Primary-layer liability insurance policies typically contain a promise by the insurer to defend the insured against suits alleging injury and damages covered by the duty to indemnify. In most states, where a suit expressly or implicitly alleges a set of facts that, if proven, would eventuate in a judgment covered by the duty to indemnify, the insurer has a duty to defend. The duty to defend applies to potentially covered indemnity claims; it applies at the outset of the case; it arises immediately and continues until such time as the insurer establishes that there no longer is any possibility that a covered indemnity claim may result in the case. See Marc S. Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995), available at http://www.spriggs.com/news/pdfs/ACF54A7.pdf.

An insurer that defends should alert its insured of the possibility that the judgment in the case against the insured might not be covered by the policy’s duty to indemnify, whether that is because an exclusion bars coverage completely or in part or because the damages that might be awarded may exceed the limits of the insurance policy. An insurer that fails to apprise the insured of this possibility risks being found to have waived its ability (or to be estopped) to assert bases to refuse to indemnify that reasonably were known to the insurer. This is the origin of reservation-of-rights letters where insurers identify those grounds that may bar coverage. See D.E.M. v. Allickson, 555 N.W.2d 596 (N.D. 1996).

An insurer that defends an insured may terminate the defense where there no longer is any prospect that the case may result in a covered judgment. See Insurance Recovery at 1000. Where the insurer has so “confined the claim,” its duty to defend will terminate prospectively; that is, it may cease performing its defense obligation (subject to its withdrawal not prejudicing the insured, but that is a special case), but its contract will be interpreted to have required it to perform up until that time.

But what happens where there never was a possibility that the duty to indemnify might arise but the insurer defended anyway? The recoupment cases deal with the situation that with respect to the entirety of the action or an allocable portion of it the insurer should never have had to defend in the first place.

This question arises in part because of the “discovery theory” of the common law, that is, that a court discovers the preexisting, if undeclared law; for example, a ruling that a policy provision means that a certain class of cases is not covered means that those cases were never covered, not just that they are not covered once the relevant state’s supreme court says so. If one is considering a type of suit, such as a nontraditional environmental liability claim that a court finds to be barred by the absolute pollution exclusion, the insurer never had any obligation to defend or indemnify.

Even if the carrier thinks the case should not be covered in such circumstances, until there is a court ruling declaring no coverage it risks (i) being held liable for breach of contract and prejudgment interest and (ii) being found to have acted in bad faith (though if its construction were reasonable, even if wrong, it won’t be found to have failed to perform in bad faith, see Marc S. Mayerson, “First Party” Insurance Bad Faith: Mooring Procedure to Substance, 38 Tort Trial & Ins. Prac. J. 861 (2003), available at http://www.spriggs.com/news/pdfs/MSM-31.pdf)). Moreover, where the carrier refuses to defend and that determination was wrong, it may also be found liable for third-party bad faith if it fails to settle a case that is covered and its unreasonable failure to settle proximately causes a verdict in excess of policy limits.

Accordingly, insurers may elect to defend initially and concurrently litigate their defense obligations or wait until the underlying case is over and then try to sort things out in a coverage case. (In some states, like Illinois, the carrier really does not have the luxury of waiting until the underlying case is over because it may be found to have waived its right to deny coverage by not bringing an early declaratory-judgment action.) The insurer will advance a claim that, though it defended, it never had an obligation to do, so it should be able to get its money back from the insured.

Insurance policies do not contain provisions explaining that where an insurer agrees to pay for the defense of a matter that does not potentially implicate indemnity coverage the policyholder will be required to reimburse the carrier. Instead, carriers seek to force such reimbursement, or to recoup their payments, through the help of the courts.

Because the insurance policy itself does not explain what happens when a defense payment is made pendente lite, the insurer must go outside the policy and rely either on (i) a new and separate contract with the policyholder or (ii) principles of equity.

