Insurers Beware: Reimbursement for Defense Under Reservation of Rights

You’re a claims manager for an insurance company, or counsel for an insurer. An insured is being sued, and they’ve tendered their defense under their liability insurance policy. The issues in the complaint are complicated – it’s not immediately clear whether the allegations are covered by their policy. What do you do? Many insurers rely on courts to allow them to offer their insured a defense under reservation of rights and continue to investigate the case, and then seek reimbursement if there is no coverage for the claim. But at some point in the last 10 years the majority view changed on this issue, and no one noticed.

The California Supreme Court’s decision in Buss v. Supreme Court is considered the exemplar of the “majority” position on reimbursement under reservation of rights. Buss held that if an insurer was tendered a defense including claims covered or potentially covered and claims clearly not covered, an insurer could be reimbursed for costs related solely to claims not covered by the policy as it did not bargain to bear those costs. Though widely considered the majority position, only seven states have actually permitted such reimbursement: Colorado, New Jersey, Montana, Florida, Delaware, Connecticut and California. Eleven federal courts have done the same in Arizona, South Dakota, Hawaii, Tennessee, Alaska, Nevada, New York, New Mexico, Michigan, Ohio and Kentucky.

But of the 11 federal courts to agree with Buss, six of them explicitly stated that they were doing so purely because it was the majority rule in the country. Five courts held that reimbursement of defense fees could be recouped under reservation of rights only if the insured did not object to the reservation of rights letter. While 18 state and federal courts permit an insurer to seek defense fees for non-covered causes of action defended under reservation of rights, only 12 of them allow the insurer to do so if the insured objects to the attempt.

In 2013, the Washington Supreme Court in National Surety v. Immunex rejected the Buss approach to reimbursement of defense fees. The Immunex court held that the language of the policy must allow reimbursement of defense fees paid under reservation of rights. The court also disallowed reimbursement on a public policy basis reasoning that if the insurer were allowed to recoup defense costs, it would allow the insurer to claim the benefit of offering a defense while shouldering no costs with that decision.

The Supreme Courts of Pennsylvania, Arkansas, Illinois, Texas and Wyoming have agreed with Washington Supreme Court’s analysis. All but Arkansas stated their decision was based on the failure of the policy language to include a right to reimbursement. So have eight federal courts, interpreting the laws of Idaho, Minnesota, Iowa, Maryland, Massachusetts, Georgia, Missouri and Virginia.

Eighteen states have not yet considered the issue. But the Eighth Circuit has concluded that all states in its jurisdiction to consider the question would deny reimbursement, and will likely do so for North Dakota and Nebraska as well if the issue is brought to federal court.

Also, courts in Alabama, Utah, and Kansas have all disallowed reimbursement for settlement costs under reservation of rights, which indicates a strong likelihood that those states would disallow reimbursement of defense costs as well.

Thus, 18 states have denied or are likely to deny reimbursement for defense fees paid under reservation of rights, while only 12 states will uphold the right to reimbursement in that scenario even if the insured objects.

So What Now?

First, insurers should recognize that around the country, the majority of courts already deny reimbursement for fees paid under reservation of rights based on current policy language. Insurers should consider including a right to reimbursement in future policy iterations. While there is no evidence that courts that permit reimbursement under reservation of rights will change their minds, anything could happen if the nation continues to shift towards denying the right.

Second, insurers should get the insured’s consent to reimbursement rights for defenses paid under reservation of rights in writing. Editing policies to include the right to reimbursement may help curtail litigation in the future, but it will not affect current litigation related to existing policies. Early correspondence requiring the insured’s signature to document their agreement to the reservation of rights and right to reimbursement will help avoid later claims that the insured did not consent.

Third, insurers should consider an increased reliance on declaratory relief actions early in the investigation to confirm that no duty to defend exists. Many courts have told insurers to file declaratory judgment actions in lieu of investigating under reservation of rights. Depending on the liability exposure, the cost of the declaratory judgment action could be significantly less than the defense or settlement fees for the underlying action. This also protects the insurer from seeking reimbursement of defense fees from an insured who cannot repay them. Thus, even in “safe” jurisdictions like California where the ability to seek reimbursement is clear, it behooves the insurer to quickly ask the courts to adjudicate coverage before the insurer invests large amounts of money in a defense or settlement.