Transamerica undertook the defense for one allegation against the insured out of 27 causes of action. The insurer sent out a reservation-of-rights letter and, at the same time, notified the insured that defense costs incurred (or to be incurred) were to be reimbursed if it was determined that there was not coverage. After the lawsuit against Buss was settled, Transamerica did, indeed, seek reimbursement for some defense costs. Buss resisted, and the result was a lawsuit between the insured and the insurer.

When the case got to the California Supreme Court, that court stated that California law clearly allows insurers to be reimbursed for attorneys' fees and other expenses paid in defending insureds against claims for which there was no obligation to defend or indemnify. The court held that an insurer may seek reimbursement from an insured for defense costs as to claims that are not even potentially covered under the liability policy, and that those specific costs that can be allocated solely to claims not even potentially covered by the policy can be reimbursed.

The court went on to say that the right of reimbursement is implied in law as quasi-contractual and thus does not have to be expressed in the policy. This right is based on the unjust enrichment theory in that the insured did not pay a premium for claims not covered by the policy, and that if the insurer had to pay the costs of defending such claims, the insured was getting a benefit without paying for it.

A more recent case that reinforces the Buss decision is Scottsdale Insurance Company v. MV Transportation, 115 P.3d 460 (Cal. 2005). The court ruled in this decision that an insurer that properly reserved its rights was entitled to reimbursement for defense costs advanced to its insured after it was judicially determined that no duty to defend ever arose because the third-party lawsuit against the insured never suggested the possibility of a covered claim.

The insurer's duty to defend its insured and the extent of that duty are rooted in basic contract principles: the insured pays for a defense against third-party claims that are potentially covered by its policy, but no more. Thus, where the insurer, acting under a reservation of rights, has financed the defense of claims as to which it owed no duty of defense, it is entitled to restitution. Otherwise, the insured, who did not bargain for a defense of uncovered claims, would receive a windfall and would be unjustly enriched.

Note that the case for reimbursement is not based solely on legal contractual grounds. The court in the Buss case upheld reimbursement also because “it makes good sense.” The idea behind this reasoning is expressed well in that decision. The court stated that “without a right of reimbursement, an insurer might be tempted to refuse to defend against an action in any part …. With such a right, the insurer would not be so tempted, knowing that if a defense of claims not even potentially covered should necessitate any costs, it would be able to seek reimbursement [for those costs].”

In other words, the insurer might hesitate to defend claims against the insured unless it knows it can get back the defense costs expended in defense of claims not covered by the policy. Any hesitation on the part of the insurer could translate into a less than capable defense effort for the insured and a possible bad-faith lawsuit, neither of which is good for any party to the insurance contract.

A majority of jurisdictions that have faced the issue have decided that the insurer does have a right of reimbursement against the insured — examples come from California, Florida, Montana, and the Sixth Circuit. These courts have found a common thread in their pro-reimbursement decisions: The claim against the insured is one that is not covered under the terms of the policy, and the insurer has told the insured up front that it has the right to seek reimbursement of certain defense costs.

Differing Opinions

Of course, the minority position also exists. The U.S. Court of Appeals for the Third Circuit offered the groundwork for those courts that reject the right of reimbursement of defense costs in a 1989 decision, Terra Nova Insurance Company v. 900 Bar, Inc., 887 F.2d 1213. Basing the ruling on its reading of Pennsylvania law, the Court of Appeals said that it found no Pennsylvania authority that permits an insurer who defends under a reservation of rights to recover defense costs from its insured.

Moreover, the court said that a rule permitting such recovery would be inconsistent with the legal principles that induce an insurer's offer to defend under a reservation of rights. The court reasoned this way:

“Faced with uncertainty as to its duty to indemnify, an insurer offers a defense under a reservation of rights to avoid the risks that an inept or lackadaisical defense of the underlying action may expose it to if it turns out that there is a duty to indemnify. At the same time, the insurer wishes to preserve its right to contest the duty to indemnify if the defense is unsuccessful. Thus, such an offer is made at least as much for the insurer's own benefit as for the insured's. 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.”

In other words, the insurer is protecting itself as much as the insured by providing a defense, so there is no reason why the insurer should get any reimbursement. It is benefitting as much as the insured.

More recent court rulings on the subject have centered on the point that, absent an express provision in the insurance policy that the insurer is entitled to reimbursement of defense costs in the event that a court determines that the insured has no coverage, the insurer has no right to later attempt to amend the insuring contract by claiming a right to reimbursement in a reservation-of-rights letter. Cases from Illinois, Pennsylvania, Minnesota, and the 4th Circuit Court of Appeals support this idea.

Regardless of the legal view of reimbursement of defense costs, those in the insurance industry have to consider a non-legal issue: the attitude of the insured. Not many insureds expect to pay a premium for insurance coverage, and then pay again to reimburse the insurance company for defending the insured. Insureds could consider this a double hit, just another tactic by insurance companies to get more money out of the insurance consumer. In such a case, the insured would either file a lawsuit or drop the insurer, either way a losing course for the insurance industry.

Is there a way to avoid this problem? The answer, as with so many other things, is education. If it has decided to seek reimbursement as a matter of business, the insurer has to take the responsibility to inform the insured of this decision, and this disclosure should be within the insuring agreement of the policy. The insurer should tell the insured before a claim or lawsuit arises that any money spent on defense costs for losses that are not covered by the policy will have to be paid back to the insurer. This may not make the insureds think better of the insurance industry, but it certainly would remove the surprise of reimbursement and therefore avoid more resentment (and more lawsuits).

David D. Thamann, JD, CPCU, ARM, is managing editor for the FC&S. He may be reached at [email protected].