Typically, the separate “contract” insurers cite is the reservation-of-rights letter sent in response to the policyholder’s notice of claim; this letter will identify the grounds that potentially apply to bar coverage, but nevertheless states the insurer will provide the defense, subject to its “right” of reimbursement. This now- boilerplate language is interpreted by some courts as establishing a new agreement whereby following the reservation-of-rights letter the policyholder’s acceptance of the defense is an acceptance of the reimbursement term. Some courts have found such agreement by the policyholder simply from the policyholder’s allowing the carrier to defend, and indeed some courts have found such an agreement even where the policyholder has objected to the insurer’s reservation of a reimbursement right but allowed the insurer to defend. This is what the Montana Supreme Court held, at least where the policyholder did not expressly object at the time to the claim for reimbursement. See RIBI, slip op. at 20 (“Ribi implicitly accepted Traveler’s defense under a reservation of rights when it posed no objections.”).

For a contractual relationship otherwise governed heavily by state regulation, it is surprising indeed that courts find an new contract created by the insurer’s stating in a lengthy letter that it “reserves” its right to reimbursement, especially in the absence of a writing confirming the policyholder’s promise to repay. Of course, where a court finds an “implied” agreement one understands that it is really imposing an agreement – the best evidence of which is the fact that the policyholder is litigating the reimbursement issue. (Obviously, if the policyholder thought it had agreed to reimburse the carrier there would be no litigation on this point.) But the court’s imposing this arrangement on policyholders does not have a sound analytical foundation: the court is seeking to protect carriers and avoid “unjust” enrichment of the policyholder – though carriers could easily protect themselves by writing provisions into their policies allowing for reimbursement rather than relying on courts to impose such an implied reimbursement agreement by a post-policy letter.

The Illinois Supreme Court refused to find such an implied agreement to reimburse: “As a matter of public policy, we cannot condone an arrangement where an insurer can unilaterally modify its contract, through a reservation of rights, to allow for reimbursement of defense costs in the event a court later finds that the insurer owes no duty to defend.”

The absence of a satisfactory contract law basis for a recoupment claim leads to the argument that at equity the carrier should be able to recoup its money on the grounds that it would be inequitable to allow the policyholder to keep the benefit conferred by the carrier that was never owed in the first place. But if the carrier never had an obligation, assuming the carrier was not seeking to waste corporate assets, one can presume that the carrier undertook the defense to protect its own interests – notably, the avoidance of a bad-faith claim cast against the backdrop of legal uncertainty of its coverage obligations or helping to ensure that the underlying claim is defended appropriately. As the Illinois court held: “We agree that when an insurer tenders a defense or pays defense costs pursuant to a reservation of rights, the insurer is protecting itself at least as much as it is protecting its insured. Thus, we cannot say that an insured is unjustly enriched when its insurer tenders a defense in order to protect its own interests, even if it is later determined that the insurer did not owe a defense.”

Once it is clear that the carrier has a dog in the fight – that it is acting to protect its own interests – then the calculus at equity changes considerably, because equity typically will not intervene if one pays money in the teeth of a legal dispute or is seeking to protect one’s own interest (even if the payment is disproportionate). Moreover, that the carrier is facing a potential bad-faith claim if it were to deny coverage incorrectly is not sufficient to render its payment involuntary (since voluntary payments are not recoverable via equity). See Genesis Ins. Co. v. Wausau Ins. Co., 343 F.3d 733 (5th Cir. 2003).

The way to balance the insurer’s interest in not paying for uncovered claims, the policyholder’s interest in obtaining a complete defense, and both side’s interests in having insurance promptly perform is to require insurers to write into their contracts a right to reimbursement. In this way, policyholders can elect to purchase a policy with a reimbursement provision or not and state insurance commissioners can determine whether or not to approve such policies. The question in these cases is whether action at the point of claim can create a reimbursement right. The Illinois Supreme Court, following other courts, such as the Third Circuit and the Wyoming Supreme court said no: “Certainly, if an insurer wishes to retain its right to seek reimbursement of defense costs in the event it later is determined that the underlying claim is not covered by the policy, the insurer is free to include such a term in its insurance contract.” Montana allows an insurer to stand silent at the point of sale but to unilaterally reserve a right to reimbursement at the time the policyholder needs to turn to its coverage or potential coverage. Were the Illinois approach followed, insurance regulators could monitor reimbursement provisions, and policyholders could elect to purchase policies from carriers that do not include such provisions. For now, however, as with so many other issues, the question of reimbursement of defense costs will continue to be fodder for litigation.