Under a duty-to-defend policy, insurers are often asked to provide a defense for lawsuits that include both non-covered and covered claims. Insurers often provide a defense to their insured for the entire lawsuit, pursuant to a reservation of their right to seek reimbursement for defense costs an insurer pays for claims encompassed within a lawsuit that are determined not to be covered under the policy. Insurers often assume that they will be entitled to recoup such defense costs for non-covered claims based on their reservation of right to do so. Recent decisions by courts in several jurisdictions around the country, however, give warning to insurers that they cannot assume that they will be able to recoup defense costs based on a reservation of rights, particularly in the absence of a policy provision specifying such a right.
Background – the Growth of the Reservation of the Right to Recoup
In the seminal case of Buss v. Superior Court of Los Angeles County (Transamerica Ins. Co.),1 the Supreme Court of California upheld the right of an insurer defending a lawsuit that includes both covered and uncovered claims (a “mixed” action) to be reimbursed for defense costs attributable to a non-covered claim, if the insurer reserved its right to recoupment when it provided its defense.
The principal rationale was that the insurer’s duty to defend runs to claims that are covered or potentially covered, but not to claims that are not even potentially covered. Thus, an insurer is entitled to reimbursement for the portion of defense costs allocable to uncovered claims. The court further noted that this right to reimbursement was both good law and good sense, as it encouraged insurers to provide a defense to lawsuits in which only some of the causes of action were even potentially covered. The court also held that while this right of reimbursement may not be expressly provided in the policy, it is implied in law. The court noted that an insured does not have a reasonable expectation that it is entitled to a defense of non-covered claims, as that would be a windfall.
Since Buss, it has become increasingly common for insurers to include in their reservations of rights letters to insureds a statement that the insurer’s provision of a defense of a lawsuit is subject to the insurer’s right to recoup defense costs attributable to the claims in the lawsuit determined to be non-covered.
Many jurisdictions have followed the Buss approach of upholding the right of an insurer to obtain reimbursement for expenses incurred for non-covered claims, if the insurer timely and explicitly reserved those rights and provided adequate notice to the insured of the possibility of having to reimburse the insurer.2
Even when the right is recognized, however, it can be difficult to enforce. As noted in Buss, the insurers’ right to recoupment is limited to “those defense expenses which can be fairly and reasonably allocated solely to non-covered claims for which there never was any potential for coverage.”3 Thus, even when an insurer’s right
to reimbursement is recognized, it is often very difficult for insurers to demonstrate what portion of defense costs were expended in defending the non-covered portion of a lawsuit as segregated from those expended to defend the covered portion.
The Erosion of Insurer’s Right to Recoup Defense Costs
Recently, courts in several jurisdictions have rejected the concept that insurers can reserve and enforce a right to recoupment of defense costs. Many such rulings cite the lack of a specific provision in the insurance policy expressly providing the insurer with a right to recover defense costs. These courts tend to reject the proposition that an insurer’s reservation of rights letter specifying that the insurer is providing a defense subject to a right to recoup creates an implied contract between an insurer and its insured. Further, these decisions often reject the insurer’s argument that an insured would be unjustly enriched by provision of a defense for non-covered claims.
The Argument for Requiring a Provision for Recoupment in the Insurance Policy
In what may be an indication of a trend away from Buss, courts in several jurisdictions have recently held that an insurer cannot recoup defense costs paid on behalf of its insured under a reservation of its rights to recover defense costs, unless the right to seek reimbursement is provided for in the insurance policy.4
For example, in American & Foreign Ins. Co. v. Jerry’s Sport Center, Inc.,5 a Pennsylvania court reversed a trial court’s grant of an insurer’s request for reimbursement of attorney’s fees it had paid on behalf of its insured. The court adopted the reasoning that the insurer’s undertaking of the defense pursuant to a reservation of a right to reimbursement that was not expressly provided for in the policy “was an attempt by [the insurer] to unilaterally modify the written insurance contract”,6 and “if [the insurer] wanted to seek reimbursement of attorney’s fees ... it could have included such a provision in the insurance contract ...”7
Courts in other jurisdictions have applied similar reasoning, requiring express authorization in the policy before upholding an insurer’s right to reimbursement of defense costs.8
The Position that a Reservation of Rights Letter May Not Create an Implied Contract
Those courts that have upheld the right of an insurer to reimbursement based on a reservation of rights letter generally characterize the reservation of rights between an insurer and its insured as an implied contract.9 These courts generally apply the reasoning that when an insured accepts its insurer’s defense offered under such a reservation, the insured accepts the conditions for the defense set forth by the insurer, including its right to seek reimbursement.10
However, an increasing number of courts have found that a reservation of rights letter does not create an implied contract, and some have characterized the letter as creating a new right and thus attempting to unilaterally modify the insurance policy, which some courts consider to be against public policy. 11
Thus, for example, in General Agents Ins. Co. of America v. Midwest Sporting Goods Co.,12 the Illinois Supreme Court rejected what it acknowledged to be the majority approach of upholding insurers’ entitlement to reimbursement of defense costs based on a reservation of that right in a letter to an insured, and held that new rights cannot be created by letter if they are not already in the policy. The court also noted that in making an offer to provide a defense that includes non-covered claims, the insurer is also protecting itself from the risk of an inept or lackadaisical defense of the underlying action that may expose it to a duty to indemnify an award, and thus such an offer is made as much for its own benefit as the insured’s.13 The Illinois Supreme Court noted that an insurer should either deny a defense at the outset if it believes there is no coverage, and if it is uncertain as to coverage it should defend and seek a declaration from a court that it had no duty to do so. It considered the route of an insurer defending under a reservation of rights to seek reimbursement from its insured as presenting insureds with a Hobson’s choice of either choosing a defense under the policy with the risk of subsequently having to pay back the insurer, or foregoing its potentially meritorious right to a defense, with the concomitant risk of insurer coercion. This reasoning, however, does not fully take into account the Hobson’s choice this imposes on insurers, who must either deny a defense at the risk of later being found to be in breach of contract or in bad faith, or commence litigation at the expense to both insurer and insured, or pay what may be significant defense costs for uncovered claims.
