They pay, you pay

You may be required to reimburse insurance companies for costs of defense of claims

If you ever have referred a claim to your commercial general liability (CGL) insurance carrier for defense of a lawsuit, you probably received a dense letter quoting and interpreting your policy and providing coverage analysis. Such a letter will often be styled as a "reservation of rights" letter whereby the carrier agrees to provide a defense, subject to certain limitations, and notifies you coverage for a claim may not apply. It is a common and certainly understandable reaction to skim or skip the legalese and simply flip to the last page and read the conclusion to find out whether the insurer will be providing a defense. But lurking within those pages may be potentially devastating language that can put you on the hook for tens of thousands of dollars in attorneys' fees.

The details

The language at issue may be only a sentence or two buried in the coverage analysis, such as: "Insurer reserves the right to seek recovery of defense costs incurred in the defense of the insured in the event that it is determined that no such defense was owed." In some states, this reservation is ineffective. In others, it is enforceable but only if the insured does not respond and object. In other states, it is enforceable regardless of any objection by the insured.

It is important you understand the rules that apply to your policy. Typically, the law governing the policy is the law of the state in which the policy is issued. In most cases, if a lawsuit is filed alleging you are responsible for bodily injury or damage to property other than the work itself, you can forward the claim to your CGL carrier, who must appoint an attorney to defend the claim even if uncovered claims—such as damage to the roof—are included in the lawsuit. The traditional interpretation and application of the rules governing CGL carriers' duty to defend and indemnify their insured entitles you to a complete defense against all claims, including those individual claims for which insurance would not be available, with the understanding that any sums awarded to the plaintiff for uncovered losses would be paid by you.

An insurer who believes no defense is owed can elect to reject the claim, but doing so could expose the insurer to liability if it is later established the claim was covered by the policy. For that reason, insurers frequently elect, instead, to defend a claim temporarily subject to a reservation of rights. The reservation of rights letter allows an insurer to investigate and/or defend a claim while determining whether coverage applies without waiving its right to later deny coverage based on information revealed by the investigation. The insurer may file a "declaratory judgment" action, which asks a court to establish the involved parties' rights as a matter of law.

If a court rules a policy does not apply to the particular person or event, the insurer may discontinue defending the claim without fear. But what about the costs the insurer has incurred defending you in the main action while awaiting a ruling in the declaratory judgment action?

Differing approaches

Courts are split about whether an insurer can recoup its defense costs from an insured. A majority of courts allow insurers to recoup defense costs as long as they follow certain criteria. A growing minority do not allow insurers to recoup defense costs unless the policy specifically provides for recoupment, regardless of the terms of a reservation of rights letter.

Under the minority position, which has been adopted by several states, including Arkansas, Illinois, Pennsylvania, Texas and Wyoming, the insurer has no right to recoupment even if it attempts to claim a right in the reservation of rights letter unless the insurance policy specifically permits an insurer to recoup defense costs.

In a 2010 case, a roofing subcontractor was named a defendant in a case arising out of a hotel's construction. The roofing subcontractor requested defense and indemnification against the construction defects claims from its insurance carrier. The carrier agreed to provide a defense but reserved its rights to investigate the claims further and "to enforce any rights it may have to recoup defense costs" should it be determined there was no duty to defend. The insurer filed a declaratory judgment action, and the court held the underlying action did not trigger a duty to defend the roofing subcontractor but denied the insurer's claim for recoupment of defense costs.

Applying Wyoming law, the court held an insurer is not permitted to unilaterally modify and change policy coverage. Accordingly, the court held a reservation of rights letter does not create a new contract allowing an insurer to recoup defense costs. Because the CGL policy did not contain a provision allowing the insurer to recoup defense costs, there was no right to be reserved, and the insurer was not entitled to recover those costs.

