. This is the procedure first provided for under the California Supreme Court’s decision in Buss v. Superior Court, 16 Cal. 4th 35, 50-51 (1997).

However, since the insurer was not able to meet its burden to show that there was never a “potential” for coverage, it was not able to recoup the defense costs it incurred in defending the claims against the insureds, again a procedure permitted under the Buss decision.

Edgar and Linda Reinoso were co-owners and managers of a number apartment buildings in Southern California. Tenants of one of these apartment building sued the Reinosos for alleged habitability deficiencies at the apartments.  The Reinosos sought coverage under their commercial general liability policies issued by Axis Surplus Lines Insurance Company. Axis agreed to represent the Reinosos under a reservation of rights.

The tenants’ lawsuit settled for $3 million, with Axis paying the majority of the settlement. Axis then sued the insured for the recovery of its settlement contribution and the defense costs it incurred. The trial court concluded that the Axis policy did not cover the tenants’ claims (since the policy and California law did not allow coverage for intentional and willful acts), and it ordered the Reinosos to pay back to Axis the insurer’s settlement contribution jointly and severally.  The couple appealed.  Edgar’s appeal was dismissed, but Linda’s claims went forward.

In her appeal, Linda argued that the trial court erred when it found that she was not an innocent insured entitled to benefits under the policy because the trial court wrongly applied the objective rather than the subjective standard in determining whether she knew about the conditions in the apartments. The Court of Appeal acknowledged that whether an injury is expected or intended under an insurance policy is determined by the insured’s subjective mental state. The appellate court concluded, however, that the trial court, in fact, did apply the subjective standard and found that there was substantial evidence that Linda knew about the conditions at the apartments and how the apartments were being managed.

Linda also challenged the trial court’s determination that she was jointly and severally liable with her husband for the repayment to Axis. The Court of Appeal rejected this argument as well, noting that, as co-owner of the apartments and as a participant in the management of the property, Linda had sufficient benefit from the settlement such that not to allocate to her joint and several liability to the insurer for the full amount paid by the insurer to settle the tenants’ lawsuit would amount to unjust enrichment.

The lesson for insurers is that reimbursement of liability policy proceeds may be possible with the issuance of a timely and comprehensive reservation of rights letter in those cases in which the claims can be shown not actually to be covered and/or a portion of the defense costs can be shown to have not even presented a potential for coverage.