Recoupment of Defense Costs

The question whether an insurance company that defends its policyholder may recoup its defense-cost payments continues to produce divergent results. Most recently, the Illinois and Montana Supreme Courts reached opposite conclusions in opinions issued a few weeks apart. See General Agents Insurance Co. of America, Inc. v. Midwest Sporting Goods Co., 215 Ill. 2d 146, 828 N.E.2d 1092 (2005); Travelers Casualty & Surety Co. v. Ribi Immunochem Research, Inc., 2005 MT 50, 326 Mont. 174, 108 P.3d 469.

Primary-layer liability insurance policies typically promise to defend the insured against suits alleging injury and damages covered by the duty to indemnify. In most states, a suit that expressly or implicitly alleges facts that, if proved, could result in a covered judgment triggers the duty to defend. That duty applies to potentially covered indemnity claims. It arises at the outset and continues until the insurer establishes that no possibility of a covered indemnity claim remains. See Marc S. Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Insurance Law Journal 997 (1995).

An insurer that defends should alert its insured that a judgment might not be covered, whether because an exclusion bars coverage in whole or in part or because the damages might exceed policy limits. An insurer that fails to identify reasonably known grounds for denying indemnity risks waiver or estoppel. This is the function of reservation-of-rights letters. See D.E.M. v. Allickson, 555 N.W.2d 596 (N.D. 1996).

An insurer may terminate its defense when there is no longer any prospect of a covered judgment. See Insurance Recovery at 1000. Once the insurer has so “confined the claim,” its duty terminates prospectively, subject to any restrictions on prejudicial withdrawal. But the contract required performance up to that point.

What happens, though, when the insurer contends that there never was a potentially covered claim, but defended anyway? The recoupment cases ask whether the insurer can recover payments for the entire action, or an allocable portion of it, on the theory that it never owed those defense costs.

The question arises in part from the “discovery theory” of the common law: a court discovers preexisting, if previously undeclared, law. An insurer may therefore argue that a ruling excluding a class of claims establishes that those claims were never covered—not merely that they ceased to be covered when the court announced its decision. But the duty to defend is a separate promise. A later ruling of no indemnity coverage does not, by itself, establish that no defense was owed in the meantime.

Even an insurer confident in its interpretation takes a risk by refusing to defend. If wrong, it may owe contract damages and prejudgment interest; depending on the governing law and the reasonableness of its position, it may also face bad-faith liability. See Marc S. Mayerson, “First Party” Insurance Bad Faith: Mooring Procedure to Substance, 38 Tort Trial & Insurance Practice Law Journal 861 (2003). An unreasonable failure to settle a covered claim may add exposure for an excess judgment.

Accordingly, insurers may defend while litigating their obligations in a declaratory-judgment action. The timing and consequences of that choice vary by jurisdiction. The recoupment claim comes later: although the insurer defended, it says it never had to—and wants its money back.

Where the policy contains no reimbursement provision, the insurer must look outside the policy for a right to recoup: either to a separate agreement with the policyholder or to principles of equity. The question is whether a reservation-of-rights letter supplies what the policy omitted.

Typically, the separate “contract” cited by insurers is the reservation-of-rights letter itself. The letter identifies potential coverage defenses and offers a defense subject to a supposed “right” of reimbursement. Some courts treat the policyholder’s subsequent acceptance of the defense as acceptance of that additional term. Others have found agreement even when the insured objected but accepted the defense. In Ribi, the Montana Supreme Court relied on the absence of an objection: “Ribi implicitly accepted Traveler’s defense under a reservation of rights when it posed no objections.” Ribi, ¶ 50.

For a contractual relationship otherwise heavily regulated by the states, it is surprising indeed that a lengthy letter can create a new repayment obligation merely by announcing that the insurer “reserves” a right absent from its policy. Where a court finds an “implied” agreement in these circumstances, it is worth asking whether the court is discovering an agreement or imposing one. Accepting a defense the insured believes it already purchased is not necessarily assent to a new obligation to repay.

The Illinois Supreme Court refused to find such an implied agreement: “As a matter of public policy, we cannot condone an arrangement where an insurer can unilaterally modify its contract, through a reservation of rights, to allow for reimbursement of defense costs in the event a court later finds that the insurer owes no duty to defend.” Midwest Sporting Goods.

The absence of a satisfactory contractual basis leads to equity: surely, the argument goes, the insured should not keep a benefit that was never owed. But an insurer undertaking a defense amid a coverage dispute is protecting its own interests too—avoiding potential bad-faith exposure and helping ensure that the underlying claim is properly defended.

As the Illinois court explained: “We agree that when an insurer tenders a defense or pays defense costs pursuant to a reservation of rights, the insurer is protecting itself at least as much as it is protecting its insured. Thus, we cannot say that an insured is unjustly enriched when its insurer tenders a defense in order to protect its own interests, even if it is later determined that the insurer did not owe a defense.” Midwest Sporting Goods.

Once it is clear that the carrier has a dog in the fight—that it is acting to protect its own interests—the equitable calculus changes. A payment made in the teeth of a legal dispute is not necessarily recoverable merely because the payer later establishes that it owed nothing. Nor does commercial or litigation pressure necessarily make the payment involuntary. See Genesis Insurance Co. v. Wausau Insurance Cos., 343 F.3d 733 (5th Cir. 2003) (applying Mississippi law to settlement contributions and remanding for resolution of a disputed agreement to preserve reimbursement claims).

The Illinois decision also rejects the attempt to define the duty to defend retrospectively. Gainsco remained obligated to defend while the possibility of coverage remained unresolved. The later declaration of no coverage did not erase that obligation. That is a separate reason to reject recoupment, not merely another way of describing the absence of an agreement.

The straightforward solution is to put the reimbursement provision in the policy. Policyholders can then choose whether to buy that coverage, and insurance regulators can scrutinize the terms. As the Illinois court put it: “Certainly, if an insurer wishes to retain its right to seek reimbursement of defense costs in the event it later is determined that the underlying claim is not covered by the policy, the insurer is free to include such a term in its insurance contract.” Midwest Sporting Goods.

The question is whether action at the point of claim can create a reimbursement right omitted at the point of sale. Illinois says no. Montana, in the circumstances of Ribi, says yes. Insurers can avoid this fight by writing the provision before collecting the premium, rather than asking a court to supply it when the policyholder needs the defense. For now, reimbursement of defense costs remains fodder for litigation.

Originally published in Insurance Scrawl on June 9, 2005. Republished with updated citation links and editorial revisions. The analysis speaks as of the original publication date.

Related: Insurance Coverage · Marc Mayerson’s biography.

Topics: Defense-Cost Recoupment · Duty to Defend · Reservation of Rights

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