Conversely, under the majority view, an insurer can recoup defense costs with a properly worded reservation of rights letter regardless of whether the policy contains such a provision. The reservation of rights letter must be timely, specifically reserve the insurer's right to recoupment and provide adequate notice to the insured about the possibility of recoupment. By notifying the insured of the reservation in a letter, the insurer conditions payment of defense costs on whether a court finds there was a duty to defend. This condition then becomes part of the contract when the insured accepts the defense. Therefore, in states adopting the majority position, the insured has the following options after receiving a reservation of rights letter:

  • Decline the offer, pay for the defense and seek to recover on the policy
  • Decline the offer and file a declaratory judgment action
  • Accept the offer subject to the reservation of rights, including the insurer's right to recoup defense costs

There are differing opinions within the majority as to when an insurer can recoup defense costs. In California, an insurer can recoup defense costs only if it can prove it never had a duty, as a matter of law, to defend the underlying lawsuit (meaning only in those cases where no duty to defend ever existed or could have existed). However, an insurer cannot recover defense costs in California if, factually, there was a potential for coverage.

A number of states, such as Florida, that have adopted and applied the majority rule, have not distinguished between an insurer having no duty to defend as a matter of law and no duty to defend based on facts. However, this does not mean these courts will not consider such a distinction in the future.

Both the majority and minority positions have public policy considerations that may support the rule. From the majority perspective, allowing an insurer to recoup defense costs promotes the policy of ensuring a defense is provided even in questionable cases. This promotes the coverage interests of insureds overall, especially because most cases settle before any final judgment or ruling that might trigger the carrier's right of recoupment.

Further, in the majority's view, an insurer is paid premiums only to undertake the risks stated plainly in the insurance contract, and when a specific claim against an insured is not covered, the obligation to defend such an uncovered claim is not a risk the insurer has bargained to bear.

From the minority perspective, recoupment is inconsistent with the insurer's traditional broad duty to defend, which exists until the point a claim is limited to a recovery the policy does not cover. The insurer had a duty to defend up until that point, so recovery of prior defense costs is inappropriate. However, this analysis may not address the California rule concerning a determination that, as a matter of law, the insurer did not have a duty to defend in the first place.

Courts adopting the minority position also have expressed concerns that allowing insurers to reserve a right of recoupment that is not expressed in the policy unfairly benefits the insurer by allowing it to hedge its defense obligations, forcing the insured to make a choice between two undesirable options: accept the insurer's additional conditions of its defense or advance the cost of paying for its own defense.

Ultimately, this is a developing area of law. States are continuing to refine their positions, and if you are faced with such a reservation of rights letter you should work with your broker and an attorney to ensure you are making strategic decisions using the best and most recent information.

The sound of silence

Some courts allow insureds to object to, and thereby defeat, an insurer's reservation of the right to recoup attorneys' fees. A policyholder that fails to object is punished with enforcement of the reservation. Several courts have held that silence in response to a reservation of rights letter, and subsequent acceptance of the defense proffered by the insurer, constitutes an implied agreement to the terms of the reservation of rights letter, including the right of recoupment.

However, in other majority rule states, courts have decided it does not matter whether the insured objects to the reservation of rights letter, holding the right to recoupment of attorneys' fees will be allowed as long as the insurer reserves the right and the insured accepts payment of defense costs, regardless of the insured's express objections to the reservation. A California court, stating its rationale for such a holding, argued it was inconsistent for an insured to accept the benefits of the agreement while purporting to refuse to accept it.

An evolving issue

Predictably, the insurance industry has begun efforts to alter policy terms to expressly provide for the right of recoupment, particularly in states that restrict insurers' abilities to provide for the right in a reservation of rights letter. These new policy endorsements have been approved by insurance regulatory commissions in some states, including Illinois and Wyoming. Consult with your agent—especially if your company is based in a majority jurisdiction—to confirm whether your policy provides for reimbursement of attorneys' fees.

Depending on the state, your options may be limited. But in any case, prompt action is recommended in response to a reservation of rights letter. Failure to respond or object to the reservation of rights letter promptly may waive your right to object later, so you should consult with an attorney soon after your receipt of such a letter.

Several courts have refused to allow an insurer's claim for recoupment where its reservation of rights letter failed to adequately articulate its intentions. Broadly drafted boilerplate language may or may not suffice. Accordingly, even if you are in a majority jurisdiction, you still should respond with an objection and attempt to counter the insurer's reservation of rights letter with written objections as to the letter's timeliness, specificity or adequacy to create a right to recoupment, or by reference to facts and equities, in an effort to set up a potential future defense against the reservation of rights letter.

David M. Gersh is an attorney with Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.


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