Hot Topic: Insurer’s Intent to Recoup Defense Costs and Reservation of Rights Letters

Whether an insurer can recoup defense costs from its own insured at the conclusion of a successful declaratory judgment action on coverage is a hot topic.

Some courts have held that, where there is no coverage, an insurer should be permitted to recoup defense costs, because to hold otherwise would be to create a duty to defend in every single instance.

Other courts have held that most insurance contracts contain no clause that explicitly permits recoupment, so it should never be allowed.

Still other courts have held that recoupment depends on whether notice to the insured was included in the Reservation of Rights (ROR) letter or pleadings.

Given the last development, insurers are now faced with the issue of whether they should, as a matter of course, include notice of intent to recoup costs in standard ROR letters. The problem is that this may have unintended effects. Insurers should thus carefully consider their goals, both from an underwriting and from a litigation strategy angle, before deciding how to proceed,

What language goes into an ROR differs from state to state.

Some states have such stringent bad faith statutes that to prepare an ROR at all can trigger a bad faith claim if the coverage action is unsuccessful. In other words, insurers must be very careful if they are issuing an ROR at all and must win on coverage, otherwise they are subject to penalty.

In other states, an insured can reject an ROR, and then the carrier has to decide if it will defend without an ROR, so the ROR does not play the same role is it would in a non-bad faith state.

For these two types of scenarios, adding recoupment language is probably ill-advised because the risk of creating or exacerbating a bad faith claim will probably outweigh the potential benefit of a successful recoupment claim.

In those states where the mere existence of an ROR will not have deleterious effect on coverage defenses, however, the question is whether all RORs should contain at least a sentence that says that the carrier reserves the right to recoup defense costs in the event of a successful declaratory judgment action.

Should notice always be included? The answer is that it depends.

Yes, notice is almost always a good idea if the only issue is whether waiving an argument is a good idea. In some jurisdictions, any coverage defense not articulated in an ROR is waived; the idea being that it is not fair to the insured to pursue a coverage defense without giving it an opportunity to collect facts and defend against all coverage challenges. Yes, the policy itself should be notice enough, and every insured is presumed to have read and understood any contract it signs, but many courts find that to be too biased in favor of insurers.

Possible Repercussions

Yet, including such recoupment notice as boilerplate language has its drawbacks.

For one thing, it will strike fear in the heart of every insured, causing the potential for a great deal of pushback on whether the insurance contract is being honored by the carrier. Where traditional grumbling upon receipt of an ROR once occurred, there will be a thunder of complaints. Insureds will begin demanding their pick of lawyers, either ones that are cheap and poorly prepared, or those that are expensive because they advertise a lot, but bring nothing extra to the table.

Another potential effect is that insurance agents could become aggressive in pressing the agendas of their customers and begin leaning on carriers to delete that clause, which may lead to even more requests for other changes. Moreover, if some carriers take up this practice and others do not, agents may divert business to those carriers who do not as a matter of course include this boilerplate language.

There are still those occasions when an ROR should indeed contain notice of an intent to seek recoupment.

For example, if coverage is nearly impossible to imagine and the carrier as a matter of generosity extends a defense while it quickly files a declaratory judgment action, that may be the time to notify the insured that the demand for coverage is absurd and recoupment will be sought.

Even then, however, arguably no notice is needed anyway because, unlike substantive defenses, there are no facts that the insured need develop to pursue coverage outside of the substantive issues. They just need to be on notice of the substantive coverage issues. Said another way, there is nothing the insured would do differently if put on notice. It is hard to imagine that an insured would decline a defense, even temporary, if it were offered.

Insurers should consider the many repercussions of including boilerplate recoupment language in their RORs so that they can make informed decisions that take into account the risks and benefits of doing so. There are more subtleties than meet the eye on this issue.

Topics Carriers