One rationale for the rejection of the implied contract approach is that the purpose of a reservation of rights letter is for an insurer to retain rights it has under the insurance policy, but not to create new rights.14 This reasoning, however, is countered by courts who note that rights of parties to a contract can be based on law apart from those provided in a contract. 15
Overall, insurers should proceed with caution when relying on a reservation of a right to reimbursement that is not expressly provided for in the insurance policy.
Whether an Insured is Unjustly Enriched by the Provision of a Defense that Includes a Non-Covered Claim
In seeking recoupment of defense costs, insurers often contend – and many courts agree – that an insured would be unjustly enriched if it were allowed to benefit from the insurer’s defense of a non-covered claim in a lawsuit, a benefit to which an insured is not entitled. However, several courts have rejected that argument, noting that an insurer’s defense of a non-covered portion of a lawsuit benefits the insurer as well, and does not unjustly enrich an insured, and instead, the insurer actually obtains a benefit from providing such a defense.16 Further, policies such as standard CGL policies generally provide that an insurer has a duty to defend any “suit” seeking covered damages, and thus arguably provide for a broad duty to defend the entire lawsuit if it contains any covered cause of action (although policies also often provide that there is no duty to defend a suit seeking damages to which the insurance does not apply).
In Terra Nova Insurance Company, Ltd. v. 900 Bar, Inc.,17 an opinion often relied on for the position that an insured is not unjustly enriched if it receives a defense that includes uncovered claims, the Third Circuit stated that an insurer benefits from providing a defense pursuant to a reservation of its rights even if the insurer is not permitted to recoup its defense costs, as it still can preserve its right to control the defense and its ability to mitigate any future indemnification responsibilities.18 In Terra Nova, the court noted “if the insurer could recover defense costs, the insured would be required to pay for the insurer’s action in protecting itself against the estoppel to deny coverage that would be implied if it undertook the defense without reservation.”19 However, this reasoning assumes that the insurer controls the defense, while in many cases in which the defense is provided under a reservation of rights the insured has the right to independent counsel, and it is the insured that controls the defense. Thus, this line of case law may be distinguishable where the insured is defended by independent counsel, and the insured, and not the insurer, is controlling the defense.
Thus, while certain jurisdictions still consider that an insured has been unjustly enriched when it does not have to return funds expended on its defense for a non-covered claim, several jurisdictions are scrutinizing and placing greater emphasis on benefits accorded an insurer from providing such a defense.
While an insurer’s reservation of its rights to seek recoupment of defense costs is often an important part of its handling of a lawsuit against its insured which contains a claim for which there may be no coverage, court decisions such as the ones cited above demonstrate that insurers cannot assume that a reservation of rights letter will be held to support a right to reimbursement. While those jurisdictions that disallowed an insurer’s right to reimbursement are generally considered to be in the minority, the tide may be changing. Several jurisdictions including Pennsylvania, Maryland, Arkansas and Illinois now hold that an insurer may not seek reimbursement of defense costs where not specifically provided for in the insurance policy. Therefore, insurers should consider adding specific provisions to their insurance policies expressly providing for a right to reimbursement. In addition, insurers faced with defending a lawsuit against their insureds for which coverage is unclear, or in which facts develop establishing that a claim is not covered, may want to seek an early declaration from a court that there is no coverage and no duty to defend, and thus limit their defense obligation and expenditure of defense costs. Insurers that anticipate the need to enforce a reservation of rights to seek reimbursement of defense costs should identify the applicable law, and evaluate whether and in what circumstances it upholds insurers’ right to reimbursement of defense costs.20