When to Allocate Defense Costs in Covered and Non-Covered Claims

It is commonplace for an insured to incur defense costs with respect to defending against covered and non-covered claims. This may happen, for example, when the plaintiff asserts negligence claims and also intentional tort claims, or where there are claims for conduct that are uninsurable or excluded but other claims that are potentially covered.

As the claims are being defended, the amounts incurred in defending covered and non-covered defense costs escalate. Seldom, if ever, does the insured or its defense counsel segregate or allocate defense costs for covered claims and defense costs for non-covered claims. The claims handler for the insurance company must decide whether and to what extent the insurance company will indemnify the insured for defense costs in this situation.

The starting point is the policy, which may contain a provision that expressly permits the insurer to allocate defense costs between covered and non-covered claims. Under New York law, an allocation provision controls. See Clifford Chance LLP v. Indian Harbor Ins. Co., 14 Misc. 3d 1209(A), 2006 WL 3821841, at *3 (Sup. Ct. N.Y. Co. Dec. 27, 2006), aff’d, 41 A.D.3d 214, 838 N.Y.S.2d 62 (1st Dep’t 2007). Therefore, where the insurance policy specifically provides that the defense costs for covered and non-covered claims must be allocated, the insured must abide by such provision.

For example, the current version of the Bermuda Form provides:

“If liabilities, losses, costs and/or expenses are in part covered by this Policy and in part not covered by this policy, the insured and company shall use their best efforts to agree upon a fair and proper allocation thereof between covered and uncovered amounts, and the insured shall cooperate with such efforts by providing all pertinent information with respect thereto.”

The rationale behind the rule is that an insurer contracts to pay the entire cost of defending a claim that is covered under the policy. The insurer has not contracted to pay defense costs for claims that are not covered by the policy or when another insurer also has an obligation to defend.

Under New York law, even absent express policy provisions, it is well-established that under an indemnity policy, there is no obligation to indemnify defense costs incurred in defending non-covered claims. See Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 10 A.D.3d 528, 782 N.Y.S.2d 19 (1st Dep’t 2004); Millennium Partners, L.P. v. Select Ins. Co., 24 Misc.3d 212, 882 N.Y.S.2d 849 (Sup. Ct. N.Y. Co. 2009), aff’d, 68 A.D.3d 420, 889 N.Y.S.2d 575 (1st Dep’t 2009). This principle has been followed by courts in other jurisdictions. See, e.g., Security Ins. Co. of Hartford v. Lumbermens Mut. Cas. Co., 264 Conn. 688, 826 A.2d 107 (2003) (Connecticut law).

If it is determined that the insured is seeking to recover defense costs for both covered and non-covered claims, then a methodology must be applied to determine how to allocate the costs between the covered and non-covered claims. If the insurance policy provides for a particular allocation methodology, that will control. See Clifford Chance, 2006 WL 3821841, at *2.

On the other hand, where the insurance policy does not provide for a particular methodology, it is not always clear how defense costs should be allocated between covered and non-covered claims. There is little New York case law on the methods to be used in allocating defense costs for covered and non-covered claims, and New York has never adopted a preferred method of allocation between covered and non-covered claims.

There are several alternative ways to allocate. One way is to allocate defense costs equally between covered and non-covered claims, assuming there is a reasonable basis for such equal allocation. Another way is to allocate defense costs pro rata to the number of covered claims and the number of non-covered claims, again assuming there is a reasonable basis for such an allocation. This may be an appropriate method where the costs appear to have been incurred in defending all claims, for example, those costs incurred in taking a deposition.

Depending upon the number and nature of covered and non-covered claims, it may be more appropriate to allocate defense costs under a “weighted” methodology, whereby there is an equitable allocation of defense costs for covered and non-covered claims. There may be situations where defense costs are allocated where they were incurred on behalf of an insured and also a non-insured. In this situation, it may be appropriate to allocate defense costs pro rata among insureds and non-insureds.

Finally, yet another method of allocating defense costs is to look at the magnitude of damages sought in the covered and non-covered claims, and then make equitable allocation based on the relative value of claims.

Whether and to what extent defense costs for covered and non-covered claims are to be allocated could well turn on applicable law. Therefore, in determining whether to allocate defense costs, claims handlers should fully familiarize themselves with applicable policy language and also applicable law.

This article originally appeared in the spring issue of Claims Journal magazine.